Join author Glenn Hubbard & Tony O’Brien in their first Sprint 2023 podcast where they revisit inflation as the major topic facing our country, our economy, and our classrooms. Glenn & Tony discuss the Federal Reserve response and the outlook for the economy. While rates have continued to move up, is a soft-landing still possible?
Category: Macroeconomics
Bad News from the Congressional Budget Office
In 1974, Congress created the Congressional Budget Office (CBO). The CBO was given the responsibility of providing Congress with impartial economic analysis as it makes decisions about the federal government’s budget. One of the most widely discussed reports the CBO issues is the Budget and Economic Outlook. The report provides forecasts of future federal budget deficits and changes in the federal government’s debt that the budget deficits will cause. The CBO’s budget and debt forecasts rely on the agency’s forecasts of future economic conditions and assumes that Congress will make no changes to current laws regarding taxing and spending. (We discuss this assumption further below.)
On February 15, the CBO issued its latest forecasts. The forecasts showed a deterioration in the federal government’s financial situation compared with the forecasts the CBO had issued in May 2022. (You can find the full report here.) Last year, the CBO forecast that the federal government’s cumulative budget deficit from 2023 through 2032 would be $15.7 trillion. The CBO is now forecasting the cumulative deficit over the same period will be $18.8 trillion. The three main reason for the increase in the forecast deficits are:
1. Congress has increased spending—particularly on benefits for military veterans.
2) Cost-of-living adjustments for Social Security and other government programs have increased as a result of higher inflation.
3) Interest rates on Treasury debt have increased as a result of higher inflation.
The CBO forecasts that federal debt held by the public will increase from 98 percent of GDP in 2023 to 118 percent in 2033 and eventually to 198 percent in 2053. Note that economists prefer to measure the size of the debt relative to GDP rather than in as absolute dollar amounts for two main reasons: First, measuring debt relative to GDP makes it easier to see how debt has changed over time in relation to the growth of the economy. Second, the size of debt relative to GDP makes it easier to gauge the burden that the debt imposes on the economy. When debt grows more slowly than the economy, as measured by GDP, crowding effects are likely to be relatively small. We discuss crowding out in Macroeconomics, Chapter 10, Section 10.2 and Chapter 16, Section 16. 5 (Economics, Chapter 20, Section 20.2 and Chapter 26, Section 26.5). The two most important factors driving increases in the ratio of debt to GDP are increased spending on Social Security, Medicare, and Medicaid, and increased interest payments on the debt.
The following figure is reproduced from the CBO report. It shows the ratio of debt to GDP with actual values for the period 1900-2022 and projected values for the period 2023-2053. Note that the only other time the ratio of debt to GDP rose above 100 percent was in 1945 and 1946 as a result of the large increases in federal government spending required to fight World War II.
The increased deficits and debt over the next 10 years are being driven by government spending increasing as a percentage of GDP, while government revenues (which are mainly taxes) are roughly stable as a percentage of GDP. The following figure from the report shows actual federal outlays and revenues as a percentage of GDP for the period 1973-2022 and projected outlays and revenues for the period 2023-2033. Note that from 1973 to 2022, outlays averaged 21.0 percent of GDP and revenues averaged 17.4 percent of GDP, resulting in an average deficit of 3.6 percent of GDP. By 2033, outlays are forecast to rise to 24.9 percent of GDP–well above the 1973-2022 average–whereas revenues are forecast to be only 18.1 percent, for a forecast deficit of 6.8 percent of GDP.
The increase in outlays is driven primarily by increases in mandatory spending, mainly spending on Social Security, Medicare, Medicaid, and veterans’ benefits and increases in interest payments on the debt. The CBO’s forecast assumes that discretionary spending will gradually decline over the next 10 years as percentage of GDP. Discretionary spending includes federal spending on defense and all other government programs apart from those, like Social Security, where spending is mandated by law.
To avoid the persistent deficits, and increasing debt that results, Congress would need to do one (or a combination) of the following:
1. Reduce the currently scheduled increases in mandatory spending (in political discussions this alternative is referred to as entitlement reform because entitlements is another name for manadatory spending).
