Imagine you fall into a freezing lake and get hypothermia. You are rushed to the ER and receive good service initially, but your body temperature continues to remain below 98.6 Fahrenheit. The doctor says he is not sure why you are so cold. It is a puzzle to him and everything he thought he knew about body temperatures seems to be wrong. He says not to worry, though, as he turns on the air-conditioner. All should be well soon, he thinks, once the room starts to cool down. The doctor leaves your room and comes back to check on you after 15 minutes. He finds that your body temperature has dropped even more and that you are shivering. He concludes the room was not cool enough so he dials up the air conditioner even more to really get the cold air blowing. The doctor leaves and
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[T]he most significant take away — the new news, if you will — was Yellen’s response to an audience question on why inflation remained so low at a time when the unemployment rate was hovering just above 4%.
After running through a “whole range of idiosyncratic kind of factors, most of which may be temporary/transitory things that affect inflation,” Yellen admitted she was “no longer certain” about inflation’s eventual rise. “My colleagues and I are not certain that it is transitory,” she said, referring to the chronic undershoot of the 2% inflation target.
Not transitory? Will this turn out to be another “conundrum” for the Fed? At her Sept. 20 press conference, Yellen elevated the chronic inflation undershoot to a “mystery,” a term Powell invoked at his confirmation hearing
So what’s the Fed’s approach to dealing with the chronic inflation undershoot? Why, raise interest rates and pare the balance sheet.
If this seems counterintuitive, it is. I have written that the Fed should either put up — run a more expansionary monetary policy to boost inflation — or shut up. Policy makers can’t continue to fret over low, stable inflation, on the one hand, and, on the other, implement policies that, all things equal, will slow economic growth and depress inflation further.
[Fed] officials remain perplexed by the past year’s surprising weakness in inflation. And yet there is something truly strange about that. How can the Fed continue to expect rate increases when it has no idea what’s going on with inflation? How can you know the economy will behave in a way that justifies rate increases while simultaneously admitting you don’t know how the economy is behaving?
The central bank appears to have put itself in an epistemological jam.
Call me crazy, but if the Fed feels it needs to raise interest rates because it is "worried about trends that could push inflation above [its] 2% objective" then maybe, just maybe its past rate hikes and signaling of future rate hikes might explain the low inflation over the past decade. Who knows, maybe monetary policy matters for long-run inflation trends after all. Or as Aaron Klein says: