Inflation

Managing Disinflation

Large, advanced economy central banks are working hard to lower inflation from 40-year highs. Policy rates are up sharply in Canada, the euro area, the United Kingdom and the United States. While disinflation has started, inflation remains far above policymakers’ common target of 2 percent.

Based on their latest projections published in December, most U.S. Federal Open Market Committee (FOMC) participants anticipate a largely benign return to price stability, without a decline in real GDP or a rise of the unemployment rate to much more than 4½ percent. Is this optimism justified? Pointing to the historical record, some prominent analysts wonder whether it is possible to engineer such a large disinflation at what would be such a low cost (see, for example, Lawrence Summers).

This is the setting for this year’s report for the U.S. Monetary Policy Forum that we wrote with Michael Feroli, Peter Hooper and Frederic Mishkin. In the report, we focus on the central challenge facing central banks today: how to minimize the costs of disinflation. To address this question, we employ two approaches: a historical analysis in which we assess the costs of sizable disinflations since the 1950s; and a model-based analysis in which we examine the degree to which policymakers might have been able to   anticipate the recent surge of inflation, as well as the path of policy that is likely needed to achieve the desired disinflation.

In the remainder of this post, we summarize the USMPF report’s analysis and conclusions….

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The Slippery Slope of a Higher Inflation Target

With inflation significantly above target in most advanced economies, there are renewed calls for central banks to raise their targets from 2% to 3% or 4%, in order to limit the prospective costs of disinflation. In this post, we review the benefits and costs of a higher inflation target.

Yet, regardless of the balance between the costs and benefits of raising the inflation target, our view is that central banks ought not be able to choose their inflation targets. The key problem with such discretion is the slippery slope. If households and firms come to expect that a central bank will opportunistically raise its inflation target to avoid the economic sacrifice associated with disinflation, inflation expectations will no longer be anchored at the target (whatever it is).

To limit the “inflation expectations ratchet”—avoiding perceptions of opportunistic central bank discretion— the Federal Reserve should follow an approach that it now employs regarding the possible introduction of a central bank digital currency: namely, the Fed should announce that it will not alter its inflation target without the explicit support of both the legislative and executive branches, ideally in the form of legislation….

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To improve Fed policy, improve communications

Since May 2021, we have criticized the Federal Reserve’s lagging response to surging inflation. In our view, both policy and communications were inadequate to address the looming challenge. Early this year, we argued that the Fed created a policy crisis by refusing to acknowledge the rise of trend inflation, maintaining a hyper-expansionary policy well after trend inflation reached levels far above their 2% target, and failing to articulate a credible low-inflation policy.

Against this background, we commend the FOMC for its recent efforts. Not only is policy moving quickly in the right direction, but communication improved markedly. In particular, despite the increasing likelihood of a near-term recession, Chair Powell made clear that price stability is necessary for achieving the second part of the Fed’s dual mandate. We suspect that the combination of the Fed’s recent promise to make policy restrictive, along with its improved communications, is playing a key role in anchoring longer-term inflation expectations.

In this post, we focus on central bank communication and its link to policy setting. By far the most important goal of communication is to clarify the authorities’ reaction function: the systematic response of central bank policy to prospective changes in key economy-wide fundamentals—usually inflation and the unemployment rate.

To anticipate our conclusions, we argue for two changes to the FOMC’s quarterly Summary of Economic Projections to better illuminate the Committee reaction function. First, we encourage publication of more detail on individual participants’ responses to link individual projections of inflation, economic growth, and unemployment to the path of the policy rate. Second, we see a role for scenario analysis in which FOMC participants provide their anticipated policy path contingent on one or more adverse supply shocks that present unappealing policy tradeoffs (for example, between the speed of returning inflation to its target and the pace at which the unemployment rate returns to its sustainable level)….

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Trend inflation: How wages and housing are sustaining momentum

While annual inflation may have peaked, it remains at levels we last saw in the early 1980s. Indeed, our preferred measure of the medium-term inflation trend– the six-month annualized change in the trimmed mean personal consumption expenditure price index—is up by nearly 5 percent. Fortunately, policymakers now realize the severity of the situation and are raising interest rates quickly as they work to catch up. Fed fund futures anticipate a rate of at least 3½ percent by yearend—the most rapid increase in more than 40 years. Will this be enough?

