Janet Yellen, the Chair of the Federal Reserve, doesn't know what determines inflation. I'm not being snarky here. I have an unimpeachable source, which is Yellen herself.
In a speech at a conference held at the Federal Reserve Bank of Boston last month (video and presentations available here), Yellen gave a keynote address on "Macroeconomic Research After the Crisis." She said: "Today I would like to reflect on some ways in which the events of the past few years have revealed limits in economists' understanding of the economy and suggest several important questions I hope the profession will try to answer." The first three questions she raised are fairly standard topics in current macroeconomic research.
"The first question I would like to pose concerns the distinction between aggregate supply and aggregate demand: Are there circumstances in which changes in aggregate demand can have an appreciable, persistent effect on aggregate supply?""My second question asks whether individual differences within broad groups of actors in the economy can influence aggregate economic outcomes--in particular, what effect does such heterogeneity have on aggregate demand?""My third question concerns a key issue for monetary policy and macroeconomics that is less directly addressed by this conference: How does the financial sector interact with the broader economy?"Her brief comments on these topics are interesting, but it was the fourth and final question that caught my eye:
"My fourth question goes to the heart of monetary policy: What determines inflation?"It's more than a little astonishing to have the chair of the Fed ask such a question. After all, one major mandate of the Fed is to keep inflation under control. In recent years, the Fed has been confronted with fears about risks of deflation, and a set of ongoing arguments that a slightly higher inflation rate in the range of 2-4% might help the economy. Concerns about Fed policies like quantitative easing were often phrased in terms of worries about inflation. If the Fed chair doesn't know what determines inflation, how are such issues to be addressed?
But Yellen deserves credit for her forthrightness, because the honest truth is that the behavior of inflation over the last 20 years is tricky to explain....MORE