2. Decrease discretionary spending, the largest component of which is defense spending.
3. Increases taxes.
There doesn’t appear to be majority support in Congress for taking any of these steps.
The CBO’s latest forecast seems gloomy, but may actually understate the likely future increases in the federal budget deficit and federal debt. The CBO’s forecast assumes that future outlays and taxes will occur as indicated in current law. For example, the forecast assumes that many of the tax cuts Congress passed in 2017 will expire in 2025 as stated in current law. Many political observers doubt that Congress will allow the tax cuts to expire as scheduled because to do so would result in increases in individual income taxes for most people. (Here is a recent article in the Washington Post that discusses this point. A subscription may be required to access the full article.) The CBO also assumes that defense spending will not increase beyond what is indicated by current law. Many political observers believe that, in fact, Congress may feel compelled to substantially increase defense spending as a result of Russia’s invasion of Ukraine in February 2022 and the potential military threat posed by China.
The CBO forecast also assumes that the U.S. economy won’t experience a recession between 2023 and 2033, which is possible but unlikely. If the economy does experience a recession, federal outlays for unemployment insurance and other programs will increase and federal personal and corporate income tax revenues will fall. The CBO’s forecast also assumes that the interest rate on the 10-year Treasury note will be under 4 percent and that the federal funds rate will be under 3 percent (interest rates on short-term Treasury debt move closely with changes in the federal funds rate). If interest rates turn out to be higher than these forecasts, the federal government’s interest payments will increase, further increasing the deficit and the debt.
In short, the federal government is clearly facing the most difficult budgetary situation since World War II.
If You Have Some Cash to Spare ….
you can bid for Paul Samuelson’s Nobel Prize Medal here. Note that at the time of posting the minimum bid required was $495,000.
You can read a brief biography of Samuelson on the Nobel site here. You can read the lecture Samuelson delivered on the occasion of being awarded the price here. (Note that the lecture contains technical material.)
11/17/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, the Fed’s Response, FTX collapse, and also share thoughts on economics themes in holiday movies!
In the Face of Hyperinflation, Some People in Argentina Don’t Save Currency, They Save … Bricks
Argentina’s Argentina’s Economy Minister Sergio Massa coming from a meeting in Washington, DC with the International Monetary Fund to discuss the country’s hyperinflation. Photo from the Wall Street Journal.
Argentina has been through several periods of hyperinflation during with the price level has increased more than 50 percent per month. The following figure shows the inflation rate as measured by the percentage change in the consumer price index from the previous month for since the beginning of 2018. The inflation rate during these years has been volatile, being greater than 50 percent per month during several periods, including staring in the spring of 2022. High rates of inflation have become so routine in Argentina that an article in the Wall Street Journal quoted on store owner as saying, “Here 40% [inflation] is normal. And when we get past 50%, it doesn’t scare us, it simply bothers us.”
As we discuss in Macroeconomics, Chapter 14, Section 14.5 (Economics, Chapter 24, Section 24.5 ), when an economy experiences hyperinflation, consumers and businesses hold the country’s currency for as brief a time as possible because the purchasing power of the currency is declining rapidly. As we noted in the chapter, in some countries experiencing high rates of inflation, consumers and businesses buy and sell goods using U.S. dollars rather than the domestic currency because the purchasing power of the dollar is more stable. This demand for dollars in countries experiencing high inflation rates is one reason why an estimated 80 percent of all $100 bills circulate outside of the United States.
The increased demand for U.S. dollars by people in Argentina is reflected in the exchange rate between the Argentine peso and the U.S. dollar. The following figure shows that at the beginning of 2018, one dollar exchanged for about 18 pesos. By November 2022, one dollar exchanged for about 159 pesos. The exchange rate shown in the figure is the official exchange rate at which people in Argentina can legally exchange pesos for dollars. In practice, it is difficult for many individuals and small firms to buy dollars at the official exchange rate. Instead, they have to use private currency traders who will make the exchange at an unofficial—or “blue”—exchange rate that varies with the demand and supply of pesos for dollars. A reporter for the Economist described his experience during a recent trip to Argentina: “Walk down Calle Lavalle or Calle Florida in the centre of Buenos Aires and every 20 metres someone will call out ‘cambio’ (exchange), offering to buy dollars at a rate that is roughly double the official one.”
