Tuesday, April 27, 2021

Inflation and expectations at NRO

Essay at National Review Online. 

Inflation: The Ingredients Are in the Pot, and the Fire Is On. (But will it boil?) 

John H. Cochrane and Kevin A. Hassett

The end of the COVID-19 recession is in sight. If the Atlanta Fed’s real-time estimate of 8.3 percent Q1 growth proves accurate, real GDP is only four-tenths of a percent below the all-time high from Fall 2019. And the vaccinated, post-COVID boom is on the way. Most people have money, and are ready to spend it. Yet unprecedented fiscal and monetary “stimulus” continues.

Is persistent inflation around the corner? Inflation and commodity prices are up sharply. The latest Michigan survey shows people expect 3.7 percent inflation next year. Shortages of everything from lumber to semiconductors have raised input prices for businesses, while the percentage of small businesses reporting that they cannot find qualified workers is at a record high. The ingredients are in the pot, and the fire is on.

But will the pot boil? Since 2008, observers have warned of imminent inflation, yet inflation has barely budged.

Inflation is hard to foresee, because inflation today depends in large part on what people expect of inflation in the future. If businesses expect higher prices and wages next year, they raise prices now. If workers expect higher prices and wages next year, they demand higher wages now.

Inflation has been so low for so long that most Americans understandably see persistent inflation as ancient history, and that any blip up today will quickly be reversed.

Yet faith that our government will take prompt action to reverse inflation seems increasingly unfounded.

The Federal Reserve’s new policy framework and its officials’ speeches are eerily reminiscent of the early 1970s, and repudiate the standard lessons of that experience. One may rightly worry that should inflation emerge, the Fed could repeat mistakes of the 1970s.

The Fed has returned to the view that it can and should strive to eliminate “shortfalls” in economic activity. But in the 1970s we learned that economies can run too hot as well as too cold.

The Fed intends to deliberately let inflation run above target, in the belief that this will drive up employment, especially among disadvantaged groups. But in the 1970s we learned that there is no lasting trade-off between inflation and employment. Sustainable employment and wages result only from microeconomic efficiency, better incentives, and well-functioning markets. The record employment and fast-rising wages just before COVID-19 struck, especially among disadvantaged groups, were not the result of inflation or of monetary policy.

The Fed now believes that the “Phillips curve,” linking inflation and unemployment or output, is “flat” and “anchored,” meaning the Fed can run the economy hot for a long time with little inflation, and that a little inflation will buy a lot of employment, not the stagflation of the 1970s.

The Fed has announced that it will delay interest-rate hikes until inflation substantially and persistently exceeds its target, just as it delayed responses in the 1970s.

If they return to the beliefs of yore, central bankers are likely to react as before. Inflation will be quickly dismissed as “transitory pressures” or “supply disruptions.” The Fed will respond slowly, always concerned that really nipping inflation will cause too much economic damage. Officials will give lots of speeches, but take little action.

Unlike in the 1970s, the Fed now knows how important inflation expectations are. But the Fed seems to think expectations are an external force, unrelated to its actions. Expectations are “anchored,” Fed officials say. Anchored by what? By speeches saying expectations are anchored? The Fed has “tools” to fight inflation, it says. What tools?

There is only one tool, but will the Fed use it? Will our Fed, and the government overall, have the stomach to repeat 20 percent interest rates, 10 percent unemployment, disproportionately hitting the vulnerable, just to squelch inflation? Or will our government follow the left-wing advice of 1980, that it’s better to live with inflation than undergo the pain of eliminating it?

Moreover, stopping inflation will be harder this time, in the shadow of debt. Federal debt held by the public hovered around 25 percent of GDP throughout the 1970s. It is four times that large, 100 percent of GDP today, and growing. The CBO forecasts unrelenting deficits, and that’s before accounting for the Biden administration’s ambitious spending agenda.

If the Federal Reserve were to raise interest rates, that would explode the deficit even more. Five percent interest rates mean an additional 5 percent of GDP or $1 trillion deficit. The Fed will be under enormous pressure not to raise rates.

More starkly, any effort to combat inflation will have to involve a swift fiscal adjustment. Inflation comes when people don’t want to hold government bonds, or Fed reserves backed by government bonds, because they don’t trust the government to repay its debts. Stopping inflation now will mean a sharp reduction and reform of entitlement spending programs, a far-reaching pro-growth tax reform, and no more bailouts and stimulus checks. And all this may have to be implemented in a recession. Almost all historic inflation stabilizations required far-reaching fiscal and pro-growth reforms.

But the Fed dares not even dare say what its “tool” is, let alone promise any such painful action. Fiscal policy is busy throwing money out the door and incentives out the window. Once people ask the question, how long will they believe that inflation will provoke such a sharp retrenchment?

