The Great American Slump (update)

I detect some chatter out there concerning the recent "unexpected" rise in the U.S. labor force participation rate. The discussion is related mainly to the question of whether the labor market has fully recovered from the effects of the Great Recession. I suggested back in 2010 (here) that American recovery dynamic might be a prolonged one, at least, taking the Great Canadian Slump as a model. I updated that analysis here in 2016. In light of the recent discussion, I thought I'd see where we stand today.

Here is EPOP (employment-to-population ratio) for Canada (beginning in 1990) and the United States (beginning in 2008).

 
The two series bear a striking resemblance 40 quarters (10 years) out. Here is what the picture looks like when we restrict attention to the prime-age (25-54) population:

 

 The Great Recession appears to have a significantly larger impact on the prime-age labor market in the United States, relative to the 1990 recession in Canada. Look how it took about 34 quarters for prime-age EPOP to recover in Canada. We are now 38 quarters out since the Great Recession began with prime-age EPOP in the U.S. still almost two points below its initial value. I interpret this to mean that the labor market has not yet fully recovered. And no, I do not think this has very much to do with "aggregate demand deficiency." (See here, here and here if you want some elaboration.)

Here is what the picture look like for the participation rate:
 
The relative decline in the U.S. participation rate here might have something to do with demographics. When we restrict attention to prime-age, we do see evidence of a recovery that is not yet complete:

Interpreting the yield curve

There's been a lot of talk lately about the flattening of the yield curve, what's causing it, and what it portends. In this post, I describe a simple "neoclassical" theory of the yield curve and ask to what extent it serves as a useful guide for our thinking on the matter.
 
Let's start by defining terms. Let I(m) denote the yield (market interest rate) on (say) a U.S. treasury bond with maturity m. So, I(1) denotes the yield on a one-year bond and I(10) denotes the yield on a ten-year bond. The slope (S) of the yield curve is given by the difference in yields between long and short bonds. In this example, S = I(10) - I(1).

Here's what the yield curve looks like for the U.S. since 1961.

Normally, the slope of the yield curve is positive. But occasionally, it turns negative -- an event that is called yield curve inversion. Market analysts care about yield curve inversion because the event is frequently (though not always) followed by a recession (the shaded bars represent recessionary episodes).

The graph above plots the nominal yield curve. Economists frequently stress the importance of real (inflation adjusted) interest rates, which I will denote R. Because there is a ten-year Treasury-Inflation-Protected Securities (TIPS), we have a market-based measure of R(10). Let me compute     R(1) = I(1) - P(1), where P(1) denotes expected year-over-year inflation. Let me use the year-over-year change in core PCE inflation as my measure of P(1). That is, I am assuming that over the short-run, the market expectation of inflation is roughly last year's core (trend) inflation rate. Since TIPS data is only available since 2003, here is what we get:
 

The nominal and real yield curve share the same broad pattern. This is consistent with what we would expect if inflation expectations are stable. Note the slight bump up in the nominal yield curve following the November 2016 presidential election. Since then, both yield curves have been flattening--the real yield curve more so than the nominal curve. Does this mean we are heading for recession, or at least a growth slowdown? And if so, why? To answer this latter question, we need some theory. [Warning: what follows in blue is wonkish. If you are not a wonk, skip the blue section--some intuition follows.]

Consider this simple model economy. There are three periods (the minimum number I need to generate a yield curve). The economy is closed and is populated by individuals with identical preferences for consumption over time, c1, c2, c3. That is, people care about their material living standards over the course of their planning horizon. If people like to smooth their consumption over time, then the following representation of preferences serves to capture this idea W = u(c1) + u(c2) + u(c3), where u(.) is an increasing concave function. For simplicity, let u(.) = log(.). To make things even simpler than they need to be, assume an endowment economy so that the real GDP is expected to evolve according to y1, y2, y3. Finally, let Rij denote the real rate of interest between periods i and j. Then the equilibrium real interest rates are given by:
R12 = y2/y1
R23 = y3/y2
R13 = square root of (y3/y1)

Let me now explain in words what this model implies. First, the model predicts that real interest rates are proportional to expected economic growth. The economic intuition for this is that if incomes are expected to grow more rapidly, then in an attempt to smooth consumption (that is, bring future income back to the present) people will want to save less (or borrow more). The decline in desired saving (increase in desired borrowing) results in upward pressure on the interest rate until the bond market clears.

