Authors Glenn Hubbard and Tony O’Brien reconsider the role of inflation in today’s economy. They discuss the Fed’s possible responses by considering responses to similar inflation threats in previous generations – notably the Fed’s response led by Paul Volcker that directly led to the early 1980’s recession. The markets are reflecting stark differences in our collective expectations about what will happen next. Listen to find out more about the Fed’s likely next steps.
Authors Glenn Hubbard & Tony O’Brien reflect on the global economic effects of Russia’s invasion of Ukraine last week. They consider the impact on the global commodity market, US monetary policy, and the impact on the financial markets in the US. Impact touches Introductory Economics, Money & Banking, International Economics, and Intermediate Macroeconomics as the effects of Russia’s aggression moves into its second week.
A map of Europe with Ukraine in the middle right below Belarus and to the east of Poland.
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.
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.
Authors Glenn Hubbard and Tony O’Brien discuss the economic impact of the recent infrastructure bill and what role fiscal policy plays in determining shovel-ready projects. Also, they explore the vast impact of the economy-wide supply-chain issues and the challenges companies face. Until the pandemic, we had a very efficient supply chain but now we’re seeing companies employ the “just-in-case” inventory method vs. “just-in-time”!
Some links referenced in the podcast:
Here’s Alan Cole’s blog: https://fullstackeconomics.com/how-i-reluctantly-became-an-inflation-crank/
Neil Irwin wrote a column referencing Cole here: https://www.nytimes.com/2021/10/10/upshot/shadow-inflation-analysis.html
Here’s a Times article on the inefficiency of subway construction in NYC: https://www.nytimes.com/2017/12/28/nyregion/new-york-subway-construction-costs.html
A recent article on the state of CA’s bullet train: https://www.kcra.com/article/california-bullet-trains-latest-woe-high-speed/37954851
A WSJ column on goods v. services: https://www.wsj.com/articles/at-times-like-these-inflation-isnt-all-bad-11634290202
Supports: Macroneconomics Chapter 15, Section 15.3; Economics Chapter 25, Section 25.3; and Essentials of Economics Chapter 17, Sections 17.3.
Solved Problem: The Fed’s Policy Dilemma
In the fall of 2021, the inflation rate was at its highest level since 2008. The unemployment rate was above 5 percent, which was much lower than in the spring of 2020, but still well above its level of early 2020 before the Covid-19 pandemic. In testifying before Congress, Fed Chair Jerome Powell stated that he believed the high inflation rate was transitory and in the longer run “inflation is expected to drop back toward our longer-run 2 percent goal.”
But Powell also stated that if inflation continued to remain high the Fed would face a policy dilemma. “Almost all of the time, inflation is low when unemployment is high, so interest rates work on both problems.” But in contrast, in the fall of 2021 both the unemployment and inflation rates were high: “That’s the very difficult situation we find ourselves in.”
a. Briefly explain what Powell meant by saying that almost all of the time “interest rates work on both problems.”
b. Why did macroeconomic conditions in the fall of 2021 present Fed policymakers with a “very difficult” situation?
Source: Kate Davidson and Nick Timiraos, “Powell Says Fed Faces ‘Difficult Trade-Off’ if Inflation Doesn’t Moderate,” Wall Street Journal, September 30, 2021; and Chair Jerome H. Powell, “Testimony Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C.” September 28, 2021, federalreserve. gov..
Solving the Problem
Step 1: Review the chapter material. This problem is about the policy situation the Fed faces when the unemployment and inflation rates are both high, so you may want to review Chapter 15, Section 15.3, “Monetary Policy and Economic Activity,” and the discussion of staflation, including Figure 13.7, in Chapter 13, Section 13.3, “Macroeconomic Equilibrium in the Long Run and the Short Run.”
Step 2: Explain what Powell meant by “interest rates work on both problems.” We’ve seen that in the typical recession the unemployment rate increases while the inflation rate decreases. We’ve also seen that if the economy is above potential GDP, the unemployment rate is very low but the inflation rate increases. (To review these facts, see Chapter 10, Section 10.3 “The Business Cycle.”) The Fed uses changes in its target for the federal funds rate to affect the level of real GDP and the price level, as it attempts to hit its policy goals of high employment and price stability.
So “almost all of the time,” the Fed can use interest rates–changes in the target for the federal funds rate–to work on the problems of high unemployment and high inflation–depending on which is occuring during a particular period.
Step 3: Explain why macroeconomic conditions in the fall of 2021 presented Fed policymakers with a “very difficult” situation. As Powell observes, “almost all the time” Fed policy is focused on reducing either high unemployment or high inflation, but not both. As we note in Chapter 13, Section 13.3, economists refer to a situation when the unemployment and inflations rates are both high at the same time as a period of stagflation. If the inflation rate is high, then expansionary monetary policy–a low target for the federal funds rate–will reduce the unemployment rate but make an already high inflation rate even higher. Similarly, if the unemployment rate is high, then contractionary monetary policy–a high target for the federal funds rate–will reduce the inflation rate but make an already high unemploument rate even higher. A very difficult policy dilemma for the Fed!
How did Fed policymakers expect to resolve this difficulty? In his testimony, Powell explained that he believed that the high inflation rate the U.S. economy was experiencing during the fall of 2021 was transitory and would begin to decline once the supply problems caused by the Covid-19 pandemic were resolved in the coming months. Referring to the supply problems he noted that “These aren’t things that we [the Fed] can control.” Therefore, the Fed did not intend to use policy to address the high inflation rate and could continue to pursue an expansionary monetary policy to push the labor market back to full employment.
It’s customary for textbook authors to note that “much has happened in the economy” since the last edition of their book appeared. To say that much has happened since we prepared our last edition in 2019 would be a major understatement. Never in the lifetimes of today’s students and instructors have events like those of 2020 and 2021 occurred. The U.S. and world economies had experienced nothing like the Covid-19 pandemic since the influenza pandemic of 1918. In the spring of 2020, the U.S. economy suffered an unprecedented decline in the supply of goods and services as a majority of businesses in the country shut down to reduce spread of the virus. Many businesses remained closed or operated at greatly reduced capacity well into 2021. Most schools, including most colleges, switched to remote learning, which disrupted the lives of many students and their parents.
During the worst of the pandemic, total spending in the economy declined as the unemployment rate soared to levels not seen since the Great Depression of the 1930s. Reduced spending and closed businesses resulted in by far the largest decline in total production in such a short period in the history of the U.S. economy. Congress, the Trump and Biden administrations, and the Federal Reserve responded with fiscal and monetary policies that were also unprecedented.
Our updated Eighth Edition covers all of these developments as well as the policy debates they initiated. As with previous editions, we rely on extensive digital resources, including: author-created application videos and audio recordings of the chapter openers and Apply the Concept features; figure animation videos; interactive real-time data graphs animations; and Solved Problem whiteboard videos.
Glenn and Tony discuss the updated edition in this video:
Sample chapters will be available by October 15.
The full Macroeconomics text will available in early to mid December.
The full Microeconomics text will be available in mid to late December.
If you would like to view the sample chapters or are considering adopting the updated Eighth Edition for the spring semester, please contact your local Pearson representative. You can use this LINK to find and contact your representative.
Authors Glenn Hubbard and Tony O’Brien discuss the recent jobs report falling short of expectations. They also discuss the comments of Fed Chairman Powell’s comments at the Federal Reserve’s recent Jackson Hole conference. They also get to some of the recommendations of a Brookings Task Force, co-chaired by Glenn Hubbard, on ways to address financial stability. Use the links below to see more information about these timely topics:
Powell’s Jackson Hole speech:
The report of Glenn’s task force:
The most recent economic forecasts of the FOMC: