Category: Macroeconomics

Are Economic Profits a Sign of Market Power?

Cecilia Rouse, chair of the Council of Economic Advisers. Photo from the Washington Post.

An article in the Washington Post discussed a debate among President Biden’s economic advisers. The debate was over “over whether the White House should blame corporate consolidation and monopoly power for price hikes.” Some members of the National Economic Council supported the view that the increase in inflation that began in the spring of 2021 was the result of a decline in competition in the U.S. economy.

Some Democratic members of Congress have also supported this view. For instance, Massachusetts Senator Elizabeth Warren argued on Twitter that: “One clear explanation for higher inflation? Giant corporations are exploiting their market power to further raise prices. And corporate executives are bragging about their higher profits.” Or, as Vermont Senator Bernie Sanders put it: “The problem is not inflation. The problem is corporate greed, collusion & profiteering.”

But according to the article, Cecilia Rouse, chair of the President’s Council of Economic Advisers (CEA), and other members of the CEA are skeptical that a lack of competition are the main reason for the increase in inflation, arguing that very expansionary monetary and fiscal policies, along with disruptions to supply chains, have been more important.

In an earlier blog post (found here), we noted that a large majority of more than 40 well-known academic economists surveyed by the Booth School of Business at the University of Chicago disagreed with the statement: “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.”

One difficulty with the argument that the sharp increase in inflation since mid-2021 was due to corporate greed is that there is no particular reason to believe that corporations suddenly became more greedy than they had been when inflation was much lower. If inflation were mainly due to corporate greed, then greed must fluctuate over time, just as inflation does. Economic writer and blogger Noah Smith poked fun at this idea in the following graph. 

It’s worth noting that “greed” is one way of characterizing the self-interested behavior that underlies the assumption that firms maximize profits and individual maximize utility. (We discuss profit maximization in Microeconomics, Chapter 12, Section 12.2, and utility maximization in Chapter 10, Section 10.1.) When economists discuss self-interested behavior, they are not making a normative statement that it’s good for people to be self-interested. Instead, they are making a positive statement that economic models that assume that businesses maximize profit and consumers maximize utility have been successful in analyzing and predicting the behavior of businesses and households. 

Corporate profits increased from $1.95 trillion in the first quarter of 2021 to $2.40 trillion in third quarter of 2021 (the most recent quarter for which data are available). Using another measure of profit, during the same period, corporate profits increased from about 16 percent of value added by nonfinancial corporate businesses to about 18 percent. (Value added measures the market value a firm adds to a product. We discuss calculating value added in Macroeconomics, Chapter 8, Section 8.1.)

There have been mergers in some industries that may have contributed to an increase in profits—the Biden Administration has singled out mergers in the meatpacking industry as having led to higher beef and chicken prices. At this point, though, it’s not possible to gauge the extent to which mergers have been responsible for higher prices, even in the meatpacking industry.   

An increase in profit is not by itself an indication that firms have increased their market power. We would expect that even in a perfectly competitive industry, an increase in demand will lead in the short run to an increase in the economic profit earned by firms in the industry. But in the long run we expect economic profit to be competed away either by existing firms expanding their production or by new firms entering the industry.

In Chapter 12, we use Figure 12.8 to illustrate the effects of entry in the market for cage-free eggs. Panel (a) shows the market for cage-free eggs, made up of all the egg sellers and egg buyers. Panel (b) shows the situation facing one farmer producing cage-free eggs. (Note the very different scales of the horizontal axes in the two panels.) At $3 per dozen eggs, the typical egg farmer is earning an economic profit, shown by the green rectangle in panel (b). That economic profit attracts new entrants to the market—perhaps, in this case, egg farmers who convert to using cage-free methods. The result of entry is a movement down the demand curve to a new equilibrium price of $2 per dozen. At that price, the typical egg farmer is no longer earning an economic profit.

