Wednesday, March 10, 2021

Inflation outlook at NRO. 1970s all over again?

Essay on monetary policy in National Review Online

Short version: The Fed's monetary policy has returned to the intellectual framework of the late 1960s. At best "expectations" now float around as an independent force, manipulable by speeches, but not tied to patterns of action by the Fed as analysis since the 1980s would require. 

If you follow the conventional reading of how monetary policy works, that observation leads to a natural prediction:  we're on the verge of reliving 1970s inflation. (Fiscal policy, entitlements, regulation and cities seem to be headed also to 1970s policy on steroids.) 

True, the Fed says "we have the tools" to stop inflation should it break out. But that tool is to rerun 1980. Does the Fed have the will? Will the Fed really induce a 2 year agonizing recession to bring down inflation, followed by 15 years of historically unprecedented high interest rates? Or will the Fed do what it did three times before that -- half-hearted interest rate rises that brought milder recessions, and a quick backtrack? Having even a nuclear weapon is useless if people stop believing you will use it. 

I don't follow that conventional reading, so I'm not confidently predicting inflation. I worry more about fiscal affairs directly than about the Fed, which leads to a fear of a larger but less predictable inflation, that the Fed will have little power to stop. But mine is definitely a minority view.   

Does the Fed’s Monetary Policy Threaten Inflation? (Contains Spoilers)

The central bank is headed back to the Seventies — a rerun that no one should want.

Does the Fed’s monetary policy threaten inflation? By conventional measures, yes. But those conventional measures have failed in the past. I believe that the short-run danger is less than it appears, but the long-run danger is larger.

If one reads Fed statements through conventional glasses, monetary policy seems to have been reset to the 1960s, and we know how that worked out.

For example, in a March 2 speech, Fed governor Lael Brainard states that

"..the new framework calls for monetary policy to seek to eliminate shortfalls of employment from its maximum level, in contrast to the previous approach that called for policy to minimize deviations when employment is too high as well as too low."

(I don’t intend to pick on Brainard. This is just a recent speech that explains clearly and concisely things that many Fed governors have said, and appear in official policy statements.)

Indeed, this represents a dramatic repudiation of the macroeconomics consensus since the early 1970s. In the 1960s, the then-dominant Keynesian paradigm regarded any shortfall of output or employment, relative to a line connecting peaks, as a deficiency of aggregate demand, remediable by fiscal or monetary stimulus. The goal of macroeconomic policy should be to fill up the valleys.

In the 1970s we discovered that economies could run too hot as well as too cold. Much as a healthy housing market has some empty houses for sale and people moving, a healthy job market has some people between jobs or looking for better jobs, and others taking time off to study, or to tend to families or other pursuits.

Most deeply, macroeconomists realized in the 1970s that the long-run level of employment (i.e., the labor-force-participation rate) and long-term wage and economic growth are the job of structural, microeconomic efficiency, not outcomes that printing more money can solve. Macroeconomics since the 1970s has thought of monetary and fiscal policy as aiming to reduce economic volatility. The Fed is going back to the 1960s filling-valleys view.

Brainard adds that the “long-standing presumption” that “accommodation should be reduced” when the economy is running at full steam “may curtail progress for racial and ethnic groups that have faced systemic challenges in the labor force.” So “appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

Just how long? Well, “Maximum employment is a broad-based and inclusive goal assessed by a wide range of indicators.” And the Fed now believes that there is a “low sensitivity of inflation to resource utilization,” meaning that it can run the economy really hot for a long time without causing inflation, or that a little bit of extra inflation will do a lot of good.

This is as 1964 as A Hard Day’s Night. Economics textbooks draw the static Phillips Curve relating inflation and unemployment, and deride the conventional wisdom of the time that the Fed could permanently lower unemployment by tolerating a little more inflation. Push on it, and the Phillips curve shifts to more inflation and unemployment, as it did in the 1970s. Today’s Fed is even more radical, though. While it has traditionally understood that its power is limited to guiding the overall economy, the Fed has now taken on inequality and social justice. Climate change is next. Another bit of hard-won 1970s wisdom was that with one tool, monetary policy could control one thing well — or, it could name ten goals, but with one tool, hit each one badly.

We also learned in the 1970s that clear goals are important to monetary policy. Using a “wide range of indicators” along with this word salad of a “strategy” is license to pick the number you want to justify whatever you want to do at the time.

When inflation does pick up, you can tell how the Fed will process the news. Brainard on inflation:

Inflation is likely to temporarily rise above 2 percent. . . . Transitory inflationary pressures are possible if there is a surge of demand that outstrips supply in certain sectors. . . . Any inflationary bottlenecks would likely be transitory. . . . A burst of transitory inflation seems more probable than a durable shift above target in the inflation trend and an unmooring of inflation expectations to the upside.

The Fed said much of the same in the 1970s. Transitory factors. Bottlenecks. Oil prices.

If you add it up, it is hard not to see here the policy package of the late 1960s and early 1970s: deliberately running the economy hot in a vain attempt to raise employment permanently; a plan to let inflation run above target before doing anything about it; excuses for inflation when it comes; and a smorgasbord of numbers and goals to cherry-pick from. I have heard strong denials from friends at the Fed. But dear friends, from the outside it’s sure hard to see what’s different.

Brainard, like other Fed officials, speaks of “anchored” inflation expectations. Anchored by what? Are expectations an anchor, or a balloon in a temporarily windless sky? Given the number of words coming out of the Fed on this long-run strategy, perhaps they believe inflation expectations are anchored by great speeches. So did their predecessors in the 1970s, culminating in President Ford’s ludicrous Whip Inflation Now (“WIN”) buttons.

Anchoring is important. If people do not expect inflation to continue, when they eventually see some of it, they treat it as a transitory blip and do not build inflation into the prices they charge or are willing to pay, the wages they offer or demand, and the prices of assets they buy and sell. Once people expect inflation in the future, we have inflation now.

There is only one “anchoring” that makes sense: anchoring by actions. People must believe that if inflation got out of hand, the Fed would quickly do what it takes to bring it back. If that means reliving the awful recessions of 1980–1982, people must believe the Fed would do it. Today, anchored expectations depend on fiscal policy as well. People must believe that if inflation were to break out, the federal government would swiftly retrench, stop spreading money around like fertilizer, and put its house in order with a tax and entitlement reform.

Indeed, Brainard writes, 

“If, in the future, inflation rises immoderately or persistently above target, and there is evidence that longer-term inflation expectations are moving above our longer-run goal, I would not hesitate to act and believe we have the tools to carefully guide inflation down to target.”

 It matters that people believe this, even if the actions cause immense short-term pain. Do people still believe the Fed has that will? Do people believe that the Treasury Department and Congress have the parallel will to take fiscal steps to contain inflation if it should come?

Does the Fed really have the tools to do it? I am doubtful. For ten years, interest rates were zero. (Interest rates were either too high or too low, depending on your view of things, but stuck at zero in any case.) For ten years, the Fed ran massive quantitative easing after quantitative easing. Inflation just sailed along slightly below 2 percent. This episode suggests the Fed has a lot less power than it thinks. But that is also a cheery view, as if the Fed’s interest-rate and bond-purchase tools are relatively powerless, then not much of what the Fed is doing will cause inflation either. In the current economy, fiscal policy and fiscal anchoring seem the greater danger to inflation than even the monetary mistakes of the 1970s.


  1. Are any historical lessons applicable in the world of Qe and huge debt.? The US has massive systemic risk.

  2. A couple points you make that concern me on the inflation side:

    (1) You mention fiscal policy may have little effect but do mention that more true power to control inflation lies with the Treasury and Congress... So the Fed can do whatever it wants to stiemy inflation concerns, but if Congress keep pumping out Trillions then there is little the Fed can do to stop the wave. As I write this US Congress looks to sign another $1.9T cheque to what?.... bring back the economy? Personal savings rates are up and we've regained growth, so what do we need another $1.9T for? (I say this half sarcastically as I truly feel for those in the bottom rungs of the socioeconomic ladder who have been hit disproportionately hard by this virus)

    (2) I feel as though we have seen large inflation in some asset classes that isn't properly captured by the CPI (someone please correct me on this if I am wrong)... while "shelter" is encapsulated as a consumer expense it does not properly reflect the inflation in housing prices. If I have my $100k home on a 20y mortgage, and sell it to buy a $150k home on a 30y mortgage with a lower interest rate it may show that my "shelter" costs have gone down when in reality I have levered up on debt. Same could be said of vehicle purchases where we now have financing plans that on average extend past 60 months.

    So are we truly as well off from a CPI metric? Or are we hiding the pain in debt that will only materialize when faced with a true economic/liquidity crisis?

