Money. Banking, and the Financial System – Page 18

Inflation, Disinflation, Deflation, and Consumers’ Perceptions of Inflation

Inflation has declined, although many consumers are skeptical. What explains consumer skepticism? First we can look at what’s happened to inflation in the period since the beginning of 2015. The figure below shows inflation measured as the percentage change in the consumer price index (CPI) from the same month in the previous year. We show both so-called headline inflation, which includes the prices of all goods and services in the index, and core inflation, which excludes energy and food prices. Because energy and food prices can be volatile, most economists believe that the core inflation provides a better indication of underlying inflation.

Both measures show inflation following a similar path. The inflation rate begins increasing rapidly in the spring of 2021, reaches a peak in the summer of 2022, and declines from there. Headline CPI peaks at 8.9 percent in June 2022 and declines to 3.7 percent in August 2023. Core inflation reaches a peak of 6.6 percent in September 2022 and declines to 4.4 percent in August 2022.

As we discuss in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5, and Essentials of Economics, Chapter 17, Section 17.5), the Fed’s inflation target is stated in terms of the personal consumption expenditure (PCE) price index, not the CPI. The PCE includes the prices of all the goods and services included in the consumption component of GDP. Because the PCE includes the prices of more goods and services than does the CPI, it’s a broader measure of inflation. The following figure shows inflation as measured by the PCE and by the core PCE, which excludes energy and food prices.

Inflation measured using the PCE or the core PCE shows the same pattern as inflation measured using the CPI: A sharp increase in inflation in the spring of 2021, a peak in the summer of 2022, and a decline thereafter.

Although it has yet to return to the Fed’s 2 percent target, the inflation rate has clearly fallen substantially during the past year. Yet surveys of consumers show that majorities are unconvinced that inflation has been declining. A Pew Research Center poll from June found that 65 percent of respondents believe that inflation is “a very big problem,” with another 27 percent believing that inflation is “a moderately big problem.” A Gallup poll from earlier in the year found that 67 percent of respondents thought that inflation would go up, while only 29 percent thought it would go down. Perhaps not too surprisingly, another Gallup poll found that only 4 percent of respondents had a “great deal” of confidence in Federal Reserve Chair Jerome Powell, with another 32 percent having a “fair amount” of confidence. Fifty-four percent had either “only a little” confidence in Powell or “almost none.”

There are a couple of reasons why most consumers might believe that the Fed is doing worse in its fight against inflation than the data indicate. First, few people follow the data releases as carefully as economists do. As a result, there can be a lag between developments in the economy—such as declining inflation—and when most people realize that the development has occurred.

Probably more important, though, is the fact that most people think of inflation as meaning “high prices” rather than “increasing prices.” Over the past year the U.S. economy has experienced disinflation—a decline in the inflation rate. But as long as the inflation rate is positive, the price level continues to increase. Only deflation—a declining price level—would lead to prices actually falling. And an inflation rate of 3 percent to 4 percent, although considerably lower than the rates in mid-2022, is still significantly higher than the inflation rates of 2 percent or below that prevailed during most of the time since 2008.

Although, core CPI and core PCE exclude energy and food prices, many consumers judge the state of inflation by what’s happening to gasoline prices and the price of food in supermarkets. These are products that consumers buy frequently, so they are particularly aware of their prices. The figure below shows the component of the CPI that represents the prices of food consumers buy in groceries or supermarkets and prepare at home. The price of food rose rapidly beginning in the spring of 2021. Althought increases in food prices leveled off beginning in early 2023, they were still about 24 percent higher than before the pandemic.

There is a similar story with respect to gasoline prices. Although the average price of gasoline in August 2023 at $3.84 per gallon is well below its peak of nearly $5.00 per gallon in June 2022, it is still well above average gasoline prices in the years leading up to the pandemic.

Finally, the figure below shows that while percentage increases in rent are below their peak, they are still well above the increases before and immediately after the recession of 2020. (Note that rents as included in the CPI include all rents, not just rental agreements that were entered into that month. Because many rental agreements, particularly for apartments in urban areas, are for one year or more, in any given month, rents as measured in the CPI may not accurately reflect what is currently happening in rental housing markets.)

Because consumers continue to pay prices that are much higher than the prices they were paying prior to the pandemic, many consider inflation to still be a problem. Which is to say, consumers appear to frequently equate inflation with high prices, even when the inflation rate has markedly declined and prices are increasing more slowly than they were.

Solved Problem: The Mexican “Super Peso”

A food market in Mexico. (Photo from mexperience.com)

Supports: Macroeconomics, Chapter 18, Economics, Chapter 28, and Essentials of Economics, Chapter 19.

In September 2023, an article in the Los Angeles Times discussed the effects on Mexico of the “’super-peso,’ as the Mexican currency has been dubbed since steadily gaining 18% on the dollar during the last 12 months.” The article focused on the effects of the rising value of the peso on people in Mexico who receive U.S. dollars from relatives and friends working in the United States. Many of the people who receive these payments rely on them to buy basic necessities, such as food and clothing. An article in the Wall Street Journal on the effects of the rising value of the peso noted that: “The peso’s strength has helped curtail inflation ….”

Briefly explain what the Los Angeles Times article means by the peso “gaining” on the U.S. dollar? Does the peso gaining on the dollar mean that someone exchanging dollars for pesos would receive more pesos or fewer pesos?
As a result of the rising value of the peso would people in Mexico receiving dollar payments from relatives in the United States be better off or worse off? Briefly explain.
Why would the increasing strength of the peso reduce the inflation rate in Mexico?
The Los Angeles Times article also noted that: “The Bank of Mexico’s benchmark interest rate of 11.25% is more than double the U.S. Federal Reserve target …” Does this fact have anything to do with the increase in the value of the peso in exchange for the dollar? Briefly explain.

