Hoover Institution Podcast with Lawrence Summers and John Cochrane

Lawrence Summers (Photo from harvardmagazine.com.)
John Cochrane (Photo from hoover.org.)

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.

Is the Fed Becoming Too Political to Remain Independent?

Neel Kashkari, president of the Federal Reserve Bank of Minneapolis. Photo from the Wall Street Journal.
Pat Toomey, U.S. Senator from Pennsylvania. Photo from http://www.toomey.senate.gov.

As we discuss in Macroeconomics, Chapter 17, Section 17.4 (Economics, Chapter 27, Section 27.4), the Federal Reserve is unusual among federal government agencies in being able to operate largely independently of Congress and the president.  Congress passed the Federal Reserve Act, which established the Federal Reserve System, in 1913, and has amended it several times in the years since. (Note that, as we discuss in the Apply the Concept, “End the Fed?” in this chapter, the U.S. Constitution does not explicitly authorized the federal government to establish a central bank.) Section 2A of the act gives the Federal Reserve System the following charge:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Elsewhere in the act, the Fed was given other specified responsibilities, such as supervising commercial banks that are members of the Federal Reserve System and serving on the Financial Stability Oversight Council (FSOC), which is charged with assessing risks to the financial system. 

Because Congress can change the structure and operations of the Fed at any time and because Congress has given the Fed only certain specific responsibilities, traditionally the Fed has avoided becoming involved in policy debates that are not directly concerned with its responsibilities. Over the years, most members of the Board of Governors have believed that if the Fed were to become involved in issues beyond monetary policy and the working of the financial system, Congress might decide to revise the Federal Reserve Act to reduce, or even eliminate, Fed independence.

In the spring of 2022, though, there were two instances where some members of Congress argued that the Fed had become involved in policy issues that went beyond the Fed’s responsibilities under the Federal Reserve Act. The first instance involved President Joe Biden’s nomination in January 2022 of Sarah Bloom Raskin to serve on the Fed’s Board of Governors. In 2010, Raskin was nominated to the Board of Governors by President Barack Obama and confirmed by the Senate in a voice vote without significant opposition. (In 2014, she resigned from the Board to accept a position in the Treasury Department.)

Her nomination by President Biden encountered significant opposition, however, largely because in July 2020 she had suggested that when the Fed expanded its lending programs during the Covid-19 pandemic it should have excluded firms in the oil, natural gas, and coal industries: “The Fed is ignoring clear warning signs about the economic repercussions of the impending climate crisis by taking action that will lead to increases in greenhouse gas emissions at a time when even in the short term, fossil fuels are a terrible investment.” Although her supporters argued that in formulating policy the Fed should take into account the threats to financial stability caused by climate change, when it became clear that a majority of the Senate disagreed, Raskin withdrew her nomination. 

In April 2022, some members of Congress, including Senator Pat Toomey of Pennsylvania, questioned whether it was appropriate for President Neel Kashkari of the Federal Reserve Bank of Minneapolis to formally support the campaign to amend the Minnesota state constitution to include a provision stating that, “All children have a fundamental right to a quality public education …. It is a paramount duty of the state to ensure quality public schools that fulfill this fundamental right.”

The Bank defended its support for the amendment in a statement on its website: “The Federal Reserve Bank of Minneapolis’ support of the Page amendment is closely linked to the mission of the Federal Reserve. Congress assigned the Federal Reserve the dual goals of achieving (1) stable prices and (2) maximum employment, and one of the greatest determinants of success in the job market is education.”

Senator Toomey strongly disagreed, arguing in a letter of Bank President Kashkari that: “This amendment is highly political, as it wades into an ongoing debate about whether government-run school systems are preferable to parental choice in education.” Toomey asserted that: “These political lobbying efforts by you and other Minneapolis Fed officials … are well beyond the Federal Reserve’s mandate, violate Federal Reserve Bank policies, constitute a misuse of Minneapolis Fed resources, and ultimately undermine the Federal Reserve’s independence and credibility.”

It remains to be seen whether Congress will ultimately accept the arguments of Federal Reserve policymakers such as Kashkari and Raskin that the Fed needs to interpret its mandate from Congress more broadly, or whether Congress will decide to amend the Federal Reserve Act to more explicitly limit the boundaries of Fed action—or to reduce Fed independence in some other ways. 

Sources: Sarah Bloom Raskin, “Why Is the Fed Spending So Much Money on a Dying Industry?” New York Times, May 28, 2020; Andrew Ackerman and Ken Thomas, “Sarah Bloom Raskin Withdraws as Biden’s Pick for Top Fed Banking Regulator,” Wall Street Journal, March 15, 2022; Michael S. Derby, “GOP Senator Criticizes Minneapolis Fed Over Education Issue,” Wall Street Journal, April 12, 2022; Federal Reserve Bank of Minneapolis, “Page Amendment: Every Child Deserves a Quality Public Education,” minneapolisfed.org; and Pat Toomey, “Letter to Neel Kashkari,” banking.senate. gov, April 11, 2022.

Did the Fed Make a Mistake by Not Preempting Inflation?

Warning: Long post!

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.

Caption: Under Chair Paul Volcker, the Fed began fighting inflation in 1979 by reducing the growth of the money supply, thereby raising interest rates. By 1982, the unemployment rate had risen to 10 percent, and the inflation rate had fallen to 6 percent. As workers and firms lowered their expectations of future inflation, the short-run Phillips curve shifted down. The adjustment in expectations allowed the Fed to switch to an expansionary monetary policy, which by 1987 brought unemployment back to the natural rate of unemployment, with an inflation rate of about 4 percent. The orange line shows the actual combinations of unemployment and inflation for each year 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. 

AIT or FAIT: How Will the Fed’s New Monetary Policy Strategy Deal with High Inflation Rates?

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 Employment Cost Index, Inflation, and the Possibility of a Wage-Price Spiral

In respect to its mandate to achieve price stability, the Federal Open Market Committee focuses on data for the personal consumption expenditure (PCE) price index and the core PCE price index. (The core PCE price index omits food and energy prices, as does the core consumer price index.) After the March, June, September, and December FOMC meetings, each committee member projects future values of these price indexes. The projections, which are made public, provide a means for investors, businesses, and households to understand what the Fed expects to happen with future inflation.

In his press conference following the December 2021 FOMC meeting, Chair Jerome Powell surprised some economists by discussing the importance of the employment cost index (ECI) in the committee’s evaluation of the current state of inflation. Powell was asked this question by a journalist: “I wonder if you could talk a little bit about what prompted your recent pivot toward greater wariness around inflation.” He responded, in part:

“We got the ECI reading on the eve of the November meeting—it was the Friday before the November meeting—and it was very high, 5.7 percent reading for the employment compensation index for the third quarter … That’s really what happened [that resulted in FOMC deciding to focus more on inflation]. It was essentially higher inflation and faster—turns out much faster progress in the labor market.”

The ECI is compiled by the Bureau of Labor Statistics and is published quarterly. It measures the cost to employers per employee hour worked. The BLS publishes data that includes only wages and salaries and data that includes, in addition to wages and salaries, non-wage benefits—such as contributions to retirement accounts or health insurance—that firms pay workers. The figure below shows the ECI including just wages and salaries (red line) and including all compensation (blue line). The difference between the two lines shows that wages and salaries have been increasing more rapidly than has total compensation. 

A focus on the labor market when analyzing inflation is unsurprising. In Macroeconomics, Chapter 17, Section 17.1 (Economics, Chapter 27, Section 27.1) we discuss how the Phillips curve links the state of the labor market—as measured by the unemployment rate—to the inflation rate. The link between the unemployment rate and the inflation rate operates through the labor market: When the unemployment rate is low, firms raise wages as they attempt to attract the relatively small number of available workers and to keep their own workers from leaving. (As first drawn by economist A.W. Phillips, the Phillips curve showed the relationship between the unemployment rate and the rate of wage inflation, rather than the relationship between the unemployment rate and the rate of price inflation.) As firms’ wage costs rise, they increase prices. So, as Powell noted, we would expect that if wages are rising rapidly, the rate of price inflation will also increase. 

