The New Keynesian Synthesis, Explained

When a central bank moves the cash rate, it’s acting on a specific model of how the economy works. That model is the New Keynesian synthesis, and it’s the closest thing modern economics has to an operating manual for monetary policy. Every inflation target, every rate decision, every line in a central bank statement about “returning inflation to target” comes out of this framework. Understanding it is the difference between watching the news cycle of rate rises and cuts and actually seeing the logic behind it.

This isn’t a history of how these ideas came together, nor an account of what exactly got synthesised between classical and Keynesian economics. It’s a walk through the intuition: how the pieces of the model fit together, and where they hold up worse than the theory suggests.

Output and Output Gaps

Every economy has a speed limit. Economists call it potential output, or Y*. It represents how much an economy can produce when its workers, factories, and capital are all fully but sustainably employed. Actual output (also known as GDP or Y) moves around this limit. The difference between the two, Y minus Y*, is called the output gap. Sometimes it’s negative and Y sits below Y*, and resources go idle. Sometimes it’s positive and Y pushes above Y*, and something has to give.

What a Real Bond Crisis Looks Like

People throw around the word "crisis" every time yields move. It's worth being precise about what that word actually covers, because the different versions call for completely different responses.

Markets reprice all the time as new information arrives. That's their job. A repricing on its own is not news. What matters is the size of the move, the speed of the move, and whether anything underneath the market itself is breaking. Those questions are what separate the ordinary from an actual crisis.

Potential: the speed limit for the economy

Every few weeks someone describes potential growth as the economy’s speed limit. The metaphor is useful, but it is attached to the wrong thing. The real speed limit is potential output, the level: the amount the economy can produce sustainably with inflation at target. Potential growth is only the rate at which that limit itself moves. The two answer different questions, and mixing them up produces bad readings of the cycle.

This post uses a small model of Australian potential output to make one point. Conventionally, the output gap is the difference between actual and potential output, a difference between two levels. This model goes one step further and splits that observed difference into an inflation-related component and a residual. Potential growth tells you how fast the potential level is moving. It does not tell you the sign of the gap, and neither potential growth nor observed GDP growth on its own tells you where inflationary pressure sits.

Two levels and the distance between them

Let's not mention the war

The latest in a series of monthly reflections on the war in Iran.

Six months ago the United States began the largest military campaign it has fought since 2003. It killed a head of state on the first morning. It has struck more than eleven thousand targets. Eighteen American service members are dead and 756 wounded. The Strait of Hormuz has been closed (again) since 11 July.

You would barely know it.

That is not an accident, and I do not think it is simple neglect. The silence is the most informative thing that happened in August.

Weekly Energy Update

 Status

• Petrol prices - elevated but stable in August. 
• Singapore refined - elevated
• Crude prices - elevated 
• Natural gas - above early Iran war prices

Charts

Who Fights Inflation

Australian inflation took off in 1973 and did not get back below five per cent, and stay there, until 1991. Eighteen years. Germany peaked at 7.9 per cent and was under 5 within three. The United States peaked at 14.8 and took nine. We peaked at 17.5, and the Reserve Bank's own 1992 conference on disinflation ranked Australia poorly on the unemployment cost of getting there, putting it down to high real rigidities.

Australia has an inflation problem

 Underlying inflation is running at 4.9% annualised and climbing.