People in Argentina are reluctant to deposit their money in banks, partly because the interest rates banks pay typically are lower than the inflation rate, causing the purchasing power of money deposited in banks to decline over time. People are also afraid that the government might keep them from withdrawing their money, which has happened in the past. As an alternative to depositing their money in banks, many people in Argentina buy more goods than they can immediately use and store them, thereby avoiding future price increases on these goods. The Wall Street Journalquoted a university student as saying: “I came to this market and bought as much toilet paper as I could for the month, more than 20 packs. I try to buy all [the goods] I can because I know that next month it will cost more to buy.”
Devon Zuegel, a U.S. software engineer and economics blogger who travels frequently to Argentina, has observed one unusual way that some people in Argentina save while experiencing hyperinflation:
“Bricks—actual bricks, not stacks of cash—are another common savings mechanism, especially for working-class Argentinians. The value of bricks is fairly stable, and they’re useful to a family building out their house. Argentina doesn’t have a mortgage industry, and thus buying a pallet of bricks each time you get a paycheck is an effective way to pay for your home in installments. (Bricks aren’t fully monetized, in that I don’t think people buy bricks and then sell them later, so people only use this method of saving when they actually have something they want to use the bricks for.)”
Sources: “Sergio Massa Is the Only Thing Standing Between Argentina and Chaos,” economist. com, October 13, 2022; Devon Zuegel, “Inside Argentina’s Currency Exchange Black Markets,” devonzuegel.com, September 10, 2022; Silvina Frydlewsky and Juan Forero, “Inflation Got You Down? At Least You Don’t Live in Argentina,” Wall Street Journal, April 25, 2022; and Federal Reserve Bank of St. Louis, FRED data set.
Glenn Will Be Speaking on Friday, October 14 at a Seminar Sponsored by the Texas Tech Economics Department
Time: Friday, October 14, 1:00 p.m.
Location: Red Raider Lounge 119 in the Student Union Building (SUB)
Ben Bernanke, Douglas Diamond, and Philip Dybvig Win the Nobel Prize in Economics
Former Federal Reserve Chair Ben Bernanke (now a Distinguished Fellow in Residence at the Brookings Institution in Washington, DC), Douglas Diamond of the University of Chicago, and Philip Dybvig of Washington University in St. Louis shared the 2022 Nobel Prize in Economics (formally called the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel). The prize of 10 million Swedish kronor (about 8.85 million U.S. dollars) was awarded for “significantly [improving] our understanding of the role of banks in the economy, particularly during financial crises.” (The press release from the Nobel committee can be read here.)
In paper published in the American Economic Review in 1983, Bernanke provided an influential interpretation of the role the bank panics of the early 1930s played in worsening the severity of the Great Depression. As we discuss in Macroeconomics, Chapter 14, Section 14.3 (Economics, Chapter 24, Section 24.3), by taking deposits and making loans banks play an important in the money supply process. Milton Friedman and Anna Schwartz in A Monetary History of the United States, 1867-1960, Chapter 7, argued that the bank panics of the early 1930s caused a decline in real GDP and employment largely through the mechanism of reducing the money supply.
Bernanke demonstrated that the bank failures affected output and employment in another important way. As we discuss in Macroeconomics, Chapter 6, Section 6.2 and Chapter 14, Section 14.4 (Economics, Chapter 8, Section 8.2 and Chapter 24, Section 24.4) banks are financial intermediaries who engage in indirect finance. Banks accept deposits and use the funds to make loans to households and firms. Households and most firms can’t raise funds through direct finance by selling bonds or stocks to individual investors because investors don’t have enough information about households or all but the largest firms to know whether these borrowers will repay the funds. Banks get around this information problemby specializing in gathering information on households and firms that allow them to gauge how likely a borrower is to default, or stop paying, on a loan.
Because of the special role banks have in providing credit to households and firms that have difficulty borrowing elsewhere, Bernanke argued that the bank panics of the early 1930s, during which more than 5,000 banks in the United States went out of business, not only caused a reduction in the money supply but restricted the ability of households and firms to borrow. As a result, households and firms decreased their spending, which increased the severity of the Great Depression.
