inflation – Page 14 – HubbardOBrienEconomics.com Blog

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-U	CPI-W	R-CPI-E	CPI for lowest income quartile	CPI 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.

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.

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

Congress has given the Fed a mandate to achieve the goal of price stability. Until 2012, the Fed had never stated explicitly how they would measure whether they had achieved this goal. One interpretation of price stability is that the price level remains constant. But a constant price level would be very difficult to achieve in practice and the Fed has not attempted to do so. In 2012, the Fed, under then Chair Ben Bernanke, announced that it was targeting an inflation rate of 2 percent, which it believed was low enough to be consistent with price stability: “When households and businesses can reasonably expect inflation to remain low and stable, they are able to make sound decisions regarding saving, borrowing, and investment, which contributes to a well-functioning economy.” (We discuss inflation targeting in Macroeconomics, Chapter 15, Section 15.5 and Economics, Chapter 25, Section 25.5.)

In August 2020, the Fed announced a new monetary policy strategy that modified how it interpreted its inflation target: “[T]he Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” The Fed’s new approach is sometimes referred to as average inflation targeting (AIT) because the Fed attempts to achieve its 2 percent target on average over a period of time, although the Fed has not explicitly stated how long the period of time may be. In other words, the Fed hasn’t indicated the time horizon during which it intends inflation to average 2 percent.

The Fed uses changes in the personal consumption expenditure (PCE) price index to measure inflation, rather than using changes in the consumer price index (CPI). The Fed prefers the PCE to the CPI because the PCE is a broader measure of the price level in that it includes the prices of more consumer goods and services than does the CPI. The following figure shows inflation for the period since 2006 measured by percentage changes in the PCE from the corresponding month in the previous year. (Members of the Fed’s Federal Open Market Committee generally consider changes in the core PCE—which excludes the prices of food and energy—to be the best measure of the underlying rate of inflation. But because the Fed’s inflation target is stated in terms of the PCE rather than the core PCE, we are looking here only at the PCE.) The figure shows that for most of the period from 2012 to early 2021, inflation was less than the Fed’s target of 2 percent.

The figure also shows that since March 2021, inflation has been running above 2 percent and has steadily increased, reaching a rate of 5.8 percent in December 2021. Note that a strict interpretation of AIT would mean that the Fed would have to balance these inflation rates far above 2 percent with future inflation rates well below 2 percent. As Ricardo Reis, an economist at the London School of Economics, noted recently: “If the [Fed’s time] horizon is 3 years, the Fed … will [have to] pursue monetary policy to achieve annual inflation of… −0.5% over the next year and a half. If the horizon is 5 years, the Fed … will [have to] pursue policy to achieve annual inflation of 0.9% over the next 3.5 years.” It seems unlikely that the Fed would want to bring about inflation rates that low because doing so would require raising its target for the federal funds rate to levels likely to cause a recession.

Another interpretation of the Fed’s monetary policy strategy is that involves a flexible average inflation target (FAIT) approach rather than a strictly AIT approach. Former Fed Vice Chair Richard Clarida discussed this interpretation of the Fed’s strategy in a speech in November 2020. He noted that the framework was asymmetric, meaning that inflation rates higher than 2 percent need not be offset with inflation rates lower than 2 percent: “The new framework is asymmetric. …[T]he goal of monetary policy … is to return inflation to its 2 percent longer-run goal, but not to push inflation below 2 percent.” And: “Our framework aims … for inflation to average 2 percent over time, but it does not make a … commitment to achieve … inflation outcomes that average 2 percent under any and all circumstances ….”

Under this interpretation, particularly if Fed policymakers believe that the high inflation rates of 2021 were the result of temporary supply chain problems and other factors caused by the pandemic, it would not need to offset them by forcing inflation to very low levels in order to make the average inflation rate over time equal 2 percent. Critics of the FAIT approach to monetary policy note that the approach doesn’t provide investors, household, and firms with much guidance on what inflation rates the Fed may find acceptable over the short-term of a year or so. In that sense, the Fed is moving away from a rules-based policy, such as the Taylor rule that we discuss in Chapter 15. Or, as a columnist for the Wall Street Journal wrote with respect to FAIT: “Of course, the word ‘flexible’ is there because the Fed doesn’t want to be tied down, so it can do anything.”