In this post, we address this question. Our conclusion is that policymakers will have to act more aggressively than financial markets anticipate if inflation is to decline to the Fed’s 2-percent target within two years. The reason is that inflation has substantial forward momentum arising from two sources. First, a tight labor market combined with elevated short-term inflation expectations appear poised to drive wage inflation higher. Second, there is the continuing impact of increases in prices of housing, both for owners and renters. So, while energy prices as well as other temporary drivers of the current high inflation are fading, and long-term inflation expectations remain reasonably contained, inflation is currently poised to remain well above 2 percent….

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No Recession . . . Yet

The press is abuzz with claims that the United States is in recession because real GDP declined in both the first and second quarters of 2022. Many people use this “two consecutive quarters of declining GDP” formula as an informal indicator of a recession. And, they are generally right, it has been useful: since 1950, nine of 11 recessions designated by the National Bureau of Economic Research (NBER) Business Cycle Dating Committee (BCDC) included at least two consecutive quarters of falling GDP. Moreover, given the recent slowdown in economic activity, people are starting to feel as if they are experiencing a recession. Indeed, going forward, we expect that a recession will be associated with the disinflation which the Federal Reserve seeks (see our recent post).

Nevertheless, in current circumstances, there are good reasons not to rely on the simple recipe that equates two consecutive quarters of falling GDP with a recession. Indeed, when people ask us whether the economy currently is in a recession—something that occurs daily—we respond: “not yet, but very likely over the next year.”

In this post, we provide a primer on the criteria that the NBER BCDC uses to produce the authoritative dating of U.S. recessions. (The complete NBER cyclical chronology is here.) We explain how economists improve upon the simple formula by using multiple sources of information that are observed frequently and are less prone to large revisions—especially around business cycle turning points. We conclude with a brief explanation of why the risk that the United States will enter a recession in the near future is very high….

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Can vacancies plunge without a significant rise of unemployment?

The primary objective of central bankers is to maintain low and stable inflation. While this task was never easy, the recent bout of large, adverse supply shocks—from the pandemic to the Russian invasion of Ukraine—combined with massive demand stimulus (both fiscal and monetary) made the task of securing price stability far more difficult.

Our favored indicator of the inflation trend, the Dallas Fed’s trimmed mean PCE price index, rose at a 4.4% annual rate over the past six months, and seems to be accelerating. Furthermore, while activity has slowed, the U.S. labor market remains extraordinarily tight: there are nearly two vacancies for each person who is unemployed—well above the peaks of the early 1950s and the late 1960s.

Against this background, a large, recession-free disinflation seems highly unlikely to us (see our recent post). In theory, a plunge of vacancies could cool a very hot labor market without raising unemployment (see, for example, Waller). In practice, however, the behavior of the relationship between vacancies and unemployment since 1950—what is known as the Beveridge Curve—suggests that this is very unlikely (see Blanchard, Domash and Summers).

That is the subject of this post….

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The Costs of Acting Too Little, Too Late

Central bankers that act too little too late risk inflation, recession, or both. Everyone, including the members of the Federal Open Market Committee, knows that the FOMC is late in its current campaign to restore price stability. This makes it essential that they do not do too little.

In this post, we highlight the continued gap between the lessons of past disinflations and the Fed’s hopes and aspirations. We find it difficult to square the FOMC’s latest projections of falling inflation with only modest policy restraint. Simply put, we doubt that the peak projected policy rate from the June Summary of Economic Projections (SEP) will be sufficient to lower inflation to 2% in the absence of a recession.

In our view, boosting the credibility of the FOMC’s price stability commitment will require not only greater realism, but a clarification of how policy would evolve if, as in past large disinflations, the unemployment rate rises by several percentage points. The overly sanguine June SEP simply does not address this key question. Indeed, no FOMC participant anticipates the unemployment rate to rise above 4½% over the forecast horizon….

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Harry Potter's Monetary Policy Wand?

