On Thursday morning, April 28, the Bureau of Economic Analysis (BEA) released its “advance” estimate for the change in real GDP during the first quarter of 2022. As shown in the first line of the following table, somewhat surprisingly, the estimate showed that real GDP had declined by 1.4 percent during the first quarter. The Federal Reserve Bank of Atlanta’s “GDP Now” forecast had indicated that real GDP would increase by 0.4 percent in the first quarter. Earlier in April, the Wall Street Journal’s panel of academic, business, and financial economists had forecast an increase of 1.2 percent. (A subscription may be required to access the forecast data from the Wall Street Journal’s panel.)
Do the data on real GDP from the first quarter of 2022 mean that U.S. economy may already be in recession? Not necessarily, for several reasons:
First, as we note in the Apply the Concept, “Trying to Hit a Moving Target: Making Policy with ‘Real-Time’ Data,” in Macroeconomics, Chapter 15, Section 15.3 (Economics, Chapter 25, Section 25.3): “The GDP data the BEA provides are frequently revised, and the revisions can be large enough that the actual state of the economy can be different for what it at first appears to be.”
Second, even though business writers often define a recession as being at least two consecutive quarters of declining real GDP, the National Bureau of Economic Research has a broader definition: “A recession is a significant decline in activity across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” Particularly given the volatile movements in real GDP during and after the pandemic, it’s possible that even if real GDP declines during the second quarter of 2022, the NBER might not decide to label the period as being a recession.
Third, and most importantly, there are indications in the underlying data that the U.S. economy performed better during the first quarter of 2022 than the estimate of declining real GDP would indicate. In a blog post in January discussing the BEA’s advance estimate of real GDP during the fourth quarter of 2021, we noted that the majority of the 6.9 percent increase in real GDP that quarter was attributable to inventory accumulation. The earlier table indicates that the same was true during the first quarter of 2022: 60 percent of the decline in real GDP during the quarter was the result of a 0.84 decline in inventory investment.
We don’t know whether the decline in inventories indicates that firms had trouble meeting demand for goods from current inventories or whether they decided to reverse some of the increases in inventories from the previous quarter. With supply chain disruptions continuing as China grapples with another wave of Covid-19, firms may be having difficulty gauging how easily they can replace goods sold from their current inventories. Note the corresponding point that the decline in sales of domestic product (line 2 in the table) was smaller than the decline in real GDP.
The table below shows changes in the components of real GDP. Note the very large decline exports and in purchases of goods and services by the federal government. (Recall from Macroeconomics, Chapter 16, Section 16.1, the distinction between government purchases of goods and services and total government expenditures, which include transfer payments.) The decline in federal defense spending was particularly large. It seems likely from media reports that the escalation of Russia’s invasion of Ukraine will lead Congress and President Biden to increase defense spending.
Notice also that increases in the non-government components of aggregate demand remained fairly strong: personal consumption expenditures increased 2.7 percent, gross private domestic investment increased 2.3 percent, and imports surged by 17.7 percent. These data indicate that private demand in the U.S. economy remains strong.
So, should we conclude that the economy will shrug off the decline in real GDP during the first quarter and expand during the remainder of the year? Unfortunately, there are still clouds on the horizon. First, there are the difficult to predict effects of continuing supply chain problems and of the war in Ukraine. Second, the Federal Reserve has begun tightening monetary policy. Whether Fed Chair Jerome Powell will be able to bring about a soft landing, slowing inflation significantly while not causing a large jump in unemployment, remains the great unknown of economic policy. Finally, if high inflation rates persist, households and firms may respond in ways that are difficult to predict and, may, in particular decide to reduce their spending from the current strong levels.
In several of our blog posts and podcasts, we’ve discussed Lawrence Summers’s forecasts of inflation. Beginning in February 2021, Summers, an economist at Harvard who served as Treasury secretary in the Clinton administration, argued that the United States was likely to experience rates of inflation that would be higher and persist longer than Federal Reserve policymakers were forecasting. In March 2021, the members of the Fed’s Federal Open Market Committee had an average forecast of inflation of 2.4 percent in 2021, falling to 2.0 percent in 2022. (The FOMC projections can be found here.)
In fact, inflation measured by the CPI has been above 5 percent every month since June 2021; the Fed’s preferred measure of inflation—the percentage change in the price index for personal consumption expenditures—has been above 5 percent every month since October 2021. Summers’s forecasts of inflation have turned out to be more accurate than those of the members of the Federal Open Committee.