A few last observations:

  1. The recent increase in profits may also be short-lived if it reflects a temporary increase in demand for some durable goods, such as furniture and appliances, raising their prices and increasing the profits of firms that produce them. The increase in spending on goods, and reduced spending on services, appears to have resulted from:  (1) Households having additional funds to spend as a result of the payments they received from fiscal policy actions in 2020 and early 2021, and (2) a reluctance of households to spend on some services, such as restaurant meals and movie theater tickets, due to the effects of the Covid-19 pandemic.
  2. The increase in profits in some industries may also be due to a reduction in supply in those industries having forced up prices. For instance, a shortage of semiconductors has reduced the supply of automobiles, raising car prices and the profits of automobile manufacturers. Over time, supply in these industries should increase, bringing down both prices and profits.
  3. If some changes in consumer demand persist over time, we would expect that the  economic profits firms are earning in the affected industries will attract the entry of new firms—a process we illustrated above. In early 2022, this process is far from complete because it takes time for new firms to enter an industry.

Source:  Jeff Stein, “White House economists push back against pressure to blame corporations for inflation,” Washington Post, February 17, 2022; Mike Dorning, “Biden Launches Plan to Fight Meatpacker Giants on Inflation,” bloomberg.com, January 3, 2022; and U.S. Bureau of Economic Analysis.ec

Does Inflation Affect Lower-Income People More than Higher-Income People?

There’s a consensus among economists that increases in unemployment during a recession typically are larger for lower-income people than for higher-income people. Lower-income people are more likely to hold jobs requiring fewer skills and firms typically expect that when they lay off less-skilled workers during a recession they will be able to higher them—or other workers with similar skills—back after the recession ends. Because higher income have skills that may be difficult to replace, firms are more reluctant to lay them off. 

For instance, in an earlier blog post (found here) we noted that during the period in 2020 when many restaurants were closed, the Cheesecake Factory continued to pay its 3,000 managers while it laid off most of its servers. That strategy made it easier for the restaurant chain to more easily expand its operations when the worst of government-ordered closures were over. More generally, Serdar Birinci and YiLi Chien of the Federal Reserve Bank of St. Louis found that workers in the lowest 20 percent (or quintile) of earnings experienced an increased unemployment rate from 4.4 percent in January 2020 to 23.4 percent in April 2020, whereas workers in the highest quintile of earnings experienced an increase only from 1.1 percent in January to 4.8 percent in April.

If lower-income people are hit harder by unemployment, are they also hit harder by inflation? Answering that question is difficult because the U.S. Bureau of Labor Statistics (BLS) doesn’t routinely release data on inflation in the prices of goods and services purchased by households at different income levels.  The main measure of consumer price inflation compiled by the BLS represents changes in the consumer price index (CPI). The CPI is an index of the prices in a market basket of goods and services purchased by households living in urban areas. The information on consumer purchases comes from interviews the BLS conducts every three months with a sample of consumers and from weekly diaries in which a sample of consumers report their purchases. (We discuss the CPI in Macroeconomics, Chapter 9,  Section 9.4 and in Economics, Chapter 19, Section 19.4.)

The BLS releases three measures of the CPI, the two most widely used of which are the CPI-U for all urban consumers and CPI-W for urban wage earners. CPI-W covers the subset of households that receive at least half their household income from clerical or wage occupations and who have at least one wage earner who worked for 37 weeks or more during the previous year. CPI-U represents about 93 percent of the U.S. population and CPI-W represents about 29 percent of the U.S. population. Finally, in 1988 Congress instructed the BLS to compile a consumer price index reflecting the purchases of people aged 62 and older. This version of the CPI is labeled R-CPI-E; the R indicates that it is a research series and the E indicates that it is intended to measure the prices of goods and services purchased by elderly people. Because the sample used to calculate the R-CPI-E is relatively small and because of some other difficulties that may reduce the accuracy of the index, the BLS considers it a series best suited for research and does not include the data in its monthly “Consumer Price Index” publication. In any event, as the following figure shows, inflation, measured as the percentage change in the CPI from the same month in the previous year, has been very similar for all three measures of the CPI.

Because the market baskets of goods and services consumed by a mix of high and low-income households is included in all three versions of the CPI, none of the versions provides a way to measure the possibly different effects of inflation on low-income and on high-income households. A study by Josh Klick and Anya Stockburger of the BLS attempts to fill this gap by constructing measures of the CPI for low-income and for high-income households. They define low-income households as those in the bottom 25 percent (quartile) of the income distribution and high-income households as those in the top quartile of the income distribution. During the time period of their analysis—December 2003 to December 2018—the bottom quartile had average annual incomes of $12,705 and the top quartile had average annual incomes of $155,045.

The BLS researchers constructed market baskets for the two groups. The expenditure weights—representing the mix of products purchased—don’t differ too strikingly between lower-income and higher-income households, as the figure below shows. The largest differences are housing, with low-income households having a market basket weight of 45.2 percent and high-income households having a market basket weight of 39.5 percent, and transportation, with low-income households having a market basket weight of 13.0 percent and high-income households having a market basket weight of 17.2 percent.

The following table shows the inflation rate as measured by changes in different versions of the CPI over the period from December 2003 to December 2018. During this period, the CPI-U (the version of the CPI that is most frequently quoted in news stories) increased at an annual rate of 2.1 percent, which was the same rate as the CPI-W. The R-CPI-E increased at a slightly faster rate of 2.2 percent. Lower-income households experienced the highest inflation rate at 2.3 percent and higher-income households experienced the lowest inflation rate of 2.0 percent.  

CPI-UCPI-WR-CPI-ECPI for lowest income quartileCPI for highest income quartile
2.1%2.2%2.1%2.3%2.0%

The differences in inflation rates across groups were fairly small. Can we conclude that the same was true during the recent period of much higher inflation rates? We won’t know with certainty until the BLS extends its analysis to cover at least the years 2021 and 2022. But we can make a couple of relevant observations. First, for many people the most important aspect of inflation is whether prices are increasing faster of slower than their wages. In other words, people are interested in what is happening to their real wage. (We discuss calculating real wage rates in Macroeconomics, Chapter 9, Section 9.5 and in Economics, Chapter 19, Section 19.5.)

The Federal Reserve Bank of Atlanta compiles data on wage growth, including wage growth by workers in different income quartiles. The following figure shows that workers in the top quartile have experienced more rapid wage growth in the months since the beginning of the Covid-19 pandemic than have workers in the other quartiles. This gap continues a trend that began in 2015. The bottom quartile has experienced the slowest rate of income growth. (Note that the researchers at the Atlanta Fed compute wage growth as a 12-month moving average rather than as the percentage from the same month in the previous year, as we have been doing when calculating inflation using the CPI.) For example, in January 2022, calculated this way, average wage growth in the top quartile was 5.8 percent as opposed to 2.9 percent in the bottom quartile.

As with any average, there is some variation in the experiences of different individuals. Although, as a group, lower-income workers have seen wage growth that lags behind other workers, in some industries that employ many lower-income people, wage growth has been strong. For instance, as measured by average hourly earnings, wages for all workers in the private sector increased by 5.7 percent between January 2021 and 2022. But average hourly earnings in the leisure and hospitality industry—which employs many lower-income workers—increased by 13.0 percent.

Overall, it seems likely that the real wages of higher-income workers have been increasing while the real wages of lower-income workers have been decreasing, although the experience of individual workers in both groups may be very different than the average experience. 

Sources: Josh Klick and Anya Stockburger, “Experimental CPI for Lower and Higher Income Households Serdar,” U.S. Bureau of Labor Statistics, Working Paper 537, March 8, 2021; Birinci and YiLi Chien, “An Uneven Crisis for Lower-Income Households,” Federal Reserve Bank of St. Louis, Annual Report 2020, April 7, 2021; and Federal Reserve Bank of Atlanta, “Wage Growth Tracker,” https://www.atlantafed.org/chcs/wage-growth-tracker.

