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. 

New 1/25/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, inflation, inflation.

Authors Glenn Hubbard and Tony O’Brien as they talk about the leading economic issue of early 2022 – inflation! They discuss the resurgence of inflation to levels not seen in 40 years due to a combination of miscalculations in monetary and fiscal policy. The role of Quantitative Easing (QE) – and its future – is discussed in depth. Listen today to gain insights into the economic landscape.

President Biden Makes Three Nominations to the Federal Reserve’s Board of Governors

Sarah Bloom Raskin. (Photo from the Wall Street Journal)
Lisa Cook (Photo from Michigan State via the Wall Street Journal)
Philip Jefferson (Photo from Davidson College via the Wall Street Journal)

The terms of the seven members of the Fed’s Board of Governors are staggered with a new 14-year term beginning each February 1 of even-numbered years. That system of appointments was intended to limit turnover on the board with the aim of avoiding sudden swings in monetary policy. But because in practice board members often resign before their terms have expired and because presidents sometimes delay making appointments to empty positions, presidents sometimes face the need to make multiple appointments at the same time. In January 2022, President Joe Biden nominated the following three people—one lawyer and two economists—to positions on the board:

  • Sarah Bloom Raskin is the Colin W. Brown Distinguished Professor of the Practice of Law at Duke University. She served on the Board of Governors from 2010 to 2014 before resigning to become deputy secretary of the Treasury, a position she held until 2017. If confirmed by the Senate, she would serve as the board’s vice chair for supervision, becoming the second person to hold that position, which was established by the 2010 Dodd-Frank Act. The vice chair for supervision has important responsibility in leading the Fed’s regulation and supervision of banks.
  • Philip Jefferson is the Paul B. Freeland Professor of Economics, vice president for academic affairs, and dean of the faculty at Davidson College. He received his PhD from the University of Virginia in 1990. He previously taught at Swarthmore College and served a year as an economist at the Board of Governors.
  • Lisa Cook is a professor of economics at Michigan State University. She received her PhD in economics from the University of California, Berkeley in 1997. She served on the Council of Economic Advisers from 2011 to 2012 during the Obama Administration. 

Before taking their positions, the three nominees must first be confirmed by the U.S. Senate. At this point, it’s unclear whether any of the three nominees will encounter significant opposition to their confirmation. Senator Pat Toomey of Pennsylvania has raised some concerns about Raskin’s nomination, arguing that she:

“has specifically called for the Fed to pressure banks to choke off credit to traditional energy companies and to exclude those employers from any Fed emergency lending facilities. I have serious concerns that she would abuse the Fed’s narrow statutory mandates on monetary policy and banking supervision to have the central bank actively engaged in capital allocation.”

If confirmed, the nominees will join these other four board members:

  • Jerome Powell has been nominated by President Biden to a second term as Fed Chair that, if the Senate votes favorably on the nomination, would begin in February 2022. Powell was first nominated to the board by President Obama in 2011 and nominated by President Trump to his first term as chair, which began in February 2018. 
  • Lael Brainard was first nominated to the board by President Obama in 2014. President Biden has nominated Brainard to serve as vice-chair of the board. If confirmed, she would succeed in that position Richard Clarida who resigned in January 2022.
  • Christopher Waller was nominated by President Trump to a term on the board in 2020. He had previously served as director of research at the Federal Reserve Bank of St. Louis. He received his PhD in economics from Washington State University and served as a professor of economics at Notre Dame University and the University of Kentucky. His term expires in 2030.
  • Michelle Bowman was nominated by President Trump to a term on the board in 2018. Bowman had served as the state bank commissioner of Kansas and as an executive at a local bank in Kansas. She has a law degree from Washburn University. She was reappointed to a full 14-year term in 2020. 

Sources: Senator Toomey’s statement on Sarah Bloom Raskin’s nomination can be found here.  An overview of the membership of the Board of Governors can be found here on the Federal Reserve’s website. An Associated Press article covering President Biden’s nominations can be found here.  

Is Bitcoin the New Gold?