In this podcast, Summers discusses his analysis of inflation with four scholars from the Hoover Institution, including economist John Cochrane. Summers explains why he came to believe in early 2021 that inflation was likely to be much higher than generally expected, how long he believes high rates of inflation will persist, and whether the Fed is likely to be able to achieve a soft landing by bringing inflation back to its 2 percent target without causing a recession. The first half of the podcast, in particular, should be understandable to students who have completed the monetary and fiscal policy chapters (Macroeconomics, Chapters 15 and 16; Economics, Chapters 25 and 26). Background useful for understanding the podcast discussion of monetary policy during the 1970s can be found in Chapter 17, Sections 17.2 and 17.3.
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.
It now seems clear that the new monetary policy strategy the Fed announced in August 2020 was a decisive break with the past in one respect: With the new strategy, the Fed abandoned the approach dating to the 1980s of preempting inflation. That is, the Fed would no longer begin raising its target for the federal funds rate when data on unemployment and real GDP growth indicated that inflation was likely to rise. Instead, the Fed would wait until inflation had already risen above its target inflation rate.
Since 2012, the Fed has had an explicit inflation target of 2 percent. As we discussed in a previous blog post, with the new monetary policy the Fed announced in August 2020, the Fed modified how it interpreted its inflation target: “[T]he Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
The Fed’s new approach is sometimes referred to as average inflation targeting (AIT) because the Fed attempts to achieve its 2 percent target on average over a period of time. But as former Fed Vice Chair Richard Clarida discussed in a speech in November 2020, the Fed’s monetary policy strategy might be better called a flexible average inflation target (FAIT) approach rather than a strictly AIT approach. Clarida noted that the framework was asymmetric, meaning that inflation rates higher than 2 percent need not be offset with inflation rates lower than 2 percent: “The new framework is asymmetric. …[T]he goal of monetary policy … is to return inflation to its 2 percent longer-run goal, but not to push inflation below 2 percent.” And: “Our framework aims … for inflation to average 2 percent over time, but it does not make a … commitment to achieve … inflation outcomes that average 2 percent under any and all circumstances ….”
Inflation began to increase rapidly in mid-2021. The following figure shows three measure of inflation, each calculated as the percentage change in the series from the same month in the previous year: the consumer price index (CPI), the personal consumption expenditure (PCE) price index, and the core PCE—which excludes the prices of food and energy. Inflation as measured by the CPI is sometimes called headline inflation because it’s the measure of inflation that most often appears in media stories about the economy. The PCE is a broader measure of the price level in that it includes the prices of more consumer goods and services than does the CPI. The Fed’s target for the inflation rate is stated in terms of the PCE. Because prices of food and inflation fluctuate more than do the prices of other goods and services, members of the Fed’s Federal Open Market Committee (FOMC) generally consider changes in the core PCE to be the best measure of the underlying rate of inflation.
The figure shows that for most of the period from 2002 through early 2021, inflation as measured by the PCE was below the Fed’s 2 percent target. Since that time, inflation has been running well above the Fed’s target. In February 2022, PCE inflation was 6.4 percent. (Core PCE inflation was 5.4 percent and CPI inflation was 7.9 percent.) At its March 2022 meeting the FOMC begin raising its target for the federal funds rate—well after the increase in inflation had begun. The Fed increased its target for the federal funds rate by 0.25 percent, which raised the target from 0 to 0.25 percent to 0.25 to 0.50 percent.
Should the Fed have taken action to reduce inflation earlier? To answer that question, it’s first worth briefly reviewing Fed policy during the Great Inflation of 1968 to 1982. In the late 1960s, total federal spending grew rapidly as a result of the Great Society social programs and the war in Vietnam. At the same time, the Fed increased the rate of growth of the money supply. The result was an end to the price stability of the 1952-1967 period during which the annual inflation rate had averaged only 1.6 percent.
The 1973 and 1979 oil price shocks also contributed to accelerating inflation. Between January 1974 and June 1982, the annual inflation rate averaged 9.3 percent. This was the first episode of sustained inflation outside of wartime in U.S. history—until now. Although the oil price shocks and expansionary fiscal policy contributed to the Great Inflation, most economists, inside and outside of the Fed, eventually concluded that Fed policy failures were primarily responsible for inflation becoming so severe.
The key errors are usually attributed to Arthur Burns, who was Fed Chair from January 1970 to March 1978. Burns, who was 66 at the time of his appointment, had made his reputation for his work on business cycles, mostly conducted prior to World War II at the National Bureau of Economic Research. Burns was skeptical that monetary policy could have much effect on inflation. He was convinced that inflation was mainly the result of structural factors such as the power of unions to push up wages or the pricing power of large firms in concentrated industries.
Accordingly, Burns was reluctant to raise interest rates, believing that doing so hurt the housing industry without reducing inflation. Burns testified to Congress that inflation “poses a problem that traditional monetary and fiscal remedies cannot solve as quickly as the national interest demands.” Instead of fighting inflation with monetary policy he recommended “effective controls over many, but by no means all, wage bargains and prices.” (A collection Burns’s speeches can be found here.)
Few economists shared Burns’s enthusiasm for wage and price controls, believing that controls can’t end inflation, they can only temporarily reduce it while causing distortions in the economy. (A recent overview of the economics of price controls can be found here.) In analyzing this period, economists inside and outside the Fed concluded that to bring the inflation rate down, Burns should have increased the Fed’s target for the federal funds rate until it was higher than the inflation rate. In other words, the real interest rate, which equals the nominal—or stated—interest rate minus the inflation rate, needed to be positive. When the real interest rate is negative, a business may, for example, pay 6% on a bond when the inflation rate is 10%, so they’re borrowing funds at a real rate of −4%. In that situation, we would expect borrowing to increase, which can lead to a boom in spending. The higher spending worsens inflation.
Because Burns and the FOMC responded only slowly to rising inflation, workers, firms, and investors gradually increased their expectations of inflation. Once higher expectation inflation became embedded, or entrenched, in the U.S. economy it was difficult to reduce the actual inflation rate without increasing the target for the federal funds rate enough to cause a significant slowdown in the growth of real GDP and a rise in the unemployment rate. As we discuss in Macroeconomics, Chapter 17, Sections 17.2 and 17.3 (Economics, Chapter 27, Sections 27.2 and 27.3), the process of the expected inflation rate rising over time to equal the actual inflation rate was first described in research conducted separately by Nobel Laureates Milton Friedman and Edmund Phelps during the 1960s.
An implication of Friedman and Phelps’s work is that because a change in monetary policy takes more than a year to have its full effect on the economy, if the Fed waits until inflation has already increased, it will be too late to keep the higher inflation rate from becoming embedded in interest rates and long-term labor and raw material contracts.
Paul Volcker, appointed Fed chair by Jimmy Carter in 1979, showed that, contrary to Burns’s contention, monetary policy could, in fact, deal with inflation. By the time Volcker became chair, inflation was above 11%. By raising the target for the federal funds rate to 22%—it was 7% when Burns left office—Volcker brought the inflation rate down to below 4%, but only at the cost of a severe recession during 1981–1982, during which the unemployment rate rose above 10 percent for the first time since the Great Depression of the 1930s. Note that whereas Burns had largely failed to increase the target for the federal funds as rapidly as inflation had increased—resulting in a negative real federal funds rate—Volcker had raised the target for the federal funds rate above the inflation rate—resulting in a positive real federal funds rate.
Because the 1981–1982 recession was so severe, the inflation rate declined from above 11 percent to below 4 percent. In Chapter 17, Figure 17.10 (reproduced below), we plot the course of the inflation and unemployment rates from 1979 to 1989.
The Fed chairs who followed Volcker accepted the lesson of the 1970s that it was important to head off potential increases in inflation before the increases became embedded in the economy. For instance, in 2015, then Fed Chair Janet Yellen in explaining why the FOMC was likely to raise to soon its target for the federal funds rate noted that: “A substantial body of theory, informed by considerable historical evidence, suggests that inflation will eventually begin to rise as resource utilization continues to tighten. It is largely for this reason that a significant pickup in incoming readings on core inflation will not be a precondition for me to judge that an initial increase in the federal funds rate would be warranted.”
Between 2015 and 2018, the FOMC increased its target for the federal funds rate nine times, raising the target from a range of 0 to 0.25 percent to a range of 2.25 to 2.50 percent. In 2018, Raphael Bostic, president of the Federal Reserve Bank of Atlanta justified these rate increases by noting that “… we shouldn’t forget that [the Fed’s] credibility [with respect to keeping inflation low] was hard won. Inflation expectations are reasonably stable for now, but we know little about how far the scales can tip before it is no longer so.”
He used the following figure to illustrate his point.
Bostic interpreted the figure as follows:
“[The red areas in the figure are] periods of time when the actual unemployment rate fell below what the U.S. Congressional Budget Office now estimates as the so-called natural rate of unemployment. I refer to these episodes as “high-pressure” periods. Here is the punchline. Dating back to 1960, every high-pressure period ended in a recession. And all but one recession was preceded by a high-pressure period….
I think a risk management approach requires that we at least consider the possibility that unemployment rates that are lower than normal for an extended period are symptoms of an overheated economy. One potential consequence of overheating is that inflationary pressures inevitably build up, leading the central bank to take a much more “muscular” stance of policy at the end of these high-pressure periods to combat rising nominal pressures. Economic weakness follows [resulting typically, as indicated in the figure by the gray band, in a recession].”