Should the Federal Reserve Issue a Digital Currency?

The Problem with Bitcoin as Money

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

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

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

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

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

The Problem with Stablecoins as Money 

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

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

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

A Federal Reserve Digital Currency?

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

The Fed report lists the benefits of a CBCD:

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

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

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

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

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

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

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

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

Inflation, Interest Rates, and Stock Prices

Caution: Long post!

An article in the Wall Street Journal quoted an economist at a financial services firm as noting that strong growth in wages could lead to sustained inflation. The article stated that as a result “the yield on the 10-year U.S. Treasury note [rose to] within reach of 2%” and that: “Rising [bond] yields this year have rattled markets and hurt tech stocks in particular ….”

What are the links between wage inflation and price inflation, inflation and bond yields, and bond yields and stock prices—particularly the prices of tech stocks?

The link between wage inflation and price inflation. The monthly “Employment Situation” reports from the Bureau of Labor Statistics (BLS), in addition to providing data on payroll employment and the unemployment rate, also provide data on average hourly earnings (AHE). AHE are the wages and salaries per hour worked that private, nonfarm business pay workers. AHE don’t include the value of benefits that firms provide workers, such as contributions to 401(k) retirement accounts or health insurance. The following figure shows changes in AHE from the same month in the previous year. The figure shows that since the Covid-19 pandemic first began to affect the U.S. economy in March 2020, AHE have moved erratically. But since the fall of 2021, growth in AHE has been consistently above the 2 percent to 4 percent range that prevailed in the years after the end of the Great Recession of 2007–2009.

Employee compensation is the largest cost for most firms.  For the economy as whole, employee compensation is about 80 percent of total costs. When firms pay higher wages per hour, their costs per unit of output don’t rise unless the wage increases are greater than the rate of growth of labor productivity, or output per hour worked. Increases in wages in the range of 5 percent to 6 percent are well above the rate of growth of labor productivity and, so, firms are likely to pass through the wage increases by raising prices. Note that the higher prices may prompt workers to push for higher wage increases to offset the decline in the real purchasing power of their wages, potentially setting off a wage-price spiral. (We discussed the possibility of a wage-price spiral in a recent post here.)

The link between inflation and bond yields.  When investors lend money by, for instance, buying a bond, they are concerned with the interest rate they will receive after correcting for the effects of inflation. In other words, they focus on the real interest rate, which is equal to the nominal interest rate, or the stated interest rate on the loan or bond, minus the expected inflation rate:

            Real interest rate = Nominal interest rate – Expected inflation rate.

We can rewrite this relationship as:

            Nominal interest rate = Real interest rate + Expected inflation rate.

The second equation indicates that if investors expect the inflation rate to increase, then, unless the real interest rate changes, the nominal interest rate will increase.  The Fisher effect is the idea associated with Yale economist Irving Fisher that the nominal interest rate rises or falls by the same number of percentage points as the expected inflation rate. So, for instance, if investors expect that the inflation rate will increase from 3 percent to 5 percent, then the nominal interest rate will also increase by two percentage points.

Because of real-world frictions, such as the broker fees that investors pay when buying and selling bonds and the taxes investors pay when they sell a bond that has increased in price, the Fisher effect doesn’t hold exactly. Still, most economists agree that an increase in the expected inflation rate will cause an increase in nominal interest rates. The following figure shows movements in the interest rate on 10-year Treasury notes (blue line) and in inflation (red line). Note that, roughly speaking, the interest rate on the 10-year Treasury note is higher when inflation is higher and lower when inflation is lower.  (We discuss real and nominal interest rates in Macroeconomics, Chapter 9, Section 9.6 and in Economics, Chapter 19, Section 19.6. We discuss the Fisher effect in Money, Banking, and the Financial System, Chapter 4, Section 4.3.)

