New SUERF Policy Brief with Mai Hakamada

 

Mai Hakamada (IMF) and I have a new SUERF Policy Brief on Inflation Shocks and Policy Delay: What are the Consequences of Falling Behind the Curve, available at https://www.suerf.org/publications/suerf-policy-notes-and-briefs/inflation-shocks-and-policy-delay-what-are-the-consequences-of-falling-behind-the-curve/.

Central banks in major industrialized economies were slow to react to the surge in inflation that began in early 2021 and have since faced difficulty taming persistent inflation. We evaluate the consequences of such a delay in responding to a temporary but persistent positive shock to inflation. Policy delay worsens inflation outcomes but can mitigate or even reverse the output decline that occurs when policy responds without delay; consequently, delay can make a recession less likely. Using a measure of loss that incorporates a “balanced-approach” to weighing fluctuations in inflation and the output gap, our research finds that loss is monotonically increasing in the length of the delay. Loss is reduced if policy, when it does react, does so more aggressively. The costs of a short delay can be eliminated by adopting a less inertial and more aggressive response to inflation.  

The policy brief summarizes the results from our March 2024 IMF Working Paper No. WP/24/42, available at https://www.imf.org/en/Publications/WP/Issues/2024/03/01/The-Consequences-of-Falling-Behind-the-Curve-Inflation-Shocks-and-Policy-Delays-Under-545507.

Taking responsibility for inflation

 

In “What we must still learn about the great inflation disaster” (April 28, 2024), Martin Wolf is correct in arguing that the Bernanke Report on the Bank of England’s forecasting performance was too narrowly focused. Shocks that are hard to forecast do happen, but, as Wolf asks, “… is it plausible that the fiscal and monetary policies that drove demand levels so strongly had nothing to do with the inflation?”

In 2021, statements by central bankers certainly gave the impression that inflation would simply fall away once shocks had passed, without making any explicit link to the monetary policy needed to ensure this occurs. The 1970s illustrated the dangers of treating inflation as if it were somehow unrelated to monetary policy. A surreal exchange captured in the transcript of the Fed’s policymaking committee meeting on September 9, 1978 is revealing. Lawrence K. Ross, President of the St. Louis Federal Reserve Bank, expressed exasperation as inflation rose towards 8 percent, said “I’m not trying to be critical, but is our monetary policy responsibility such that we should maybe discuss whether we’re satisfied to see the economy drift into an 8 percent inflation rate? And if not, are there things we can do to affect this? …Are we in any way masters of what happens, or are we merely observers on the sidelines? I’m lost...” To which Fed Chair G. William Miller drew upon the U.S. Constitution’s 5^th Amendment protection against self-incrimination in responding “I take the fifth.”

One would hope that no central banker today would fail to connect inflation developments to monetary policy actions. Yet focusing on forecasting errors seems a convenient way for policymakers to shift blame for errors onto the Bank’s staff. If inflation targeting is to have teeth, it is the policymakers who should be held to account when the target is so grossly missed.

New paper on the consequences of policy delay

My recent paper with Mai Hakamada of the IMF on monetary policy in the face of inflation surges, "The consequences of falling behind the curve: Inflation shocks and policy delays under rational and behavioral expectations," has been issued as IMF Working Paper WP/24/42 and is available at https://www.imf.org/en/Publications/WP/Issues/2024/03/01/The-Consequences-of-Falling-Behind-the-Curve-Inflation-Shocks-and-Policy-Delays-Under-545507?cid=em-COM-123-47987

Abstract: Central banks in major industrialized economies were slow to react to the surge in inflation that began in early 2021. The proximate causes of this surge were the supply chain disruptions associated with the easing of COVID restrictions, fiscal policies designed to cushion the economic impact of COVID, and the impact on commodity prices and supply chains of the war in Ukraine. We investigate the consequences of policy delay in responding to inflation shocks. First, using a simple three-period model, we show how policy delay worsens inflation outcomes, but can mitigate or even reverse the output decline that occurs when policy responds without delay. Then, using a calibrated new Keynesian framework and two measures of loss that incorporate a “balancedapproach” to weigh inflation and the output gap, we find that loss is monotonically increasing in the length of the delay. Loss is reduced if policy, when it does react, is more aggressive. To investigate whether these results are sensitive to the assumption of rational expectations, we consider cognitive discounting as an alternative assumption about expectations. With cognitive discounting, forward guidance is less powerful and results in a reduction in the costs of delay. Under either assumption about expectations, the costs of a short delay can be eliminated by adopting a less inertial policy rule and a more aggressive response to inflation. JEL: E31, E51, E52, E58, E61, Keywords: monetary policy; inflation; policy delay; behavioral expectations; falling behind the curve

What the House of Lord’s Report on the Bank of England got wrong

 

Over the past two years, many economies with independent central banks and formal inflation targets, including the UK, the U.S., and the Euro Area, have experienced inflation rates well above their proclaimed targets. While inflation rates are now declining, none of these central banks, or their leaders, have been held accountable for letting inflation soar to heights not seen for over 40 years.

