Mark Thoma (here) and William Polley (here) commend to you Governor Don Kohn's speech, delivered Friday, titled "Modeling Inflation: A Policymaker's Perspective." So do I, but first a word of warning: Both the Governor's speech and my comments below are a bit of inside baseball, so if you are uninterested such things this would be an opportune time to stop reading.
First a small clarification. Mark starts his post with this:
Here are some remarks on the nuts and bolts of how the Fed forecasts inflation by Governor Donald L. Kohn.
It would actually be more accurate to say this is the Board of Governor's staff forecasts, apparently from the so-called Greenbook. (One of the best descriptions I've read of the Greenbook, and its role in the Fed policymaking process, is in the speech "Come with Me to the FOMC" by former Governor Laurence Meyer.) Although it is fair to say that Board staff forecasts represent the benchmark around which Committee discussions are organized, they do not really represent "FOMC forecasts." The closest you get to that, I think, is contained in the semi-annual Monetary Policy Report to Congress. (See, for example, section 1 of the February 2005 report.)
It is well known that Greenbook forecasts are judgmental, informed by formal economic modeling to be sure, but ultimately generated by the expert opinion of Board staff. The opinions therein would not necessarily reflect those of the Board of Governors, the District Bank Presidents, or the Federal Open Market Committee (although they often come pretty close.) Furthermore, the analytical core of the Greenbook -- that is, one of the central inputs into the staff forecasts generated by formal econometric analysis -- is the so-called FRB-US model. As far as I know, specific use of the FRB-US model is unique to the board staff. The staffs of the District Banks tend to have their own approach to generating inflation forecasts.
That said, this comment from the Governor's speech is right on the money:
I find it remarkable how fundamentally stable our basic framework for analyzing inflation has remained over the past thirty-five years or so: That basic framework is essentially the expectations-augmented Phillips curve introduced by Milton Friedman and Edmund Phelps in the late 1960s.
One of the key assumptions underlying this basic framework is the temporary rigidity of wages and prices. It is because of these nominal rigidities that monetary shocks have real effects: In the well-known litany, wages and prices do not change immediately in response to a positive monetary surprise, so real interest rates fall, and spending is stimulated. But higher demand cannot be met without pushing firms up their marginal cost curves as they compete for scarce labor and other resources. As opportunities to raise prices present themselves, firms take them to better align prices with costs. That process may be gradual, because firms' competitors may not be raising their prices at the same time…
This is as true at the frontier of macroeconometric policy modeling as it is in older, more established, models like FRB-US. Governor Kohn has lots of good insights about the missing pieces of the dominant framework.
A better understanding of the motivation and dynamics of how compensation is determined between firms and individuals or small groups of workers would help unravel a number of the inflation puzzles I think we face, including those involving productivity growth, globalization, markups, and expectations formation.
Right. But I'm not sure this goes far enough. With your indulgence, I'll share my thoughts on the subject, originally presented as part of a panel discussion at a recent conference honoring Chris Sims' "Macroeconomics and Reality".
Why do I think there is a chance we will ultimately have to abandon, or substantially revisit, the... frameworks that we accept as truth today? ...
There is, of course, no formal agreed-upon inflation target for the Fed, but it is no secret that the possibility of adopting one has been discussed by the Federal Open Market Committee. Enough participants have talked about the issue to reveal that 1-3 percent CPI inflation is a reasonable approximation to what a target might look like, and a level that even those who do not favor a formal target would find desirable.
One thing I feel reasonably confident about. This objective was not arrived at by virtue of analysis under the assumptions of the prototype New Keynesian model. Almost without exception this class of models suggests an optimal rate of inflation that is somewhat negative, zero, or just a little bit positive, depending on the precise details. I don’t perceive much of a taste among world central bankers for getting very close to these levels as a matter of practice...
In fact, this points to what I think is a broader problem. We are close to falling dangerously in love with the basic New Keynesian framework, the sticky price aspects of it in particular. Here is a simple observation: In [standard statistical analyses], inflation wants to drop like a rock in response to a basic technology shock. Models that engineer significant price inertia don’t want to let that happen... This general problem has been emphasized by the Bank of Portugal’s Nuno Alves (2004): The New Keynesian framework seems to have difficulty reconciling both sticky-looking behavior with respect to monetary policy surprises with the very flexible-looking response to technology shocks. One wonders if continually tweaking that framework can bring about a successful resolution.
One final point. In my time at the Fed, I have come to appreciate that most of the really important policy choices have nothing to do with Taylor rules or the like. They have to do with those episodes of financial crisis in which Taylor-like rules are woefully inadequate. Think here October 1987, the period from summer 1997 through the end of 1998, and the aftermath of September 11, 2001.
I have in the past agreed that it is useful to think of the policy choices in those periods as policy shocks. I would still argue that today. But it sure would be helpful if at least some of these events would appear as something more than completely random disturbances. In other words, it would be very useful to have usable measures of what we loosely call “financial market fragility,” and more useful still to have a coherent quantitative model... that captures them.
If anyone is looking for interesting and important research questions in which to dive, you have my suggestions.
NOTE: The references to the papers cited above are:
Alves, Nuno. “A View on Flexible Prices,” WP 6-04, Bank of Portugal, 2004.
Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, vol. 48(1), pages 1-48.