Powell noted that the FOMC is concerned that rising wages might eventually lead to a wage-price spiral in which higher wages lead to higher prices, which, in turn, cause workers to press for higher nominal wages to keep their real wages from falling, which then leads firms to increases their prices even more, and so on. Some economists interpret the inflation rates during the Great Inflation for 1968–1982 as resulting from a wage-price spiral. One condition for a wage-price spiral to begin is that workers and firms cease to believe that the Fed will be able to return to its target inflation rate—which is currently 2 percent.

In terms of the Phillips curve analysis of Chapter 17, a wage-price spiral can be interpreted as a shifting up of the short-run Phillips curve. The Phillips curve shifts up when households, firms, and investors increase their expectations of future inflation. We discuss this process in Chapter 17, Section 17.2. As the short-run Phillips curve shifts up the tradeoff between inflation and unemployment becomes worse. That is, the inflation rate is higher at every unemployment rate.  For the Fed to reduce the inflation rate—bring it back down to the Fed’s target—becomes more difficult without causing a recession. The Great Inflation was only ended after the Fed raised its target for the federal funds rate to levels that helped cause the severe recession of 1981–1982.

The FOMC has been closely monitoring movements in the ECI to make sure that it heads off a wage-price spiral before it begins.  

Sources:  The transcript of Chair Powell’s press conference can be found here; the most recent economic projections of FOMC members can be found here; and a news article discussing Powell’s fears of a wage-price spiral can be found here (subscription may be required).

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.

Macroeconomics or Microeconomics? Is a Lack of Competition in Some Industries Behind the Increase in Inflation?

Photo from the Wall Street Journal

In January 2022, the Bureau of Labor Statistics (BLS) announced that inflation, measured as the percentage change in the consumer price index (CPI) from December 2020 to December 2021, was 7 percent. That was the highest rate since June 1982, which was near the end of the Great Inflation that lasted from 1968 to 1982. The following figure shows the inflation rate since the beginning of 1948. 

What explains the surge in inflation? Most economists believe that it is the result of the interaction of increases in aggregate demand resulting from very expansionary monetary and fiscal policy and disruptions to supply in some industries as a result of the Covid-19 pandemic. (We discuss movements in aggregate demand and aggregate supply during the pandemic in the updated editions of Economics, Chapter 23, Section 23.3 and Macroeconomics, Chapter 13, Section, 13.3.)

But President Joe Biden has suggested that mergers and acquisitions in some industries—he singled out meatpacking—have reduced competition and contributed to recent price increases. Massachusetts Senator Elizabeth Warren has made a broader claim about reduced competition being responsible for the surge in inflation: “Market concentration has allowed giant corporations to hide behind claims of increased costs to fatten their profit margins. [Corporations] are raising prices because they can.” And “Corporations are exploiting the pandemic to gouge consumers with higher prices on everyday essentials, from milk to gasoline.”

Do many economists agree that reduced competition explains inflation? The Booth School of Business at the University of Chicago periodically surveys a panel of more than 40 well-known academic economists for their opinions on significant policy issues. Recently, the panel was asked whether they agreed with these statements:

  1. A significant factor behind today’s higher US inflation is dominant corporations in uncompetitive markets taking advantage of their market power to raise prices in order to increase their profit margins.
  2. Antitrust interventions could successfully reduce US inflation over the next 12 months.
  3. Price controls as deployed in the 1970s could successfully reduce US inflation over the next 12 months.