When demand soars and supply is constrained, inflation will rise. When people question policy and find it feckless, they expect more inflation, and inflation grows more and becomes entrenched. Persistent inflation grows suddenly, unexpectedly and intractably, just as it did in the 1970s. Some worry that a burst of inflation will lead the Fed to raise rates and thereby stymie the recovery. It is a far greater worry that the Fed will not react promptly, thereby letting inflation and inflation expectations spiral upwards.


 

22 comments:

  1. And of course Kevin Hassett (as a member of the Trump administration) was busy pushing for a reduction in the federal debt, or an end to open market operations (FOMC buying government debt), or a long lasting reform of the banking system?

    "Almost all historic inflation stabilizations required far-reaching fiscal and pro-growth reforms."

    I presume that the Reagan tax cuts (that exploded the debt and the interest payments on that debt) and that were eliminated in large part by Bush I, don't count as part of the far-reaching fiscal reforms.

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    Replies
    1. I don't think he had any influence.

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    2. https://en.wikipedia.org/wiki/Kevin_Hassett

      "In 2007, Hassett argued that the United States was on the wrong side of the Laffer curve in terms of corporate tax rates."

      "In the Trump administration, Hassett was the 29th Chairman of the Council of Economic Advisers from September 2017 to June 2019."

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  2. John,

    "There is only one tool, but will the Fed use it? Will our Fed, and the government overall, have the stomach to repeat 20 percent interest rates?"

    Government bond auctions will start failing long before the Fed reaches 20 percent interest rates. Right now the Ponzi ceiling is at about 7-8% interest rates across all maturities of government debt.

    After that point, all of the federal government's tax revenue goes toward debt service.

    But more than that, before the Fed could even consider raising interest rates, it would need to find buyers for about $5 trillion in existing government debt.

    https://fred.stlouisfed.org/series/FDHBFRBN

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  3. Best guess is that the increases in the relative prices of inputs are indeed temporary, and that the Fed will keep the policy rate at zero through early 2024, at least. For reasons you've discussed before, that makes me confident that we'll actually be undershooting the 2% inflation target next year.

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    1. I'm predicting a small bump up in rate--say 25 points-- by the Fed this fall---partly in response to increasing prices and wages, but mainly as a signaling gesture.
      I'll probably turn out to be wrong, but I think John and Kevin are more wrong about an imminent wage-price spiral. Workers across a broad range of incomes don't have bargaining power for annual salary increases. It was a different story in the 70's when there was more union participation and expectations were different (or so I've read, I was in diapers).

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  4. This time really does seem to be different. Central Banks seem to have a real hard time being symmetric. "Inflation dove" vs "inflation hawks", instead of what does the data say about a lack of, or surplus of stimulus.

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  5. Since 1/1/2001 the Univ. Mich. time series for the expected inflation index has exhibited zero trend. The mean value for observations from 2/1/2001-2/1/2021 (241 monthly obs.) is 2.93% (s.e.: 0.5835%). An observation (3/1/2021) of 3.7% is within 1.32 standard deviations, and likely not significant (statistically), per se. The PCE chained-price index and the year-over-year change in CPI-all items urban consumers both show greater variability (standard error: PCE, 0.935%; CPI, 1.22%) over the same period (mean values: PCE, 1.7697%; CPI, 2.055%; neither statistically significant).

    From December 2008, the Univ. Mich. index of expected inflation has been consistently higher than either PCE inflation or CPI inflation. Full chart can be found by navigating to https://fred.stlouisfed.org/graph/?g=DtQ3

    The above doggerel doesn't negate the cautions of the blog article in the least. If the doggerel above has any import, it might be that a single data point is a frail reed on which to hinge an argument.

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  6. "The Fed has returned to the view that it can and should strive to eliminate “shortfalls” in economic activity."

    No, supply shocks, including those self-imposed, do not exist. There were no oil price hikes in the 70's were there?

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  7. "The Fed now believes that the “Phillips curve,” linking inflation and unemployment or output, is “flat” and “anchored,” meaning the Fed can run the economy hot for a long time with little inflation, and that a little inflation will buy a lot of employment ..."

    Flat so long as inflation stays constant and only real shocks occur.
    Anchored? Yup, people are stupid, right?

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  8. Unless someone here can show how a wage breakout will occur as in the 70s, then no-one can elucidate on how Inflation actually rises for a significant period

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    1. 1. Supply shocks.
      2. Drop in the demand for money, after this largely self-made contraction is over, as people would no longer be scared out of their brains. FED could sleep through this so as not to have to raise interest rates, for that would not be nice. :-)

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  9. Inflation is hard to foresee, because inflation today depends in large part on what people expect of inflation in the future. If businesses expect higher prices and wages next year, they raise prices now. If workers expect higher prices and wages next year, they demand higher wages now.---JC

    If a business or a laborer can raise their price now and have it stick, they will raise prices regardless of what they believe the future rate of inflation will be.

    And vice versa.

    I don't have the figures in front of me, but consumers in Japan expect higher rates of inflation. According to this FRED chart, the Japan CPI today is almost unchanged from 1997.

    https://fred.stlouisfed.org/series/JPNCPIALLMINMEI

    Indeed, one reason so many people dislike inflation is they believe inflation will inflate costs, but they will be unable to increase the price of their labor or products.