In a 1983 paper published in the Journal of Political Economy, Diamond and Dybvig presented what came to be known as the Diamond and Dybvig model of the economic role of banks. This model, along with later research by Diamond, provided economists with a better understanding of the potential instability of banking. Diamond and Dybvig note that banking involves transforming long-run, illiquid assets—loans—into short-run, liquid assets—deposits. Recall that liquidity is the ease with which an asset can be sold. Households and firms want the loans they receive from a bank to be illiquid in the sense that they don’t want the bank to be able to demand that the funds borrowed be repaid, except on a set schedule. Someone receiving a mortgage loan to buy a house wouldn’t want the bank to be able to insist on being paid back any time the bank chose. But households and firms also want the assets they hold to be liquid so that they can quickly convert the assets into money if they need the funds. By taking in deposits and using the funds to make loans, banks provide a service to households and firms by providing both a source of long-run credit and a source of short-term assets.
But Diamond and Dybvig note that because banks hold long-terms assets that can’t easily be sold, if a large number of people attempt simultaneously to withdraw their deposits, the banks lack the funds to meet these withdrawals. The result is a run on a bank as depositors become aware that unless they quickly withdraw their deposits, they may not receive their funds for a considerable time. If the bank is insolvent—the value of its loans and other assets is less than the value of its deposits and other liabilities—the bank may fail and some households and firms will never receive the full value of their deposits. In the Diamond and Dybvig model, if depositors expect that other depositors will not withdraw their funds, the system can be stable because banks won’t experience runs. But because banks know more about the value of their assets and liabilities than depositors do, depositors may have trouble distinguishing solvent banks from insolvent banks. As a result of this information problem, households and firms may decide to withdraw their deposits even from solvent banks. Households and firms may withdraw their deposits from a bank even if they know with certainty that the bank is solvent if they expect that other households and firms—who may lack this knowledge—will withdraw their deposits. The result will be a bank panic, in which many banks simultaneously experience a bank run.
With many banks closing or refusing to make new loans in order to conserve funds, households and firms that depend on bank loans will be forced to reduce their spending. As a result, production and employment will decline. Falling production and employment may cause more borrowers to stop paying on their loans, which may cause more banks to be insolvent, leading to further runs, and so on. We illustrate this process in Figure 14.3.
Diamond and Dybvig note that a system of deposit insurance—adopted in the United States when Congress established the Federal Deposit Insurance Corporation (FDIC) in 1934—or a central bank acting as a lender of last resort to banks experiencing runs are necessary to stabilize the banking system. When Congress established the Federal Reserve System in 1914, it gave the Fed the ability to act as a lender of last resort by making discount loans to banks that were solvent but experiencing temporary liquidity problems as a result of deposit withdrawals.
During the Global Financial Crisis that began in 2007 and accelerated following the failure of the Lehman Brothers investment bank in September 2008, it became clear that the financial firms in the shadow banking system could also be subject to runs because, like commercial banks, shadow banks borrow short term to financial long term investments. Included in the shadow banking system are money market mutual funds, investment banks, and insurance companies. By 2008 the size of the shadow banking system had grown substantially relative to the commercial banking system. The shadow banking system turned out to be more fragile than the commercial banking system because those lending to shadow banks by, for instance, buying money market mutual fund shares, do not receive government insurance like bank depositors receive from the FDIC and because prior to 2008 the Fed did not act as a lender of last resort to shadow banks.
Bernanke believes that his study of financial problems the U.S. experienced during the Great Depression helped him as Fed chair to deal with the Global Financial Crisis. In particular, Bernanke concluded from his research that in the early 1930s the Fed had committed a major error in failing to act more vigorously as a lender of last resort to commercial banks. The result was severe problems in the U.S. financial system that substantially worsened the length and severity of the Great Depression. During the financial crisis, under Bernanke’s leadership, the Fed established several lending facilities that allowed the Fed to extend its role as a lender of last resort to parts of the shadow banking system. (In 2020, the Fed under the leadership of Chair Jerome Powell revived and extended these lending facilities.) Bernanke is rare among economists awarded the Nobel Prize in having had the opportunity to implement lessons from his academic research in economic policymaking at the highest level. (Bernanke discusses the relationship between his research and his policymaking in his memoir. A more complete discussion of the financial crises of the 1930s, 2007-2009, and 2020 appears in Chapter 14 of our textbook Money, Banking, and the Financial System, Fourth Edition.)