The link between bond yields and stock prices. As wage inflation leads to price inflation and price inflation leads to higher interest rates on bonds—particularly U.S. Treasury bonds—why might stock prices be affected? First, investors consider U.S. Treasury bonds to be default risk free, which means that investors are certain that the Treasury will make the interest and principal payments on the bonds. Stock investments are much riskier because they depend on the future profits of the firms issuing the stocks and those profits may fluctuate in ways that are difficult for investors to anticipate. So as interest rates on Treasury bonds increase, some investors will decide to sell stocks and buy bonds, which will cause a decline in stock prices. 

Second, most people value funds they will receive now or soon more highly than funds they will receive in the more distant future. For instance, if someone offered to pay you $1,000 today or $1,000 one year from now, you will prefer to receive the money today.  In other words, the present value, or value today, of a payment you won’t receive until the future is worth less than the face value of the payment. For instance, the present value of $1,000 you won’t receive for a year is worth less than $1,000 in present value. The higher the interest rate is, the lower the present value of payments, such as dividends, that you will receive in the future. 

Economists believe that price of a financial investment, like a bond or a stock, is equal to the present value of the payments you will receive from owning the asset. If you own a bond, you will receive interest payments and payment of the bond’s principal when the bond matures. If you own a stock, you will receive dividends, which are the payments that firms make to shareholders from the firms’ profits. Therefore stock prices should reflect the present value of the dividends that investors expect to receive from owning the stock. (We discuss present value and the relationship between interest rates and stock and bond prices in Macroeconomics, Chapter 6, Appendix, in Economics, Chapter 8, Appendix, and, more completely, in Money, Banking, and the Financial System, Chapter 3, Section 3.2 and Chapter 6, Section 6.2.)

The Wall Street Journal article we quoted above notes that the rising interest rate on the 10-year Treasury note was causing price declines in tech stocks in particular. The explanation is that tech firms often go through an initial period in which they may make very low profits or even suffer losses. Investors may still be willing to buy stock in tech firms because they expect the firms eventually to increase their profits and the dividends they pay. But because those profits will be earned in the future—often after a period of losses that may stretch for years—the present value of the profits and, therefore, the price of the stock depends more on the interest rate than would be true of a firm making breakfast cereal or frozen pizza that will be steadily earning profits through the years. Therefore, we would expect, as the article indicates, that the prices of tech firms are more likely to decline—or to decline more—when interest rates rise than is true of other firms. 

The following figure shows the interest rate on the 10-year Treasury note (blue line with scale given on the left) and the values of the Nasdaq composite stock index (red line with the value for January 1, 2010 set equal to 100 and the scale given on the right). The Nasdaq includes the stocks of more tech firms than is true of the other widely followed stock market indexes—the S&P 500 and the Dow Jones Industrial Average. The figure shows that the declining interest rate on 10-year Treasury notes that began in late 2018 and continued through mid-2020 coincided with increases in the prices of the stocks in the Nasdaq index—apart from the spring of 2020 during the beginning of the Covid-19 pandemic.  The most recent period shows that increases in the interest rate on the 10-year Treasury note have corresponded with a decline in the Nasdaq, as noted in the article.

Source: Sam Goldfarb, “Elevated Bond Yields Approach Key Milestone,” Wall Street Journal, February 7, 2022; U.S. Bureau of Economic Analysis, “Prices, Costs, and Profit per Unit of Real Gross Value Added of Nonfinancial Domestic Corporate Business,” January 27, 2022; and Federal Reserve Bank of St. Louis.

The Controversy over Modern Monetary Theory (MMT)

On Sunday, February 6, the New York Times ran an article on Modern Monetary Theory (MMT) on the front page of its business section with the title, “Time for a Victory Lap.” Link here, subscription may be required. (Note: The title of the article was later changed on the nytimes.com site to “Is This What Winning Looks Like?” perhaps because of the controversy linked to below.)

The article led to a controversy on Twitter (but, then, what topic doesn’t lead to a controversy on Twitter?). Social media is, obviously, not always the best place to discuss economic theory and policy, but instructors and students interested in the debate may find the following links useful both because of the substantive issues raised and as an example of how debates over economic policy can sometimes become heated.

