The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Tuesday, May 24, 2011

Krugman proposes lifting inflation target/dumping headline inflation/dumping core inflation!?

I mean, seriously, how bizarre can Paul Krugman really get when it comes to inflation. He overlooks a hundred years of history and seems incapable of acknowledging inflationary risks. Every time he is proven wrong on inflation in the US, he wants to rewrite the rules of the game to rationalise his policy view: rates must be kept low to boost employment, no matter the costs. The problem with this is it is far too binary: the Fed could lift rates 200bps and it would still be highly stimulatory.

Let's summarise what Krugman has said, as far as I can discern (I am not a regular reader). First, raise the US inflation target, implicitly because there is a long-run trade-off between inflation and employment.

Second, keep interest rates low in the face of high headline inflation, even though that is what consumers have to deal with, and is ultimately the key driver of inflation expectations. This recalls the classic line by an ECB official who said central bankers that focus on core inflation don't eat food or drive cars.

Third, keep rates low even in the face of high core inflation, because that still seems to be capturing rapidly growing variables. Krugman belatedly acknowledges that core inflation is increasing in the US. He attributes this to the cost of imported materials. But why has the cost of imported materials risen? Because the US dollar has been artificially deflated by the Fed through its program of buying bounds to cut yields.

Like the UK, imported inflation is a direct consequence of excessively easy monetary policy. The most galling thing about all of this is that the Fed seems to be repeating its same pre-GFC mistakes: namely, provide a put option to the financial system when the going gets tough (ie, don't allow the market to do its job and discipline badly managed businesses), and blow artificial bubbles--today US equities, US bonds, US inflation and global commodity prices--in the hope that this will feedback into wealth and confidence, and, ultimately, spending and lending.

Krugman's logic seems even more irresponsible than the decision-making errors Alan Greenspan made. Could it be the case that the US economy needs a long period of repair, which might just mean higher unemployment and lower growth than Krugman accepts?