We should note that Bernanke’s actions at the Fed have been subject to criticism by some economists and policymakers. As a member of the Fed’s Board of Governors beginning in 2002 and then as Fed chair beginning in 2006, Bernanke, like other members of the Fed and most economists, was slow to recognize the problems in the shadow banking system and, particularly, the problems caused by the rapid increase in housing prices and increasing number of mortgages being granted to borrowers who had either poor credit histories or who made small down payments. Some economists and policymakers also argue that Bernanke’s actions during the financial crisis took the Fed beyond the narrow role of stabilizing the commercial banking system spelled out by Congress in the Federal Reserve Act and may have undermined Fed independence. They also argue that by broadening the Fed’s role as a lender of last resort to include shadow banks, Bernanke may have increased the extent of moral hazard in the financial system.
Finally, Laurence Ball of Johns Hopkins University argues that the worst of the financial crisis could have been averted if Bernanke had acted to save the Lehman Brothers investment bank from failing by making loans to Lehman. Bernanke has argued that the Fed couldn’t legally make loans to Lehman because the firm was insolvent but Ball argues that, in fact, the firm was solvent. Decades later, economists continue to debate whether the Fed’s actions in allowing the Bank of United States to fail in 1930 were appropriate and the debate over the Fed’s actions with respect to Lehman may well last as long. (A working paper version of Ball’s argument can be found here. He later extended his argument in a book. Bernanke’s account of his actions during the failure of Lehman Brothers can be found in his memoir cited earlier.)
Sources: Paul Hannon, “Nobel Prize in Economics Winners Include Former Fed Chair Ben Bernanke,” Wall Street Journal, October 10, 2022; David Keyton, Frank Jordans, and Paul Wiseman, “Former Fed Chair Bernanke Shares Nobel for Research on Banks,” apnews.com, October 10, 2022; and Greg Ip, “Most Nobel Laureates Develop Theories; Ben Bernanke Put His Into Practice,” Wall Street Journal, October 10, 2022.
A Handy Way to Track Recession Indicators
In a blog post at the end of August, we noted that real GDP declined during the first two quarters of 2022. On September 29, the Bureau of Economic Analysis (BEA) slightly revised the real GDP data, but after the revisions the BEA’s estimates still showed real GDP declining during those quarters.
A popular definition of a recession is two consecutive quarters of declining real GDP. But, as we noted in the earlier blog post, most economists do not follow this definition. Instead, for most purposes, economists rely on the National Bureau of Economic Research’s business cycle dating, which is based on a number of macroeconomic data series. The NBER defines a recession as “a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” The NBER discusses its approach to business cycle dating here.
The Federal Reserve Bank of St. Louis’s invaluable FRED economic data site has collected the data series that the NBER’s Business Cycle Dating Committee relies on when deciding when a recession began. The FRED page collecting these data can be found here.
Note that although the Business Cycle Dating Committee analyzes a variety of data series, “In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.” The following figures show movements in those two data series. These data series don’t give a strong indication that the economy was in recession during the first half of 2022. Real personal income minus transfer payments did decline by 0.4 percent between January and June 2022 (before increasing during July and August), but nonfarm payroll employment increased by 1.4 percent during the same period (and increased further in July and August).
As we noted in our earlier blog post, the message from most data series other than real GDP seems to be that the U.S. economy was not in a recession during the first half of 2022.
Solved Problem: How Does the Value of the U.S. Dollar Affect the U.S. and World Economies?
Supports: Macroeconomics, Chapter 18, Economics, Chapter 28, and Essentials of Economics, Chapter 19.
Between June 2021 and September 2022, the exchange rate between the U.S. dollar and an average of the currencies of the major trading partners of the United States increased by 14 percent. (This movement is shown in the figure above.) An article in the New York Times had the headline “The Dollar Is Strong. That Is Good for the U.S. but Bad for the World.”