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 it means for the peso to be “gaining” on the U.S. dollar. The peso gaining on the dollar means that someone can exchange fewer pesos to receive a dollar. Or, alternatively, someone exchanging dollars for pesos will receive fewer pesos.

Step 3: Answer part b. by explaining why people in Mexico receiving dollar payments from relatives in the United States will be worse off because of the rising value of the peso. People living in Mexico needs pesos to buy food and clothing from Mexican stores. Because people will receive fewer pesos in exchange for the dollars they receive from relatives in the United States, these people will have been made worse off by the rising value of the peso.

Step 4: Answer part c. by explaining why the increasing strength of the peso will reduce inflation in Mexico. A country’s inflation rate includes the prices of imported goods as well as the prices of domestically produced goods. A stronger peso means that fewer pesos are needed to buy the same quantity of a foreign currency, which reduces the peso price of imports from that country. For example, a stronger peso reduces the number of pesos Mexican consumers pay to buy $10 worth of cucumbers imported from the United States. Falling prices of imported goods will reduce the inflation rate in Mexico.

Step 5: Answer part d. by explaining why higher interest rates in Mexico relative to interest rates in the United States will increase the value of the peso in exchange for the U.S. dollar. If interest rates in Mexico rise relative to interest rates in the United States, Mexican financial assets, such as Mexican government bonds, will be more desirable, causing investors to increase their demand for the pesos they need to buy Mexican financial assets. The resulting shift to the right in the demand curve for pesos will cause the equilibrium exchange rate between the peso and the dollar to increase.

Sources: Patrick J. McDonnell, “Mexico’s Peso Is Soaring. That’s Bad News for People Who Rely on Dollars Sent from the U.S.,” Los Angeles Times, September 5, 2023; and Anthony Harrup, “Mexico’s Peso Surges to Strongest Level Since 2015,” Wall Street Journal, July 13, 2023.

What Explains the Surprising Surge in the Federal Budget Deficit?

Figure from CBO’s monthly budget report.

During 2023, GDP and employment have continued to expand. Between the second quarter of 2022 and the second quarter of 2023, nominal GDP increased by 6.1 percent. From July 2022 to July 2023, total employment increased by 3.3 million as measured by the establishment (or payroll) survey and by 3.0 as measured by the household survey. (In this post, we discuss the differences between the employment measures in the two surveys.)

We would expect that with an expanding economy, federal tax revenues would rise and federal expenditures on unemployment insurance and other transfer programs would decline, reducing the federal budget deficit. (We discuss the effects of the business cycle on the federal budget deficit in Macroeconomics, Chapter 16, Section 16.6, Economics, Chapter 26, Section 26.6, and Essentials of Economics, Chapter 18, Section 18.6.) In fact, though, as the figure from the Congressional Budget Office (CBO) at the top of this post shows, the federal budget deficit actually increased substantially during 2023 in comparison with 2022. The federal budget deficit from the beginning of government’s fiscal year on October 1, 2022 through July 2023 was $1,617 billion, more than double the $726 billion deficit during the same period in fiscal 2022.

The following figure from an article in the Washington Post uses data from the Committee for a Responsible Federal Budget to illustrate changes in the federal budget deficit in recent years. The figure shows the sharp decline in the federal budget deficit in 2022 as the economic recovery from the Covid–19 pandemic increased federal tax receipts and reduced federal expenditures as emergency spending programs ended. Given the continuing economic recovery, the surge in the deficit during 2023 was unexpected.

As the following figure shows, using CBO data, federal receipts—mainly taxes—are 10 percent lower this year than last year, and federal outlays—including transfer payments—are 11 percent higher. For receipts to fall and outlays to increase during an economic expansion is very unusual. As an article in the Wall Street Journal put it: “Something strange is happening with the federal budget this year.”

Note: The values on the vertical axis are in billions of dollars.

The following figure shows a breakdown of the decline in federal receipts. While corporate taxes and payroll taxes (primarily used to fund the Social Security and Medicare systems) increased, personal income tax receipts fell by 20 percent, and “other receipts” fell by 37 percent. The decline in other receipts is largely the result of a decline in payments from the Federal Reserve to the U.S. Treasury from $99 billion in 2022 to $1 billion in 2023. As we discuss in Macroeconomics, Chapter 17, Section 17.4 (Economics, Chapter 27, Section 27.4), Congress intended the Federal Reserve to be independent of the rest of the government. Unlike other federal agencies and departments, the Fed is self-financing rather than being financed by Congressional appropriations. Typically, the Fed makes a profit because the interest it earns on its holdings of Treasury securities is more than the interest it pays banks on their reserve deposits. After paying its operating costs, the Fed pays the rest of its profit to the Treasury. But as the Fed increased its target for the federal funds rate beginning in March 2022, it also increased the interest rate it pays banks on their reserve deposits. Because most of the securities it holds pay low interest rates, the Fed has begun running a deficit, reducing the payments it makes to the Treasury.

Note: The values on the vertical axis are in billions of dollars.