Harvard economist Lawrence Summers reacts negatively to the content of the New York Times article (and to MMT) here.

Economics blogger Noah Smith also reacts negatively to the article here. Smith’s blog post discussing the article at length is here, subscription may be required.

Former Fed economist Claudia Sahm defends the article (and MMT) here.

Jeanna Smialek, the author of the New York Times article, reacts to critics of the article here and to Noah Smith’s blog post here. Smith responds to her response here.

Jason Furman of Harvard’s Kennedy School provides a brief discussion of whether MMT has had much influence on monetary policy here. 

We discuss MMT in the Apply the Concept, “Modern Monetary Theory: Should We Stop Worrying and Love the Debt?” in Macroeconomics, Chapter 16, Section 16.6 and in Economics, Chapter 26, Section 26.6.

The National Debt Just Hit $30 Trillion. Who Owns It?

On February 1, 2022, a headline in the Wall Street Journal noted that: “U.S. National Debt Exceeds $30 Trillion for the First Time.” The national debt—or, more formally, the federal government debt—is the value of all U.S. Treasury securities outstanding. Treasury securities include Treasury bills, which mature in one year or less; Treasury notes, which mature between 2 years and 10 years; Treasury bonds, which mature in 30 years; U.S. savings bonds purchased by individual investors; and Treasury Inflation-Protected Securities (TIPS), which, unlike other Treasury securities, have their principal amounts adjusted every six months to reflect changes in the consumer price index (CPI).  

With a value of $30 trillion, the federal government debt in early February is about 120 percent of GDP, a record that exceeds the ratio of government debt to GDP during World War II. In 2007, at the beginning of the Great Recession of 2007–2009, the ratio of government debt to GDP was only 35 percent. (We discuss the federal government debt in Macroeconomics, Chapter 16, Section 16.6 and in Economics, Chapter 26, Section 26.6.)

There are many important economic issues involved with the federal government debt, but in this blog post we’ll focus just on the question of who owns the debt.

The pie chart below shows the shares of the debt held by different groups. The largest slice shown is for “intragovernmental holdings,” which represent ownership of Treasury securities by government trust funds, notably the Social Security trust funds. The Social Security system makes payments to retired or disabled workers. The system operates on a pay-as-you-go basis, which means that the payroll taxes collected from today’s workers are used to make payments to retired workers. Because of slowing population growth, Congress authorized an increase in payroll taxes above the level necessary to make current payments. The Social Security system has invested the surplus in special Treasury securities that the Treasury redeems when the funds are necessary to make payments to retired workers. (In the Apply the Concept “Is Spending on Social Security and Medicare a Fiscal Time Bomb?” in Macroeconomics, Chapter 16, Section 16.1, we discuss the long-term funding problems of the Social Security and Medicare systems.)

Some economists argue that the value of these Treasury securities should not be counted as part of the federal government debt because the securities are not marketable in the way that Treasury bills, notes, and bonds are and because the securities represent a flow of funds from one federal agency to another federal agency. If we exclude the value of these securities, the national debt on February 1, 2022 was $23.5 trillion rather than $30.0 trillion. 

The Federal Reserve System holds about 19 percent of federal government debt. The Fed buys and sells Treasury securities as part of its normal conduct of monetary policy. In addition, the Fed accumulated large holdings of Treasury securities as part of its quantitative easing operations during and following the 2007–2009 financial crisis and from 2020 to 2022 during the worst of the Covid-19 pandemic. (We discuss quantitative easing in Macroeconomics, Chapter 15, Section 15.3.)

About 27 percent of the debt is held by foreign central banks, foreign commercial banks, and foreign investors. The largest amount of Treasury debt is held by Japan, followed by China and the United Kingdom. All other countries combined hold about 16 percent of the debt.

