Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared at Project Syndicate.
When Fed Chairman William McChesney Martin delivered his famous line about central banks, his key point was that it is their job to take away the punch bowl just when the party really gets going, rather than waiting until revelers have turned drunken and raucous. In the aftermath of the 1970s inflation, it became an item of faith that monetary authorities shouldn’t wait until elevated inflation shows its face, before reining in an overheating economy. They are currently developing a renewed appreciation for the wisdom of this old metaphor.
During the decade that began with the Global Financial Crisis (GFC) in 2008, some central bankers arguably followed this time-honored practice into episodes of unnecessarily tight monetary policy. In retrospect, they at times over-estimated the dangers of inflation. [More on this below.] They were “fighting the last war.”
Last year, central bankers once again “fought the last war,” this time by under-estimating the danger of inflation, as economic recovery began to run into capacity constraints. The US unemployment rate dipped below 4.0 percent by December. In the end, 2021 inflation reached 7 percent, the highest in 40 years. A good old-fashioned Phillips curve could have predicted this. The prominent inflation warnings of Larry Summers and Olivier Blanchard in February of 2021 were proven right. The Fed’s view that any inflation would be transitory was shown to be overly optimistic. It is now having to play catch-up.
- Central banks over-estimated inflation in 2008-18
The experience of 2008-18 suggested that expansionary monetary policy could promote growth, and ultimately drive US unemployment below 4 %, with few adverse effects in terms of inflation and interest rates. This realization did not require a fundamental re-thinking of macroeconomic theory, contrary to what one often reads. The conclusion, rather, followed naturally from the proposition that the economy at that time was operating on the low, flat part of the “LM curve,” and the low, flat part of the Phillips curve.
Consider four cases during 2008-18 when the danger that monetary ease would lead to inflation was over-estimated.
First, the European Central Bank (ECB) actually raised its policy interest rate in July 2008. It soon corrected its mistake, easing sharply in November-April, after the full-fledged GFC had become evident. But then it raised rates again in April-July 2011. The first hike was probably an over-reaction to rising oil prices, and the second was a premature expression of victory in combating the GFC. (Mario Draghi came to the rescue in 2011.)
Second, Sweden’s Riksbank did the same: it raised interest rates in 2008, up through September, and, more egregiously, raised rates by 175 basis points in 2010-11.
Third, even more clearly mistaken in 2010 was a famous letter to Fed Chairman Ben Bernanke from a group of 24 economists, academics, and hedge fund managers, opposing the Quantitative Easing then underway and warning that it would not promote employment, but rather would risk “currency debasement and inflation.” As should have been clear at a time when unemployment still exceeded 9 %, there was in fact no reason to fear that stimulus would lead to excessive inflation. The consensus among economists is that the aggressive easing of monetary policy in the aftermath of the 2007-09 recession was fully justified. (The same is true of Obama’s 2009-10 fiscal stimulus, which, if anything, should have been bigger and more sustained.)
Fourth, and more of a surprise to most economists, was the period 2016-18. US GDP rose above its estimated potential and unemployment fell below 4 percent. In the past, this had usually signaled overheating of the economy. So, it is understandable that the Fed began to raise interest rates in 2016, and continued to do so through the end of 2018, in an attempt to move back toward normalcy. Yet, in the end, very little of the feared inflation materialized, suggesting in retrospect that the economy could have been allowed to “run hot” for longer. Apparently, the Phillips curve, if not dead, was supine.
- Central bankers under-estimated inflation in 2021-22
Now inflation is back. It turns out that when demand increases faster than supply, inflation results after all, just as the textbooks say. The sloping Philips Curve is alive and back on its feet again. But the Fed, not wishing to repeat the mistake of 2018, under-estimated the danger of inflation in 2021.
Incidentally, contrary to widespread reporting, US inflation did not “rise 7%” last year. Rather, the price level rose 7%. Or inflation reached a 7% level. But to say “inflation rose 7%” would imply that inflation rose from its 2020 rate of about 1 percent, to 1.07%. (Or perhaps from 1 % to 8 %, though that should be described as inflation rising “7 percentage points,” if one really wanted to be clear.) The point may sound pedantic. But there are contexts in which the habit of mixing up the level of inflation and the change in inflation could leave the reader at sea, unable to tell which is meant.
The pandemic in March 2020 caused both a fall in Aggregate Supply and a fall in Aggregate Demand. That explains the sharp recession in the second quarter. The big monetary and fiscal stimulus in the US explains the subsequent rapid recovery.
What explains the absence of inflation in 2020? (Inflation actually fell in the 2nd quarter, largely due to a brief plunge in oil prices.) The obvious textbook answer is that the negative shock to demand must have been initially larger than the negative shock to supply, before monetary and fiscal stimulus kicked in.
A second possible answer is less orthodox. Consider the example of a run on toilet paper, resulting from emergency or disaster like the pandemic. Although economists think the best response is to raise prices before inventories disappear entirely, nobody else thinks that. Consumers, retailers, and toilet paper manufacturers – who are the ones that matter — would call it “price-gouging” and express moral disapproval. So, prices remain unchanged. Later, when the sense of emergency eases, manufacturers and retailers can raise their prices without the same moral opprobrium, especially when they can point to rising costs (including supply-chain disruptions). Despite well-known shortages early in 2020, the price of toilet paper did not rise until 2021.
If there is any truth in this hypothesis, the 7 % inflation rate of the last year may have included some “catch-up” by firms. That could in turn imply some moderation in inflation during the coming year — unless rising prices for oil, natural gas, wheat, and other commodities dominate the price indices.
- Time for the disappearing punch bowl
In any case, it is time to take the punch bowl away. Inflation is not the only evidence of overheating. US GDP growth has been rapid and the labor market is tight.
The Fed has almost completed the accelerated ending of QE. Taking away the punch bowl means more than this, however. It means raising interest rates, of course, as the Fed is expected to start doing in March. As Jason Furman and others have pointed out, an increase in expected inflation calls for a matching increase in the nominal interest rate, even before the Fed begins to raise the real interest rate and to tighten financial conditions generally.
It also means the central bank normalizing by gradually getting rid of unconventional assets that it has accumulated on its balance sheet, particularly (in the case of the US) mortgage-backed securities. (The Fed even bought corporate bonds in March 2020, selling them in 2021.) The Bank of England has already begun to sell off some of the bonds it holds, including corporate debt.
It is still a good principle that, leaving aside exceptional circumstances like the GFC and covid recessions, central banks should seek to minimize holdings of assets that influence the sectoral allocation of credit. The reasoning is that, when society wants to boost a particular sector, it should do so directly through the government, which has democratic accountability.
Another advisable step would be a return to more aggressive financial regulation. In some countries, this starts by tightening reserve requirements on banks.
Meanwhile, the European Central Bank may still be fighting the last war. Unlike the Fed and the Bank of England, it has not yet begun to taper QE, let alone to raise its interest rate, which is still negative 50 basis points. It may be seeking to avoid mistakes of 2008-2011, when it failed to sustain stimulus in the wake of the GFC. (Admittedly, Europe has not seen quite as much demand expansion, growth, and inflation as the US.)
The syndrome of “fighting the last war” stems from human nature. The events of recent years, such as 2008-2018, are more salient in perceptions than is the longer-term history. Paying extra attention to the developments of the recent past can be justified by pointing to fast-paced fundamental changes in technology and society. But the long-term history contains wisdom derived from a wider variety of circumstances.
This post written by Jeffrey Frankel.
1. “Central banks over-estimated inflation in 2008-18”: Depression
2. “Central bankers under-estimated inflation in 2021-22”: Suppression
Paint by numbers is not art. And the parrot formerly from Qprincetqon knows nothing about macroeconomics. Polly want a cracker
https://www.cnn.com/2022/02/26/europe/ukraine-russia-invasion-sunday-intl-hnk/index.html
There are only two ways to take Putin’s nuclear threat – either he is bluffing and should not be taken seriously or he has gone mad and should be removed from power by the Russians.