The reasons for the sharp decline in individual income taxes are less clear. The decline was in the “nonwithheld category” of individual income taxes; federal income taxes withheld from worker paychecks increased. People who are self-employed or who receive substantial income from sources such as capital gains from selling stocks, make quarterly estimated income tax payments. It’s these types of personal income taxes that have been unexpectedly low. Accordingly, smaller capital gains may be one explanation for the shortfall in federal revenues, but a more complete explanation won’t be possible until more data become available later in the year.

The following figure shows the categories of federal outlays that have increased the most from 2022 to 2023. The largest increase is in spending on Social Security, Medicare, and Medicaid, with spending on Social Security alone increasing by $111 billion. This increase is due partly to an increase in the number of retired workers receiving benefits and partly to the sharp rise in inflation, because Social Security is indexed to changes in the consumer price index (CPI). Spending on Medicare increased by $66 billion or a surprisingly large 18 percent. Interest payments on the public debt (also called the federal government debt or the national debt) increased by $146 billion or 34 percent because interest rates on newly issued Treasury securities rose as nominal interest rates adjusted to the increase in inflation and because the public debt had increased significantly as a result of the large budget deficits of 2020 and 2021. The increase in spending by the Department of Education reflects the effects of the changes the Biden administration made to student loans eligible for the income-driven repayment plan. (We discuss the income-driven repayment plan for student loans in this blog post.)

Note: The values on the vertical axis are in billions of dollars.

The surge in federal government outlays occurred despite a $120 billion decline in refundable tax credits, largely due to the expiration of the expansion of the child tax credit Congress enacted during the pandemic, a $98 billion decline in Treasury payments to state and local governments to help offset the financial effects of the pandemic, and $59 billion decline in federal payments to hospitals and other medical facilities to offset increased costs due to the pandemic.

In this blog post from February, we discussed the challenges posed to Congress and the president by the CBO’s forecasts of rising federal budget deficits and corresponding increases in the federal government’s debt. The unexpected expansion in the size of the federal budget deficit for the current fiscal year significantly adds to the task of putting the federal government’s finances on a sound basis.

The Labor Market Continues to Cool

As we discussed in this post, most recent data are consistent with the labor market having cooled, which should reduce upward pressure on wages and prices. On Friday morning, the Bureau of Labor Statistics (BLS) released its employment report for August 2023. (The report can be found here.) On balance, the data in the report are consistent with the labor market continuing to cool.

Data from the establishment survey showed an increase in payroll employment of 187,000, which is close to the increase of 170,000 economists surveyed by the Wall Street Journal had forecast. The following figure shows monthly changes in payroll employment since January 2021.

Although the month-to-month changes have been particularly volatile during this period as the U.S. economy recovered from the Covid–19 recession, the general trend in job creation has been downward. The following table shows average monthly increases in payroll employment for 2021, 2022, and 2023 through August. In the most recent three-month period, the average monthly increase in employment was 150,000.

Period	Average Monthly Increases in Employment
2021	606,000
2022	399,000
Jan.-Aug. 2023	236,000

The BLS revised downward its previous estimates of employment increases in June and July by a combined 110,000. The changes to the estimate of the employment increase for June are particularly notable. As the following graph shows, on July 7, the BLS initially estimated the increase as 209,000. The BLS’s first revision on August 4, lowered the estimate to an increase of 187,000. The BLS’s second revision on September 1, lowered the estimate further to 105,000. In other words, the BLS now estimates that employment increased by only half as much in June as it initially reported. As we discuss in Macroeconomics, Chapter 9, Section 9.1 (Economics, Chapter 19, Section 19.1 and Essentials of Economics, Chapter 13, Section 13.1), the revisions that the BLS makes to its employment estimates are likely to be particularly large when the economy is about to enter a period of significantly lower or higher growth. So, the large revisions to the June employment estimate may indicate that during the summer economic growth slowed and labor market conditions eased.

Data from the household survey showed the unemployment rate increasing from 3.5 percent in July to 3.8 percent in August. The following figure shows that the unemployment rate has fluctuated in a narrow range since March 2022. Employment as estimated from the household survey increased by 222,000. The seeming paradox of the number of people employed and the unemployment rate both increasing is accounted for by the substantial 736,000 increase in the labor force.

Finally, as the first of the following figures shows, measured as the percentage change from the same month in the previous year, the increase in average hourly earnings (AHE) remained in its recent range of between 4.25 and 4.50 percent. That rate is down from its peak in mid-2022 but still above the rate of increase in 2019, before the pandemic. But, as the second figure shows, if we look at the compound rate of increase in AHE—that is the rate at which AHE would increase for the year if the current rate of monthly increase persisted over the following 11 months—we can see a significant cooling in the rate at which wages are increasing.

As a reminder, AHE are the wages and salaries per hour worked that private, nonfarm businesses 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. As an economy-wide average they suffer from a composition effect during periods in which employment either increases or decreases substantially because the mix of high-wage and low-wage workers may change. AHE are also subject to significant revisions. Therefore, short-range changes in AHE can sometimes be misleading indicators of the state of the labor market.

Powell at Jackson Hole: No Change to Fed’s Inflation Target

Federal Reserve Chair Jerome Powell at Jackson Hole, Wyoming, August 2023 (Photo from the Associated Press.)

Congress has given the Federal Reserve a dual mandate to achieve price stability and high employment. To reach its goal of price stability, the Fed has set an inflation target of 2 percent, with inflation being measured by the percentage change in the personal consumption expenditures (PCE) price index.

