Bidenflation and the Powell Shock (2/2)
Will the US need a drastic response to inflation?
Last week, the topic was how the US economy got to the point where inflation was so high - and now comes the turn of the solutions. Why did the Fed mess up? And what can they do to fix this?
Facts, figures, no feelings
Last week, I talked in more detail about US inflation, and discussed the situation. I’m not gonna repeat what I said because I’d have only written one post and not two. Instead I’ll just copy the key takeaways and you go read that one if you haven’t
Inflation is always and everywhere too much money chasing too few stuff. The total amount of nominal spending in the economy determines how high inflation goes, and this can be measured by Nominal GDP better than CPI.
Too much money doesn’t preclude too few stuff. The 2021 stimulus might have been excessive, but it also was coupled with supply shocks that reduced the total amount of things available. Ergo, even on-trend demand would have resulted in inflation, and above-trend demand just made it worse.
The stimulus was only too big because the Fed didn’t do enough. Biden’s stimulus was so big, besides politics, because of uncertainty about how bad COVID would be. This was reasonable. What wasn’t reasonable was the Fed not noticing inflation was getting out of hand and not offsetting it.
The labor market isn’t driving inflation. Wage-price spirals aren’t really possible in the present US given anchored expectations and labor market institutions. The Phillips Curve only exists because of bad monetary policy.
The part with the most important implications for monetary policy is that the fiscal multiplier on real output isn’t zero but the fiscal multiplier on nominal demand is - becuase the Fed offsets the excess demand with tighter policy. Additionally, you only see a negative relationship between inflation and unemployment when things are going badly, since it means that the Fed isn’t doing it’s job - seeing a fat person dieting or an overly thin person bulking up is expected, and seeing someone not care about their weight is generally a sign they consider themselves healthy.
Asleep at the wheel…?
So did the stimulus cause inflation? Well, the problem here is very simple: the Fed didn’t offset the big fiscal stimulus, proving Sumner right and wrong. Why they didn’t do it is a point of debate, but generally there’s three reasons a Central Bank doesn’t do what they should:
They know the problem is a problem, but can’t do anything: for whatever reasons, the Federal Reserve didn’t think it could act without either endangering its independence or provoking some backlash. This happened during the Great Depression, since the Fed wasn’t allowed to lend money to solvent banks facing runs on their deposits - which everyone knew they should.
They know the problem is a problem, but won’t do anything: the Federal Reserve thought inflation was going to go up, but didn’t think it had to pick up the slack or didn’t think it could help. For example, for a big chunk of the Great Inflation, the Fed simply thought it couldn’t do anything about rising inflation, so it didn’t, and inflation kept going up.
They don’t think there’s a problem: for a big part of 2021, it wasn’t self evident that inflation was going to be as widespread or as high as it was, so maybe the Fed bought into “Team Transitory” talking points about the supply chain and erred on the side of caution. This hasn’t really happened in the US besides maybe the 60s, but did happen in mid 2000s Argentina (it ended badly).
Either way, the Fed notice the warning signs until too late (basically, very late 2021 or early 2022) and didn’t tighten policy. I don’t really think the Fed felt threatened politically by Biden, so I don’t really see how they’d want to please him. So the likeliest candidates are “the Fed didn’t think it could help inflation” or “the Fed didn’t think it had to end inflation”. Why would it think either? The first one is easy: for some months in 2021, especially the third quarter, inflation was driven by specific items going up a lot - cars, tourism packages, etc. Less volatile measurements, such as Trimmed Mean PCE Inflation (basically the core of core inflation) only spiked during the early fourth quarter. “Team Transitory” had a very big presence on discussion, so it’s possible that the Board simply agreed with them and thought price instability would go away on its own. The final alternative is a bit more complicated, and you can have two views on it: fighting the last war, or trying to go back to the 60s.