As we discuss in the chapter, initially, bitcoin was thought of as a way to buy and sell goods and services. Some stores accepted bitcoin and allowed customers to make payment by scanning a bar code with a phone. Some websites offered merchants a way to process purchases made with bitcoins in a manner similar to the way merchants process credit card payments.

In practice, though, swings in the value of bitcoin have been much too large to make it a good substitute for cash, checks, or credit cards in everyday transactions. For instance, at the beginning of 2015, one bitcoin was worth about $300. Over the following five years, the price of bitcoin rose as high at $17,000 before falling to about $8,000 at the beginning of 2020. During 2021, the volatility of bitcoin prices increased, rising as high as $62,000 in April and falling as low as $30,000 in July before rising back above $60,000 in October. (The following chart shows movements in the price of bitcoin from early July to mid-October 2021; the vertical axis shows the price as dollars per bitcoin.)

Some economists have suggested that rather being a medium of exchange, like dollar bills, bitcoin has become a speculative asset, like gold. Bitcoin shares with gold the characteristic that ultimately its total supplied is limited. The supply of Bitcoin can’t increase beyond 21 million, a limit that is expected to be reached in 2030. The gold stock slowly increases as mines produce more gold, although the output of mines is small compared with the existing stock of gold. Some investors and speculators are reassured that, in contrast to the assets in M1 and M2 that can increase as much as the Fed chooses, gold and bitcoin have limits on how much they can increase.

Will Bitcoin Be a Good Hedge Against Inflation? Can It Be Useful in Diversifying a Portfolio?

Some investors and speculators believe that the limited quantities of gold and bitcoin available make them good hedges against inflation—that is, they believe that the prices of gold and bitcoin will reliably increase during periods of inflation.  In fact, though, gold has proven to be a poor hedge against inflation because in the long run the price of gold has not reliably increased faster than the inflation rate. There is no good economic reason to expect that over the long run bitcoin would be a good inflation hedge either.

From a broader perspective than as just an inflation hedge, some economists argue that gold has a role to play in an investor’s portfolio—which is the collection of assets, such as stocks and bonds, that an investor owns. Investors can reduce the financial risk they face through diversification, or spreading their wealth among different assets. For instance, an investor who only holds Apple stock in her portfolio is subject to more risk than an investor with the same dollar amount invested in a portfolio that holds the stocks of multiple firms as well as non-stock investments. An investor obtains the benefits of diversification best by adding assets to her portfolio that are not well correlated with the assets she already owns—that is the prices of the assets she adds to her portfolio don’t typically move in the same direction as the prices of the assets she already owns.

For instance, during a typical recession sales of consumer staples, like baby diapers and laundry detergent, hold up well, while sales of consumers durables, like automobiles, usually decline significantly. So adding shares of stock in Proctor & Gamble to a portfolio that already has many shares of General Motors achieves diversification and reduces financial risk because movements in the price of shares of Proctor & Gamble are likely not to be highly correlated with movements in the price of shares of General Motors.

Studies have shown that during some periods movements in gold prices are not correlated with movements in prices of stocks or bonds. In other words, gold prices may rise during a period when stock prices are declining. As a result, an investor may want to add gold to her portfolio to diversify it. To this point, bitcoin hasn’t been around long enough to draw firm conclusions about whether adding bitcoin to a portfolio provides significant diversification, although some investors believes that it does. 

Finance professionals are divided in their opinions on whether bitcoin is a good substitute for gold in a financial portfolio. In an interview, billionaire investor Ray Dalio, founder of Bridgewater Associates, the world’s hedge fund, noted that while he believes that bitcoin may serve as a hedge against inflation, but if he could only hold gold or bitcoin, “I would choose gold.” His preference for gold is due in part to his belief that the federal government may increase regulation of bitcoin and that regulators might eventually even decide to ban it. A businessinsider.com survey of 10 financial experts found them divided with five preferring gold as an investment and five preferring bitcoin.

Sources: Jade Scipioni, “Bitcoin vs. Gold: Here’s What Billionaire Ray Dalio Thinks,” cnbc.com, August 4, 2021; and Isabelle Lee and Will Daniel, “Bitcoin vs. Gold: 10 Experts Told Us Which Asset They’d Rather Hold for the Next 10 Years, and Why,” businessinsider.com, February 20, 2021.

What’s Going on with Inflation?

   The U.S. inflation rate has accelerated. As the following figure shows, in mid-2021, inflation, measured as the percentage change in the CPI from the same month in the previous year (the blue line), rose above 5 percent for the first time since the summer of 2008.

As we discuss in an Apply the Concept in Chapter 25, Section 25.5 (Chapter 15, Section 15.5 of Macroeconomics), the Fed prefers to measure inflation using the personal consumption expenditures (PCE) price index. The PCE price index is a measure of the price level similar to the GDP deflator, except it includes only the prices of goods and services from the consumption category of GDP. Because the PCE price index includes more goods and services than the CPI, it is a broader measure of inflation. As the red line in the figure shows, inflation as measured by the PCE price index is generally lower than inflation measured by the CPI. The difference is particularly large during periods in which CPI inflation is especially high, as it was during 2008, 2011, and 2021.

Prices of food and energy are particularly volatile, so the measure of inflation the Fed focuses on most closely is the PCE price index, excluding food and energy prices (the green line in figure). The figure shows that this measure of inflation is more stable than either of the other two measures. For instance, during June 2021, measured by the CPI, inflation was 5.3 percent, but was 3.5 percent when measured by the PCE, excluding food and energy.

In the summer of 2021, even inflation measured by the PCE, excluding food and energy, is running well above the Fed’s long-run target rate of 2 percent. Why is inflation increasing? Most economists and policymakers believe that two sets of factors are responsible:

  1. Increases in aggregate demand. Consumption spending (see the first figure below) has increased as the economy has reopened and people have returned to eating in restaurants, going to the movies, working out in gyms, and spending at other businesses that were closed or operating at reduced capacity. Households have been able to sharply increase their spending because household saving (see the second figure below) soared during the pandemic in response to payments from the federal government, including supplemental unemployment insurance payments and checks sent directly to most households. The increase in federal government expenditures that helped fuel the increase in aggregate demand is shown in the third figure below.

Fed policy has also been strongly expansionary, with the target for the federal funds kept near zero and the Fed continuing its substantial purchases of Treasury notes and mortgage-backed securities. The continuing expansion of the Fed’s balance sheet through the summer of 2021 is shown in the last of the figures below. The Fed’s asset purchases have help keep interest rates low and provided banks with ample funds to loan to households and firms. 

2. Reductions in aggregate supply. The pandemic disrupted global supply chains, reducing the goods available to consumers.  In the summer of 2021, not all of these supply chain issues had been resolved. In particular, a shortage of computer chips had reduced output of motor vehicles. New cars, trucks, SUVs, and minivans were often selling above their sticker prices. High prices for new vehicles led many consumers to increase their demand for used vehicles, driving up their prices. Between July 2020 and July 2021, prices of new vehicles rose 6.4 percent and prices for used vehicles rose an extraordinary 41.7 percent.

Supply issues also exist in some service industries, such as restaurants and hotels, that have had difficulty hiring enough workers to fully reopen. 

Economists and policymakers differ as to whether high inflation rates are transitory or whether the U.S. economy might be entering a prolonged period of higher inflation. Most Federal Reserve policymakers argue that the higher inflation rates in mid-2021 are transitory. For instance, in a statement following its July 28, 2021 meeting, the Federal Open Market Committee noted that: “Inflation has risen, largely reflecting transitory factors.”  Although the statement also noted that inflation is “on track to moderately exceed 2 percent for some time.”

In a speech at the end of July, Fed Governor Lael Brainard expanded on the Fed’s reasoning:

“Recent high inflation readings reflect supply–demand mismatches in a handful of sectors that are likely to prove transitory…. I am attentive to the risk that inflation pressures could broaden or prove persistent, perhaps as a result of wage pressures, persistent increases in rent, or businesses passing on a larger fraction of cost increases rather than reducing markups, as in recent recoveries. I am particularly attentive to any signs that currently high inflation readings are pushing longer-term inflation expectations above our 2 percent objective.”