Large majorities of the panel disagreed with statements 1. and 2.—that is, they don’t believe that a lack of competition explains the surge in inflation or that antitrust actions by the federal government would be likely to reduce inflation in the coming year. A smaller majority disagreed with statement 3., although even some of those who agreed that price controls would reduce inflation stated that they believed price controls were an undesirable policy. For instance, while he agreed with statement 3., Oliver Hart of Harvard noted that: “They could reduce inflation but the consequence would be shortages and rationing.”

One way to characterize the panel’s responses is that they agreed that the recent inflation was primarily a macroeconomic issue—involving movements in aggregate demand and aggregate supply—rather than a microeconomic issue—involving the extent of concentration in individual industries. 

The panels responses can be found here

Sources for Biden and Warren quotes: Greg Ip, “Is Inflation a Microeconomic Problem? That’s What Biden’s Competition Push Is Betting,” Wall Street Journal, January 12, 2022; and Patrick Thomas and Catherine Lucey, “Biden Promotes Plan Aimed at Tackling Meat Prices,” Wall Street Journal, January 3, 2022; and https://twitter.com/SenWarren/status/1464353269610954759?s=20

Lawrence Summers Remains Pessimistic about Inflation

By LHSummers – I had this photo taken of me for personal puposes. Previously published: My website, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=23123636

Lawrence Summers, professor of economics at Harvard University and secretary of the Treasury under President Bill Clinton, has been outspoken in arguing that monetary and fiscal have been too expansionary. In February 2021, just before Congress passed the American Rescure Plan, which increased federal government spending by $1.9 trillion, Summers cautioned that “there is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability.”

In a brief CNN interview found at this LINK, Summers indicates that he remains concerned that inflation may persist at high levels for a longer period than many other economists, including policymakers at the Federal Reserve, believe.

Source for quote: Lawrence H. Summers, “The Biden Stimulus Is Admirably Ambitious. But It Brings Some Big Risks, Too,” Washington Post, February 4, 2021.

How Do We Know When the Economy Is at Maximum Employment?

Photo from the Wall Street Journal

According to the Federal Reserve Act, the Fed must conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Neither “maximum employment” nor “stable prices” are defined in the act.

The Fed has interpreted “stable prices” to mean a low rate of inflation. Since 2012, the Fed has had an explicit inflation target of 2 percent. When the Fed announced its new monetary policy strategy in August 2020, it modified its inflation target by stating that it would attempt to achieve an average inflation rate of 2 percent over time. As Fed Chair Jerome Powell stated: “Our approach can be described as a flexible form of average inflation targeting.” (Note that although the consumer price index (CPI) is the focus of many media stories on inflation, the Fed’s preferred measure of inflation is changes in the core personal consumption expenditures (PCE) price index. The PCE is a broader measure of the price level than is the CPI because it includes the prices of all the goods and services included in consumption category of GDP. “Core” means that the index excludes food and energy prices. For a further discussion see, Economics, Chapter 25, Section 15.5 and Macroeconomics, Chapter 15, Section 15.5.) 

There is more ambiguity about how to determine whether the economy is at maximum employment. For many years, a majority of members of the Federal Open Market Committee (FOMC) focused on the natural rate of unemployment (also called the non-accelerating rate of unemployment (NAIRU)) as the best gauge of when the U.S. economy had attained maximum employment. The lesson many economists and policymakers had taken from the experience of the Great Inflation that lasted from the late 1960s to the early 1980s was if the unemployment rate was persistently below the natural rate of unemployment, inflation would begin to accelerate. Because monetary policy affects the economy with a lag, many policymakers believed it was important for the Fed to react before inflation begins to significantly increase and a higher inflation rate becomes embedded in the economy.

At least until the end of 2018, speeches and other statements by some members of the FOMC indicated that they continued to believe that the Fed should pay close attention to the relationship between the natural rate of unemployment and the actual rate of unemployment. But by that time some members of the FOMC had concluded that their decision to begin raising the target for the federal funds rate in December 2015 and continuing raising it through December 2018 may have been a mistake because their forecasts of the natural rate of unemployment may have been too high. For instance, Atlanta Fed President Raphael Bostic noted in a speech that: “If estimates of the NAIRU are actually too conservative, as many would argue they have been … unemployment could have averaged one to two percentage points lower” than it actually did.