Regarding the first view, the Federal Reserve had trouble meeting its 2% mandate for basically the entirety of the 2000s, which was due to them keeping total spending (NGDP) too low and therefore have too many people without jobs. In brief, this caused the economy to take basically a decade to recover from the Great Recession. The good faith explanation for why the Fed did what it did is that they thought that acting too early on inflation risked repeating this mistake. This also explains their nearly incomprehensible new monetary policy framework, announced in 2020: Flexible Average Inflation Targeting, or FAIT. FAIT was designed very simply: the Fed promises 2% inflation. If it gets too much inflation one year, there will be less inflation later, so that the average inflation remains at 2%. Meanwhile, if it gets too little, it will allow more inflation in the future, so the average returns to 2%. The problem is nobody understood what the hell FAIT was or how it worked, or how long the Fed was going to take to cancel out imperfections. Everyone assumed it meant year to year, but the Fed is obviously not crashing the economy Great Depression style to get to -6% inflation and average 2021 out. One of the most criticized aspects was that they were going to wait until inflation was actually too high to raise rates, which seems inexplicable now looking back but is perfectly rational: the Fed worried about having to spike the football every time inflation (and the economy) were below capacity.
The other possibility is that the Fed thought it shouldn’t, or didn’t have to, stabilize the price level because it believes in a quasi-exploitable Phillips Curve tradeoff that meant that having prices run up for a bit would end up reducing unemployment. This view is fairly well argued by Robert Hetzel at Mercatus, and while I disagree with him on it, I think it’s compatible with the facts and non-trivial. Basically, the story is that the change from inflation targeting to FAIT was caused by the Fed starting to believe that it could influence the unemployment rate directly, and that the flatness of the Phillips Curve during the four previous decades pointed to the trade-off being very mild: because inflation was below 2% at 3.5% unemployment, they could simply get to very low unemployment without significant inflation. Due to these beliefs, they switched over to FAIT, and wouldn’t reduce inflation until the target was exceeded because it was unnecessary. But believing that you can exploit the Phillips Curve was exactly how the Great Inflation started, especially because its flatness relies on monetary policy being optimal (which too much inflation obviously isn’t) and on nobody thinking you were going to do it - which nobody did at first in either case, but during the 70s people eventually caught on.
Either way, it’s actually necessary to look back at the Great Inflaion So let’s look back.
… or driving the wrong way?
I’ve written about the Great Inflation before and I’ll probably bring it up it again because I’m fascinated by it. People make three common mistakes: that the Great Inflation began in the 70s, that it was caused by the oil shock, and that the reason monetary policy was so bad was political corruption. The first claim is simply not very compatible with reality: core inflation was already pretty high by the late 60s, and Nixon was so concerned about it that he literally imposed price controls during the 1972 election. The oil shock bit was elaborated on my post, but even people who do believe in a supply-side explanation also believe that there was a significant component not explained by them.
A lot of people have really odd beliefs about why the Federal Reserve made mistakes for basically two entire decades, which was why such a painful correction was necessary. The traditional story comes from DeLong (1996) and general wisdom: the Federal Reserve didn’t believe it had to end inflation because they believed (wrongly) it was caused by non-monetary factors, and consequently they thought that raising rates would start a second Great Depression. There’s also the fact that Arthur Burns, the Fed Chairman for most of the period, was close to Richard Nixon and considered himself more an economic advisor to him than a referee of the economy. Ergo, Burns consistently made bad calls so he wouldn’t have to damage his friend’s career (also, that Nixon was a huge crook and could just do something really stupid with the Fed for it). I do think that the shadow of the Depression matters, but the answer is much much simpler.
We can actually look at what the Fed actually believed, and what data they based their decisions on at real time. Many economists in the present recommend the Fed follow something called the Taylor Rule: an equation linking the interest rate to a weighted average depending on inflation and the output gap (i.e. the difference between inflation and unemployment). Turns out if you assume they followed reasonable parameters for both, and look at real time data (especially their estimate of economic slack) the Fed’s decisions make perfect sense - so the problem wasn’t in how they decided to tighten or loosen, it ran deeper. The only way your estimates were consistently, persistently, increasingly wrong was that something fundamental about them was faulty - both in theory and empirics.