- Briefly explain what the headline means by a “strong” dollar.
- Do you agree with the assertion in the headline that a stronger dollar is good for the United States but bad for the economies that the United States trades with? Briefly explain.
- During this period the Federal Reserve was taking actions that raised U.S. interest rates. The article noted that “Those interest rate increases are pumping up the value of the dollar ….” Why would increases in U.S. interest rates relative to interest rates in other countries increase the value of the dollar?
Solving the Problem
Step 1: Review the chapter material. This problem is about the effect of fluctuations in the exchange rate and the relationship between interest rates and exchange rates, so you may want to review Macroeconomics, Chapter 18, Section 8.2, “The Foreign Exchange Market and Exchange Rates,” or the corresponding sections in Economics, Chapter 28 or Essentials of Economics, Chapter 19.
Step 2: Answer part a. by explaining what a “strong” dollar means. A strong dollar is one that exchanges for more units of foreign currencies, such as British pounds or euros. (A “weak” dollar means the opposite: A dollar that exchanges for fewer units of foreign currencies.)
Step 3: Answer part b. by explaining whether you agree with the assertion that a stronger dollar is good for the United States but bad for the economies of other countries. A stronger U.S. dollar produces winners and losers both in the United States and in other countries. U.S. consumers win because a stronger dollar means that fewer dollars are needed to buy the same quantity of a foreign currency, which reduces the dollar price of imports from that country. For example, a stronger dollar reduces the number of dollars U.S. consumers pay to buy a bottle of French wine that has a 40 euro price. A strong dollar is bad news for foreign consumers because they must pay more units of their currency to buy goods imported from the United States. For example, Japanese consumers will have to pay more yen to buy an imported Hershey’s candy bar with a $1.25 price.
The situation is reversed for U.S. and foreign firms exporting goods. Because foreign consumers have to pay higher prices in their own currencies for goods imported from the United States, they are likely to buy less of them, buying more domestically produced goods or goods imported from other countries. U.S. firms will either to have accept lower sales, or cut the prices they charge for their exports. In either case, U.S. exporters’ revenue will decline. Foreign firms that export to the United States will be in the opposite situation: The dollar prices of their exports will decline, increasing their sales.
We can conclude that the article’s headline is somewhat misleading because not all groups in the United States are helped by a strong dollar and not all groups in other countries are hurt by a strong dollar.
Step 4: Answer part c. by explaining why higher interest rates in the United States relative to interest rates in other countries will increase the exchange value of the dollar. If interest rates in the United States rise relative to interest rates in other countries—as was true during the period from the spring of 2021 to the fall of 2022—U.S. financial assets, such as U.S. Treasury bills, will be more desirable, causing investors to increase their demand for the dollars they need to buy U.S. financial assets. The resulting shift to the right in the demand curve for dollars will cause the equilibrium exchange rate between the dollar and other currencies to increase.
Source: Patricia Cohen, “The Dollar Is Strong. That Is Good for the U.S. but Bad for the World,” New York Times, September 26, 2022.
The Federal Open Market Committee’s September 2022 Meeting and the Question of Whether the Fed Should Focus Only on Price Stability
In the Federal Reserve Act, Congress charged the Federal Reserve with conducting monetary policy so as to achieve both “maximum employment” and “stable prices.” These two goals are referred to as the Fed’s dual mandate. (We discuss the dual mandate in Macroeconomics, Chapter 15, Section 15.1, Economics, Chapter 25, Section 25.1, and Money, Banking, and the Financial System, Chapter 15, Section 15.1.) Accordingly, when Fed chairs give their semiannual Monetary Policy Reports to Congress, they reaffirm that they are acting consistently with the dual mandate. For example, when testifying before the U.S. Senate Committee on Banking, Housing, and Urban Affairs in June 2022, Fed Chair Jerome Powell stated that: “The Fed’s monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people.”