  3. So, how exactly are we going to see substantive inflation taking place over ensuing years with most economists being wrong with all the money that appeared on the scene post the Financial Crisis?
    If we in a low growth economy, post getting back to a baseline of pre Covid economy and growth outlook which then was not so great, what are the catalysts for that growth?
    What is debt capacity of US in terms of magnitude of debt it can carry vs. the ability to raise taxes which in a comparative view vs. other mature economies might suggest there is flexibility here?
    If we in a low growth economic environment post return to baseline should the worry be more about stagflation if one is really worried about inflation?
    Like you i think the power of the Fed is overestimated, and do worry about the fiscal side of the equation more. But that has to take in to account not only tax capacity, but also the relative debt burden of US vs. other countries. If all levered up seems less of a concern.

  4. I always read your posts. You are great.

  5. It was one thing to raise rates in 1980 with debt ~30% GDP quite another to do it now with debt 100%+ of GDP. Refinancing all that at 1980 rates mean we need to borrow more just to pay interest. Much less find anything else...

  6. a return to the 70s would see severe supply shocks and wages rising to compensate.

    you really have not addressed that. Did you live in the 70s?

  7. Why, why, why? This is the equivalent of technical regress.

  8. Some thoughts...
    One would have had to have lived through the 60s, 70s and 80s to have an appreciation of the author's take on this topic. Esp., one would have either had to study that period or lived through the years leading up to and during Paul Volker's chairmanship of the Federal Reserve and the monetary policy impacts that Chmn. Volker's decisions gave rise to, to have gained a deep appreciation of the damage that those policy decisions wrought. Those amongst us who have come of age during the past two decades can hardly imagine a world in which the Fed Funds rate is 10% and higher, mortgage rates are 22% or greater, or a world in which the Fed Funds rate rises at the pace that it did in 1981-2. Could today's financial titans survive at their current elevated gearing ratios under those conditions?

    John Cochrane is right to be concerned. History has demonstrated that the FOMC usually gets it wrong; that its sense of timing is far from impeccable; that it misses the turn going in as well as coming out; that its members' hubris is the cause of much grief and woe amongst those who have to bear the greater part of the subsequent economic costs; that it shields its own members from recriminations or consequences; that those least able to bear the burden of faulty policy contribute least to the circumstance that create the necessity for the FOMC to act, yet suffer the greatest harm and take the longest to recover, if ever recovery is possible for them.

    Good on John Cochrane for his courage and boldness to draw our attention to this emerging issue of concern.

    1. Old Eagle Eye,

      "History has demonstrated that the FOMC usually gets it wrong; that its sense of timing is far from impeccable.."

      So this has been going on for a while, and yet...

      "Good on John Cochrane for his courage and boldness to draw our attention to this emerging issue of concern..."

      FOMC mistakes in policy are an emerging issue?

      You can't have it both ways.

      "Could today's financial titans survive at their current elevated gearing ratios under those conditions?"

      Sure they (including the federal government) could, but only by relying on less debt and more equity.

    2. "that it misses the turn going in as well as coming out" I'm not aware of any anti-cyclical interventions which did not peak long after the peak of the crisis, making private sector recovery more difficult and imposing long-term costs. In Australia, the Rudd government's GFC intervention was a classic example of what not to do.

  9. When will we see inflation in Japan?

    People who are concerned about inflation should devote a few paragraphs anyway to the elimination of property zoning.

    Even a nation on the gold standard would have inflation (as measured) if it was afflicted by chronically worsening housing shortages. More importantly, it would have declining living standards.

    I will note that two luminaries of the industry, Martin Feldstein and Paul Volcker, spent the last 40 years of their lives intoning against impending higher rates of inflation and subsequent interest rates.

    Instead, the opposite happened.

    I am not a fan of social welfare programs. However, I think a democratic society, if it wishes the employee class to buy in, needs to maintain chronically tight labor markets.

    Rather high inflation than high unemployment.

    1. Still sticking with the Phillips Curve nonsense?

  10. I don't follow your last paragraph. The Fed raised interest rates while modeling below 2% inflation years out. From a revealed preference perspective, they wanted an inflation range below 2%. How does their actions, given their expectations, in any way support the idea that they were unable to hit their inflation targets?

  11. So far the Fed and the Government have gotten away with craeting money at an incredible pace. Maybe they have discovered the Founatin of Yout or the Perpetual Motion Machine. Maybe they haven't.

    I think we should take Bob Marley's warning seriously:

    “Every day the bucket a-go a well, one day the bottom a-go drop out.”

  12. An article appearing in today's The Wall Street Journal titled "Wave of New
    Debt to Test Treasury Market", by reporter Sam Goldfarb, describes the onset of jitters in the bond market to the on-set of a steep ramp-up of bill, note, and bond issuance by the Treasury department to fund the latest expansion in spending by the government.

    The response: rising interest rates demanded by buyers of new Treasury issues amid expectations of increasing inflation rates going forward.