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  10. Are you backing off the FTPL?

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  11. Comment on the Fed no longer publishing M1 and M2 weekly numbers anymore (just M2 on a monthly basis now, 1 month in arrears, if I recall correctly)?

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  12. Dr. Cochrane,

    In the comments of a WSJ article on inflation, people write that they remember the times of 10% interest on Certificates of Deposit, and how great that was. My first thought was "Hmm, the real rate of interest was probably about the same as it is now. It's not like the Fed can change the [long term] real rate of interest. Only supply/demand can do that".

    Is that correct?

    Similarly, you hit on something a commenter there wrote:

    "If the Federal Reserve were to raise interest rates, that would explode the deficit even more. Five percent interest rates mean an additional 5 percent of GDP or $1 trillion deficit. The Fed will be under enormous pressure not to raise rates."

    Why would that be true? The real rate of interest, as measured by time premium and risk premium, faced by the US government should remain about the same. It will be 5% higher in nominal terms, but there will be more ("nominal") dollars and Americans will earn more of them to pay for the higher "nominal" interest. Could you explain why the deficit nominally "exploding" is an issue?

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    Replies
    1. Great questions. Real (after inflation) rates were indeed low throughout the 1970s. From the 1980s on though, real rates of interest were very large. Whether that was understood ahead of time or reflected an expected return to inflation that did not happen is a somewhat open question. Yes, only supply and demand should be able to move the expected real interest rate, at least eventually. But inflation does seem to be a bit "sticky," and the Fed's nominal interest rate changes do seem to affect real interest rates for quite some time. Yes, in the last point I mostly meant a 5% real rate of interest as the same principles apply to the government. However, a 5% nominal rate with 5% inflation would still register as a $1 trillion deficit. The fact that we are implicitly inflating away debt by $1 trillion to "pay for it" might not register. So, in terms of political pressure and bond market perceptions, it's not so obvious that 5% nominal and 5% inflation would be a wash.

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    2. Anonymous,

      Something else to consider. The federal government makes interest payments in nominal tax dollars based upon a nominal economic growth rate.

      T (Tax Revenue Growth Rate) = NGDP (Nominal Growth Rate) * TR (Tax Rate)

      NGDP = RDGP (Real Growth Rate) + INF (Inflation Rate)

      Under a stagflation scenario, inflation may rise, but real growth may go negative. In that event, even inflation does not generate sufficient tax revenue to make the interest payments on the debt.

      For instance:
      INF = 4%
      RGDP = -6%
      TR = 20%

      NGDP = -6% + 4% = -2%

      T (Tax Revenue Growth Rate) = -2% * 20% = NEGATIVE 0.4% even with 4% inflation.

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    3. Thanks very much Dr. Cochrane and FRestly.

      FRestly, if real growth is negative, real tax revenue would decrease regardless of inflation. So, unless you are making the case that inflation *causes* decreased real growth, I don't see how inflation would change the ability of the government to pay its debts, Dr. Cochrane's response excluded.

      I think I am implicitly taking a Friedmanian perspective that only the quantity and velocity of money affects prices, etc...

      I understand the short-term stuff is trickier.

      I was born in 1994 so the historical part of the 1970s/1980s is a bit lost on me. Thanks to both for the insight.

      It sounds like the short-term effects can be nefarious beyond "menu costs".

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    4. Anonymous,

      "So, unless you are making the case that inflation causes decreased real growth..."

      Ah, causality - this is always a tricky subject in economics.

      Economists try to rely on "expectations" or "rational expectations" but they miss that any expectations (rational or irrational) must be grounded in a legal framework to have any traction.

      For instance, without the protection of property rights, everything taught in economics is essentially meaningless.

      I can expect to be able to sell a house that I build or crops that I grow, but that expectation is meaningless if someone else (government included) can steal it from me without recourse.

      Also,

      "It sounds like the short-term effects can be nefarious beyond menu costs."

      The "short term" can last a very long time.

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  13. "Or will our government follow the left-wing advice of 1980, that it’s better to live with inflation than undergo the pain of eliminating it?"

    Meanwhile the left-wing: ​https://noahpinion.substack.com/p/why-do-people-hate-inflation
    The last two paragraphs from the post:

    "In other words, people probably hate inflation because of upward nominal wage rigidity. That means economists should study upward nominal wage rigidity more. Why is it so hard for workers to negotiate cost-of-living raises? Why was this so hard even in the late 60s and 70s, when unions were much stronger than they are today? What is broken in our wage-setting process?
    If we can answer that question, we might have a chance of fixing it. And if we can fix that — if we can figure out how to let workers get paid more when prices go up — then we can make inflation a much less scary thing than it is now."

    Coming from a country with high inflation, this only sounds all too familiar. The next step would be to suggest price controls and mandatory wage increases.

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