Bullies always double down on their bullying before they slink away.
A huge amount of anti-aircraft and anti-tank weapons are being send from Europe to Ukraine. Putin is trying to push Ukraine to accept most of his terms before it becomes obvious that this is going to take a long time. He has to force them to give him at least some face saving confessions, and the longer this goes on the less likely they will give him big confessions. This is a before the meeting tomorrow statement from Putin that ” no matter what I will win and you will suffer”.
nice!
putin lets the planes and trains carry these things in to ukraine!
he is not only a bully, he is inept at running a war, like usa generals.
i think putin has some good points, none of which are shared with the american people.
i also think that what you see as ‘possible’ is not and what the press sees as ‘slow’ is more: russia don’t go in to cities and do falluja like the usa in iraq….
“russia don’t go in to cities and do falluja like the usa in iraq….”
its not for lack of trying. they are having difficulty getting into the major cities. my guess is they will conduct a genocide wants they breach the city.
Prof. Frankel I think you’re giving Larry Summers too much credit. Contrary to popular belief, he did not predict accelerating inflation. What he actually said was that there was a one in three chance of accelerating inflation. Here’s Summers’ own words:
I think there is about a one-third chance that inflation will accelerate significantly over the next several years, and we’ll be in a stagflationary situation, like the one that materialized between 1966 and 1969, where inflation went from the range of ones to the range of sixes. I think there’s a one-third chance that we won’t see inflation, but the reason we won’t see it is that the Fed hits the breaks hard, markets get very unstable, the economy skids downward close to recession. And I think there’s about a one-third chance that the Fed and the Treasury will get what they’re hoping for, and we’ll get rapid growth that will moderate in a non-inflationary way.
Talk about hedging your bets!!!
The right way to think about this is to look at an important counterfactual. When the Fed saw the risk of inflation as transitory it was based on a correlative assumption that the COVID risk would be transitory thanks to the vaccines. The Fed did not anticipate Delta. The Fed did not anticipate human stupidity. That’s strikes me as a more likely reason why the aggregate supply curve did not bounce back. Since we now have a better appreciation of both the cleverness of the virus and the stupidity of humans, the Fed should recognize the fact that the supply curve will not shrink back.
As to toilet paper, the reason for the shortage was because toilet manufacturing is bifurcated into a home product and a commercial/industrial product. Those are different manufacturers using different processes. When people quit going to work and quit going to airports the demand for commercial/industrial toilet paper collapsed and the demand for home toilet paper surged. It took some time before the supply systems were able to react to the change in demand patterns.
I have withdrawn or removed myself from judging the case of Larry Summers’ “call” on inflation, due to personal bias. Something to do with GSC and blind luck on the official numbers, but…….. I’m glad someone else sees it similar to how I do. It makes me feel a little better that maybe I have not lost my mind (totally I mean, I mean on certain topics, I mean…. ok too many conditions to list here on when I am crazy vs when I am not crazy. You will have to decipher)
An insightful reply. We would ask Princeton Steve to do the same but he can’t
https://www.nytimes.com/2022/02/25/opinion/inflation-debate-us-economy.html
February 25, 2022
Wonking Out: Overheaters, skewers and the nonlinear economy
By Paul Krugman
It seems … off to write about macroeconomics with the grim news from Ukraine as a backdrop. But even as the bombs fall, the ordinary business of life goes on; getting and spending and Federal Open Market Committee meetings will continue. In short, we still need to talk about inflation.
So where are we in the inflation debate? As I see it, there are two serious points of view, which I think of as the Overheaters and the Skewers. That is, one side of the debate sees inflation as a result of too much overall demand, pushing the economy as a whole above its speed limit. The other side sees inflation mainly as a result of the distortion of spending caused by the pandemic, with consumers shunning services and rushing to buy goods, overstressing supply chains. I’ve been mainly a Skewer, although one who’s willing to give some credence to the Overheater view.