The fundamental theoretical problem with the Federal Reserve’s theory of the economy wasn’t that they thought stupid things about raising rates - it was that they thought stupid things about economics in general. The Phillips Curve, which was fundamental to their understanding of the economy and the relationship between inflation and unemployment, had basically no microeconomic underpinnings, they believed shockingly dumb things about how it worked in the first place, such as the tradeoff between inflation and unemployment being stable and permanent, that the equilibrium rate of unemployment was very low, and that inflation was very insensitive to economic slack. Empirically, their econometrics were a disaster, plagued by shoddy assumptions, never-verified exogeneity, and stuff like assuming coefficients for things such as the propensity to change were policy invariant - i.e. that higher interest rates didn’t make people save more. Now, this wasn’t unreasonable to believe, given the state of econometrics (tests on exogeneity weren’t proposed until 1972), but these assumptions and methods had to be revised much sooner than they were. The Great Inflation killed Old Keynesian macroeconomics not because of politics and opinions, but simply because it was wrong - positive over normative.
Other people’s blood
The “Volcker Shock” was a period during the late 70s and early 80s when Fed Chairman Paul Volcker hiked interest rates to extremely high levels, sometimes nearing 20%, to tame inflation1. There’s a quote from Reagan economic advisor Michael Mussa I really like about Volcker’s policies: "to establish its credibility, the Federal Reserve had to demonstrate its willingness to spill blood, lots of blood, other people’s blood.” But why?
The traditional, mainstream, wrong and bad view of why Volcker had to do this is quite simple. The Phillips Curve wasn’t flat, insensitive to slack, centered on a very low value, focused on stable, long-term trade-offs, or ruled by nonmonetary issues, so it had to be very steep and very sensitive to short term slack and monetary policy. Volcker had to hike up rates because the only way to get inflation down from the double digits and counting terrain was to bring unemployment way up. This made the Fed’s reputation as an independent agency, giving it credibility and keeping inflation down at a healthy 2% (save for oil hijinks) ever since. Problem is, the Phillips Curve actually was pretty flat anyways (but not the other things), so this view suffers from the start. The reason why is because economists have fundamentally muddled views of credibility and expectations.
Economists normally treat credibility as equivalent to independence, but that’s not quite it. In my view, credibility has three components: personal reputation, i.e. the “respect” given to Central Bankers (whether they’re respected professionals or presidential cronies), independence, i.e. whether the Central Bank takes marching orders from politicians, and commitment, aka whether the Central Bank will actually follow through on what’s necessary to fulfill its targets. Of course, the first one is the least important, but isn’t completely worthless (just ask Mauricio Macri). The second one is very well discussed in economics, and is really importance, but I believe it mostly acts as an obstacle to the third one. Commitment is the most important part of credibility because it’s the one that has the capability to anchor expectations over the long term - and inflation specifically shortens terms, since higher inflation is inherently more volatile and more volatile inflation requires frequent revisions to contracts. 2
The Federal Reserve didn’t need to raise rates because the Phillips Curve was tall - it needed to raise rates because it had to convince everyone that, after 15 years asleep at the wheel, the Federal Reserve was back in town and was serious about inflation. The problem with disinflation isn’t just that it’s politically hard to do, it’s that it’s hard to convince everyone you’re committed to the bit. There’s many explanations of why, but the easiest one is time inconsistency.
