The carry trade and mortgage rates: Shifts and movements

Anyone who has done first year economics will know about shifts and movements.  When I tutored the course I would make funny hand gestures trying to illustrate it, hand gestures that were mildly less weird then when I talk about price floors and ceilings.

Still, there has been a lot of banging on about the carry trade and mortgage rates, and I think some of it stems from a little confusion regarding shifts and movements.  As an example I’ll work with this post from the Standard (ht BK Drinkwater).

Note: This is being added to the inflation debate, as a discussion of interest rate determination in a small open economy.  Starting from the bottom, the combination of posts under that tag gives a fuller idea of what we are talking about with inflation targeting and our (narrow) view of monetary policy.

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Discussing inflation targeting and our exchange rate concerns

In a recent speech (ht Rates Blog) Goff committed to destroying monetary policy independence and damaging the New Zealand economy if he gets into power.  That is all well and good.  However, I think part of the reason this issue has occurred is because of a lack of understand around the necessity of monetary policy independence and inflation targeting, and how all these other factors (like the exchange rate) are determined.  Lets discuss them a little bit here:

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Why we have to be careful equating CPI growth to inflation

We have previously mentioned how important it is to interpret CPI growth carefully. Inflation is the trend rate of growth in the “general price level”, and as a result there are other factors that get caught up in our attempts to measure inflation.

James Hamilton at Econbrowser pointed to a paper by Reis and Watson which points out just how essential this difference is in a “low inflation environment”. The money quote from the abstract for me:

We find that pure inflation accounts for 15-20% of the variability in inflation while our aggregate relative-price index accounts most of the rest.

The pure inflation mentioned above is the fundamental increase in the general price level we often complain about as economists. “Inflation” in this paper is growth in the private consumption expenditure deflator (which is similar to the CPI – except that the bundle of goods is not fixed).

Now we don’t want to try and prevent relative price shifts – as that is the whole purpose of the price signal. So understanding this distinction is important. Very interesting.

Update: I don’t think I was clear enough on where I think the value is here. The paper seems to indicate to me that movements in the CPI and PCE deflator are relatively poor indicators of the magnitude of any change in inflation. This is a very good point, and I love it that this paper was able to mince the data up and show this.

Update 2:  Paul Walker blogs on a pre-release of the paper here.  Paul concludes:

They found that once they controlled for relative price changes, the correlation between (pure) inflation and real activity is essentially zero

That is true.  But let us be clear here, this implies that there is no money illusion (which economists currently assume), and so all quantity issues stem from nominal rigidities in prices (which we have discussed).   As a result, even pure inflation is still costly, as nominal rigidities exist causing a mis-allocation of resources (since relative prices get messed up).

Another interesting conclusion in the paper is that the rigidities in the labour market aren’t as strong as we would expect.  If this is shown to be the case over time it would change my implicit view of the economy.  Man I wish I could do a study like this for the NZ economy 🙂

Consumer prices – not asset prices

Earlier I mentioned a piece by Steven Gjerstand and Vernon Smith that was a bit harsh on monetarism – as it ignored that the monetarist explanation and a economic readjustment explanation could be complements instead of substitutes.

Now Barry Ritholtz points out another interesting point from the piece – their discussion of the fact that house price growth was effectively taken out of the CPI.  The money quote is:

If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%. With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off.

Let’s discuss.
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Price indicies: A discussion

Note: Other posts in this discussion are available under the tag “inflation debate“.

With the trade-off between inflation and other things behind us, and a justification for inflation targeting, we have a good base to discuss current activity and issues. The aim is to now discuss other methods of fighting inflation – however, before discussing this I think it is important to discuss another technical issue: How do we measure inflation?

This is both an incredibly important issue, and a highly contentious one. While I was going to write a long post on this, Dr Chinn at Econobrowser beat me to it (and also did an infinitely better job than I could have 😉 ). Dr Chinn discusses how we use the CPI to measure inflation, and the limitations of this measure (especially in terms of individuals expectations of what inflation is!). As a result, he covered all my main points 🙂

However, I will write some additional stuff anyway 😉

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Inflation targeting vs inflation trade-offs: What’s the score?

Note: Other posts in this discussion are available under the tag “inflation debate“.

After placing down all the trade-offs between inflation and output, it was not clear that fighting inflation was necessarily the best cause of action. Although there are definitely costs from inflation, there are also costs from fighting it. Ultimately, it would be nice to have a method of dealing with inflation that got rid of these trade-offs, and just made us better off. One way we could try and do this is through explicit inflation targeting.

We have touched on the benefits associated with inflation targeting before here and here. However, now we will try to tie these benefits down amongst the costs and trade-offs associated with inflation and inflation fighting.

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