IU economist at Jackson Hole: Analysis should make room for ‘confounding dynamics’

Central bankers and academic economists often see the job of monetary policy as keeping the economy on a steady path guided by a target rate of inflation and an ideal rate of growth in economic output.

But Indiana University economist Eric Leeper and a co-author argue that they should be paying more attention to so-called disparate confounding dynamics — factors such as unstable prices in some sectors and puzzling behavior of long-term rates that are often ignored in setting policy.

Leeper and Jon Faust of Johns Hopkins University made their case in a paper titled “The Myth of Normal: The Bumpy Story of Inflation and Monetary Policy,” which they presented Saturday at the annual Jackson Hole, Wyo., Economic Policy Symposium sponsored by the Federal Reserve Bank of Kansas City.

Eric Leeper

Eric Leeper

They argue that economics and policymakers need to make a concerted effort to include disparate confounding dynamics, or DCDs, in their modeling and analysis.

“We can do better,” Leeper said. “Over time, we will be able to slowly add the most important of these disparate confounding dynamics to our more rigorous frameworks.”

The invitation-only Jackson Hole meeting includes high-level discussions by central bankers, policymakers and economists from around the world. Attendees this year included Federal Reserve Board Vice Chairman Stanley Fischer, Bank of England Governor Mark Carney and Reserve Bank of India Governor Raghuram Rajan, as well as several regional Federal Reserve presidents.

The paper co-authored by Leeper, a professor in the Department of Economics in the College of Arts and Sciences and a former Federal Reserve Board economist, is one of four academic papers that were presented and discussed at the symposium.

He and Faust take issue with what they call the “nice view” that dominates macroeconomic policy, which holds that the goal is to keep the economy as close as possible to a steady state undisturbed by external shocks. Under that approach, policymakers and economists either ignore confounding dynamics or “look through” them, using statistical methods that wash out their effects. Cyclical shifts in economic activity are accounted for, but long-term and structural changes are outside the realm of policy.

The name “nice view” is a play on the so-called NICE decade of 1995-2005 – an acronym for noninflationary and consistently expansionary. But Leeper and Faust argue that, even during the NICE period, it was a myth that confounding dynamics were not significant.

The authors analyze several examples of DCDs that should be incorporated into analysis and modeling.

One is labor share, the fraction of total income that goes toward compensation for workers. It has been shrinking for 20 years, a trend associated with growing economic inequality. If labor share were to grow, that would arguably be a good thing. But under the nice view, policymakers should push back by raising interest rates to prevent overheating of the economy.

Another confounding dynamic is demographic change such as the aging of populations, which affects productivity and consumption. An older population, for example, uses more medical care, raising prices and leading to higher-than-expected inflation for services.

Leeper and Faust commend central bankers for their efforts to allow for confounding dynamics in guiding policy through the recovery from the financial crisis of 2008-09. But they worry that, with the crisis receding, decision-makers could “go back to a policy framework founded on myth.”

In the long term, they write, central banks and policy organizations should shift resources into studying disparate confounding dynamics in an effort to develop more useful and accurate models. Until that happens, they say, officials should continue to bring an awareness of DCDs into their policy discussions in a transparent and systematic manner.

You can read more about the Jackson Hole symposium, including coverage of Leeper’s paper, in The New York Times, Wall Street Journal, Bloomberg News Service, Financial Times, Market News International, MarketWatch and elsewhere.

Tags: , , ,