Despite statements of that kind, some economists argue that in practice during some periods the Fed’s policymaking Federal Open Market Committee (FOMC) acts as if it were more concerned with one of the two mandates. In particular, in the decades following the Great Inflation of the 1970s, FOMC members appear to have put more emphasis on price stability than on maximum employment. These economists argue that during these years, FOMC members were typically reluctant to pursue a monetary policy sufficiently expansionary to lead to maximum employment if the result would be to cause the inflation rate to rise above the Fed’s target of an annual target of 2 percent. (Although the Fed didn’t announce a formal inflation target of 2 percent until 2012, the FOMC agreed to set a 2 percent inflation target in 1996, although they didn’t publicly announce at the time. Implicitly, the FOMC had been acting as if it had a 2 percent target since at least the mid–1980s.)
In July 2019, the FOMC responded to a slowdown in economic growth in late 2018 and early 2019 but cutting its target for the federal funds rate. It made further cuts to the target rate in September and October 2019. These cuts helped push the unemployment rate to low levels even as the inflation rate remained below the Fed’s 2 percent target. The failure of inflation to increase despite the unemployment rate falling to low levels, provides background to the new monetary policy strategy the Fed announced in August 2020. The new monetary policy, in effect, abandoned the Fed’s previous policy of attempting to preempt a rise in the inflation rate by raising the target for the federal funds rate whenever data on unemployment and real GDP growth indicated that inflation was likely to rise. (We discussed aspects of the Fed’s new monetary policy in previous blog posts, including here, here, and here.)
In particular, the FOMC would no longer see the natural rate of unemployment as the maximum level of employment—which Congress has mandated the Fed to achieve—and, therefore, wouldn’t necessarily begin increasing its target for the federal funds rate when the unemployment rate dropped by below the natural rate. As Fed Chair Powell explained at the time, “the maximum level of employment is not directly measurable and [it] changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.”
Many economists interpreted the Fed’s new monetary strategy and the remarks that FOMC members made concerning the strategy as an indication that the Fed had turned from focusing on the inflation rate to focusing on unemployment. Of course, given that Congress has mandated the Fed to achieve both stable prices and maximum employment, neither the Fed chair nor other members of the FOMC can state directly that they are focusing on one mandate more than the other.
The sharp acceleration in inflation that began in the spring of 2021 and continued into the fall of 2022 (shown in the following figure) has caused members of the FOMC to speak more forcefully about the need for monetary policy to bring inflation back to the Fed’s target rate of 2 percent. For example, in a speech at the Federal Reserve Bank of Kansas City’s annual monetary policy conference held in Jackson Hole, Wyoming, Fed Chair Powell spoke very directly: “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.” According to an article in the Wall Street Journal, Powell had originally planned a longer speech discussing broader issues concerning monetary policy and the state of the economy—typical of the speeches that Fed chairs give at this conference—before deciding to deliver a short speech focused directly on inflation.
Members of the FOMC were concerned that a prolonged period of high inflation rates might lead workers, firms, and investors to no longer expect that the inflation rate would return to 2 percent in the near future. If the expected inflation rate were to increase, the U.S. economy might enter a wage–price spiral in which high inflation rates would lead workers to push for higher wages, which, in turn, would increase firms’ labor costs, leading them to raise prices further, in response to which workers would push for even higher wages, and so on. (We discuss the concept of a wage–price spiral in earlier blog posts here and here.)
With Powell noting in his Jackson Hole speech that the Fed would be willing to run the risk of pushing the economy into a recession if that was required to bring down the inflation rate, it seemed clear that the Fed was giving priority to its mandate for price stability over its mandate for maximum employment. An article in the Wall Street Journal quoted Richard Clarida, who served on the Fed’s Board of Governors from September 2018 until January 2022, as arguing that: “Until inflation comes down a lot, the Fed is really a single mandate central bank.”
This view was reinforced by the FOMC’s meeting on September 21, 2022 at which it raised its target for the federal funds rate by 0.75 percentage points to a range of 3 to 3.25 percent. The median projection of FOMC members was that the target rate would increase to 4.4 percent by the end of 2022, up a full percentage point from the median projection at the FOMC’s June 2022 meeting. The negative reaction of the stock market to the announcement of the FOMC’s decision is an indication that the Fed is pursuing a more contractionary monetary policy than many observers had expected. (We discuss the relationship between stock prices and economic news in this blog post.)