If you promise disinflation, and people buy it, then you don’t actually have to do it - and under a very strong Phillips Curve setting, you get less unemployment and more inflation. But fool me once, shame on you; fool me twice, can’t get fooled again, so you have to overpromise to keep hooking people. After a while, you’d have to announce really overly aggressive targets to convince anyone inflation is going down - and you might not even do that, because they might also think that, while you’re committed to keeping your word now, you might feel tempted to fool them again. So Paul Volcker didn’t have to crash the economy with no survivors because the Phillips Curve was slopey, he had to do it so people would be in such awe at the amount of blood spilled that nobody would question whether or not he’d go soft halfway through. This meant that inflation expectations went down, since expectations are mostly expectations of monetary policy controlling inflation, and this lengthened the term during which they were anchored.
This also points to the problem with Powell Shock, election year recession diagnostics. The point about spilling blood to control inflation is that you have to do it the one time because nobody believes you’ll go through with it. This happened not because inflation was high, but because inflation had been high for a very long time and the Fed hadn’t done anything about it (at least in terms of results) - the equivalent isn’t a Volcker Shock in 1966, it’s a rate hike in 2036. If Arthur Burns actually decided to bring inflation down in the 60s, then there wouldn’t have been a Burns Shock, just a Burns Sparkle. And after you do a Volcker Shock, if you keep inflation low, then there’s not any real reason for people to suddenly forget 40 years of good times and go straight back to the age of double digit unanchored expectations.
Consequently, Powell shouldn’t have to raise rates enough to offset all of inflation (the Fed can’t do anything about supply-side factors), and to control aggregate demand it only needs to bring monetary policy from stimulative to neutral. But he doesn’t have to go beyond neutral simply because everyone understands that 1) the Fed can’t print semiconductors, and 2) if the Fed says “we’ll keep inflation down”, they mean it. There’s a big concern that Powell can’t get monetary policy back to neutral levels fast enough to not need to go further but not fast enough that it crashes the economy - aka a “soft landing”, called like that because it means that the recovery from a recession is over but stopping stimulus doesn’t mean starting a new one. I don’t really want to make big claims, but I do agree with claims that a soft landing is hard to pull off, and very hard in conditions like the present ones - but I disagree that the only alternative is a hard landing. A “middle landing” where the Fed kind of holds the economy together but also occasionally tightens too much seems more plausible.
More stuff, not less money
This is going to be the controversial one. As I’ve said in the previous post, the US is beset on all sides by supply side constraints. Now, plenty of them come from things like the Russian invasion of Ukraine and China’s issues with COVID, but many of them don’t, and instead come from policy choices such as tariffs, regulations, zoning codes, and a variety of related supply-side policies. Now, if inflation is too much money chasing too little stuff, why reduce the amount of money when you can increase the supply of stuff?
In principle, there’s not a lot to disagree with. The US easing tariffs on imported steel, imported lumber, imported baby formula, or allowing foreign cargo ships to dock in or dredge US ports would obviously reduce tensions at the port a lot. There’s also a shortage of truckers, partially caused by low wages (guess how that one is solved) and also by stuff like mandatory drug testing despite weed being legal in the biggest port state, California. Generalized labor shortages could be improved by not even reforming immigration law, but just by tinkering with it. The housing shortage is obviously caused by excessive regulations, and investments in thing like transit and freight could reduce the dependency on gasoline that causes such high pass-throughs to the US economy. Lack of competition and excessive regulations (such as CON laws in healthcare or occupational licensing) also drove up the cost of services. Government investment in a variety of things, like education, healthcare, and even some welfare programs have a positive effect on human capital and ergo are a positive for supply. All of these are good policies (depending on stuff for the last bit), and I support all of them on principle - I wrote in favor of a lot of them, in fact.
The problem isn’t that increasing supply isn’t good, or that these policies don’t work, it’s that this is not a realistic anti inflation agenda. More supply is good because it means more jobs, higher wages, and a better standard of living. Most of the supply issues are transitory (China isn’t going to be in lockdown forever), and while trade liberalization is probably the only one that can make them better before they’re over, it’s also small potatoes and doesn’t really move the needle that much.3 The rest do tackle real issues, and in many cases tackle them over the long term, but I don’t think that anyone thinks that keeping inflation at 5% a year until the US builds ten million homes is a very reasonable idea. Once again, these are very good ideas the US should do, but they’re not the kind of ideas that will make an “imaculate disinflation” possible.
An addendum I think is useful concerns government investment, that bipartisan infrastructure bill and the Build Back Better bill. While I don’t know that much about BBB, and don’t follow any news on it because most discussion is annoying politicking and not substance, I don’t necessarily believe it was inflationary, even at a 3.5 trillion price tag, and even with a chunk of it being basically direct cash transfers. While the parts about childcare subsidies were probably inflationary because there are significant regulatory burdens on childcare provision (many of which, like how many puppets they should have, are very silly), the rest was probably not. The answer is very simple. The ARP spent two trillion dollars or so in one year. BBB would spend 3.5 over ten years - so 350 billion per year, give or take, and the infrastructur bill would probably add another 120 billion. Let’s round it up to 500 billion a year.
The thing is, that’s a quarter of the ARP - and while it does have a positive multiplier (the NKs are right on that one), it’s on real output, meaning it increases supply (and probably demand, since building things requires builders). Giving people money, through things such as the CTC (which the Biden Administration somewhat laughably tried to depict as “human infastructure”), could be inflationary, but there’s also a lot of evidence that poor people face really high marginal tax rates to working - and reducing the marginal tax rate people pay for working was the core of the Reaganite supply-side agenda. And if that’s not enough, monetary offset is still real and possible.
Conclusion
The core takeaways from what the Fed did and didn’t do in 2021 are:
The Fed learned the lessons of the Great Recession much too well. Concern with excessively tight monetary policy leading to a weakened economy, the Fed announced a policy framework nobody understood to prevent this, resulting in ambiguity over future actions and an overly dovish policy.
The Great Inflation was caused by fundamental wrongness regarding the economy. Instead of oil or politics, what ultimately led to inflation getting out of hand was the Fed (and most macroeconomists) being simply extremely misled over how the economy worked and how to conduct monetary policy.
The Volcker Shock was only necessary due to the Great Inflation being as prolonged, and severe, as it was. If monetary policy had been more prudent in the 60s and 70s, then a much smaller rate hike would have disinflated the economy without such an intense recession, since expectations wouldn’t have needed such a profound shock to be stabilized.
A supply-side agenda is net good, but not a serious attempt at disinflation. While in theory “more stuff” is a sound approach, in practice too many constraints are transitory, and a volatile rate of inflation while large changes to regulatory and investment policies are made is not a sure bet.
Sources
Obviously, last week’s post on US inflation
Clarida, “The Federal Reserve's New Framework: Context and Consequences”, 2020
Hetzel, “Learning from the Pandemic Monetary Policy Experiment”, Mercatus Center, 2022
The Great Inflation
DeLong (1996), “America's Only Peacetime Inflation: The 1970s”
Orphanides (2002), “Monetary Policy Rules and the Great Inflation”
Romer (2005), “Commentary on "Origins of the Great Inflation"“
Blanchard (2000), “What do we know about Macroeconomics that Fisher and Wicksell did not?”
Lucas & Prescott (1979), “After Keynesian Macroeconomics”
Expectations and credibility
Kydland & Prescott (1977), “Rules Rather than Discretion: The Inconsistency of Optimal Plans”
The supply side agenda
Previous posts on housing, competition, and immigration
Lindsey Brink & Samuel Hammond, “Faster Growth, Fairer Growth”, Niskanen Center
He also cut rates to 5% the one time because of a weird ad-hoc experiment in monetary aggregates targeting, which didn’t work.
Actually lack of commitment to stimulus is also a relevant issue, and one that the Japanese have as much experience with as the Argentinians have with commitment to disinflation.
Much that it pains me to admit it, trade just isn’t that big of an issue compared to occupational licensing, exclusionary zoning, or immigration restrictions.
Phenomenal piece of writing, thank you.
You are top notch.