“Currently, I do not see such signs. Most measures of survey- and market-based expectations suggest that the current high inflation pressures are transitory, and underlying trend inflation remains near its pre-COVID trend…. Many of the forces currently leading to outsized gains in prices are likely to dissipate by this time next year. Current tailwinds from fiscal support and pent-up consumption are likely to shift to headwinds, and some of the outsized price increases associated with acute supply bottlenecks may ease or partially reverse as those bottlenecks are resolved.”

Brainard’s remarks highlight a point that we make in Chapter 27, Section 27.1 (Chapter 17, Section 17.1 of Macroeconomics): The expectations of households and firms of future inflation play an important part in determining current inflation. Inflation can rise above and fall below the expected inflation rate in response to changes in the labor market—which affect the wages firms pay and, therefore, the firms’ costs—as well as in response to fluctuations in aggregate supply resulting from positive or negative supply shocks—such as the pandemic’s negative effects on aggregate supply. Fed Chair Jerome Powell has argued that with households and firms’ expectations still well-anchored at around 2 percent, inflation was unlikely to remain above that level in the long run.

Some economists are less convinced that households and firms will continue to expect 2 percent inflation if they experience higher inflation rates through the end of 2021. The Wall Street Journal’s editorial board summed up this view: “One risk for the Fed is that more months of these price increases will become what consumers and businesses come to expect. To use the Fed jargon, prices would no longer be ‘well-anchored.’ That may be happening.”

As we discuss in Chapter 27, Sections 27.2 and 27.3 (Macroeconomics, Chapter 17, Sections 17.2 and 17.3), during the late 1960s and early 1970s, higher rates of inflation eventually increased households and firms’ expectations of the inflation rate, leading to an acceleration of inflation that was difficult for the Fed to reverse. 

Earlier this year, Olivier Blanchard of the Peterson Institute for International Economics, formerly a professor of economics at MIT and director of research at the International Monetary Fund, raised the possibility that overly expansionary monetary and fiscal policies might result in the Fed facing conditions similar to those in the 1970s. The Fed would then be forced to choose between two undesirable policies:

“If inflation were to take off, there would be two scenarios: one in which the Fed would let inflation increase, perhaps substantially, and another—more likely—in which the Fed would tighten monetary policy, perhaps again substantially. Neither of these two scenarios is ideal. In the first, inflation expectations would likely become deanchored, cancelling one of the major accomplishments of monetary policy in the last 20 years and making monetary policy more difficult to use in the future. In the second, the increase in interest rates might have to be very large, leading to problems in financial markets. I would rather not go there.”

In a recent interview, Lawrence Summers of Harvard University, who served as secretary of the Treasury in the Clinton administration, made similar points: 

“We have inflation that since the beginning of the year has been running at a 5 percent annual rate. …. Starting at high inflation, we’ve got an economy that’s going to grow at extremely high rates for the next quarter or two. … I think we’re going to find ourselves with a new normal of inflation above 3 percent. Then the Fed is either going to have to be inconsistent with all the promises and commitments it’s made [to maintain a target inflation rate of 2 percent] or it’s going to have to attempt the task of slowing down the economy, which is rarely a controlled process.”

Clearly the pandemic and the resulting policy responses have left the Fed in a challenging situation.

Sources: Federal Reserve Open Market Committee, “Federal Reserve Press Release,” federalreserve.gov, July 28, 2021; Lael Brainard, “Assessing Progress as the Economy Moves from Reopening to Recovery,” speech at “Rebuilding the Post-Pandemic Economy” 2021 Annual Meeting of the Aspen Economic Strategy Group, Aspen, Colorado, federalreserve.gov, July 30, 2021; Wall Street Journal editorial board, “Powell Gets His Inflation,” Wall Street Journal, July 13, 2021; Olivier Blanchard, “In Defense of Concerns over the $1.9 Trillion Relief Plan,” piie.com, February 21, 2012; “Former Treasury Secretary on Consumer Prices, U.S. Role in Global Pandemic, Efforts,” wbur.org, August 22, 2021; and Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org.