It’s reasonable to ask whether “price stability” is achieved only when the price level is constant—that is, at a zero inflation rate. In practice, Congress has given the Fed wide latitude in deciding when price stability and high employment has been achieved. The Fed didn’t announce a formal inflation target of 2 percent until 2012. But the members of the Federal Open Market Committee (FOMC) had agreed to set a 2 percent inflation target much earlier—in 1996—although they didn’t publicly announce it at the time. (The transcript of the FOMC’s July 2-3, 1996 meeting includes a discussion of the FOMC’s decision to adopt an inflation target.) Implicitly, the FOMC had been acting as if it had a 2 percent target since at least the mid–1980s.

But why did the Fed decide on an inflation target of 2 percent rather than 0 percent, 1 percent, 3 percent, or some other rate? There are three key reasons:

As we discuss in Macroeconomics, Chapter 9, Section 9.4 (Economics, Chapter 19, Section 29.4 and Essentials of Economics, Chapter 13, Section 13.4), price indexes overstate the actual inflation rate by 0.5 percentage point to 1 percentage point. So, a measured inflation of 2 percent corresponds to an actual inflation rate of 1 to 1.5 percent.
As we discuss in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5), the FOMC has a target for the long-run real federal funds rate. Although the target has been as high as 2 percent, in recent years it has been 0.5 percent. With an inflation target of 2 percent, the long-run nominal federal funds rate target is 2.5 percent. (The FOMC’s long-run target federall funds target can be found in the Summary of Economic Projections here.) As the Fed notes, with an inflation target of less than 2 percent “there would be less room to cut interest rates to boost employment during an economic downturn.”
An inflation target of less than 2 percent would make it more likely that during recessions, the U.S. economy might experience deflation, or a period during which the price level is falling. Deflation can be damaging if falling prices cause consumers to postpone purchases in the hope of being able to buy goods and services at lower prices in the future. The resulting decline in aggregate demand can make a recession worse. In addition, deflation increases the real interest rate associated with a given nominal interest rate, imposing costs on borrowers, particularly if the deflation is unexpected.

The following figure shows that for most of the period from late 2008 until the spring of 2021, the inflation rate as measured by the PCE was below the Fed’s 2 percent target. Beginning in the spring of 2021, inflation soared, reaching a peak of 7.0 percent in June 2022. Inflation declined over the following year, falling to 3.0 in June 2023.

On August 25, at the Fed’s annual monetary policy symposium in Jackson Hole, Wyoming, Fed Chair Jerome Powell made clear that the Fed intended to continue a restrictive monetary policy until the inflation rate had returned to 2 percent: “It is the Fed’s job to bring inflation down to our 2 percent goal, and we will do so.” (The text of Powell’s speech can be found here.) Some economists have been arguing that once the Fed had succeeded in pushing the inflation rate back to 2 percent it should, in the future, consider raising its inflation target to 3 percent. At Jackson Hole, Powell appeared to rule out this possibility: “Two percent is and will remain our inflation target.”

Why might a 3 percent inflation target be preferrable to a 2 percent inflation target? Proponents of the change point to two key advantages:

Reducing the likelihood of monetary policy being constrained by the zero lower bound. Because the federal funds rate can’t be negative, zero provides a lower bound on how much the FOMC can cut its federal funds rate target in a recession. Monetary policy was constrained by the zero lower bound during both the Great Recession of 2007–2009 and the Covid recession of 2020. Because an inflation target of 3 percent could likely be achieved with a federal funds rate that is higher than the FOMC’s current long-run target of 2.5 percent, the FOMC should have more room to cut its target during a recession.
During a recession, firms attempting to reduce costs can do so by cutting workers’ nominal wages. But, as we discuss in Macroeconomics, Chapter 13, Section 13.2 (Economics, Chapter 23, Section 23.2 and Essentials of Economics, Chapter 15, Section 15.2), most workers dislike wage cuts. Some workers will quit rather than accept a wage cut and the productivity of workers who remain may decline. As a result, firms often use a policy of freezing wages rather than cutting them. Freezing nominal wages when inflation is occurring results in cuts to real wages. The higher the inflation rate, the greater the decline in real wages and the more firms can reduce their labor costs without laying off workers.

Why would Powell rule out increasing the Fed’s target for the inflation rate? Although he didn’t spell out the reasons in his Jackson Hole speech, these are two main points usually raised by those who favor keeping the target at 2 percent:

A target rate above 2 percent would be inconsistent with the price stability component of the Fed’s dual mandate. During the years between 2008 and 2021 when the inflation rate was usually at or below 2 percent, most consumers, workers, and firms found the inflation rate to be low enough that it could be safely ignored. A rate of 3 percent, though, causes money to lose its purchasing power more quickly and makes it less likely that people will ignore it. To reduce the effects of inflation people are likely to spend resources in ways such as firms reprinting menus or price lists more frequently or labor unions negotiating for higher wages in multiyear wage contracts. The resources devoted to avoiding the negative effects of inflation represent an efficiency loss to the economy.
Raising the target for the inflation rate might undermine the Fed’s credibility in fighting inflation. One of the reasons that the Fed was able to bring down the inflation rate without causing a recession—at least through August 2023—was that the expectations of workers, firms, and investors remained firmly anchored. That is, there was a general expectation that the Fed would ultimately succeed in bringing the inflation back down to 2 percent. If expectations of inflation become unanchored, fighting inflation becomes harder because workers, firms, and investors are more likely to take actions that contribute to inflation. For instance, lenders won’t assume that inflation will be 2 percent in the future and so will require higher nominal interest rates on loans. Workers will press for higher nominal wages to protect themselves from the effects of higher inflation, thereby raising firms’ costs. Raising its inflation target to 3 percent may also cause workers, firms, and investors to question whether during a future period of high inflation the Fed will raise its target to an even higher rate. If that happens, inflation may be more persistent than it was during 2022 and 2023.

It seems unlikely that the Fed will raise its target for the inflation rate in the near future. But the Fed is scheduled to review its current monetary policy strategy in 2025. It’s possible that as part of that review, the Fed may revisit the issue of its inflation target.

How Did the United States Reduce the Debt-to-GDP Ratio after World War II?

Main Gun Mount Assembly Plant, Northern Pump Co. Plant, Fridley, Minnesota, 1942. (Photo from the Franklin D. Roosevelt Presidential Library & Museum.)

To fight World War II, the federal government had to dramatically increase spending. As the following figure shows, total federal spending rose from $6.8 billion in 1940 to a peak of $100.1 billion in 1944. National defense spending made up most of the increase, rising from $2.8 billion in 1940 to $97.3 billion in 1944.

Part of the increased spending was paid for by increases in taxes. Total federal tax receipts rose from $6.2 billion in 1940 to $35.8 billion in 1945. Individual income taxes rose from $1.0 billion in 1940 to 18.6 billion in 1945. Tax rates were raised and the minimum income at which people had to pay tax on their income was reduced. From the introduction of the federal individual income tax in 1913 until 1940, only people who had at least upper middle class incomes paid any federal income taxes. Following the passage by Congress of the Revenue Act of 1942, most workers had to pay federal income taxes. In 1940, 7.4 million people had to pay federal individual income taxes. In 1945, 42.7 million people had to. For the first time, the federal government withheld taxes from workers paychecks. Previously, all taxes were due on March 15th of the year following the year being taxed. Milton Friedman, who in the 1970s won the Nobel Prize in Economics, was part of the team at the U.S. Treasury that designed and implemented the system of withholding income taxes. Withholding of individual income taxes has continued to the present day.

Although large, the increases in federal taxes were insufficient to fund the massive military spending required to win the war. As a result, the U.S. Treasury had to greatly increase its sales of Treasury bonds. Recall from Macroeconomics, Chapter 16, Section 16.6 (Economics, Chapter 26, Section 26.6 and Essentials of Economics, Chapter 18, Section 18.6) that the total value of outstanding Treasury bonds is called the federal government debt, sometimes called the national debt. The part of federal government debt held by the public rather than by government agencies, such as the Social Security Trust Funds, is call the public debt. In order to gauge the effects of the debt on the economy, economists typically look at the size of the public debt relative to GDP. The following figure shows the public debt as a percentage of GDP for the years from 1929 to 2022.

The figure shows that the ratio of debt to GDP increased sharply from 1929 to the mid-1930s, reflecting the federal budget deficits resulting from the Great Depression, and then soared beginning in 1940. Debt peaked at 113 percent of GDP in 1945 and then began a long decline that lasted until 1974, when debt had fallen to 23 percent of GDP. The ratio of debt to GDP then fluctuated until the Great Recession of 2007-2009 when it began a steady increase that turned into a surge during and after the Covid-19 pandemic. (We discuss the causes of the recent surge in debt in this blog post.)

What caused the long decline in the ratio of debt to GDP that began in 1946 and continued until 1974? The usual explanation is that the decline was not primarily due to the federal government paying off a signficiant portion of the debt. The public debt did decline from a peak of $241.9 billion in 1946 to $214.3 billion in 1949 but there were no significant declines in the level of the public debt after 1949. Instead the ratio of debt to GDP declined because GDP grew faster than did the debt.

Recently in a National Bureau of Economic Research Working Paper, “Did the U.S. Really Grow Out of Its World War II Debt?” Julien Acalin and Laurence M. Ball of Johns Hopkins University have analyzed the issue more closely. They conclude that economic growth played a smaller role in reducing the debt-to-GDP ratio than has previously been thought. In particular, they highlight the fact that for significant periods through the 1970s, the Treasury was able to pay a real interest rate on the debt that was lower than market rates. Lower real interest rates reduced the amount by which the debt might otherwise have grown.

As we discuss in Money, Banking, and the Financial System, Chapter 13, Section 13.2, in April 1942, to support the war effort, the Federal Reserve announced that it would fix interest rates on Treasury securities at low levels: 0.375 percent on Treasury bills and 2.5 percent on Tresaury bonds. This policy continued after the end of the war in 1945 until the Fed was allowed to abandon the policy of pegging the interest rates on Treasury securities following the March 1951 Treasury-Federal Reserve Accord. Acalin and Ball also note that even after the Accord, there were periods in which actual inflation was well above expected inflation, causing the real interest rate the Treasury was paying on debt to be below the expected real interest rate. In other words, part of the falling debt-to-GDP ratio was financed by investors receiving lower returns on their purchases of Treasury securities than they had expected to.

Acalin and Ball conclude that if the Treasury had not done the relatively small amount of debt repayment mentioned earlier and if it had had to pay market real interest rates on the debt, debt would have declined to only 74 percent of GDP in 1974, rather than to 23 percent.

Sources: The debt and GDP data are from the Congressional Budget Office, which can be found here, and from the Office of Management and the Budget, which can be found here.

The Surprising Effect of Weight-Loss Drugs on Monetary Policy in Denmark

Novo Nordisk production facility in Denmark (Photo from Bloomberg News via the Wall Street Journal.)