Some economists and policymakers have raised a broader issue concerning the Fed’s mandate: Should Congress amend the Federal Reserve Act to give the Fed the single mandate of achieving price stability? As we’ve already noted, one interpretation of the FOMC’s actions from the mid–1980s until 2019 is that it was already implicitly acting as if price stability were a more important goal than maximum employment. Or as Stanford economist John Cochrane has put it, the Fed was following “its main mandate, which is to ensure price stability.”
The main argument for the Fed having price stability as its only mandate is that most economists believe that in the long run, the Fed can affect the inflation rate but not the level of potential real GDP or the level of employment. In the long run, real GDP is equal to potential GDP, which is determined by the quantity of workers, the capital stock—including factories, office buildings, machinery and equipment, and software—and the available technology. (We discuss this point in Macroeconomics, Chapter 13, Section 13.2 and in Economics, Chapter 23, Section 23.2.) Congress and the president can use fiscal policy to affect potential GDP by, for example, changing the tax code to increase the profitability of investment, thereby increasing the capital stock, or by subsidizing apprentice programs or taking other steps to increase the labor supply. But most economists believe that the Fed lacks the tools to achieve those results.
Economists who support the idea of a single mandate argue that the Fed would be better off focusing on an economic variable they can control in the long run—the inflation rate—rather than on economic variables they can’t control—potential GDP and employment. In addition, these economists point out that some foreign central banks have a single mandate to achieve price stability. These central banks include the European Central Bank, the Bank of Japan, and the Reserve Bank of New Zealand.
Economists and policymakers who oppose having Congress revise the Federal Reserve Act to give the Fed the single mandate to achieve price stability raise several points. First, they note that monetary policy can affect the level of real GDP and employment in the short run. Particularly when the U.S. economy is in a severe recession, the Fed can speed the return to full employment by undertaking an expansionary policy. If maximum employment were no longer part of the Fed’s mandate, the FOMC might be less likely to use policy to increase the pace of economic recovery, thereby avoiding some unemployment.
Second, those opposed to the Fed having single mandate argue that the Fed was overly focused on inflation during some of the period between the mid–1980s and 2019. They argue that the result was unnecessarily low levels of employment during those years. Giving the Fed a single mandate for price stability might make periods of low employment more likely.
Finally, because over the years many members of Congress have stated that the Fed should focus more on maximum employment than price stability, in practical terms it’s unlikely that the Federal Reserve Act will be amended to give the Fed the single mandate of price stability.
In the end, the willingness of Congress to amend the Federal Reserve Act, as it has done many times since initial passage in 1914, depends on the performance of the U.S. economy and the U.S. financial system. It’s possible that if the high inflation rates of 2021–2022 were to persist into 2023 or beyond, Congress might revise the Federal Reserve Act to change the Fed’s approach to fighting inflation either by giving the Fed a single mandate for price stability or in some other way.
Sources: Board of Governors of the Federal Reserve System, “Federal Reserve Issues FOMC Statement,” federalreserve.gov, September 21, 2022; Board of Governors of the Federal Reserve System, “Summary of Economic Projections,” federalreserve.gov, September 21, 2022; Nick Timiraos, “Jerome Powell’s Inflation Whisperer: Paul Volcker,” Wall Street Journal, September 19, 2022; Matthew Boesler and Craig Torres, “Powell Talks Tough, Warning Rates Are Going to Stay High for Some Time,” bloomberg.com, August 26, 2022; Jerome H. Powell, “Semiannual Monetary Policy Report to the Congress,” June 22, 2022, federalreserve.gov; Jerome H. Powell, “Monetary Policy and Price Stability,” speech delivered at “Reassessing Constraints on the Economy and Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, federalreserve.gov, August 26, 2022; John H. Cochrane, “Why Isn’t the Fed Doing its Job?” project-syndicate.org, January 19, 2022; Board of Governors of the Federal Reserve System, “Minutes of the Federal Open Market Committee Meeting on July 2–3, 1996,” federalreserve.gov; and Federal Reserve Bank of St. Louis.
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