The slope of the yield curve in this model economy is given by S = R13 - R12. This is roughly the ratio of expected long-term growth (y3/y1) relative to expected short-term growth (y2/y1). Thus, a positively-sloped yield curve in this economy is symptomatic of a bullish economic outlook (growth is expected to accelerate). Conversely, a negatively-sloped yield curve is symptomatic of a bearish outlook (growth is expected to decelerate). The interpretation offered here of the flattening yield curve is that expectations are turning increasingly bearish--people are cutting back on planned consumption, increasing their desired saving (reducing planned borrowing)--all of which serves to put downward pressure on long rates.

As with all simple theories, it would be wrong to view this as "the" explanation for the yield curve. At best what the theory does is highlight certain forces that may be at work in the real economy. Whether the forces identified are quantitatively important is an empirical question. Nevertheless, I think the model offers a good place to organize our thinking on the matter.

A conventional view among economists is that the Fed has little or no control over long real interest rates. If long-rates are declining because of an increasingly bearish sentiment, then there's little the Fed can do about it. But what justifies the recent policy of raising the short-term rate? The model above suggests that the Fed is simply responding to market forces--the market "wants" higher short rates and the Fed is simply accommodating this want. I'm not sure this is the best way to think about what's happening. One thing missing from this simple model that may be important to consider is the liquidity premium on short-term government debt. Is the current Fed policy affecting this liquidity premium and, if so, what effect is it having on real economic activity? I'll try to address these and other questions in future posts.


Postscript 11/27/2017 Some further thoughts. ***********************

Consider a world where real economic growth remained constant, i.e., y2/y1 = y3/y2 = y4/y3 = ...
In such a world, the yield curve would be perpetually flat. In a world where output fluctuated around a constant trend, the slope of the yield curve would be zero on average. (I am abstracting from inflation risk, etc.)

In reality, the yield curve is usually positively sloped. It seems unlikely that the explanation for this is that investors are perennially bullish (in the sense of expecting accelerated growth). There are other factors that may impinge on bond yields at different horizons and hence on the slope of the yield curve. One such factor is the liquidity premium attached to short-maturity debt. If the short bond in the model above is valued for its liquidity (and if liquidity is "scarce" in a well-defined sense that I don't have room to explain here), then the market yield of the short bond will be lower than what is dictated by "fundamentals." In other words, short bonds will seem very expensive. If this is the case, then the yield curve may be positively sloped even if the growth outlook is stable (instead of bullish).

To the extent that the Fed can influence the liquidity premium on bonds (and there is good reason to believe it can), then raising the policy rate in the present environment would serve to diminish the liquidity premium on bonds. In the model economies I know of where such a liquidity premium exists, eliminating it actually stimulates economic activity. This is because liquid bonds, to the extent they are used as exchange media, actually complement investment spending instead of crowding it out (as is the case in other models that abstract from the liquidity services that bonds provide).

The interpretation in this case is that raising the policy rate is reducing "financial repression," which is likely to offer modest stimulus. This policy action in itself will have no measurable impact on inflation and the associated flattening of the yield curve is what we would expect if growth prospects remain stable (the flattening yield curve does not necessarily portend recession).

**************************************************************************

Tyler Cowen on Central Bank Cryptocurrencies

I enjoy reading Tyler Cowen and have learned a lot from his columns. So before I criticize his most recent effort, I want to thank him for all his fine contributions! Unfortunately, I think he drops the ball a little bit on his most recent effort. No worries--we all do sooner or later. What follows are some thoughts that came to my mind as I read his most recent article entitled "Cryptocurrencies Don't Belong in Central Banks." My (unedited/uncensored thoughts are recorded in blue...Tyler, take note: "uncensored"= risk-taking central banker!) 

Should central banks embrace cryptocurrencies, or even pioneer their own? In a nutshell, no. Crypto assets are an unusual innovation, still in flux and often poorly understood. Trying to centralize them in a bureaucracy is exactly the wrong way to go. 

