Does monetary policy need to respond to the surge in inflation during pandemic?

Inflation went up to 2.5% in the March quarter, its highest rate since 2011. This was a fair amount above expectations, with the RBNZ expecting a 2.2% rate. They were not alone with private sector forecasters also expecting weaker inflation outcomes. 

This raised two questions from me:

  1. Is this evidence that COVID was a supply shock more than a demand shock?  
  2. And does it mean that monetary policy should respond? 

I want to think about the later point in this post – as the first question will get answered as we work through it.

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A decade without recession as monetary policy failure?

A post by Scott Sumner said that a decade of growth in the US wasn’t good enough – and was a monetary policy failure.  In New Zealand, we have had nearly a decade without a technical recession (the last one was the second half of 2010) – so has this been a monetary policy failure too?

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The coronavirus and the general NZ economy

The coronavirus has been in the news, with its relatively rapid spread a cause for concern.  This has important welfare and wellbeing effects associated with the pain people might experience due to the coronavirus. 

However, today I am going to discuss how we can think about the consequences of a disease outbreak for the general economy – or in terms of broad macro stabilisation or monetary policy. 

These lessons can help us understand some of the broad consequences of a disease outbreak which can then be extended to ask other policy related questions (eg how the virus might disproportionately affect industry sectors in NZ, what areas are harm reduction policies particularly important).

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From the Great Depression to the contemporary days: is the reallocation of resources a solution?

Former Governor of the Bank of England, Mervyn King is suggesting that Economics Needs a Post-Crash Revolution in a seeming admission that current frameworks don’t work in a world of radical uncertainty and necessary reallocation.

Is the former BOE governor and academic icon correct, or is this an unfair critique of the mainstream?  As a summary, I have two issues with his argument:

  1. Reallocation does not have anything to do with “average demand”, which is predominantly a monetary policy issue,
  2. If excessive reallocation is necessary and requires government assistance, where are the “high return” industries that need reallocation to them?

Let me explain.

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A note on Qualitative easing

While the concept of quantitative easing has received a lot of attention amongst economists, qualitative easing was not as widely discussed. Qualitative easing is a monetary easing program that was used by Japan in 2013 and represents some elements of the QE programmes in the US. 

The outline of how it works is well described here, and so I want to focus a little bit more on why.

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Do we make choices based on income or prices?

Last time we noted the following regarding thinking about NGDP level targeting:

To understand what is going on we need to ask what expectations are being “set”, what is the “target” and how do these reflect what a central bank can “do”?

Expectations: We know they can be adaptive (backward looking) or rational (forward looking), but what do they refer to? Are people making choices based on expected prices, or are they making choices based on expected incomes? Do they view shocks as permanent or temporary?

Target: Is the goal to anchor the price level, or to anchor the level of expected nominal income growth? Is it to limit variability in prices and output?

What they do: If a central bank wants to increase prices can it, if it wants to increase nominal incomes can it?  If they can do both, how does this influence their ability to “close output gaps”?

Here I want to discuss a little more about expectations.

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