NEW! 11/17/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the Fed’s Response, FTX collapse, and also share thoughts on economics themes in holiday movies!

In the Face of Hyperinflation, Some People in Argentina Don’t Save Currency, They Save … Bricks

Argentina’s Argentina’s Economy Minister Sergio Massa coming from a meeting in Washington, DC with the International Monetary Fund to discuss the country’s hyperinflation. Photo from the Wall Street Journal.

Argentina has been through several periods of hyperinflation during with the price level has increased more than 50 percent per month. The following figure shows the inflation rate as measured by the percentage change in the consumer price index from the previous month for since the beginning of 2018. The inflation rate during these years has been volatile, being greater than 50 percent per month during several periods, including staring in the spring of 2022. High rates of inflation have become so routine in Argentina that an article in the Wall Street Journal quoted on store owner as saying, “Here 40% [inflation] is normal. And when we get past 50%, it doesn’t scare us, it simply bothers us.”

As we discuss in Macroeconomics, Chapter 14, Section 14.5 (Economics, Chapter 24, Section 24.5 ), when an economy experiences hyperinflation, consumers and businesses hold the country’s currency for as brief a time as possible because the purchasing power of the currency is declining rapidly. As we noted in the chapter, in some countries experiencing high rates of inflation, consumers and businesses buy and sell goods using U.S. dollars rather than the domestic currency because the purchasing power of the dollar is more stable. This demand for dollars in countries experiencing high inflation rates is one reason why an estimated 80 percent of all $100 bills circulate outside of the United States. 

The increased demand for U.S. dollars by people in Argentina is reflected in the exchange rate between the Argentine peso and the U.S. dollar. The following figure shows that at the beginning of 2018, one dollar exchanged for about 18 pesos. By November 2022, one dollar exchanged for about 159 pesos. The exchange rate shown in the figure is the official exchange rate at which people in Argentina can legally exchange pesos for dollars. In practice, it is difficult for many individuals and small firms to buy dollars at the official exchange rate. Instead, they have to use private currency traders who will make the exchange at an unofficial—or “blue”—exchange rate that varies with the demand and supply of pesos for dollars. A reporter for the Economist described his experience during a recent trip to Argentina: “Walk down Calle Lavalle or Calle Florida in the centre of Buenos Aires and every 20 metres someone will call out ‘cambio’ (exchange), offering to buy dollars at a rate that is roughly double the official one.” 

People in Argentina are reluctant to deposit their money in banks, partly because the interest rates banks pay typically are lower than the inflation rate, causing the purchasing power of money deposited in banks to decline over time.  People are also afraid that the government might keep them from withdrawing their money, which has happened in the past. As an alternative to depositing their money in banks, many people in Argentina buy more goods than they can immediately use and store them, thereby avoiding future price increases on these goods. The Wall Street Journalquoted a university student as saying: “I came to this market and bought as much toilet paper as I could for the month, more than 20 packs. I try to buy all [the goods] I can because I know that next month it will cost more to buy.”

Devon Zuegel, a U.S. software engineer and economics blogger who travels frequently to Argentina, has observed one unusual way that some people in Argentina save while experiencing hyperinflation:

“Bricks—actual bricks, not stacks of cash—are another common savings mechanism, especially for working-class Argentinians. The value of bricks is fairly stable, and they’re useful to a family building out their house. Argentina doesn’t have a mortgage industry, and thus buying a pallet of bricks each time you get a paycheck is an effective way to pay for your home in installments. (Bricks aren’t fully monetized, in that I don’t think people buy bricks and then sell them later, so people only use this method of saving when they actually have something they want to use the bricks for.)”

Sources: “Sergio Massa Is the Only Thing Standing Between Argentina and Chaos,” economist. com, October 13, 2022;  Devon Zuegel, “Inside Argentina’s Currency Exchange Black Markets,” devonzuegel.com, September 10, 2022; Silvina Frydlewsky and Juan Forero, “Inflation Got You Down? At Least You Don’t Live in Argentina,” Wall Street Journal, April 25, 2022; and Federal Reserve Bank of St. Louis, FRED data set.

Ben Bernanke, Douglas Diamond, and Philip Dybvig Win the Nobel Prize in Economics

Ben Bernanke (Photo from the Brookings Institution.)

Douglas Diamond (Photo from Reuters.)

Philip Dybvig (Photo from Washington University.)

Former Federal Reserve Chair Ben Bernanke (now a Distinguished Fellow in Residence at the Brookings Institution in Washington, DC), Douglas Diamond of the University of Chicago, and Philip Dybvig of Washington University in St. Louis shared the 2022 Nobel Prize in Economics (formally called the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel). Card received half of the prize of 10 million Swedish kronor (about 8.85 million U.S. dollars) for “significantly [improving] our understanding of the role of banks in the economy, particularly during financial crises.” (The press release from the Nobel committee can be read here.)

In paper published in the American Economic Review in 1983, Bernanke provided an influential interpretation of the role the bank panics of the early 1930s played in worsening the severity of the Great Depression. As we discuss in Macroeconomics, Chapter 14, Section 14.3 (Economics, Chapter 24, Section 24.3), by taking deposits and making loans banks play an important in the money supply process. Milton Friedman and Anna Schwartz in A Monetary History of the United States, 1867-1960, Chapter 7, argued that the bank panics of the early 1930s caused a decline in real GDP and employment largely through the mechanism of reducing the money supply.