"Crypo assets are an unusual innovation" -- this is a claim that makes little sense without first defining what is meant by the term. Most people have in mind some notion of a distributed (shared) append-only ledger of information updated and maintained by members of a community through some consensus algorithm that makes use of cryptography in securing information. I'm not sure how "unusual" this idea is where fintech is concerned (advances in information management systems have been happening for a long time). And, as I explain here, the concept of distributed ledgers updated via communal consensus is an ancient idea. 

"Trying to centralize them in a bureaucracy" makes no sense at all if the very concept depends on a decentralized record-keeping arrangement. And in any case, a central bank that experiments with such a protocol is not "centralizing" all crypto assets--just its own crypto asset. What is inherently wrong with this? The fact that a central bank is a "bureaucracy?" 

Yet China’s central bank claims it is working toward a blockchain-based digital currency. Singapore has already experimented in this direction. The phrase “Fedcoin” is sometimes bandied about, though I’ve seen no concrete sign of the U.S. Federal Reserve jumping on this bandwagon. In its recent quarterly review, the Bank of International Settlements asked central banks to consider whether cryptocurrencies might make sense for them.

The "Yet" beginning the paragraph does not belong there. It presumes we've accepted the premise laid out in the previous paragraph which, as I have suggested, makes little sense. 

Central banks, however, are intrinsically conservative bureaucracies. They shun bad publicity, and they don’t like to be “out there” ahead of the curve. They don’t want their names connected with potential mishaps -- because they value their credibility and their political capital so highly. That’s appropriate, because central bank independence is typically fragile.

Almost everyone shuns bad publicity. No one wants their names connected with potential mishaps. It's not that central banks don't like to be "out there"--it's that they are usually prevented from being "out there" by government legislation. Of course, central bankers should be "conservative" in the sense of respecting the legislation that is designed to govern them.  

Given that background, (which is wrong) should we foist a new and potentially risky responsibility on them? Central banks will feel some anxiety at having to manage a crypto project. (central bankers will always feel anxiety). To conserve their political capital, they will take fewer risks elsewhere, such as unorthodox monetary policy or larger balance sheets. (what justifies this bald speculation?) Yet the response to the 2008 financial crisis shows a certain amount of central bank risk-taking is needed. (those conservative central bankers again, I guess). I’m worried about central banks taking on unnecessary risky projects, thereby rendering them too cautious in other areas. (there's no need to worry about this in my opinion.)

 An additional reason for skepticism stems from the nature of crypto assets. The word “cryptocurrency” is far more common than “crypto asset,” but it’s a misleading term. Bitcoin, for instance, is used only rarely in retail transactions, and for all its success it isn’t becoming more important as a medium of exchange. Bitcoin thus isn’t much of a currency in the literal sense of that term. There is a version of bitcoin, Bitcoin Cash, that changed the initial rules to be better suited as an exchange medium, but it isn’t nearly as popular. (I don't disagree, but I also don't understand the point of this paragraph.)

If you think of these assets as “cryptocurrencies,” central bank involvement will seem natural, because of course central banks do manage currencies. Instead, this new class of assets is better conceptualized as ledger systems, designed to create agreement about some states of the world without the final judgment of a centralized authority, which use a crypto asset to pay participants for maintaining the flow and accuracy of information. (Good, I agree with all this.) Arguably these innovations come closer to being substitutes for corporations and legal systems than for currencies. (Except that in monetary theory, we understand money as a ledger -- a record-keeping system. See, e.g., Kocherlakota, 1998). 

Put in those terms, an active (rather than merely supervisory) role for central banks in crypto assets is suddenly far from obvious. Consider other financial innovations: Does anyone suggest that central banks should run their own versions of ETFs or high-frequency trading? Is there a need for central banks to start managing the development of accounting and governance systems?

Um, yes, yes, and yes. Central banks are already like bond ETFs (assets are bonds, liabilities are reserves and currency). High-frequency trading--like Fedwire, you  mean? And I'm not sure why better accounting and governance systems should not be employed by central banks if it makes sense for other institutions?