    Also in today's issue of The Wall Street Journal, a book review written by Edward Chancellor (in the 'Bookshelf' column) of "Empire of Silver" by Jin Xu, editor at the Financial Times, Shanghai, PRC (Yale, 374 pages, $30). The book will find an audience amongst those who take an active interest in monetary policy and its effects on inflation, economic development, and national competitiveness.

    From the introduction of the book review:
    "China may have been the first country to experiment with paper money, but modern finance took off in Europe rather than the Far East. In the West, banks and credit markets seeded the growth of capitalism. By contrast, China gave up on paper money long before Columbus set sail for the New World. From the 15th century through the 1930s, the Chinese were stuck with silver
    money. Without access to credit, the Middle Kingdom yielded economic primacy to England and later the United States."

    The book, as noted by Mr. Chancellor, provides interesting insights into the inter-play between commercial interests, political decisions both internal and external to the country, and the consequences of excessive supply of paper money not backed by sufficient commodity reserves held by the issuer.

    According to the author, the advantage of paper currency was recognized by commercial interests early on. One version of paper currency traded at a premium to the metallic currency of the day, for example. But, as the history tells it, excessive production of paper currency invariably led to inflation and hyper-inflation. It remains to be seen whether history will repeat in our own case under the on-slaught of excessive expenditures authorised by Congress in 2020 and now in 2021, with more to come (apparently).

    Mr. Chancellor's column ends with this apt quotation from Jin Xu's book: “History always knocks twice, first as comedy and then possibly as tragedy.”

    The footnote to the column states: 'Mr. Chancellor is the author of “Devil Take the Hindmost: A History of Financial Speculation".'

  13. to repeat myself but in a different way.
    how will inflation rise to dangerous levels.
    I am very interested in how wages will jump or have you and others not thought that through.
    Perhaps go back to the 70s and discover why inflation rose would be a good thing to do.

  14. "If you add it up, it is hard not to see here the policy package of the late 1960s and early 1970s: deliberately running the economy hot in a vain attempt to raise employment permanently;"

    With all due respect, I think you've badly estimated one of the very important goals of the Fed's policy change at Jackson Hole in August 2020. Social/ESG goals aside (a different topic for a different post...), the primary motivation behind literally redefining their 2 mandates was and is NOT to raise employment permanently.

    The primary motivation is to retain policy tools which have the chance to be effective.

    The most dangerous characteristic a Central Bank can have is lack of credibility. In the case of the past 20 years, it is more precisely: the lack of INFLATION-CREATING credibility. If I don't believe your policies have the ability to create inflation - when that is a prominently stated goal - I will stop listening to you. You become irrelevant. Your policy tools do not move the needle. Simply, it is what happens when deflationary mindsets take not only root, but take hold.

    The BOJ has gone down this path. Nobody cares what they do. It doesn't matter to markets, it doesn't matter to their economy. The ECB is very close to that point, as well. It is a black hole for monetary policy, and the Fed is hell-bent on making sure it does not cross that event horizon (for to do so would render it irrelevant, the scariest thing in the world for a bureaucrat).

    Importantly, the Fed believes it has the tools to deal with inflation - should it arise. Whether they do or not is fully irrelevant. I don't care if you don't think they do or I don't think they do - THEY think they do. They would and do welcome inflation because - as the scarcest macroeconomic thing in the world for the past 12 years - it is insanely valuable. And it would cement in the mind of the market and economy that, dammit, the Fed can create inflation if it wants to. Its tools still work.

    The other side of that coin is too gruesome for them to consider.


  15. Brainard: "I would not hesitate to act and believe we have the tools to carefully guide inflation down to target.”

    Don't you find that alarming? I mean, the words "carefully guide". That's not how it works. In 1980-1982 the Fed beat inflation, but only with a ruthless battle, an intentional recession. Whether the Fed has the guts to do it again, it would help expectations to say

    "I would not hesitate to act and believe we have the tools to ruthlessly force inflation down to target, whatever the cost in jobs.”

    That Brainard would make such a weak statement is almost as bothersome as choosing such a feeble response to inflation.

  16. Your views more or less echo two of my Barron's articles. One from May 21 last year “This Is No Textbook Recession” (the essential questions about the sequencing of the recovery) which envisaged a supply-constrained inflationary scenario and anticipated the change in FED rules to accommodate this; and the other from a couple of weeks ago “With $1.9 Trillion in New Spending, America is Headed for Financial Fragility” A modest inflation could help on debt. But a shift in inflation expectations--which could happen more rapidly than actual inflation--would raise real interest rates and could prove dire for government debt dynamics.


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