By July 2019, a majority of the members of the FOMC, including Chair Powell, had come to believe that with no sign of inflation accelerating, they could safely cut the federal funds rate. But they had not yet explicitly abandoned the view that the FOMC should act to preempt increases in inflation. The formal change came in August 2020 when, as discussed earlier, the FOMC announced the new FAIT.
At the time the FOMC adopted its new monetary policy strategy, most members expected that any increase in inflation owing to problems caused by the Covid-19 pandemic—particularly the disruptions in supply chains—would be transitory. Because inflation has proven to be more persistent than Fed policymakers and many economists expected, two aspects of the FAIT approach to monetary policy have been widely discussed: First, the FOMC did not explicitly state by how much inflation can exceed the 2 percent target or for how long it needs to stay there before the Fed will react. The failure to elaborate on this aspect of the policy has made it more difficult for workers, firms, and investors to gauge the Fed’s likely reaction to the acceleration in inflation that began in the spring of 2021. Second, the FOMC’s decision to abandon the decades-long policy of preempting inflation may have made it more difficult to bring inflation down to the 2 percent target without causing a recession.
Federal Reserve Governor Lael Brainard recently remarked that “it is of paramount importance to get inflation down” and some Fed policymakers believe that the FOMC will have to begin increasing its target for the federal funds rate more aggressively. (The speech in which Governor Brainard discusses her current thinking on monetary policy can be found here.) For instance James Bullard, president of the Federal Reserve Bank of St. Louis, has argued in favor of raising the target to above 3 percent this year. With the Fed’s preferred measure of inflation running above 5 percent, it would take substantial increases int the target to achieve a positive real federal funds rate.
It is an open question whether Jerome Powell finds himself in a position similar to that of Paul Volcker in 1979: Rapid increases in interest rates may be necessary to keep inflation from accelerating, but doing so risks causing a recession. In a recent speech (found here), Powell pledged that: “We will take the necessary steps to ensure a return to price stability. In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
But Powell argued that the FOMC could achieve “a soft landing, with inflation coming down and unemployment holding steady” even if it is forced to rapidly increase its target for the federal funds rate:
“Some have argued that history stacks the odds against achieving a soft landing, and point to the 1994 episode as the only successful soft landing in the postwar period. I believe that the historical record provides some grounds for optimism: Soft, or at least softish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession.”
Some economists have been skeptical that a soft landing is likely. Harvard economist and former Treasury Secretary Lawrence Summers has been particularly critical of Fed policy, as in this Twitter thread. Summers concludes that: “I am apprehensive that we will be disappointed in the years ahead by unemployment levels, inflation levels, or both.” (Summers and Harvard economist Alex Domash provide an extended discussion in a National Bureau of Economic Research Working Paper found here.)
Clearly, we are in a period of great macroeconomic uncertainty.
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.
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.
On Sunday, February 6, the New York Times ran an article on Modern Monetary Theory (MMT) on the front page of its business section with the title, “Time for a Victory Lap.” Link here, subscription may be required. (Note: The title of the article was later changed on the nytimes.com site to “Is This What Winning Looks Like?” perhaps because of the controversy linked to below.)
The article led to a controversy on Twitter (but, then, what topic doesn’t lead to a controversy on Twitter?). Social media is, obviously, not always the best place to discuss economic theory and policy, but instructors and students interested in the debate may find the following links useful both because of the substantive issues raised and as an example of how debates over economic policy can sometimes become heated.
Harvard economist Lawrence Summers reacts negatively to the content of the New York Times article (and to MMT) here.
Economics blogger Noah Smith also reacts negatively to the article here. Smith’s blog post discussing the article at length is here, subscription may be required.
Former Fed economist Claudia Sahm defends the article (and MMT) here.
Jeanna Smialek, the author of the New York Times article, reacts to critics of the article here and to Noah Smith’s blog post here. Smith responds to her response here.
Jason Furman of Harvard’s Kennedy School provides a brief discussion of whether MMT has had much influence on monetary policy here.
We discuss MMT in the Apply the Concept, “Modern Monetary Theory: Should We Stop Worrying and Love the Debt?” in Macroeconomics, Chapter 16, Section 16.6 and in Economics, Chapter 26, Section 26.6.
