In a recent speech to the National Association of Business Economics, Federal Reserve Chairwoman Janet Yellen discussed the difficulties she and her Fed colleagues face in determining when and by how much to raise interest rates. The challenge stems from the fact that their preferred inflation indicators are heading south at a time and under conditions where conventional wisdom says they should be trucking north.
The Fed's bright line for inflation heartburn is marked by sustained price level growth around 2 percent annually. Today's number, at about a half percentage point below that bright line, seems troubling. But meanwhile, the nation is experiencing a growing labor force and low levels of unemployment, which should ordinarily signal more inflation.
Yellen acknowledged that with all their collective wisdom, Fed economists have no consistent explanation as to why inflation is undershooting the Fed's objective. Known for speaking frankly, Yellen called the situation a mystery. Perhaps she sees the situation this way because Fed statistical models, which are calibrated on the basis of past experience, are unable to forecast accurately what is happening to the price level, and thus what might be appropriate interest rate policy.
Could it be that we are living in a period so unlike the past that the best statistical models must be rethought or replaced with something else? And what might have caused the real world to buck the models?
The work of Matt Ridley, author of The Rational Optimist (2010), member of the U.K. House of Lords, and former editor of the Economist, suggests that we account for growing interconnections to the "collective human brain." That's right. We should have a variable that accounts for humankind's ability to tap into the combined knowledge of the 6 billion people who inhabit the Earth and who form the world economy.
Wow! But how might that be done?
This may sound crazy, but why not consider the number of people who have iPhones, a piece of technology that is still just 10 years old? Smartphones enable people across the world to connect to the worldwide web, to communicate, to organize transactions, to buy and sell.
This is revolutionary stuff that we're still grappling with. To an economist, smartphones can be thought of as origins for individual supply curves. Each individual with a smartphone can know about opportunities to offer his or her goods, services, and knowledge to the world's producers. More smartphones mean more supply. More supply, with all else equal, means lower prices. Could that be the reason prices aren't rising to the degree we've come to expect?
Today, more than 2.5 billion people, or about 42 percent of the world population, have smartphones, up from zero in 2006. I suggest that the Fed economists give serious thought to the number of people who have smartphones.
Giving thought to something is one thing, and successfully specifying a variable for an econometric model is something else. Still, there may be a fundament lesson here. It's called supply-side economics. Something that came into style with the Reagan administration and was later forgotten may help solve the low inflation mystery.