What I want to argue now is that the Overheater and Skewer positions have a lot more in common than many seem to realize. Specifically, given the data, the only way to tell an overheating story about inflation is to accept a view about how the economy works that also makes the Skewer position credible. And conversely, the assumptions behind the Skewer position also leave room for an overheating story.
What am I talking about? Let’s look at some numbers.
Textbook macroeconomics relies a lot on the concept of “potential output,” the maximum level of real gross domestic product consistent with stable inflation. There are problems both with that concept and with the estimates of potential output produced by official bodies like the Congressional Budget Office and the European Commission, but we can ignore those issues today and focus on what the official estimates are telling us.
Here’s the official U.S. output gap — the percentage difference between actual G.D.P. and the budget office estimate of potential G.D.P. — since 2000:
https://static01.nyt.com/images/2022/02/25/opinion/krugman250222_1/krugman250222_1-jumbo.png?quality=75&auto=webp
Mind the output gap.
Ignore the huge gap during the height of the pandemic, which was more about lockdowns than about conventional economic forces. Focus instead on where we are now and where we were in the aftermath of the 2008 financial crisis.
According to these numbers, the U.S. economy is still operating slightly below capacity, which if true would mean that we have no inflationary overheating at all. In reality, the budget-office estimates probably overstate potential output right now, especially because they don’t take into account the Great Resignation, the drop in labor force participation during the pandemic. So it’s likely that we’re actually running somewhat above capacity, maybe even by several percent.
But historical experience suggests that the effect of the output gap on inflation, while clear, is fairly modest….
https://fred.stlouisfed.org/graph/?g=MrlG
January 30, 2018
(Real Gross Domestic Product minus Real Potential Gross Domestic Product) / Real Potential Gross Domestic Product, 2007-2021
(Indexed to 2007)
https://fred.stlouisfed.org/graph/?g=Mr7r
January 30, 2018
(Real Gross Domestic Product minus Real Potential Gross Domestic duct) / Real Potential Gross Domestic Product, 2000-2021
(Indexed to 2000)
https://fred.stlouisfed.org/graph/?g=Gb0g
January 30, 2018
Consumer Prices for China, United States, India, Japan and Germany, 2017-2021
(Percent change)
https://fred.stlouisfed.org/graph/?g=MtVZ
January 30, 2018
Consumer Prices for China, United States, India, Japan and Germany, 2017-2021
(Indexed to 2017)
So I missed this part of the column~~the next Fed rate move should be 25bps or 50 bps??
Did anyone else catch what paragraph that was in??
I see no arguments for allowing real interest rates to fall further. So it is definitely time to let rates go up. However it has to be done with an eye to the fact that inflation is mostly driven by temporary supply chain issues. If they end up jacking rates too high, it would be hard to reverse before substantial damage materialized. Would it be better for them to start selling from their stash of bonds? That would help getting rates up but also be politically easier to tone down, if needed.
i agree except in energy…… the supply chain problem is inventory “draw”. and crude supply has not responded to pricing.
i see two reasons: opec+ does not trust the virus to be over (still!) and negligible but culpatory usa’s hesitance to increase crude supply.
the draw is such, 7 or so year low inventory that spec’ed refining output would scarcely over supply with current demand.
that implies demand cut by price, not popular and itself makes inflation hard to fight.
a corrundrum!
Has “balance sheet normalization” already not aged well, because central banks will have to turn the liquidity spigots back on due to Ukraine?
Why not fight inflation directly on an individual level by paying the inflation rate as interest on a Fed CBDC deposit account, to encourage savings as inflation rises?
All of you people here are good people, and I want to say a “comedian” would answer his own joke, The “comedian” would answer his own joke and say “never mind”. Did you get it???? OK if you didn’t you’re the slow one in the room