Like most other small European countries, imports and exports are more important in the Danish economy than in the U.S. economy. In 2022, imports were 59 percent of Danish GDP and exports were 70 percent. In contrast, in 2022 imports were only 16 percent of U.S. GDP and exports were only 12 percent.

The Danish company Novo Nordisk makes the weight-loss prescription injections Ozempic and Wegovy. Because these and related pharmaceuticals are the first to result in significant weight loss among patients, demand for them has been very strong. (Note that some researchers believe that is not yet clear whether long-term use of these drugs might have side effects.) Demand has been so strong that Novo Nordisk’s market cap—the total value of its outstanding shares of stock—is now larger than Denmark’s GDP. According to the Wall Street Journal, Novo Nordisk now has the second largest market cap in Europe, behind only luxury good manufacturer LVMH Moët Hennessy Louis Vuitton

Most of Novo Nordisk’s customers are outside of Denmark, so to buy Ozempic or Wegovy, these customers much exchange their domestic currency—for example, euros, U.S. dollars, pounds, or yen—for Danish kroner. This increase in demand, increases the value of kroner relative to dollars, euros, and other currencies. (We discuss the effects of changes in demand and supply of a currency relative other currencies in Macroeconomics, Chapter 18, Section 18.2, Economics, Chapter 28, Section 28.2, and Essentials of Economics, Chapter 19, Section 19.6.)

Denmark has been a member of the European Union (EU), since the EU’s formation in 1991. But it is one of two EU countries (Sweden is the other) that has retained its own currency rather than using the euro. Because most of Denmark’s trade has traditionally been with other countries in the EU, the Danmarks Nationalbank, Denmark’s central bank, has pegged the value of the krone to the euro. Pegging makes it easier for Danish firms to plan because they know the prices their goods and services will sell for in eurozone countries. In addition, Danish firms that borrow in euros know how much in interest they will be paying in kroner. Finally, if the krone rises in value against other currencies, prices of imported goods and services will increase, raising the Danish inflation rate. (We discuss currency pegs in Macroeconomics, Chapter 18, Section 18.3, and Economics, Chapter 28, Section 28.3.) Inflation is a significant concern in Denmark because, as the following figure shows, the inflation rate reached 10.1 percent in October 2022. Although by July 2023, the inflation rate had decline to 3.1 percent, that rate was still above the Nationalbank’s inflation target of 2 percent.

Source: Statistics Denmark, dst.dk.

To keep the the krone pegged against the euro, the Nationalbank has to reduce the demand for the krone. The key tool that a central bank has to reduce demand for its country’s currency is interest rates. If the Nationalbank keeps interest rates in Denmark below interest rates in eurozone countries, investors will demand fewer kroner in exchange for euros. Accordingly, the Nationalbank as kept its key monetary policy rate below the corresponding rate set by the European Central Bank. In August the ECB’s policy rate was 3.75 percent, whereas the Nationalbank’s corresponding policy rate was 3.35 percent.

It’s unusual even for a small country that its central bank has to take steps to respond to a surge in demand for a single product. But that was the situation of the Danish central bank in 2023.

Sources: Joseph Walker, Dominic Chopping, and Sune Engel Rasmussen Wall Street Journal, August 17, 2023; Matthew Fox, “America’s Favorite Weight Loss Drugs Are Impacting Denmark’s Currency and Interest Rates,” finance.yahoo.com, August 18, 2023; Christian Weinberg, “Novo’s Value Surpasses Denmark GDP After Obesity Drug Boost,” bloomberg.com, August 9, 2023; Tom Fairless, “European Central Bank Raises Rates, Says Pausing Is an Option” Wall Street Journal, July 27, 2023; and “Official Interest Rates,” nationalbanken.dk.

Is the U.S. Economy Coming in for a Soft Landing?

The Federal Reserve building in Washington, DC. (Photo from Bloomberg News via the Wall Street Journal.)

The key macroeconomic question of the past two years is whether the Federal Reserve could bring down the high inflation rate without triggering a recession. In this blog post from back in February, we described the three likely macroeconomic outcomes as:

A soft landing—inflation returns to the Fed’s 2 percent target without a recession occurring.
A hard landing—inflation returns to the Fed’s 2 percent target with a recession occurring.
No landing—inflation remains above the Fed’s 2 percent target but no recession occurs.

The following figure shows inflation measured as the percentage change in the personal consumption expenditures (PCE) price index and in the core PCE, which excludes food and energy prices. Recall that the Fed uses inflation as measured by the PCE to determine whether it is hitting its inflation target of 2 percent. Because food and energy prices tend to be volatile, many economists inside and outside of the Fed use the core PCE to better judge the underlying rate of inflation—in other words, the inflation rate likely to persist in at least the near future.

The figure shows that inflation first began to rise above the Fed’s target in March 2021. Most members of the Federal Open Market Committee (FOMC) believed that the inflation was caused by temporary disruptions to supply chains caused by the effects of the Covid–19 pandemic. Accordingly, the FOMC didn’t raise its target for the federal funds from 0 to 0.25 percent until March 2022. Since March 2022, the FOMC has raised its target for the federal funds rate in a series of steps until the target range reached 5.25 to 5.50 percent following the FOMC’s July 26, 2023 meeting.

PCE inflation peaked at 7.0 percent in June 2022 and had fallen to 2.9 percent in June 2023. Core PCE had a lower and earlier peak of 5.4 percent in February 2023, but had experienced a smaller decline—to 4.1 percent in June 2023. Inflation as measured by the consumer price index (CPI) followed a similar pattern, as shown in the following figure. Inflation measured by core CPI reached a lower peak than did inflation measured by the CPI and declined by less through June 2023.

As inflation has been falling since mid-2022, , the unemployment rate has remained low and the employment-population ratio for prime-age workers (workers aged 25 to 54) has risen above its 2019 pre-pandemic peak, as the following two figures show.

So, the Fed seems to be well on its way to achieving a soft landing. But in the press conference following the July 26 FOMC meeting Chair Jerome Powell was cautious in summarizing the inflation situation:

“Inflation has moderated somewhat since the middle of last year. Nonetheless, the process of getting inflation back down to 2 percent has a long way to go. Despite elevated inflation, longer-term inflation expectations appear to remain well anchored, as reflected in a broad range of surveys of households, businesses, and forecasters, as well as measures from financial markets.”

By “longer-term expectations appear to remain well anchored,” Powell was referring to the fact that households, firms, and investors appear to be expecting that the inflation rate will decline over the following year to the Fed’s 2 percent target.

Those economists who still believe that there is a good chance of a recession occuring during the next year have tended to focus on the following three points:

1. As shown in the following two figures, the labor market remains tight, with wage increases remaining high—although slowing in recent months—and the ratio of job openings to the number of unemployed workers remaining at historic levels—although that ratio has also been declining in recent months. If the labor market remains very tight, wages may continue to rise at a rate that isn’t consistent with 2 percent inflation. In that case, the FOMC may have to persist in raising its target for the federal funds rate, increasing the chances for a recession.

2. The lagged effect of the Fed’s contractionary monetary policy over the past year—increases in the target for the federal funds rate and quantitative tightening (allowing the Fed’s holdings of Treasury securites and mortgage-backed securities to decline; a process of quantitative tightening (QT))—may have a significant negative effect on the growth of aggegate demand in the coming months. Economists disagree on the extent to which monetary policy has lagged effects on the economy. Some economists believe that lags in policy have been significantly reduced in recent years, while other economists believe the lags are still substantial. The lagged effects of monetary policy, if sufficiently large, may be enough to push the economy into a recession.

3. The economies of key trading partners, including the European Union, the United Kingdom, China, and Japan are either growing more slowly than in the previous year or are in recession. The result could be a decline in net exports, which have been contributing to the growth of aggregate demand since early 2021.

In summary, we can say that in early August 2023, the probability of the Fed bringing off a soft landing has increased compared with the situation in mid-2022 or even at the beginning of 2023. But problems can still arise before the plane is safely on the ground.

Glenn on Bank Regulation

(Photo from the Wall Street Journal.)

This opinion column first appeared on barrons.com. It is also on the web site of the American Enterprise Institute.

Runs at Silicon Valley Bank and others emerged quickly and drove steep losses in regional bank equity values. Regulators shouldn’t have been caught by surprise, but at least they should take lessons from the shock. The subsequent ad hoc fixes to deposit insurance and assurances that the banking system is sufficiently well-capitalized don’t yet suggest a serious policy focus on those lessons. Calls for much higher levels of bank capital and tighter financial regulation notwithstanding, deeper questions about bank regulation merit greater attention.

Runs are a feature of banking. Banks transform short-term, liquid (even demandable) deposits into longer-term, sometimes much less liquid assets. Bank capital offers a partial buffer against the risk of a run, though a large-scale dash for cash can topple almost any institution, as converting blocks of assets to cash quickly to satisfy deposit withdrawals is almost sure to bring losses. The likelihood of a run goes up with bad news or rumors about the bank and correlation among depositors’ on their demand for funds back. That’s what happened at Silicon Valley Bank. Think also George Bailey’s impassioned speech in the classic movie It’s a Wonderful Life, explaining how maturity and liquidity transformations can unravel, with costs to depositors, bankers, and credit reductions to local businesses and households. The bank examiner in the movie, eager to get home, didn’t see it coming.

While bank runs and banking crises can be hard to predict, a simple maxim can guide regulation and supervision: Increase scrutiny in areas and institutions in which significant changes are occurring over a short period. On an aggregate level, the sharp, rapid increase in the federal funds rate since March 2022 should have focused attention on asset values and interest rate risks. So, too, should the fast potential compression in values of office real estate in many locations as a consequence of pandemic-related working shifts and rate hikes. At the bank level, significant inflows of deposits—particularly uninsured deposits—merit closer risk review. This approach isn’t limited to banking. A recent report of the Brookings-Chicago Booth Task Force on Financial Stability, co-chaired by Donald Kohn and me, put forth a similar change-based approach to scrutiny of nonbank financial institutions.

Such an approach would have magnified supervisory attention to Silicon Valley Bank and First Republic Bank . It also suggests the desirability of greater scrutiny and stress testing of midsize banks generally facing interest rate and commercial real estate risk. Those stress tests can give the Fed and the Federal Deposit Insurance Corp. an indication of capital adequacy concerns that could give rise to mergers or bank closures.

Even with this enhanced regulatory and supervisory attention, two major questions remain: For bank liabilities, what role should deposit insurance play in forestalling costly runs? For bank assets, what role should banks play in commercial lending?

Actions taken since Silicon Valley Bank’s collapse have effectively increased deposit-insurance guarantees for troubled institutions. But the absence of a clearer policy framework for dealing with uninsured deposits dragged out the unwinding of First Republic Bank and threatens other institutions experiencing rapid deposit increases and interest rate risk. When regulators asserted in the wake of the runs that the status quo of a $250,000 limit remained unchanged, they lacked both credibility and a means to reduce uncertainty about future policy actions in a run. That makes runs at vulnerable institutions both more likely and more severe. One reform would be to increase deposit insurance limits for transaction accounts of households and small and midsize firms, as recently proposed by the FDIC. Of course, even this reform raises concerns about implementation, how to price the enhanced coverage, and whether supervision will shift toward the “focus on the changes” framework I outlined earlier.