Finally, bitcoin and other crypto assets are still in the midst of rapid evolution, with basic questions still unanswered. Should bitcoin “fork” to allow for greater speed in processing transactions? Is the future going to favor bitcoin, the Ethereum platform, or something else altogether? How many initial coin offerings make economic sense, as opposed to being bubbles? Should initial coin offerings be used to fund startups? How many crypto assets should survive in the long run? Can blockchains be used to record and settle the transfer of property titles? Are there any circumstances when it should be possible to revise transactions on a blockchain?

Yes, there are always questions concerning the outcome of fintech. This has been happening for hundreds of years. What is the point of stating this obvious fact and why should the prospect of evolving information technology discourage central banks from experimenting with it? What if such an attitude was adopted when email first appeared on the scene? 

In general, I think the central banks in the world’s developed economies have done a pretty good job. But consider a simple question: Would any central bank have had the inspiration or taken the risk of initiating the bitcoin protocol in the first place?

Let's assume that the answer to this question is no. The only thing that follows from this is that we should not rely on central banks as our only source of fintech. But we already do not have such a reliance. So what is the point being made here? Let's experiment away, I say! 

Well, maybe not. My own sense of the discussion concerning central banks and cryptocurrencies is that people are confounding two conceptually distinct issues. 

The first issue is whether central banks should open the digital component of their balance to the general public (say, the way the U.S. Treasury does at https://www.treasurydirect.gov/). And why not? After all, central banks allow anyone in the world to hold the paper component of their liabilities. This idea is actually very old--it is related to the question of whether a central bank (or post offices) should permit people to open book-entry utility accounts.  This remains a good question and there are many issues to sort out, including what impact such an innovation would have on banks. But it has nothing to do with "cryptocurrencies" except to the extent that cryptography is used to secure communications--something that is already widely employed.

The second issue is whether central banks should issue "digital cash." The digital reserve money associated with the scheme in the paragraph above is not cash-like in the sense that it is not a bearer instrument. People have to identify themselves when they open accounts at the U.S. Treasury. Presumably, they'd have to do the same thing if they opened up a digital money account at at post office or central bank. Digital cash is something more akin to paper money. As far as I can tell, the technology to create digital cash has been around for a long time. That is, there is nothing technological that prevents a central bank (or anyone) from issuing numbered accounts (think of the good ol' anonymous Swiss bank account, for example). Even PayPal could issue digital cash--if it was legally permitted to, which it isn't. So, the question here is whether a central bank should issue digital cash. The wallet-to-wallet debit/credit activity could be done in-house via a central book-keeper, or the activity could be delegated to some third parties (e.g., Bitcoin miners). I don't really see central banks getting into this business, but they will have to think about how private-sector digital cash may impinge on their ability to conduct monetary policy. (Note: the innovation with Bitcoin is not digital cash per se, rather the innovation has to do with P2P digital cash--debit/credit operations that do not rely on a central book-keeper.)

A monetary-fiscal theory of inflation

On December 17, 2015, the FOMC has raised its policy rate (IOER) from 25bp to 50bp. It has since raised the IOER rate three more times to 1.25%. Many on the committee seem convinced that further rate hikes are needed (in addition to actions designed to shrink the Fed's balance sheet, which is already shrinking relative to the size of the economy). What is the source of this enthusiasm for monetary policy tightening, given that the unemployment rate is close to target, and given a PCE inflation rate that has been undershooting the Fed's 2% inflation target for several years now?

The short answer is the Phillips curve. Or, to be more precise, a belief in the Phillips curve theory of inflation. The basic idea is that at very low rates of unemployment, competition for workers will lead to higher wages, with the associated costs passed on to consumers in the form of higher prices. Even if this wage pressure has been largely absent to date, it will (form sign of the cross here) eventually happen, and it's better for the Fed to get ahead of the curve, rather than risk having to raise its policy rate abruptly (and disruptively) in the future.

But what if the Phillips curve theory of inflation is not the best way to guide our thinking on the matter? What other theory might we turn to for guidance? Binyamin Appelbaum of the New York Times discusses a number of alternatives here (which I review in my previous post). In addition to the Phillips curve theory, he mentions explanations that I labeled: [1] Monetarist, [2] Expectations, [3] Internationalist/Technology. I mentioned in my previous post that I'd return to examining the Monetarist view, which I think is too often given a short shrift. I explain below how the Monetarist view is consistent with [2] and [3]. There is also the question of what the Monetarist view implies for policy. While the Phillips curve view has turned doves into hawks, I argue below that the Monetarist view should turn hawks into doves (given the present state of the economy).
 
Many people feel Monetarism has been discredited because economists who employed the theory to predict the inflationary consequences of QE were proved embarrassingly wrong. But this is along the lines of viewing scissors as a lousy tool because many barbers have used scissors to give awful haircuts.

To be fair to their critics, Monetarists sometimes overstate the role of money supply in determining the price-level and inflation. But let's also give credit where credit is due. We know how to create inflation. Just look at Venezuela today. No one can take seriously the notion that inflation is very high in Venezuela because the unemployment rate is far below its natural rate. Moreover, we know how to stop inflation. Tom Sargent's The Ends of Four Big Inflations showed us how it was done in history. Our understanding of these episodes revolve around Monetarist explanations that also take seriously fiscal considerations. Why can't the same theory be used to understand the present low-inflation environment and help guide policy? I think it can.
 
By the way, I've worked this all out in an open-economy version of the model I describe here. But nothing I say below hinges on this specific formalization; the basic idea is much more general. The two essential elements are: [1] safe government debt is a close substitute for central bank money; and [2] the demand for government money/debt can wax and wane over time (perhaps in St. Louis Fed regime-switching style).

The first property is important for understanding the economic consequences of open-market operations like QE. In the old days, when U.S. treasuries were yielding (say) 10% and Fed reserve liabilities were yielding 0%, an open-market swap of money for bonds could be expected to have a big effect. The same size open-market swap in a world of 1% reserves and 2% treasuries is not likely to have as great an impact. In the extreme case where reserves and treasuries have identical yields, open-market operations are not likely to have any effect at all--apart from inducing banks to accumulate excess reserves (in place of the treasuries they would have otherwise held). I think this is the main reason for why large-scale asset-purchase (LSAP) programs have had much smaller effects than what many had expected.

The fact that bonds become close substitutes for money when their yields are similar explains how the supply and demand for bonds can influence the inflation rate. Normally, we think of an increase in the demand for bonds as lowering bond yields. This is correct. But what happens when those yields approach the corresponding yield on interest-bearing money? (In the old days, when interest on reserves was zero, this limit was called the zero-lower-bound). An increase in the demand for bonds in this case must manifest itself in other ways. One way is for the price-level to fall. That is, a market-mechanism for expanding the real supply of nominal bonds is for the price-level to fall. One way this manifests itself is as China selling its goods for less USDs to acquire the USTs it so desperately wants.

The second property is important for understanding how inflation can fall even in the face of a growing supply of money/bonds. Admittedly, a bit of religion is required here, but I'm not sure what else to believe in. Suppose we can observe the supply of oil. We see a sudden increase in the supply of oil. At the same time, we see the price of oil rise. While the demand for oil is not directly observable, I think it's fair to say that most people would conclude that the (unobserved) demand for oil must have increased by more than the (observed) increase in supply. I want to apply the same thought-organizing principle to the price of money and bonds.

The story is familiar to those who point to declining money (and debt) velocity. In my formal model, I have a parameter that indexes the growth rate in the demand for real money/bond balances (where money and bonds take the form of USDs and USTs, respectively). In the open-economy version of my model, I have a "money demand growth regime" originating from the foreign sector. In the model, this regime translates into persistent U.S. trade deficits, representing the foreign sector's desire to acquire USD/UST at an elevated pace. There is in fact considerable evidence suggesting a large and growing foreign appetite for U.S. money/bonds over the past decade. Japan and China have each accumulated about one trillion dollars in USTs, for example. Moreover, it is known that USTs play an important role as exchange media (collateral) in credit derivatives markets and the shadow banking sector. Lately, the demand for such securities has been enhanced by a variety of regulatory reforms targeting the banking sector.

Bringing these elements together, the story that unfolds goes something like this. For years, several forces have conspired to elevate the (growth in the) demand for USD/USTs, driving yields ever lower. The financial crisis and associated "flight to quality" phenomenon served to exacerbate this secular force (with subsequent regulatory reforms adding to it further). Given an historically normal pace of money/debt expansion, these forces would have been hugely deflationary. The effect of the large increase in USTs following the crisis was to counteract this deflationary effect. But the U.S. debt-to-GDP ratio has essentially flat-lined since 2013. In the meantime, demand for the product continues to grow. With bond yields very close to the Fed's IOER rate, the result is persistently low inflation. And it's no surprise that now, after years of low inflation, that inflation expectations remain subdued.