U.S. commercial banks hold more than 15 percent of the debt. Banks hold Treasury securities partly because since the 2007–2009 financial crisis most interest rates, including those on loans and on corporate and municipal bonds, have been very low compared with historic averages. The interest rates on these assets are in some cases too low to compensate banks for the risk of owning the assets rather than default-risk free Treasury securities. In addition, large banks are required to meet a liquidity coverage ratio, which means that they have to hold sufficient liquid assets—those that can be easily converted into cash—to meet their need for funds in a financial crisis. Many banks meet their liquidity requirements, in part, by owning Treasury securities. 

The remaining Treasury securities—about 16.5 percent of the total federal government debt—are held by the U.S. nonbank public. The nonbank public includes financial firms—such as investment banks, insurance companies, and mutual funds—as well as individual investors.

Sources: Amara Omeokwe, “U.S. National Debt Exceeds $30 Trillion for First Time,” Wall Street Journal, February 1, 2022; “Debt to the Penny,” fiscaldata.treasury.gov; “Major Foreign Holders of Treasury Securities,” ticdata.treasury.gov; and Federal Reserve Bank of St. Louis.

The Surprisingly Strong Employment Report for January 2022

Leisure and hospitality was one of the industries showing surprisingly strong job growth during January 2022. Photo from the New York Times.

The Bureau of Labor Statistics’ monthly report on the “Employment Situation” is generally considered the best source of information on the current state of the labor market. As we discuss in Macroeconomics, Chapter 9, Section 9.1 (and in Economics, Chapter 19, Section 19.1), economists, policymakers, and investors generally focus more on the establishment survey data on total payroll employment than on the household survey data on the unemployment rate. The initial data on employment from the establishment survey are subject to substantial revisions over time (we discuss this point further below). But the establishment survey has the advantage of being determined by data taken from actual payrolls rather than by unverified answers to survey questions, as is the case with the household survey data. 

The establishment survey data for January 2022 (released on February 4, 2022) showed a surprisingly large increase in employment of 467,000. The consensus forecast had been for a significantly smaller increase of 150,000, with many economists expecting that the data would show a decrease in employment. The establishment survey is collected for pay periods that include the 12th of the month. In January 2022, in many places in the United States that pay period coincided with the height of the wave of infections from the Omicron variant of Covid-19. And, in fact, according to the household survey, the number of people out of work because of illness was 3.6 million in January—the most during the Covid-19 pandemic. So it seemed likely that payroll employment would have declined in January. But despite the difficulties caused by the pandemic, payroll employment increased substantially, likely reflecting firms’ continuing high demand for workers—a demand reflected in the very high level of job openings.

The employment report includes the BLS’s annual data revisions, which are based on a comprehensive payroll count for a particular month in the previous year—in this case, March 2021. The revisions also incorporate changes to the BLS’s seasonal adjustment factors. Each month, the BLS adjusts the raw payroll employment data to reflect seasonal fluctuations such as occur during and after the end-of-year holiday period. For instance, the change from December 2020 to January 2021 in the raw employment data was −2,824,000, whereas the adjusted change was 467,000 (as noted earlier). Obviously this difference is very large and is attributable to the BLS’s seasonal adjustments removing the employment surge in December attributable to seasonal hiring by retail stores, delivery firms, and other businesses strongly affected by the holidays.

The changes to the seasonal adjustment factors made the revisions to the 2021 payroll employment numbers unusually large. For instance, the BLS initially reported that employment increased from June 2021 to July 2021 by 1,091,000, whereas the revision reduced the increase to 689,000. Table A below is reproduced from the BLS report; the figure below the table shows the changes in employment from the previous month as originally published and as revised in the January report. Overall, the BLS revisions now show that employment increased by 217,000 more from 2020 to 2021 than initially estimated. The BLS expressed the opinion that: “Going forward, the updated models should produce more reliable estimates of seasonal movements. [Because there are now] more monthly observations related to the historically large job losses and gains seen in the pandemic-driven recession and recovery, the models can better distinguish normal seasonal movements from underlying trends.”

Source: The BLS “Employment Situation” report can be found here.

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).