Retaining a more modest role for deposit insurance raises a larger question: What role should banks play in business lending for working capital, investment, and commercial real estate? The FDIC is mandated to resolve bank failures at the least cost to the deposit-insurance fund, but following that path may lead to more mergers of vulnerable institutions into the nations’ largest banks. While consolidation may mitigate risks for depositors with greater diversification of deposits, it leaves open effects on the mix of lending. Knowing local borrowers better, small and midsize banks have a prominent local lending presence in commercial and industrial loans and real estate. Whether such projects would be financed in a similar mix by local branches of megabanks is a question. Congress should consider whether other alternatives might be reasonable. It might permit consolidation among smaller institutions, even if more costly in resolution in the near term to taxpayers. Or nonbank institutions could be permitted to play a role in resolving troubled banks. The latter mechanism should be considered, as nonbank asset managers like Blackstone or BlackRock could fund loans originated by local banks.

Two lessons for regulation loom large. The first is that attention should be paid to policy risk management as well as bank risk management in identifying areas of concern. Think easy money and the reach for yield, inflationary fiscal and monetary policy during the pandemic, and the Fed’s rapid-fire increase in short-term rates to combat stubborn inflation. Second, regulators and Congress need to be wary of both too much deposit insurance (with likely increased risk-taking and pressure on supervision) and too little deposit insurance (with likely jumps in banking concentration and disruption of local credit to businesses).

One can reasonably anticipate additional erosion of capital in non-money-center banks from rising interest rates and lower office real estate collateral values, hopefully motivating a quick grasp of these lessons. While banks don’t have to mark assets to market if current and can survive turbulence until monetary policy eases, potential runs can upset this equilibrium. Declining regional bank stock prices make this risk clear. Only good fortune or a more thoughtful policy stand in the way of additional bank distress and attendant credit supply reductions.

The Fed Continues to Walk a Tightrope

Photo from the Associated Press of Fed Chair Jerome Powell at a news conference

At its Wednesday, May 3, 2023 meeting, the Federal Open Market Committee (FOMC) raised its target for the federal funds rate by 0.25 percentage point to a range of 5.00 to 5.25. The decision by the committee’s 11 voting members was unanimous. After each meeting, the FOMC releases a statement (the statement for this meeting can be found here) explaining its reasons for its actions at the meeting.

The statement for this meeting had a key change from the statement the committee issued after its last meeting on March 22. The previous statement (found here) included this sentence:

“The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.”

In the statement for this meeting, the committee rewrote that sentence to read:

“In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

This change indicates that the FOMC has stopped—or at least suspended—use of forward guidance. As we explain in Money, Banking, and the Financial System, Chapter 15, Section 5.2, forward guidance refers to statements by the FOMC about how it will conduct monetary policy in the future.

After the March meeting, the committee was providing investors, firms, and households with the forward guidance that it intended to continue raising its target for the federal funds rate—which is what the reference to “additional policy firming” means. The statement after the May meeting indicated that the committee was no longer giving guidance about future changes in its target for the federal funds rate other than to state that it would depend on the future state of the economy. In other words, the committee was indicating that it might not raise its target for the federal funds rate after its next meeting on June 14. The committee didn’t indicate directly that it was pausing further increases in the federal funds rate but indicated that pausing further increases was a possible outcome.

Following the end of the meeting, Fed Chair Jerome Powell conducted a press conference. Although not yet available when this post was written, a transcript will be posted to the Fed’s website here. Powell made the following points in response to questions:

He was not willing to move beyond the formal statement to indicate that the committee would pause further rate increases.
He believed that the bank runs that had led to the closure and sale of Silicon Valley Bank, Signature Bank, and First Republic Bank were likely to be over. He didn’t believe that other regional banks were likely to experience runs. He indicated that the Fed needed to adjust its regulatory and supervisory actions to help ensure that similar runs didn’t happen in the future.
He repeated that he believed that the Fed could achieve its target inflation rate of 2 percent without the U.S. economy experiencing a recession. In other words, he believed that a soft landing was still possible. He acknowledged that some other members of the committee and the committee’s staff economist disagreed with him and expected a mild recession to occur later this year.
He stated that as banks have attempted to become more liquid following the failure of the three regional banks, they have reduced the volume of loans they are making. This credit contraction has an effect on the economy similar to that of an increase in the federal funds rate in that increases in the target for the federal funds rate are also intended to reduce demand for goods, such as housing and business fixed investment, that depend on borrowing. He noted that both those sectors had been contracting in recent months, slowing the economy and potentially reducing the inflation rate.
He indicated that although inflation had declined somewhat during the past year, it was still well above the Fed’s target. He mentioned that wage increases were still higher than is consistent with an inflation rate of 2 percent. In response to a question, he indicated that if the inflation rate were to fall from current rates above 4 percent to 3 percent, the FOMC would not be satisfied to accept that rate. In other words, the FOMC still had a firm target rate of 2 percent.

In summary, the FOMC finds itself in the same situation it has been in since it began raising its target for the federal funds rate in March 2022: Trying to bring high inflation rates back down to its 2 percent target without causing the U.S. economy to experience a significant recession.