Accordingly, when the Fed announced its new monetary policy strategy in August 2020, it indicated that it would consider a wider range of data—such as the employment-population ratio—when determining whether the labor market had reached maximum employment. At the time, Fed Chair Powell noted that: “the maximum level of employment is not directly measurable and [it] changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.”

As the economy recovered from the effects of the Covid-19 pandemic, the Fed faced particular difficulty in assessing the state of the labor market. Some labor market indicators appeared to show that the economy was close to maximum employment while other indicators showed that the labor market recovery was not complete. For instance, in December 2021, the unemployment rate was 3.9 percent, slightly below the average of the FOMC members estimates of the natural rate of unemployment, which was 4.0 percent. Similarly, as the first figure below shows, job vacancy rates were very high at the end of 2021. (The BLS calculates job vacancy rates, also called job opening rates, by dividing the number of unfilled job openings by the sum of total employment plus job openings.) As the second figure below shows, job quit rates were also unusually high, indicating that workers saw the job market as being tight enough that if they quit their current job they could find easily another job. (The BLS calculates job quit rates by dividing the number of people quitting jobs by total employment.) By those measures, the labor market seemed close to maximum employment.

But as the first figure below shows, total employment in December 2021 was still 3.5 million below its level of early 2020, just before the U.S. economy began to experience the effects of the pandemic. Some of the decline in employment can be accounted for by older workers retiring, but as the second figure below indicates, employment of prime-age workers (those between the ages of 25 and 54), had not recovered to pre-pandemic levels. 

How to reconcile these conflicting labor market indicators? In January 2022, Fed Chair Powell testified before the Senate Banking Committee as the Senate considered his nomination for a second four-year term as chair. In discussing the state of the economy he offered the opinion that: “We’re very rapidly approaching or at maximum employment.” He noted that inflation as measured by changes in the CPI had been running above 5 percent since June 2021: “If these high levels of inflation get entrenched in our economy, and in people’s thinking, then inevitably that will lead to much tighter monetary policy from us, and it could lead to a recession.” In that sense, “high inflation is a severe threat to the achievement of maximum employment.”

At the time of Powell’s testimony, the FOMC had already announced that it was moving to a less expansionary monetary policy by reducing its purchases of Treasury bonds and mortgage-backed securities and by increasing its target for the federal funds rate in the near future. He argued that these actions would help the Fed achieve its dual mandate by reducing the inflation rate, thereby heading off the need for larger increases in the federal funds rate that might trigger a recession. Avoiding a recession would help achieve the goal of maximum employment.

Powell’s remarks did not make explicit which labor market indicators the Fed would focus on in determining whether the goal of maximum employment had been obtained. It did make clear that the Fed’s new policy of average inflation targeting did not mean that the Fed would accept inflation rates as high as those of the second half of 2021 without raising its target for the federal funds rate. In that sense, the Fed’s monetary policy of 2022 seemed consistent with its decades-long commitment to heading off increases in inflation before they lead to a significant increase in the inflation rate expected by households, businesses, and investors. 

Note: For a discussion of the background to Fed policy, see Economics, Chapter 25, Section 25.5 and Chapter 27, Section 17.4, and Macroeconomics, Chapter 15, Section 15.5 and Chapter 17, Section 17.4.

Sources: Jeanna Smialek, “Jerome Powell Says the Fed is Prepared to Raise Rates to Tame Inflation,” New York Times, January 11, 2022; Nick Timiraos, “Fed’s Powell Says Economy No Longer Needs Aggressive Stimulus,” Wall Street Journal, January 11, 2022; and Federal Open Market Committee, “Meeting Calendars, Statements, and Minutes,” federalreserve.gov, January 5, 2022.