Bernanke demonstrated that the bank failures affected output and employment in another important way. As we discuss in Macroeconomics, Chapter 6, Section 6.2 and Chapter 14, Section 14.4 (Economics, Chapter 8, Section 8.2 and Chapter 24, Section 24.4) banks are financial intermediaries who engage in indirect finance. Banks accept deposits and use the funds to make loans to households and firms. Households and most firms can’t raise funds through direct finance by selling bonds or stocks to individual investors because investors don’t have enough information about households or all but the largest firms to know whether these borrowers will repay the funds. Banks get around this information problemby specializing in gathering information on households and firms that allow them to gauge how likely a borrower is to default, or stop paying, on a loan.

Because of the special role banks have in providing credit to households and firms that have difficulty borrowing elsewhere, Bernanke argued that the bank panics of the early 1930s, during which more than 5,000 banks in the United States went out of business, not only caused a reduction in the money supply but restricted the ability of households and firms to borrow. As a result, households and firms decreased their spending, which increased the severity of the Great Depression.

In a 1983 paper published in the Journal of Political Economy, Diamond and Dybvig presented what came to be known as the Diamond and Dybvig model of the economic role of banks. This model, along with later research by Diamond, provided economists with a better understanding of the potential instability of banking. Diamond and Dybvig note that banking involves transforming long-run, illiquid assets—loans—into short-run, liquid assets—deposits. Recall that liquidity is the ease with which an asset can be sold. Households and firms want the loans they receive from a bank to be illiquid in the sense that they don’t want the bank to be able to demand that the funds borrowed be repaid, except on a set schedule. Someone receiving a mortgage loan to buy a house wouldn’t want the bank to be able to insist on being paid back any time the bank chose. But households and firms also want the assets they hold to be liquid so that they can quickly convert the assets into money if they need the funds. By taking in deposits and using the funds to make loans, banks provide a service to households and firms by providing both a source of long-run credit and a source of short-term assets. 

But Diamond and Dybvig note that because banks hold long-terms assets that can’t easily be sold, if a large number of people attempt simultaneously to withdraw their deposits, the banks lack the funds to meet these withdrawals. The result is a run on a bank as depositors become aware that unless they quickly withdraw their deposits, they may not receive their funds for a considerable time. If the bank is insolvent—the value of its loans and other assets is less than the value of its deposits and other liabilities—the bank may fail and some households and firms will never receive the full value of their deposits. In the Diamond and Dybvig model, if depositors expect that other depositors will not withdraw their funds, the system can be stable because banks won’t experience runs. But because banks know more about the value of their assets and liabilities than depositors do, depositors may have trouble distinguishing solvent banks from insolvent banks. As a result of this information problem, households and firms may decide to withdraw their deposits even from solvent banks. Households and firms may withdraw their deposits from a bank even if they know with certainty that the bank is solvent if they expect that other households and firms—who may lack this knowledge—will withdraw their deposits. The result will be a bank panic, in which many banks simultaneously experience a bank run. 

With many banks closing or refusing to make new loans in order to conserve funds, households and firms that depend on bank loans will be forced to reduce their spending. As a result, production and employment will decline. Falling production and employment may cause more borrowers to stop paying on their loans, which may cause more banks to be insolvent, leading to further runs, and so on. We illustrate this process in Figure 14.3. 

Diamond and Dybvig note that a system of deposit insurance—adopted in the United States when Congress established the Federal Deposit Insurance Corporation (FDIC) in 1934—or a central bank acting as a lender of last resort to banks experiencing runs are necessary to stabilize the banking system. When Congress established the Federal Reserve System in 1914, it gave the Fed the ability to act as a lender of last resort by making discount loans to banks that were solvent but experiencing temporary liquidity problems as a result of deposit withdrawals.

During the Global Financial Crisis that began in 2007 and accelerated following the failure of the Lehman Brothers investment bank in September 2008, it became clear that the financial firms in the shadow banking system could also be subject to runs because, like commercial banks, shadow banks borrow short term to financial long term investments. Included in the shadow banking system are money market mutual funds, investment banks, and insurance companies. By 2008 the size of the shadow banking system had grown substantially relative to the commercial banking system.  The shadow banking system turned out to be more fragile than the commercial banking system because those lending to shadow banks by, for instance, buying money market mutual fund shares, do not receive government insurance like bank depositors receive from the FDIC and because prior to 2008 the Fed did not act as a lender of last resort to shadow banks.

Bernanke believes that his study of financial problems the U.S. experienced during the Great Depression helped him as Fed chair to deal with the Global Financial Crisis.  In particular, Bernanke concluded from his research that in the early 1930s the Fed had committed a major error in failing to act more vigorously as a lender of last resort to commercial banks. The result was severe problems in the U.S. financial system that substantially worsened the length and severity of the Great Depression.  During the financial crisis, under Bernanke’s leadership, the Fed established several lending facilities that allowed the Fed to extend its role as a lender of last resort to parts of the shadow banking system. (In 2020, the Fed under the leadership of Chair Jerome Powell revived and extended these lending facilities.) Bernanke is rare among economists awarded the Nobel Prize in having had the opportunity to implement lessons from his academic research in economic policymaking at the highest level. (Bernanke discusses the relationship between his research and his policymaking in his memoir. A more complete discussion of the financial crises of the 1930s, 2007-2009, and 2020 appears in Chapter 14 of our textbook Money, Banking, and the Financial System, Fourth Edition.)

We should note that Bernanke’s actions at the Fed have been subject to criticism by some economists and policymakers. As a member of the Fed’s Board of Governors beginning in 2002 and then as Fed chair beginning in 2006, Bernanke, like other members of the Fed and most economists, was slow to recognize the problems in the shadow banking system and, particularly, the problems caused by the rapid increase in housing prices and increasing number of mortgages being granted to borrowers who had either poor credit histories or who made small down payments. Some economists and policymakers also argue that Bernanke’s actions during the financial crisis took the Fed beyond the narrow role of stabilizing the commercial banking system spelled out by Congress in the Federal Reserve Act and may have undermined Fed independence. They also argue that by broadening the Fed’s role as a lender of last resort to include shadow banks, Bernanke may have increased the extent of moral hazard in the financial system.

Finally, Laurence Ball of Johns Hopkins University argues that the worst of the financial crisis could have been averted if Bernanke had acted to save the Lehman Brothers investment bank from failing by making loans to Lehman. Bernanke has argued that the Fed couldn’t legally make loans to Lehman because the firm was insolvent but Ball argues that, in fact, the firm was solvent. Decades later, economists continue to debate whether the Fed’s actions in allowing the Bank of United States to fail in 1930 were appropriate and the debate over the Fed’s actions with respect to Lehman may well last as long. (A working paper version of Ball’s argument can be found here. He later extended his argument in a book. Bernanke’s account of his actions during the failure of Lehman Brothers can be found in his memoir cited earlier.)

Sources: Paul Hannon, “Nobel Prize in Economics Winners Include Former Fed Chair Ben Bernanke,” Wall Street Journal, October 10, 2022; David Keyton, Frank Jordans, and Paul Wiseman, “Former Fed Chair Bernanke Shares Nobel for Research on Banks,” apnews.com, October 10, 2022; and Greg Ip, “Most Nobel Laureates Develop Theories; Ben Bernanke Put His Into Practice,” Wall Street Journal, October 10, 2022. 

The Federal Open Market Committee’s September 2022 Meeting and the Question of Whether the Fed Should Focus Only on Price Stability

The Federal Reserve building in Washington, DC. (Photo from the Wall Street Journal.)

In the Federal Reserve Act, Congress charged the Federal Reserve with conducting monetary policy so as to achieve both “maximum employment” and “stable prices.”  These two goals are referred to as the Fed’s dual mandate.  (We discuss the dual mandate in Macroeconomics, Chapter 15, Section 15.1, Economics, Chapter 25, Section 25.1, and Money, Banking, and the Financial System, Chapter 15, Section 15.1.) Accordingly, when Fed chairs give their semiannual Monetary Policy Reports to Congress, they reaffirm that they are acting consistently with the dual mandate. For example, when testifying before the U.S. Senate Committee on Banking, Housing, and Urban Affairs in June 2022, Fed Chair Jerome Powell stated that: “The Fed’s monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people.”

Despite statements of that kind, some economists argue that in practice during some periods the Fed’s policymaking Federal Open Market Committee (FOMC) acts as if it were more concerned with one of the two mandates. In particular, in the decades following the Great Inflation of the 1970s, FOMC members appear to have put more emphasis on price stability than on maximum employment. These economists argue that during these years, FOMC members were typically reluctant to pursue a monetary policy sufficiently expansionary to lead to maximum employment if the result would be to cause the inflation rate to rise above the Fed’s target of an annual target of 2 percent. (Although the Fed didn’t announce a formal inflation target of 2 percent until 2012, the FOMC agreed to set a 2 percent inflation target in 1996, although they didn’t publicly announce at the time. Implicitly, the FOMC had been acting as if it had a 2 percent target since at least the mid–1980s.)

In July 2019, the FOMC responded to a slowdown in economic growth in late 2018 and early 2019 but cutting its target for the federal funds rate. It made further cuts to the target rate in September and October 2019. These cuts helped push the unemployment rate to low levels even as the inflation rate remained below the Fed’s 2 percent target. The failure of inflation to increase despite the unemployment rate falling to low levels, provides background to the new monetary policy strategy the Fed announced in August 2020. The new monetary policy, in effect, abandoned the Fed’s previous policy of attempting to preempt a rise in the inflation rate by raising the target for the federal funds rate whenever data on unemployment and real GDP growth indicated that inflation was likely to rise. (We discussed aspects of the Fed’s new monetary policy in previous blog posts, including here, here, and here.)

In particular, the FOMC would no longer see the natural rate of unemployment as the maximum level of employment—which Congress has mandated the Fed to achieve—and, therefore, wouldn’t necessarily begin increasing its target for the federal funds rate when the unemployment rate dropped by below the natural rate. As Fed Chair Powell explained at the time, “the maximum level of employment is not directly measurable and [it] changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.”

Many economists interpreted the Fed’s new monetary strategy and the remarks that FOMC members made concerning the strategy as an indication that the Fed had turned from focusing on the inflation rate to focusing on unemployment. Of course, given that Congress has mandated the Fed to achieve both stable prices and maximum employment, neither the Fed chair nor other members of the FOMC can state directly that they are focusing on one mandate more than the other. 

The sharp acceleration in inflation that began in the spring of 2021 and continued into the fall of 2022 (shown in the following figure) has caused members of the FOMC to speak more forcefully about the need for monetary policy to bring inflation back to the Fed’s target rate of 2 percent. For example, in a speech at the Federal Reserve Bank of Kansas City’s annual monetary policy conference held in Jackson Hole, Wyoming, Fed Chair Powell spoke very directly: “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.” According to an article in the Wall Street Journal, Powell had originally planned a longer speech discussing broader issues concerning monetary policy and the state of the economy—typical of the speeches that Fed chairs give at this conference—before deciding to deliver a short speech focused directly on inflation.

Members of the FOMC were concerned that a prolonged period of high inflation rates might lead workers, firms, and investors to no longer expect that the inflation rate would return to 2 percent in the near future. If the expected inflation rate were to increase, the U.S. economy might enter a wage–price spiral in which high inflation rates would lead workers to push for higher wages, which, in turn, would increase firms’ labor costs, leading them to raise prices further, in response to which workers would push for even higher wages, and so on. (We discuss the concept of a wage–price spiral in earlier blog posts here and here.)

With Powell noting in his Jackson Hole speech that the Fed would be willing to run the risk of pushing the economy into a recession if that was required to bring down the inflation rate, it seemed clear that the Fed was giving priority to its mandate for price stability over its mandate for maximum employment. An article in the Wall Street Journal quoted Richard Clarida, who served on the Fed’s Board of Governors from September 2018 until January 2022, as arguing that: “Until inflation comes down a lot, the Fed is really a single mandate central bank.”

This view was reinforced by the FOMC’s meeting on September 21, 2022 at which it raised its target for the federal funds rate by 0.75 percentage points to a range of 3 to 3.25 percent. The median projection of FOMC members was that the target rate would increase to 4.4 percent by the end of 2022, up a full percentage point from the median projection at the FOMC’s June 2022 meeting. The negative reaction of the stock market to the announcement of the FOMC’s decision is an indication that the Fed is pursuing a more contractionary monetary policy than many observers had expected. (We discuss the relationship between stock prices and economic news in this blog post.)

Some economists and policymakers have raised a broader issue concerning the Fed’s mandate: Should Congress amend the Federal Reserve Act to give the Fed the single mandate of achieving price stability? As we’ve already noted, one interpretation of the FOMC’s actions from the mid–1980s until 2019 is that it was already implicitly acting as if price stability were a more important goal than maximum employment. Or as Stanford economist John Cochrane has put it, the Fed was following “its main mandate, which is to ensure price stability.”

The main argument for the Fed having price stability as its only mandate is that most economists believe that in the long run, the Fed can affect the inflation rate but not the level of potential real GDP or the level of employment. In the long run, real GDP is equal to potential GDP, which is determined by the quantity of workers, the capital stock—including factories, office buildings, machinery and equipment, and software—and the available technology. (We discuss this point in Macroeconomics, Chapter 13, Section 13.2 and in Economics, Chapter 23, Section 23.2.) Congress and the president can use fiscal policy to affect potential GDP by, for example, changing the tax code to increase the profitability of investment, thereby increasing the capital stock, or by subsidizing apprentice programs or taking other steps to increase the labor supply. But most economists believe that the Fed lacks the tools to achieve those results. 

Economists who support the idea of a single mandate argue that the Fed would be better off focusing on an economic variable they can control in the long run—the inflation rate—rather than on economic variables they can’t control—potential GDP and employment. In addition, these economists point out that some foreign central banks have a single mandate to achieve price stability. These central banks include the European Central Bank, the Bank of Japan, and the Reserve Bank of New Zealand.

Economists and policymakers who oppose having Congress revise the Federal Reserve Act to give the Fed the single mandate to achieve price stability raise several points. First, they note that monetary policy can affect the level of real GDP and employment in the short run. Particularly when the U.S. economy is in a severe recession, the Fed can speed the return to full employment by undertaking an expansionary policy. If maximum employment were no longer part of the Fed’s mandate, the FOMC might be less likely to use policy to increase the pace of economic recovery, thereby avoiding some unemployment.

Second, those opposed to the Fed having single mandate argue that the Fed was overly focused on inflation during some of the period between the mid–1980s and 2019. They argue that the result was unnecessarily low levels of employment during those years. Giving the Fed a single mandate for price stability might make periods of low employment more likely.

Finally, because over the years many members of Congress have stated that the Fed should focus more on maximum employment than price stability, in practical terms it’s unlikely that the Federal Reserve Act will be amended to give the Fed the single mandate of price stability.

In the end, the willingness of Congress to amend the Federal Reserve Act, as it has done many times since initial passage in 1914, depends on the performance of the U.S. economy and the U.S. financial system. It’s possible that if the high inflation rates of 2021–2022 were to persist into 2023 or beyond, Congress might revise the Federal Reserve Act to change the Fed’s approach to fighting inflation either by giving the Fed a single mandate for price stability or in some other way. 

Sources: Board of Governors of the Federal Reserve System, “Federal Reserve Issues FOMC Statement,” federalreserve.gov, September 21, 2022; Board of Governors of the Federal Reserve System, “Summary of Economic Projections,” federalreserve.gov, September 21, 2022; Nick Timiraos, “Jerome Powell’s Inflation Whisperer: Paul Volcker,” Wall Street Journal, September 19, 2022; Matthew Boesler and Craig Torres, “Powell Talks Tough, Warning Rates Are Going to Stay High for Some Time,” bloomberg.com, August 26, 2022; Jerome H. Powell, “Semiannual Monetary Policy Report to the Congress,” June 22, 2022, federalreserve.gov; Jerome H. Powell, “Monetary Policy and Price Stability,” speech delivered at “Reassessing Constraints on the Economy and Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, federalreserve.gov, August 26, 2022; John H. Cochrane, “Why Isn’t the Fed Doing its Job?” project-syndicate.org, January 19, 2022; Board of Governors of the Federal Reserve System, “Minutes of the Federal Open Market Committee Meeting on July 2–3, 1996,” federalreserve.gov; and Federal Reserve Bank of St. Louis.

Podcasts Back for Fall 2022! – 9/9/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the Fed’s Response, cryptocurrency, and also briefly touch on labor markets.

Are the Fed’s Forecasts of Inflation and Unemployment Inconsistent?

The Federal Reserve building in Washington, DC. Photo from the Wall Street Journal.

Four times per year, the members of the Federal Reserve’s Federal Open Market Committee (FOMC) publish their projections, or forecasts, of the values of the inflation rate, the unemployment, and changes in real gross domestic product (GDP) for the current year, each of the following two years, and for the “longer run.”  The following table, released following the FOMC meeting held on March 15 and 16, 2022, shows the forecasts the members made at that time.

  Median Forecast Meidan Forecast Median Forecast 
 202220232024Longer runActual values, March 2022
Change in real GDP2.8%2.2%2.2%1.8%3.5%
Unemployment rate3.5%3.5%3.6%4.0%3.6%
PCE inflation4.3%2.7%2.3%2.0%6.6%
Core PCE inflation4.1%2.6%2.3%No forecast5.2%

Recall that PCE refers to the consumption expenditures price index, which includes the prices of goods and services that are in the consumption category of GDP. Fed policymakers prefer using the PCE to measure inflation rather than the consumer price index (CPI) because the PCE includes the prices of more goods and services. The Fed uses the PCE to measure whether it is hitting its target inflation rate of 2 percent. The core PCE index leaves out the prices of food and energy products, including gasoline. The prices of food and energy products tend to fluctuate for reasons that do not affect the overall long-run inflation rate. So Fed policymakers believe that core PCE gives a better measure of the underlying inflation rate. (We discuss the PCE and the CPI in the Apply the Concept “Should the Fed Worry about the Prices of Food and Gasoline?” in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5)).

The values in the table are the median forecasts of the FOMC members, meaning that the forecasts of half the members were higher and half were lower.  The members do not make a longer run forecast for core PCE.  The final column shows the actual values of each variable in March 2022. The values in that column represent the percentage in each variable from the corresponding month (or quarter in the case of real GDP) in the previous year.  Links to the FOMC’s economic projections can be found on this page of the Federal Reserve’s web site.

At its March 2022 meeting, the FOMC began increasing its target for the federal funds rate with the expectation that a less expansionary monetary policy would slow the high rates of inflation the U.S. economy was experiencing. Note that in that month, inflation measured by the PCE was running far above the Fed’s target inflation rate of 2 percent. 

In raising its target for the federal funds rate and by also allowing its holdings of U.S. Treasury securities and mortgage-backed securities to decline, Fed Chair Jerome Powell and the other members of the FOMC were attempting to achieve a soft landing for the economy. A soft landing occurs when the FOMC is able to reduce the inflation rate without causing the economy to experience a recession. The forecast values in the table are consistent with a soft landing because they show inflation declining towards the Fed’s target rate of 2 percent while the unemployment rate remains below 4 percent—historically, a very low unemployment rate—and the growth rate of real GDP remains positive. By forecasting that real GDP would continue growing while the unemployment rate would remain below 4 percent, the FOMC was forecasting that no recession would occur.

Some economists see an inconsistency in the FOMC’s forecasts of unemployment and inflation as shown in the table. They argued that to bring down the inflation rate as rapidly as the forecasts indicated, the FOMC would have to cause a significant decline in aggregate demand. But if aggregate demand declined significantly, real GDP would either decline or grow very slowly, resulting in the unemployment rising above 4 percent, possibly well above that rate.  For instance, writing in the Economist magazine, Jón Steinsson of the University of California, Berkeley, noted that the FOMC’s “combination of forecasts [of inflation and unemployment] has been dubbed the ‘immaculate disinflation’ because inflation is seen as falling rapidly despite a very tight labor market and a [federal funds] rate that is for the most part negative in real terms (i.e., adjusted for inflation).”

Similarly, writing in the Washington Post, Harvard economist and former Treasury secretary Lawrence Summers noted that “over the past 75 years, every time inflation has exceeded 4 percent and unemployment has been below 5 percent, the U.S. economy has gone into recession within two years.”

In an interview in the Financial Times, Olivier Blanchard, senior fellow at the Peterson Institute for International Economics and former chief economist at the International Monetary Fund, agreed. In their forecasts, the FOMC “had unemployment staying at 3.5 percent throughout the next two years, and they also had inflation coming down nicely to two point something. That just will not happen. …. [E]ither we’ll have a lot more inflation if unemployment remains at 3.5 per cent, or we will have higher unemployment for a while if we are actually to inflation down to two point something.”

While all three of these economists believed that unemployment would have to increase if inflation was to be brought down close to the Fed’s 2 percent target, none were certain that a recession would occur.

What might explain the apparent inconsistency in the FOMC’s forecasts of inflation and unemployment? Here are three possibilities:

  1. Fed policymakers are relatively optimistic that the factors causing the surge in inflation—including the economic dislocations due to the Covid-19 pandemic and the Russian invasion of Ukraine and the surge in federal spending in early 2021—are likely to resolve themselves without the unemployment rate having to increase significantly. As Steinsson puts it in discussing this possibility (which he believes to be unlikely) “it is entirely possible that inflation will simply return to target as the disturbances associated with Covid-19 and the war in Ukraine dissipate.”
  2. Fed Chair Powell and other members of the FOMC were convinced that business managers, workers, and investors still expected that the inflation rate would return to 2 percent in the long run. As a result, none of these groups were taking actions that might lead to a wage-price spiral. (We discussed the possibility of a wage-price spiral in earlier blog post.) For instance, at a press conference following the FOMC meeting held on May 3 and 4, 2022, Powell argued that, “And, in fact, inflation expectations [at longer time horizons] come down fairly sharply. Longer-term inflation expectations have been reasonably stable but have moved up to—but only to levels where they were in 2014, by some measures.” If Powell’s assessment was correct that expectations of future inflation remained at about 2 percent, the probability of a soft landing was increased.
  3. We should mention the possibility that at least some members of the FOMC may have expected that the unemployment rate would increase above 4 percent—possibly well above 4 percent—and that the U.S. economy was likely to enter a recession during the coming months. They may, however, have been unwilling to include this expectation in their published forecasts. If members of the FOMC state that a recession is likely, businesses and households may reduce their spending, which by itself could cause a recession to begin. 

Sources: Martin Wolf, “Olivier Blanchard: There’s a for Markets to Focus on the Present and Extrapolate It Forever,” ft.com, May 26, 2022; Lawrence Summers, “My Inflation Warnings Have Spurred Questions. Here Are My Answers,” Washington Post, April 5, 2022; Jón Steinsson, “Jón Steinsson Believes That a Painless Disinflation Is No Longer Plausible,” economist.com, May 13, 2022; Federal Open Market Committee, “Summary of Economic Projections,” federalreserve.gov, March 16, 2022; and Federal Open Market Committee, “Transcript of Chair Powell’s Press Conference May 4, 2022,” federalreserve.gov, May 4, 2022. 

New! – 4/07/22 Podcast – Authors Glenn Hubbard & Tony O’Brien revisit the role of inflation in today’s economy & likely Fed responses in trying to manage it.

Authors Glenn Hubbard and Tony O’Brien reconsider the role of inflation in today’s economy. They discuss the Fed’s possible responses by considering responses to similar inflation threats in previous generations – notably the Fed’s response led by Paul Volcker that directly led to the early 1980’s recession. The markets are reflecting stark differences in our collective expectations about what will happen next. Listen to find out more about the Fed’s likely next steps.

New 3/01/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss Russia’s Invasion of Ukraine.

Authors Glenn Hubbard & Tony O’Brien reflect on the global economic effects of Russia’s invasion of Ukraine last week. They consider the impact on the global commodity market, US monetary policy, and the impact on the financial markets in the US. Impact touches Introductory Economics, Money & Banking, International Economics, and Intermediate Macroeconomics as the effects of Russia’s aggression moves into its second week.

A map of Europe with Ukraine in the middle right below Belarus and to the east of Poland.

Should the Federal Reserve Issue a Digital Currency?

The Problem with Bitcoin as Money

Bitcoin has failed in their original purpose of providing a digital currency that could be used in everyday transactions like buying lunch and paying a cellphone bill. As the following figure shows, swings in the value of bitcoin have been too large to make useful as a medium of exchange like dollar bills. During the period shown in the figure—from July 2021 to February 2022—the price of bitcoin has increased by more than $30,000 per bitcoin and then fallen by about the same amount. Bitcoin has become a speculative asset like gold. (We discuss bitcoin in the Apply the Concept, “Are Bitcoins Money?” which appears in Macroeconomics, Chapter 14,  Section 14.2 and in Economics, Chapter 24, Section 24.2. In an earlier blog post found here we discussed how bitcoin has become similar to gold.)

The vertical axis measures the price of bitcoin in dollars per bitcoin.

The Slow U.S. Payments Increases the Appeal of a Digital Currency

Some economists and policymakers argue that there is a need for a digital currency that would do what bitcoin was originally intended to do—serve as a medium of exchange. Digital currencies hold the promise of providing a real-time payments system, which allow payments, such as bank checks, to be made available instantly. The banking systems of other countries, including Japan, China, Mexico, and many European countries, have real-time payment systems in which checks and other payments are cleared and funds made available in a few minutes or less. In contrast, in the United States, it can two days or longer after you deposit a check for the funds to be made available in your account. 

The failure of the United States to adopt a real-time payments system has been costly to many lower-income people who are likely to need paychecks and other payments to be quickly available. In practice, many lower-income people: 1) incur bank overdraft fees, when they write checks in excess of the funds available in their accounts, 2) borrow money at high interest rates from payday lenders, or 3) pay a fee to a check cashing store when they need money more quickly than a bank will clear a check. Aaron Klein of the Brookings Institution estimates that lower-income people in the United States spend $34 billion annually as a result of relying on these sources of funds. (We discuss the U.S. payments system in Money, Banking, and the Financial System, 4th edition, Chapter 2, Section 2.3.)

The Problem with Stablecoins as Money 

Some entrepreneurs have tried to return to the original idea of using cryptocurrencies as a medium of exchange by introducing stablecoins that can be bought and sold for a constant number of dollars—typically one dollar for one stablecoin. The issuers of stablecoins hold in reserve dollars, or very liquid assets like U.S. Treasury bills, to make credible the claim that holders of stablecoins will be able to exchange them one-for-one for dollars. Tether and Circle Internet Financial are the leading issuers of stablecoins. 

So far, stablecoins have been used primarily to buy bitcoin and other cryptocurrencies rather than for day-to-day buying and selling of goods and services in stores or online. Financial regulators, including the U.S. Treasury and the Federal Reserve, are concerned that stablecoins could be a risk to the financial system. These regulators worry that issuers of stablecoins may not, in fact, keep sufficient assets in reserve to redeem them. As a result, stablecoins might be susceptible to runs similar to those that plagued the commercial banking system prior to the establishment of the Federal Deposit Insurance Corporation in the 1930s or that were experienced by some financial firms during the 2008 financial crisis.  In a run, issuers of stablecoins might have to sell financial assets, such as Treasury bills, to be able to redeem the stablecoins they have issued. The result could be a sharp decline in the prices of these assets, which would reduce the financial strength of other firms holding the assets.

In 2019, Facebook (whose corporate name is now Meta Platforms) along with several other firms, including PayPal and credit card firm Visa, began preparations to launch a stablecoin named Libra—the name was later changed to Diem. In May 2021, the firms backing Diem announced that Silvergate Bank, a commercial bank in California, would issue the Diem stablecoin. But according to an article in the Wall Street Journal, the Federal Reserve had “concerns about [the stablecoin’s] effect on financial stability and data privacy and worried [it] could be misused by money launderers and terrorist financiers.” In early 2022, Diem sold its intellectual property to Silvergate, which hoped to still issue the stablecoin at some point.

A Federal Reserve Digital Currency?

If private firms or individual commercial banks have not yet been able to issue a digital currency that can be used in regular buying and selling in stores and online, should central banks do so? In January 2022, the Federal Reserve issued a report discussing the issues involved with a central bank digital currency (CBCD). As we discuss in Macroeconomics, Chapter 14, Section 14.2, most of the money supply of the United States consists of bank deposits. As the Fed’s report points out, because bank deposits are computer entries on banks’ balance sheets, most of the money in the United States today is already digital. As we discuss in Section 14.3, bank deposits are liabilities of commercial banks. In contrast, a CBCD would be a liability of the Fed or other central bank.

The Fed report lists the benefits of a CBCD:

“[I]t could provide households and businesses [with] a convenient, electronic form of central bank money, with the safety and liquidity that would entail; give entrepreneurs a platform on which to create new financial products and services; support faster and cheaper payments (including cross-border payments); and expand consumer access to the financial system.” 

Importantly, the Fed indicates that it won’t begin issuing a CBCD without the backing of the president and Congress:  “The Federal Reserve does not intend to proceed with issuance of a CBDC without clear support from the executive branch and from Congress, ideally in the form of a specific authorizing law.”

The Fed report acknowledges that “a significant number of Americans currently lack access to digital banking and payment services. Additionally, some payments—especially cross-border payments—remain slow and costly.” By issuing a CBDC, the Fed could help to reduce these problems by making digital banking services available to nearly everyone, including lower-income people who currently lack bank checking accounts, and by allowing consumers to have payments instantly available rather than having to wait for a check to clear. 

The report notes that: “A CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk.” Credit risk is the risk that the value of the currency might decline. Because the Fed would be willing to redeem a dollar of CBDC currency for a dollar or paper money, a CBDC has no credit risk. Liquidity risk is the risk that, particularly during a financial crisis, someone holding CBDC might not be able to use it to buy goods and services or financial assets. Fed backing of the CBDC makes it unlikely that someone holding CBDC would have difficulty using it to buy goods and services or financial assets.

But the report also notes several risks that may result from the Fed issuing a CBDC:

  • Banks rely on deposits for the funds they use to make loans to households and firms. If large numbers of households and firms switch from using checking accounts to using CBDC, banks will lose deposits and may have difficulty funding loans. 
  • If the Fed pays interest on the CBDC it issues, households, firms, and investors may switch funds from Treasury bills, money market mutual funds, and other short-term assets to the CBDC, which might potentially disrupt the financial system. Money market mutual funds buy significant amounts of corporate commercial paper. Some corporations rely heavily on the funds they raise from selling commercial paper to fund their short-term credit needs, including paying suppliers and financial inventories. 
  • In a financial panic, many people may withdraw funds from commercial bank deposits and convert the funds into CBDC. These actions might destabilize the banking system. 
  • A related point: A CBDC might result in large swings in bank reserves, particularly during and after a financial panic. As we discuss in Macroeconomics, Chapter 14, Section 14.4 (Economics, Chapter 24, Section 24.4), increasing and decreasing bank reserves is one way in which the Fed carries out monetary policy. So fluctuations in bank reserves may make it more difficult for the Fed to conduct monetary policy, particularly during a financial panic. (This consideration is less important during times like the present when banks hold very large reserves.)
  • Because the Fed has no experience in operating a retail banking operation, it would be likely that if it began issuing a CBDC, it would do so through commercial banks or other financial firms rather than doing so directly. These financial firms would then hold customers CBDC accounts and carry out the actual flow of payments in CBDC among households and firms.

The report notes that the Fed is only beginning to consider the many issues that would be involved in issuing a CBDC and still needs to gather feedback from the general public, financial firms, nonfinancial firms, and investors, as well as from policymakers in Washington. 

Sources:  Peter Rudegeair and Liz Hoffman, “Facebook’s Cryptocurrency Venture to Wind Down, Sell Assets,” Wall Street Journal, January 26, 2022; Liana Baker, Jesse Hamilton, and Olga Kharif, “Mark Zuckerberg’s Stablecoin Ambitions Unravel with Diem Sale Talks,” bloomberg.com, January 25, 2022; Amara Omeokwe, “U.S. Regulators Raise Concern With Stablecoin Digital Currency,” Wall Street Journal, December 17, 2022; Jeanna Smialek, “Fed Opens Debate over a U.S. Central Bank Digital Currency with Long-Awaited Report,”, January 20, 2022;  Board of Governors of the Federal Reserve System, Money and Payments: The U.S. Dollar in the Age of Digital Transformation, January 2022; and Aaron Klein, “The Fastest Way to Address Income Inequality? Implement a Real Time Payments System,” brookings.edu, January 2, 2019.

Takeaways from the January 25-26 Federal Open Market Committee Meeting

Fed Chair Jerome Powell (Photo from the Associated Press)

The results of the meeting were largely as expected: The FOMC statement indicated that the Fed remained concerned about “elevated levels of inflation” and that “the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.” 

In a press conference following the meeting, Fed Chair Jerome Powell suggested that the FOMC would begin raising its target for the federal funds at its March meeting. He also noted that it was possible that the committee would have to raise its target more quickly than previously expected: “We will remain attentive to risks, including the risk that high inflation is more persistent than expected, and are prepared to respond as appropriate.”

Some other points:

  •  The Federal Reserve Act gives the Federal reserve the dual mandate of “maximum employment” and “price stability.” Neither policy goal is defined in the act. In its new monetary policy strategy announced in August 2020, the Fed stated that it would consider the goal of price stability to have been achieved if annual inflation measured by the change in the core personal consumption expenditures (PCE) price index averaged 2 percent over time. The Fed was less clear about defining the meaning of maximum employment, as we discussed in this blog post.

As we noted in the post, as of December, some labor market indicators—notably, the unemployment rate and the job vacancy rate—appeared to show that the labor market’s recovery from the effects of the pandemic was largely complete. But both total employment and employment of prime age workers remained significantly below the levels of early 2020, just before the effects of the pandemic began to be felt on the labor market.

In his press conference, Powell indicated that despite these conflicting labor market indicators: “Most FOMC participants agree that labor market conditions are consistent with maximum employment in the sense of the highest level of employment that is consistent with price stability. And that is my personal view.” 

  • In March 2020, as the target for the federal funds rate reached the zero lower bound, the Fed turned to quantitative easing (QE), just as it had in November 2008 during the Great Financial Crisis. To carry out its policy of QE, the Fed purchased large quantities of long-term Treasury securities with maturities of 4 to 30 years and mortgage backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae—so-called agency MBS. As a result of these purchases, the Fed’s asset holdings (often referred to as its balance sheet) soared to nearly $9 trillion. 

In addition to raising its target for the federal funds rate, the Fed intends to gradually shrink the size of this asset holdings. Some economists refer to this process as quantitative tightening (QT). Following its January meeting, the FOMC issued a statement on “Principles for Reducing the Size of the Federal Reserve’s Balance Sheet.” The statement indicated that increases in the federal funds rate, not QT, would be the focus of its shift to a less expansionary monetary policy: “The Committee views changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy.” The statement also indicated that as the process of QT continued the Fed would eventually hold primarily Treasury securities, which means that the Fed would eventually stop holding agency MBS. Some economists have speculated that the Fed’s exiting the market for agency MBS might have a significant effect on that market, potentially causing mortgage interest rates to increase.

  • Finally, Powell indicated that the FOMC would likely raise its target for the federal funds more rapidly than it had during the 2015 to 2018 period. Financial market are expecting three or four 0.25 percent increases during 2022, but Powell would not rule out the possibility that the target could be raised during each remaining meeting of the year—which would result in seven increases. The FOMC’s long-run target for the federal funds rate—sometime referred to as the neutral rate—is 2.5 percent. With the target for the federal funds rate currently near zero, four rate increases during 2022 would still leave the target well short of the neutral rate.

Sources: The statements issued by the FOMC at the close of the meeting can be found here; Christopher Rugaber, “Fed Plans to Raise Rates Starting in March to Cool Inflation,” apnews.com, January 26, 2022; Nick Timiraos, “Fed Interest-Rate Decision Tees Up March Increase,” Wall Street Journal, January 26, 2022; Olivia Rockeman and Craig Torres, “Powell Back March Liftoff, Won’t Rule Out Hike Every Meeting,” bloomberg.com, January 26, 2022; and Olivia Rockeman and Reade Pickett, “Powell Says U.S. Labor Market Consistent with Maximum Employment,” bloomberg.com, January 26, 2022.