The Fed’s actions during 2022 will likely provide a better understanding of how it intends to implement its new monetary policy strategy during conditions of high inflation.

Sources: Board of Governors of the Federal Reserve, “Why does the Federal Reserve aim for inflation of 2 percent over the longer run?” federalreserve.gov, August 27, 2020; Board of Governors of the Federal Reserve, “2020 Statement on Longer-Run Goals and Monetary Policy Strategy,” federalreserve.gov, January 14, 2021; Ricardo Reis’s comments are from this Twitter thread: https://mobile.twitter.com/R2Rsquared/status/1488552608981827590, Richard H. Clarida, “The Federal Reserve’s New Framework: Context and Consequences,” federalreserve.gov, November 16, 2020; and James Mackintosh, “On Inflation Surge, the Fed Is Running Out of Excuses,” Wall Street Journal, November 14, 2021.

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

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

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

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

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

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

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

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

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

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

Takeaways from the January 25-26 Federal Open Market Committee Meeting

Fed Chair Jerome Powell (Photo from the Associated Press)

The results of the meeting were largely as expected: The FOMC statement indicated that the Fed remained concerned about “elevated levels of inflation” and that “the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”

In a press conference following the meeting, Fed Chair Jerome Powell suggested that the FOMC would begin raising its target for the federal funds at its March meeting. He also noted that it was possible that the committee would have to raise its target more quickly than previously expected: “We will remain attentive to risks, including the risk that high inflation is more persistent than expected, and are prepared to respond as appropriate.”

Some other points:

The Federal Reserve Act gives the Federal reserve the dual mandate of “maximum employment” and “price stability.” Neither policy goal is defined in the act. In its new monetary policy strategy announced in August 2020, the Fed stated that it would consider the goal of price stability to have been achieved if annual inflation measured by the change in the core personal consumption expenditures (PCE) price index averaged 2 percent over time. The Fed was less clear about defining the meaning of maximum employment, as we discussed in this blog post.

As we noted in the post, as of December, some labor market indicators—notably, the unemployment rate and the job vacancy rate—appeared to show that the labor market’s recovery from the effects of the pandemic was largely complete. But both total employment and employment of prime age workers remained significantly below the levels of early 2020, just before the effects of the pandemic began to be felt on the labor market.

In his press conference, Powell indicated that despite these conflicting labor market indicators: “Most FOMC participants agree that labor market conditions are consistent with maximum employment in the sense of the highest level of employment that is consistent with price stability. And that is my personal view.”

In March 2020, as the target for the federal funds rate reached the zero lower bound, the Fed turned to quantitative easing (QE), just as it had in November 2008 during the Great Financial Crisis. To carry out its policy of QE, the Fed purchased large quantities of long-term Treasury securities with maturities of 4 to 30 years and mortgage backed securities guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae—so-called agency MBS. As a result of these purchases, the Fed’s asset holdings (often referred to as its balance sheet) soared to nearly $9 trillion.

In addition to raising its target for the federal funds rate, the Fed intends to gradually shrink the size of this asset holdings. Some economists refer to this process as quantitative tightening (QT). Following its January meeting, the FOMC issued a statement on “Principles for Reducing the Size of the Federal Reserve’s Balance Sheet.” The statement indicated that increases in the federal funds rate, not QT, would be the focus of its shift to a less expansionary monetary policy: “The Committee views changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy.” The statement also indicated that as the process of QT continued the Fed would eventually hold primarily Treasury securities, which means that the Fed would eventually stop holding agency MBS. Some economists have speculated that the Fed’s exiting the market for agency MBS might have a significant effect on that market, potentially causing mortgage interest rates to increase.

Finally, Powell indicated that the FOMC would likely raise its target for the federal funds more rapidly than it had during the 2015 to 2018 period. Financial market are expecting three or four 0.25 percent increases during 2022, but Powell would not rule out the possibility that the target could be raised during each remaining meeting of the year—which would result in seven increases. The FOMC’s long-run target for the federal funds rate—sometime referred to as the neutral rate—is 2.5 percent. With the target for the federal funds rate currently near zero, four rate increases during 2022 would still leave the target well short of the neutral rate.