No doubt some of you will find holes in this story, some inconsistencies perhaps, with past episodes or other countries. But I'm not claiming that this is the story; I'm simply suggesting that it may be an important part of it. And to the extent that it is, what does it imply about the current configuration of monetary and fiscal policy?

In my model, raising the policy rate in the face of stable or declining inflation has the effect of increasing the attractiveness of government money/bonds. The model highlights a portfolio substitution effect where savers redirect resources away from private capital spending (including expenditure on recruiting activities) toward money and bonds. The effect is contractionary. Is this really what we want/need right now? Moreover, in my model, the effect a higher policy rate on inflation depends critically on how the fiscal authority responds. (As Eric Leeper and others keep on reminding us, every monetary policy action must have a fiscal consequence.) A higher policy rate will increase the carrying cost of the debt, and Fed remittances to the U.S. treasury will decline. How will this added fiscal burden be financed? If the government makes no adjustment to its tax/spend policies, then the treasury will be forced to increase debt-issuance at a more rapid pace--an effect that is likely to increase the inflation rate (a result consistent with the so-called NeoFisherian view). Alternatively, if the government goes into austerity mode, cutting expenditures and/or raising taxes, the effect is likely to be disinflationary. This is all based on standard Monetarist thinking--we do not need the Phillips curve (which, by the way, exists in my model via a Tobin effect).

To the extent that the forces I've described above are present in reality, the analysis here calls into question the need for monetary policy tightening too rapidly at this time. Low unemployment does not necessarily portend higher inflation. And keep in mind that other measures of labor market activity, like the prime-age employment-to-population ratio, are still below their historical norms. Of course, this does not mean that monetary policy makers can afford to ignore the threat of inflation. While the worldwide demand for U.S. nominal debt instruments has been robust for a long time now, this "high U.S. money demand" regime is not likely to last forever. When the growth in money demand abates, the consequence is likely to manifest itself as higher inflation expectation (and bond yields)--much like what we observed following the November 2016 presidential election in the United States, except on a much larger scale. A good policy framework should make provisions for these and other contingencies, including sudden changes in the structure of fiscal policy.

Let me sum up and conclude. An elevated demand for U.S. dollars and treasuries has put downward pressure on bond yields and the inflation rate. Both the Fed and U.S. Treasury have partially accommodated this elevated demand. The result is a PCE inflation rate averaging about 1.5% since 2009, only 50bp below the Fed's official 2% target. The economic losses (or gains) associated with this "missing" 50bp of inflation going forward are difficult to quantify, but it's difficult for me to imagine that they are very large (and especially at this point in the recovery dynamic, where inflation expectations appear roughly consistent with the actual inflation rate).

But suppose that I am wrong and that it would be desirable to raise the price-level path back to its pre-2008 trend (something that would require a few years of inflation running above 2%). Is this even economically feasible? Does economic theory and experience provide a recipe? The answer is yes: have the central bank monetize the deficit until the price-level hits its target. (If the price-level never rises, then the government can enjoy a perpetual free lunch, cutting taxes and paying for goods and services with newly-issued non-inflationary money.)

But don't hold your breath for this to happen anytime soon. The constraints in place are not economic, they are political. Many public officials and the people they represent are growing uncomfortable with historically high debt-to-GDP ratios and large central bank balance sheets. They see the large supply of government debt, but they cannot see the large demand for the product driving yields down. Instead, they interpret low interest rates as enabling a large supply. And so, political pressure is presently running in the direction of austerity and smaller central bank balance sheets. Of course, if this is what the people want, this is what the people should get. But then, let's not spend so much time fretting over a 50bp miss on inflation, or bemoan the apparent lack of a coherent theory of inflation.

*******

PS. This post was motivated in part by Noah Smith, who tweeted:

Conclusion:
NO ONE KNOWS HOW INFLATION WORKS.