Glenn and Donald Kohn on the Report of the Task Force on Financial Stability

   Glenn co-chairs the Task Force on Financial Stability with Donald Kohn, now a fellow at the Brookings Institution and formerly vice-chair of the Board of Governors of the Federal Reserve. The Task Force on Financial Stability was formed by the Initiative on Global Markets at the University of Chicago and the Hutchins Center on Fiscal & Monetary Policy at the Brookings Institution to make recommendations intended to increase the stability of the U.S. financial system.

On June 29, 2021, the Task Force issued a report, which can be found HERE. Glenn and Donald Kohn discuss the reports findings in an opinion column published on bloomberg. com.

The Federal Reserve building in Washington, D.C.

Our Financial Early Warning System Is Broken

The U.S. financial system emerged from the reforms that followed the 2008 global crisis stronger than it had been going in. But the onset of the pandemic in March 2020 demonstrated how much was left undone: Although banks weathered the storm well, financial disruptions elsewhere — in money market funds, in the Treasury market — necessitated extraordinary measures to prevent an even greater economic disaster.

A group that we co-chair, the Task Force on Financial Stability, has just released a report on how to make the system more resilient. Among other things, we see the need for a structural change: Overhaul the agencies tasked with identifying and addressing threats outside traditional banks.

The Dodd-Frank financial reform of 2010 created two new entities focused on systemic risk. The Financial Stability Oversight Council, which included the Treasury Secretary and the heads of all the major financial regulatory agencies, was supposed to foster collaboration in finding and fixing dangerous buildups, wherever they might arise. And the Office of Financial Research, formed within Treasury and equipped with subpoena power, was supposed to provide the FSOC with the data and analysis needed to do the job well.

This financial early warning system didn’t operate as intended. The FSOC’s efforts to impose special scrutiny on certain systemically important non-bank institutions, such as insurance companies, ran into legal and political headwinds. Its member agencies often proved reluctant to encroach on one another’s turf, and the FSOC lacked the power to compel action. The OFR never subpoenaed anything, for fear of making enemies. Ultimately, the Trump administration deemphasized and defunded the whole apparatus.

As a result, the U.S. was much less prepared for the shock of the pandemic than it could have been. A rush to cash triggered runs on certain money-market mutual funds, threatened the flow of credit to everyone from homebuyers to municipalities, and — in a troubling departure from the usual “flight to quality” — caused the prices of Treasury securities to fall sharply. The Treasury and the Federal Reserve had to go to extreme lengths and pledge trillions of dollars to restore stability.

Regulators’ objective should not be merely to put out fires once they see smoke, but to prevent the dangerous accumulation of combustible material. New threats will emerge in unexpected ways; solutions will prompt unanticipated responses. So regulation must be dynamic, requiring an ongoing assessment process, not just periodic changes. To meet that challenge, we urge a restructuring of the FSOC and the OFR.

  1. Congress should give each FSOC member agency an explicit financial stability mandate, and require each to establish a similarly focused office to inform its rule making. This would force agencies such as the Securities and Exchange Commission, the Commodities Futures Trading Commission, and the Consumer Financial Protection Bureau to consider systemic-risk issues that they can otherwise too often neglect.
  2. Only the Treasury Secretary should issue the FSOC’s annual report, avoiding the consensus-building process among member agencies that can weaken identification of risks and accountability for dealing with them. While each agency would write a separate appendix, the Secretary would bear ultimate responsibility. The report should include a look back at what risks were missed, why, and how they will be addressed. To ensure the subject gets adequate attention, a new under-secretary for financial stability should act as the secretary’s point person.
  3. The OFR should receive a clear new mandate to gather the data that policymakers need (and, today, often lack). To underscore its importance, it should be renamed the Comptroller for Data and Resilience — echoing the stature of the Comptroller of the Currency — and its head should have a voting seat at the FSOC, a level of authority that would help the government recruit talent and experience to the post.

As the pandemic begins to recede, concern over financial stability should not. We don’t know what major shock will next hit the economy and financial system. But a process to scan for risks and adapt to them should be front and center.