Sources: The statements issued by the FOMC at the close of the meeting can be found here; Christopher Rugaber, “Fed Plans to Raise Rates Starting in March to Cool Inflation,” apnews.com, January 26, 2022; Nick Timiraos, “Fed Interest-Rate Decision Tees Up March Increase,” Wall Street Journal, January 26, 2022; Olivia Rockeman and Craig Torres, “Powell Back March Liftoff, Won’t Rule Out Hike Every Meeting,” bloomberg.com, January 26, 2022; and Olivia Rockeman and Reade Pickett, “Powell Says U.S. Labor Market Consistent with Maximum Employment,” bloomberg.com, January 26, 2022.

New 1/25/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss inflation, inflation, inflation.

Authors Glenn Hubbard and Tony O’Brien as they talk about the leading economic issue of early 2022 – inflation! They discuss the resurgence of inflation to levels not seen in 40 years due to a combination of miscalculations in monetary and fiscal policy. The role of Quantitative Easing (QE) – and its future – is discussed in depth. Listen today to gain insights into the economic landscape.

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

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

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

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

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

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.
Antitrust interventions could successfully reduce US inflation over the next 12 months.
Price controls as deployed in the 1970s could successfully reduce US inflation over the next 12 months.

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

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

The panels responses can be found here.

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

Lawrence Summers Remains Pessimistic about Inflation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sticker Shock in the Market for Used Cars

The term “sticker shock” was first used during the 1970s to describe the surprise car buyers experienced when seeing how much car prices had risen. Because inflation during that decade was so high, anyone who hadn’t bought a car for several years was unprepared for the jump in car prices. During 2020 and 2021, sticker shock returned, particularly to the used car market. Prices were increasing so rapidly that even people who had purchased a car a year or two before were surprised by the increases.

The following graph shows U.S. Bureau of Labor Statistics (BLS) data on inflation in the market for used cars in the months since January 2015. Inflation is measured as the percent change from the same month in the previous year in the used cars and trucks component of the Consumer Price Index (CPI). The CPI is the most widely used measure of inflation. Used car prices began rising in August 2020, peaking at a 45 percent increase in June 2021. Inflation at such rates over a period longer than a year is very unusual in any of components of the CPI.

What explains the extraordinary burst of inflation in used car prices during 2020 and 2021? Three factors seem to have been of greatest importance:

A decline in the supply of new cars resulting from a shortage in semiconductors caused an increase in new car prices. Rising new car prices led some consumers who would otherwise have bought a new car to enter the used car market, increasing the demand for used cars.
Because of the Covid-19 pandemic, some people became reluctant to ride buses and other mass transit, increasing the demand for both new and used cars.
As the pandemic increased in severity in the spring of 2020, most rental car companies decided to purchase fewer new cars for their fleets. After keeping a car in its fleet for one year, rental car companies typically sell the car to used car dealers for resale. Because rental car companies were selling them fewer cars, used car dealers had fewer cars on their lots. So the supply of used cars declined.

We can use the demand and supply model to explain the jump in used car prices. As shown in the following figure, the demand curve for used cars shifted to the right from D₁ to D₂, as some consumers who would otherwise have bought new cars, bought used cars instead, and as some people swithced from public transportation to driving their cars to work. At the same time, the supply of used cars shifted to the left from S₁ to S₂ because used car dealers were able to buy fewer used cars from rental car companies. The result was that the price of used cars rose from P₁ to P₂ at the same time that the quantity of used cars sold fell from Q₁ to Q₂.

Sources: Yueqi Yang, “U.S. Used-Car Prices, Key Inflation Driver, Surge to Record,” bloomberg.com, October 7, 2021; Nora Naughton, “Looking to Buy a Used Car? Expect High Prices, Few Options,” wsj.com, May 10, 2021; Cox Automotive, “13-Month Rolling Used-Vehicle SAAR,” coxautoinc.com, October 15, 2021; and Federal Reserve Bank of St. Louis.