Congress has given the Fed a mandate to achieve the goal of price stability. Until 2012, the Fed had never stated explicitly how they would measure whether they had achieved this goal. One interpretation of price stability is that the price level remains constant. But a constant price level would be very difficult to achieve in practice and the Fed has not attempted to do so. In 2012, the Fed, under then Chair Ben Bernanke, announced that it was targeting an inflation rate of 2 percent, which it believed was low enough to be consistent with price stability: “When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy.” (We discuss inflation targeting in Macroeconomics, Chapter 15, Section 15.5 and Economics, Chapter 25, Section 25.5.)
In August 2020, the Fed announced a new monetary policy strategy that modified how it interpreted its inflation target: “[T]he Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” The Fed’s new approach is sometimes referred to as average inflation targeting (AIT) because the Fed attempts to achieve its 2 percent target on average over a period of time, although the Fed has not explicitly stated how long the period of time may be. In other words, the Fed hasn’t indicated the time horizon during which it intends inflation to average 2 percent.
The Fed uses changes in the personal consumption expenditure (PCE) price index to measure inflation, rather than using changes in the consumer price index (CPI). The Fed prefers the PCE to the CPI because the PCE is a broader measure of the price level in that it includes the prices of more consumer goods and services than does the CPI. The following figure shows inflation for the period since 2006 measured by percentage changes in the PCE from the corresponding month in the previous year. (Members of the Fed’s Federal Open Market Committee generally consider changes in the core PCE—which excludes the prices of food and energy—to be the best measure of the underlying rate of inflation. But because the Fed’s inflation target is stated in terms of the PCE rather than the core PCE, we are looking here only at the PCE.) The figure shows that for most of the period from 2012 to early 2021, inflation was less than the Fed’s target of 2 percent.
The figure also shows that since March 2021, inflation has been running above 2 percent and has steadily increased, reaching a rate of 5.8 percent in December 2021. Note that a strict interpretation of AIT would mean that the Fed would have to balance these inflation rates far above 2 percent with future inflation rates well below 2 percent. As Ricardo Reis, an economist at the London School of Economics, noted recently: “If the [Fed’s time] horizon is 3 years, the Fed … will [have to] pursue monetary policy to achieve annual inflation of… −0.5% over the next year and a half. If the horizon is 5 years, the Fed … will [have to] pursue policy to achieve annual inflation of 0.9% over the next 3.5 years.” It seems unlikely that the Fed would want to bring about inflation rates that low because doing so would require raising its target for the federal funds rate to levels likely to cause a recession.
Another interpretation of the Fed’s monetary policy strategy is that involves a flexible average inflation target (FAIT) approach rather than a strictly AIT approach. Former Fed Vice Chair Richard Clarida discussed this interpretation of the Fed’s strategy in a speech in November 2020. He noted that the framework was asymmetric, meaning that inflation rates higher than 2 percent need not be offset with inflation rates lower than 2 percent: “The new framework is asymmetric. …[T]he goal of monetary policy … is to return inflation to its 2 percent longer-run goal, but not to push inflation below 2 percent.” And: “Our framework aims … for inflation to average 2 percent over time, but it does not make a … commitment to achieve … inflation outcomes that average 2 percent under any and all circumstances ….”
Under this interpretation, particularly if Fed policymakers believe that the high inflation rates of 2021 were the result of temporary supply chain problems and other factors caused by the pandemic, it would not need to offset them by forcing inflation to very low levels in order to make the average inflation rate over time equal 2 percent. Critics of the FAIT approach to monetary policy note that the approach doesn’t provide investors, household, and firms with much guidance on what inflation rates the Fed may find acceptable over the short-term of a year or so. In that sense, the Fed is moving away from a rules-based policy, such as the Taylor rule that we discuss in Chapter 15. Or, as a columnist for the Wall Street Journal wrote with respect to FAIT: “Of course, the word ‘flexible’ is there because the Fed doesn’t want to be tied down, so it can do anything.”
The Fed’s actions during 2022 will likely provide a better understanding of how it intends to implement its new monetary policy strategy during conditions of high inflation.
Sources: Board of Governors of the Federal Reserve, “Why does the Federal Reserve aim for inflation of 2 percent over the longer run?” federalreserve.gov, August 27, 2020; Board of Governors of the Federal Reserve, “2020 Statement on Longer-Run Goals and Monetary Policy Strategy,” federalreserve.gov, January 14, 2021; Ricardo Reis’s comments are from this Twitter thread: https://mobile.twitter.com/R2Rsquared/status/1488552608981827590, Richard H. Clarida, “The Federal Reserve’s New Framework: Context and Consequences,” federalreserve.gov, November 16, 2020; and James Mackintosh, “On Inflation Surge, the Fed Is Running Out of Excuses,” Wall Street Journal, November 14, 2021.
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.
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.