Macroeconomists need to go back to the drawing board on inflation. Square one.

— Noah Smith (@Noahpinion) August 4, 2017

I discuss the case of Japan in greater detail here: The failure to inflate Japan

Where's the inflation?

The PCE inflation rate in the United States has been consistently below the Fed's official 2% target for many years now. Equally persistent are the forecast errors of those who have expected inflation to rise to its target level (and possibly beyond).

What accounts for the missing inflation? In a recent NYT article, Binyamin Appelbaum mentions four theories of inflation: (1) Monetarist, (2) Phillips Curve, (3) Expectations, and (4) Internationalist. Let me briefly describe and comment on these four views.

Monetarist. The price-level is determined by the supply of money relative to the demand for money. Inflation (the rate of change in the price-level) is therefore determined by the rate of growth of the money supply net of the rate of growth in the demand for money (often proxied by the growth rate in real GDP).

This theory has been discredited by conservative economists using it to forecast impending inflation following the large increase in the supply of money, as measured (say) by the Fed's liabilities. (Whether the theory deserves to be discredited is another matter, to which I will return in a subsequent post.)

Phillips Curve. This theory, held by Janet Yellen and other FOMC members, is based on empirical evidence like this:

That is, it appears that the inflation rate is negatively correlated with the unemployment rate, which is
used widely as a proxy for aggregate demand. The interpretation of this data goes something like this: As the aggregate demand for goods and services picks up, firms are motivated to hire more workers. As the unemployment rate declines, workers are able to demand higher wages. These costs are then passed on to consumers through higher product prices.

While the story sounds plausible, it is not without problems. It seems sensible to suppose that the bargaining power of workers is improved when the unemployment rate is low. And growing worker productivity is an important source of economic growth. Both of these forces suggest that the real (inflation-adjusted) wage should rise when unemployment is low (or falling). But why should rising real wages result in higher wage and price inflation? The answer is not immediately clear.

Another problem associated with this view seems is the propensity of its adherents to take the statistical evidence of the Phillips curve as prima facie evidence of their theory of the Phillips curve. In fact, economists have known for a long time that there are many other mechanisms that might generate a negative relationship between the unemployment rate and inflation. The Tobin effect, for example, asserts that the direction of causality runs in the opposite direction: higher inflation induces a portfolio substitution out of government securities into private investment (including recruiting investment), which leads to lower unemployment.

Finally, as one can see from the data, the Phillips curve slopes down. Except for when it doesn't.  (This is not entirely fair as it is what one would expect from an inflation-targeting central bank adjusting its policy rate judiciously in response to various shocks.)

Expectations. There are several variants of this view. One is that the rate of inflation depends on the expected rate of inflation and that inflation expectations are largely indeterminate in the sense that they can become a self-fulfilling prophecy. After almost a decade of low inflation, what else are individuals supposed to believe? Eventually, low inflation expectations get baked into lower wage settlements and lower pricing decisions, which results in low inflation.

This story sounds plausible. But it suggests an inertial aspect to expectation formation that may have less to do with recent experience and more to do with how individuals expect policy to evolve in the near future. This latter possibility has been demonstrated convincingly by Tom Sargent in The Ends of Four Big Inflations.
 
Internationalist. As explained by Binyamin, this view holds that low inflation across the developed world is due to the rise of the developing world. The threat of outsourcing keeps a lid on domestic wage pressures, while a flood of cheap goods from foreign countries helps to keep domestic product prices down, both directly (because we pay less for imports) and indirectly (because the threat of competition from imports induces domestic producers to keep prices low).

This view was also expressed as a reason for low inflation by Janet Yellen. Quoting the article, "She and other officials also have noted that the weakness of the global economy allowed the United States to import foreign goods at low prices." There is some evidence suggesting this is true. The following diagram plots the PCE inflation rate (blue) against the inflation rate associated with the import price deflator:

What are we to make of all this? According to Adam Posen, "policy makers are sailing without the guidance of a convincing model."  This sounds right to me, but not because a convincing (or at least, semi-plausible) model is absent. In particular, I can think of a model that is broadly consistent with observation. Moreover, it's a model that's not inconsistent with any of the theories described above.

I'll describe this model in my next post (stay tuned, I won't keep you waiting too long).