The Federal Open Market Committee (FOMC) is reassuring us that, so long as we are patient, price stability will return without further pain. But its narrative seems less grounded in historical experience and more like something Harry Potter might have conjured at Hogwarts. By the end of 2024, the Committee expects trend inflation (measured by the price index of personal consumption expenditures excluding food and energy) to drop by more than 3 percentage points while economic growth remains above (and the unemployment rate below) its sustainable level. And, all this magic materializes with the real (inflation-adjusted) policy rate barely turning positive.

The principal means by which the Fed affects the inflation outlook is by influencing financial conditions. Yet, having telegraphed its policy shift for months, the FOMC’s most recent actions on March 16—initiating a series of rate hikes and suggesting that balance sheet tapering could begin soon—barely affected the ease with which firms and households obtain financing. And, while financial conditions are indeed a bit tighter than six months ago—when about one-half of FOMC participants anticipated no interest rate hikes in 2022—these conditions remain quite accommodative (see here).

Is the FOMC’s current policy path consistent with its longer-term price stability goals? In this post, we address this question by exploring policymakers’ newly published projections. Our conclusion is that bringing the inflation trend back to 2% will require a tightening of financial conditions significantly beyond what the Fed currently envisions….

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Fed Monetary Policy in Crisis

The Federal Open Market Committee (FOMC) is facing a crisis of its own making. The crisis has four elements. Policymakers failed to forecast the rise in inflation. They failed to appreciate how persistent inflation can be. They are failing to articulate a credible low inflation policy. And, so far, there is little sign that monetary policymakers recognize the need to react decisively.

Our fear is that matters have now progressed to the stage where the Fed’s credibility for delivering price stability is at serious risk. And, as experience teaches us, the less credible the central bank, the more painful it is to lower inflation to target.

In this post, we discuss the policy crisis and suggest how to respond. In our view, the FOMC needs a plan to raise rates quickly and substantially. For the FOMC to ensure inflation returns to its target of 2%, policymakers likely will need to bring the short-term real interest rate into significantly positive territory. Put slightly differently, we suspect that the policy rate needs to rise to at least one percent above expected inflation.

Won’t a sharp policy tightening trigger a huge recession? In our view, credibility is the key to how much pain disinflation will cause. Applying the painful lesson of the 1970s and early 1980s leads us to conclude that the FOMC now needs to show clear resolve. Inflation rose very quickly over the past year, so it may still be possible to bring it down sharply without a recession. The more decisively policymakers act, the lower the long-run costs are likely to be. Failure to restore price stability in a timely way would almost surely render this expansion disturbingly short compared to recent norms.

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From Inflation Targeting to Employment Targeting?

Last year, the Federal Open Market Committee (FOMC) modified its monetary policy framework to focus on average inflation targeting. They stated that “appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time” after “periods when inflation has been running persistently below 2%.” At the same time, the Committee scaled back efforts to preempt inflation, introducing an asymmetric “shortfall” strategy which responds to employment only when it falls below its estimated maximum. FOMC participants view these strategic changes as means to secure their legally mandated dual objectives of price stability and maximum employment (see our earlier posts here and here).

Prior to this week’s FOMC meeting, the Committee’s forward guidance explicitly balanced these two goals. However, in what we view as a remarkable shift, changes in the December 15 statement are difficult to square with any type of inflation targeting strategy. Despite the recent surge of inflation, the Committee’s new forward guidance removes any mention of price stability as a condition for keeping policy rates near zero. Instead, it focuses exclusively on reaching maximum employment.

In this post, we provide two reasons why such an unbalanced approach is concerning. First, a monetary policy strategy that ranks maximum employment well above price stability is unlikely to secure price stability over the long run. Second, FOMC participants’ projections for 2022-24 are a combination of strong economic growth, further labor market tightening and a policy rate well below long-run norms. This mix seems inconsistent with the large decline in trend inflation that participants anticipate. While policymakers certainly can and do revise their projections, persistent underestimates of inflation fuel the perception that price stability is a secondary, rather than equal, goal of policy….

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Inflation Policy

“Headline” inflation is making painful headlines again. In October, consumer prices rose by 6.2 percent from a year ago—the most rapid gain in at least three decades. Measures of trend inflation also are showing unsettling increases, with the trimmed mean CPI up by 4%. And there are reasons to believe that inflation will stay well above policymakers’ 2% target for an extended period.

In this post, we briefly summarize how we got here and argue that the Federal Reserve needs to change course now. In our view, current monetary policy is far too accommodative. Moreover, the sooner the Fed acts, the more likely it is that policymakers will be able to restore price stability without undermining the post-COVID expansion.

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Stagflation: A Primer

The term stagflation came into common use in the mid-1970s, when many advanced economies experienced higher inflation and slower growth than they had in the 1960s. At the time, the joint behavior of inflation and economic growth confused many economists. Throughout the 1950s and 1960s, growth and inflation generally moved in the same direction. Most important, inflation tended to fall during recessions and to rise in booms. Stagflation meant that these two key summary measures of macroeconomic performance moved in opposite directions. What caused this dramatic, painful, and persistent shift?

To understand the sources of stagflation in the 1970s—and how we subsequently avoided a repeat of that episode (at least so far)—we start with the simple premise that there are two types of disturbances hitting the economy: demand and supply. The first, changes in demand, moves inflation and growth in the same direction. The broad array of things that shift demand include fluctuations in consumer or business confidence, shifts in government tax and expenditure policy, and variation in the appeal of imports to domestic residents or of exports to foreigners. When any of these goes up or down, inflation and output rise and fall together.

Supply disturbances—which alter the cost of production—are fundamentally different. These stagflationary shocks move growth and inflation in opposite directions. For example, an adverse supply shock that raises the cost of production at least temporarily drives inflation up and growth down.

Importantly, these cost shocks cannot be the whole story behind a decade-long surge of inflation. Whether the consequences of a cost shock are one-off adjustments in the price level or an increase of the trend of inflation depends on the monetary policy response. Put differently, monetary policy determines whether we experience stagflation over any longer interval….

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The ECB's New Strategy: Codifying Existing Practice . . . plus

When the ECB began operation in 1999, many observers focused on its differences from the Federal Reserve. Yet, since the start, the ECB was much like the Fed. And, over the past two decades, the ECB and the Fed have learned a great deal from each other, furthering convergence.

Against this background, it is unsurprising that the broad monetary policy strategies in the United States and the euro area converged as well. On July 8, the ECB published the culmination of the strategy review that began in early 2020, the first since 2003. The implementation of the new strategy comes nearly one year after the Fed revised its longer-run goals in August 2020 (see our earlier posts here and here).

If past is prologue, observers will exaggerate the differences. Perhaps most obvious, unlike the Fed, the ECB’s strategic update did not introduce an averaging framework in which they would “make up” for past errors. Nevertheless, we suspect that it will be difficult to distinguish most Fed and ECB policy actions based on the modest differences in their strategic frameworks. For the most part, both revised strategies codify existing practice, as they permit extensive discretion in how they employ their growing set of policy tools.

In this post, we summarize the motivations for the ECB’s new strategy and describe three notable changes: target 2% inflation, symmetrically and unambiguously; integrate climate change into the framework; and outline a plan to introduce owner-occupied housing into the price index they target (the euro area harmonised index of consumer prices). While the new strategy can help the ECB achieve its price stability mandate, in our view the overall impact of the revisions is likely to be modest….

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Inflation: Don't Worry, Be Prepared

Everyone seems to be worried about inflation (see here and here). People also are concerned that the rising media salience of inflation could raise inflation expectations, leading to a sustained rise in inflation itself.

April price readings certainly boosted these worries: the conventional measure of core inflation—the CPI excluding food and energy—rose by nearly 3% from a year ago, the biggest gain since 1995. Fed Vice Chair Richard Clarida summed up the nearly universal reaction when he said: “I was surprised. This number was well above what I and outside forecasters expected.”

The experience of the high-inflation 1970s makes people prone to worrying about such things. Our reaction is different. After all, worry alone is not going to prevent a sustained pickup of inflation. Only credible anti-inflationary monetary policy can do that. To ensure that inflation expectations remain low, it is up to the central bank to make sure everyone understands how policy will respond if the latest elevated inflation readings prove to be more than temporary. As we have written before, the key is effective communications, not premature action….

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Is Inflation Coming?

For more than a generation, the U.S. inflation-targeting framework has delivered impressive results. From 1995 to 2007, U.S. inflation averaged 2.1% (as measured by the Federal Reserve’s preferred index). Since 2008, average inflation dropped to only 1.5%, but expectations have fluctuated in a narrow range: for example, the market-based five-year, five-year forward (CPI) inflation expectation rarely dipped below 1.5% and never exceeded 3%.

However, the pandemic brought with it many dramatic changes. Fiscal and monetary policy mobilized, responding swiftly to the economic plunge with a combination of extraordinary debt-financed expenditure and balance sheet expansion. As a matter of accounting and arithmetic, these actions have had a profound impact on the balance sheets of banks and households, spurring dramatic growth in traditional monetary aggregates. From the end of February to the end of May 2020, broad money (M2) grew from $15.5 trillion to $17.9 trillion—a 16% jump in just three months.

Won’t the record 2020 gain in M2 be highly inflationary? We doubt it, and in this post we explain why. At the same time, we highlight the chronic uncertainty that plagues inflation. In our view, the difficulty in forecasting inflation makes it important that the Fed routinely communicate how it will react to inflation surprises—even when, as now, policymakers wish to promote extremely accommodative financial conditions….

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Has the U.S. Distribution of Wealth Worsened?

Wealth inequality in the United States is obvious to everyone. The Federal Reserve’s triennial Survey of Consumer Finance (SCF) documents the glaring and persistent divide between rich and poor, confirming that ownership of financial and real assets in the United States has been highly concentrated for decades (see our earlier post). The most recent 2016 estimates suggest that the top 10% of the wealth distribution own nearly three-quarters of all marketable assets, with the top 1% owning more than half of that. And, Saez and Zucman (SZ) estimate that the U.S. distribution has been getting worse, with the top 1% share of marketable wealth rising by more than 10 full percentage points since 1989.

But, as Catherine, Miller and Sarin (CMS) recently highlight, adding in the present discounted value of Social Security benefits (net of taxes) to construct a more comprehensive measure of wealth alters these patterns. First, according to CMS’s estimates, the share of marketable wealth in total wealth has plunged by more than 18 percentage points since 1989. Second, over the past three decades, the top 1% share of total wealth has risen only modestly, while the share owned by the top 10% has declined somewhat.

In this post, we highlight the CMS results, and decompose their changes in total wealth shares into two parts: the changes in marketable and Social Security wealth shares accruing to each group, and the aggregate decline over time of marketable wealth as a share of total wealth. We show that the latter dominates the overall trend in this more comprehensive measure of inequality….

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Fiscal Space Has Limits, Too

In the battle against the economic impact of COVID-19, governments around the world are pulling out all the stops. In advanced economies, leading central banks have pushed interest rates to zero or below. And, a recent IMF estimate puts the combination of discretionary spending and automatic fiscal stabilizers (including unemployment insurance and progressive income taxation) at $9 trillion―more than 10 percent of global GDP.

With bond yields low or negative, the limits to monetary policy are clear (see our pre-COVID post). How large is the scope for additional countercyclical fiscal policy? With sovereign yields so low, the cost of additional financial expansion looks to be minimal, at least for now (see, for example, Blanchard).

Nevertheless, each time public debt-to-GDP ratios ratchet higher—as they did in the 2007-09 crisis and are now doing again—the question of “fiscal space” reemerges. When the next economic shock hits, will governments again be able to provide relief and stimulus on the scale required to meet society’s needs?

In this post, we highlight recent fiscal developments in advanced economies, and review the factors affecting the sustainability of their high and rising levels of debt. To foreshadow our conclusion, the fact that many countries’ fiscal positions were precarious even before the COVID crisis does not weaken the current case for stimulus. But, doubts about fiscal space are growing. So, it is important that governments find a way to make a credible commitment to future fiscal consolidation when their economies have returned to full employment. Failure to do so could threaten confidence both in government finances and in economic performance….

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The Price is Not Right: Measuring Inflation in a Pandemic

Are prices really plummeting? If you watch the official government gauge of prices in the economy, you would think so. Between March and April, the Consumer Price Index (CPI) dropped by 0.8 percent―that’s a decline of 9.1 percent at an annual rate! Even if we exclude food and energy, prices still fell at half that rate. And, both price measures already had begun to fall the previous month. Is this the new trend? Are we in the midst of a deflation? The short answer is no.

The pandemic is an enormous shock to both supply and demand (see our earlier post). The productive capacity of the economy is lower both now (with the lockdown) and in the medium term (with the need to make economic activity biologically safer). Similarly, demand is lower both temporarily while people stay at home and in the longer term as the propensity to save rises to enable people to pay off elevated debts and build precautionary buffers. Determining which of these shifts prevails is essential for policymakers. If the demand contraction dominates, then trend inflation will fall and policymakers will need to implement further expansionary policies. Conversely, if trend inflation rises (implying that the supply constraints prevail), then policymakers will eventually need to introduce restraint.

In this post, we discuss the difficulties of measuring inflation during a pandemic—when demand and supply both shift dramatically. Our conclusion is that some indices provide better high-frequency signals of the trend. Unsurprisingly, headline measures of inflation are especially poor. Yet, traditional measures of “core inflation” that exclude food and energy may be equally bad. Instead, we suggest focusing on the “trimmed mean,” a statistical construct that disregards all goods and services whose prices change by the largest amounts (either up or down). In recent months, the trimmed mean CPI shows suggest that inflation has edged lower, but remains between 1½ and 2 percent per year….

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Inflation is not (and should not be) a key worry today

A very simple version of 1960s monetarism has two elements. First, controlling money growth is necessary and sufficient to control inflation. Second, leaving aside a financial crisis, the monetary base―the sum of currency in circulation and commercial bank deposits at the central bank―determines the quantity of money. Putting those together means that, in order to control inflation, all central bankers need to do is ensure that their liabilities grow at the appropriate rate. Conversely, when the central bank’s balance sheet grows quickly, inflation inevitably follows.

This simple monetarist reasoning was still on display in 2010, when Ben Bernanke received this letter from a group of 24 economists warning against further large-scale asset purchases by the Fed. At that stage, the central bank’s assets exceeded 250% of their level in September 2008. Over just over two years, the Fed had purchased roughly $400 billion in Treasury securities and $1 trillion in federally guaranteed mortgage-backed securities. But, as Bernanke explained at the time, the purpose of these asset purchases was to aid the economy in recovering from the crisis-induced recession. Moreover, in contrast to prior norms, since October 2008 the Fed had been paying interest on reserves, raising the opportunity cost for banks to lend.

Subsequent experience proved the letter writers very wrong. The Fed’s balance sheet continued to grow, peaking at $4.5 trillion in early 2015. And, over the decade just ended, inflation (measured by the Fed’s preferred consumption expenditures price index) averaged 1.6%―below the central bank’s long-run goal of 2%. If anything, in recent years, and despite massive central bank balance sheet expansions, inflation both in the United States and in other advanced economies has been too low, not too high.

With central bank balance sheets now surging again, we recount this history in the hopes of blunting any inflation concerns, which we see as profoundly misguided. Over the six weeks ending April 22, the Fed’s assets have grown by the same amount as they did from September 2008 to March 2013. While this does raise some serious concerns, inflation is not high among them….

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COVID-19: What can monetary policy do?

Two weeks prior to their regularly scheduled mid-March meeting, the members of the Federal Open Market Committee (FOMC) voted unanimously to cut their target policy rate by 50 basis points to the 1 to 1¼ percent range. Policymakers attributed their exceptional decision to the “evolving risks” posed by the coronavirus. This move was the first inter-meeting policy rate shift, and the largest cut, since late 2008, at the depth of the financial crisis. Moreover, this time the move came against the background of a strong economy. Nevertheless, based on futures prices, market participants anticipate a further 75-basis-point cut in the target federal funds rate this month!

The coronavirus has thrust us into uncharted territory. Do central bankers really have any tools to guide us back to safer ground?

In the remainder of this post, we discuss the importance for policymakers of distinguishing between shocks to aggregate supply and demand. Importantly, while monetary policy can combat demand shocks, it can do nothing to cushion the impact of reductions in supply without sacrificing the commitment to price stability. The coronavirus shock involves some as-yet-unknown mix of these two very different types of shocks. Yet, given the limited amount of conventional policy space, and the decline of long-term inflation expectations, there is a good case for the FOMC to act rapidly and aggressively….

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