Over the past summer things did heat up for Bank of England Governor Andrew Bailey. After a string of Bank forecasts that underestimated inflation, and pressure from the House of Commons Treasury Committee to conduct a review of its forecasting record, the Bank has established a committee chaired by Ben Bernanke to evaluate its forecasting methods. In addition, in November the Economic Affairs Committee (CEA) of the House of Lords issued “Making an independent Bank of England work better,” a report on the performance of the operational independence that was granted by the Bank of England Act 1998.

There is much to praise in the Lord’s report. Unfortunately, the report was marred by its analysis of inflation forecasting and by its inconsistent views on operational independence.

The Lord’s report criticizes the Bank’s forecasting record, noting that it, like other major central banks, systematically underestimated the level and the persistence of recent inflation. This isn’t surprising; did anyone predict the pandemic or Russia’s invasion of Ukraine? What is surprising was the call in the Lord’s for the Bernanke-led review “…to explain the value of models that seldom predict anything other than a return to the two per cent target over their forecast horizon.” (Para. 134) Why surprising? Whatever model the Bank uses to generate forecasts, those forecasts depend, explicitly or implicitly, on an assumption about monetary policy. What would it mean then if the Bank published a forecast for inflation that did not show a return to target? If the Bank’s is credibly committed to its inflation target, all its medium-term forecasts should show a return to two percent inflation. The most recent remit letter from the Chancellor to the Bank Governor actually, states “…monetary policy remains vital in supporting businesses and households by ensuring inflation returns to target sustainably in the medium term.” (emphasis added). For the Bank to forecast otherwise would be a red flag under any system of accountability. A private forecast might show inflation not returning to target, but that expresses a lack of confidence in the Bank’s commitment to its primary objective. A firm that signs an important contract to deliver goods at a future date but then immediately turns around and says they forecast delivering only half the promised amount would certainly be punished by financial markets.

A second issue with the Lord’s report is it seemingly calls for undercutting the Bank’s operational independence. The Bank’s primary objective – the inflation target – is set by HM Treasury, but with operational independence, the Bank has the freedom to act as it sees best to achieve that target. However, the report acknowledges that achieving the target may require the Bank to adopt a policy stance “... that counteracts the economic impact of the Government’s fiscal policy. It is therefore imperative that the Bank’s activities and its remit are effectively scrutinised by, and its officials are held accountable to, Parliament.” (para. 161) But that is exactly what operational independence is meant to prevent. It is the purpose of central bank independence, not a flaw, as the report recognizes when it states that “It is the Government’s job to ensure they (fiscal policy and the remit) are consistent with each other, not the Bank’s.” (para. 46) 

If the Government adopts an expansionary fiscal stance that the Bank believes will lead inflation to rise above target, the Bank must raise interest rates to offset the fiscal expansion. If it can’t do that for fear of being scrutinized by the fiscal authorities, what is the meaning of operational independence? And how then can the Bank be held accountable based on whether it achieves the inflation target? 

The report contains very little discussion on how to hold the Bank accountable. The issue is not whether an independent central bank should be accountable. Of course it should be. The issue is how accountability should be enforced. The original Bank of England Act 1998 Act established that the Governor write a letter to the Chancellor explaining any deviation from the inflation target of one percentage point or more. Being forced to write a letter seems like a very weak disciplinary punishment for letting inflation average almost 6 percentage points above the target since February 2021. Would the CEO of a private company whose profit guidance was that far off for almost two years still have a job?

Who called it the 'Hahn problem'?

In chapter 2 of my book Monetary Theory and Policy (The MIT Press, 4^th ed., 2017), I called the problem of establishing a positive value for money the 'Hahn problem'. Hahn described this problem in “On Some Problems of Proving the existence of an equilibrium in a monetary economy,” published in The Theory of Interest Rates, F. H. Hahn and F. P. R. Brechling eds. London: Macmillan, 1965. Pp. 126- 135. In the 4th edition of Monetary Theory and Policy, the reference to the Hahn problem appears on p. 41, and I credited Truman Bewley with naming it in his paper “A difficulty with the optimum quantity of money”, Econometrica 1983, 51(5), 1485-1504. 

Recently, Pierrick Clerc of the HEC Liège School of Management (https://sites.google.com/site/pierrickclerc/) has pointed out to me that the term was used a decade earlier by Kevin Sontheimer in “The determination of money prices”, Journal of Money Credit and Banking, 1972, 4(3), 489-508. Sontheimer solves the Hahn problem by employing a model in which there are costs to transacting that take the form of foregone leisure. This means his model falls within the general class of shopping time models discussed in section 3.2.1 of chapter 3 of Monetary Theory and Policy.

I would like to thank Pierrick for sending me the Sontheimer paper.

Claudia Goldin and measuring the experience of women in the labor force

 

Congratulations to Claudia Goldin, the 2023 recipient of the Nobel Prize in Economics. Goldin was cited “for having advanced our understanding of women’s labour market outcomes.” The press release from the Royal Swedish Academy of Sciences highlighted that she “provided the first comprehensive account of women’s earnings and labour market participation through the centuries. Her research reveals the causes of change, as well as the main sources of the remaining gender gap.” Goldin’s work has shown how women’s historical contributions to the labor force frequently went unmeasured, illustrating how what is not counted often ends up not counting in policy discussion.

As a Lecturer at Auckland University in New Zealand in the late 1970s, I encountered an example of how official statistics could conceal women’s labor market experiences. At that time, unemployment was calculated as the number of workers who had officially registered for unemployment benefits. However, unemployment benefits were effectively limited to heads of households. Secondary workers were not eligible for unemployment benefits and therefore had no incentive to register if they lost their jobs. And any unemployed worker who failed to register disappeared from the measured labor force. This approach meant the true extent of unemployment was understated, and the understatement was likely to be largest among women as they were less likely to register because they were more likely to be classified as secondary workers and not qualify for unemployment benefits. 

I attempted to overcome these measurement issues to obtain a more inclusive estimate of New Zealand’s unemployment rate. The results were published in 1978 in the New Zealand Economic Papers (“Unemployment in New Zealand: An Errors in Variables Approach to Measuring the Number of Unemployed,” NZEP, 12:1, 13-48). Based on data from 1965-1976, my estimates suggested New Zealand’s official unemployment figures captured about half of total male unemployment but only a tenth that of females. I also found the female unemployment rate over the estimation period was roughly three times the rate for males. 

With the election of David Lange’s government in 1984, New Zealand entered a period of economic reform, not least of which was the Reserve Bank Act of 1989 that established formal inflation targeting. And in 1985, New Zealand introduced a household survey to measure labor participation and unemployment so that their statistics could be brought in line with international best practice, making it no longer necessary to rely on the admittingly crude approach I had to use in the late 1970s. 

From 1988 to 2001, the female unemployment rate was less than the rate for males. Since then, the reverse has been true, though in general, the unemployment rates for both groups have been similar. Importantly, these data are now subject to less systematic measurement bias and therefore provide more accurate, and useful, information on the experience of women in the New Zealand economy.

New version of paper on super-active fiscal policy

Roberto Billi and I have a new version of our paper "Seemingly Irresponsible but Welfare Improving Fiscal Policy at the Lower Bound: The Role of Expectations." The addition of "The Role of Expectations" to the title emphasizes that a key contribution of the paper is an evaluation of how cognitive discounting affects the performance of an active fiscal policy, passive monetary policy regime in the face of occasional periods at the zero lower bound. The new draft also provides a more integrated introduction and literature review, as well as a streamlined discussion of the basic intuition for the results. It is available at https://people.ucsc.edu/~walshc/MyPapers/fslb_231010.pdf or on Roberto's home page at http://www.rmbilli.com/.

Keywords: automatic stabilizers, cognitive discounting, fiscal and monetary interactions, government debt. JEL: E31, E52, E63.

Is it too soon to revisit the Fed’s 2020 monetary policy framework? No!

 

On August 27, 2020, the FOMC released a revised Statement on Longer-Run Goals and Monetary Policy Strategy. This document laid out the goals for monetary policy, articulated the policy framework, and was designed to serve as the foundation for the Committee's policy actions. The statement indicated that the FOMC intends to conduct a regular review of its monetary policy strategy, tools, and communication practices roughly every five years.

That means that the next review may take place in 2025, and, if the past review is a guide, the Fed will launch the review in early 2024 as it prepares the groundwork for (possibly) revising its policy framework. It is time to start that review now.

Outside the Fed, the review has already started. The Brookings Institution, on May 23, 2023, hosted a conference titled “The Fed: Lessons learned from the past three years.” Gauti Eggertsson and Don Kohn discussed how the FOMC’s 2020 policy framework may have contributed to its delay in responding to the surge in inflation experienced in 2021, while a panel consisting of Ben Bernanke, Olivier Blanchard, Rich Clarida, Kristen Forbes, and Ellen Meade discussed potential reforms of the FOMC’s policy framework.

With hindsight, the 2020 review resulted in a policy framework that was designed, quite clearly, to fight the last monetary policy war, the battle against an inflation rate that was systematically too low in an environment of low interest rates. It was ill-suited for the current environment of high inflation. The next policy framework needs to be robust, not tailored to one set of circumstances that could quickly change.

At its core, any monetary policy framework needs to ensure inflation remains low and stable, promote financial stability, and make certain the central bank has the flexibility to respond in the face of shocks to the macro economy. It should also facilitate the central bank’s ability to clearly communicate policy to the public.

The shift in 2020 from inflation targeting to a form of average inflation targeting (AIT) meant the Fed’s inflation goal became ill-defined and, therefore, less transparent. At the Brookings event, Kristen Forbes and Rich Clarida both noted that a target range for inflation should be given serious consideration. A range would be easy for the public to understand, while avoiding the specious appearance that the Fed can preciously control inflation.

A new statement on goals and strategy must also address the “maximum employment” part of the Fed’s Congressional mandate. This part of the dual mandate has always been harder to translate into a specific measurable objective. If the FOMC wishes to maintain its asymmetric “shortfalls of employment” language, it needs to explain more clearly the basis on which it will judge whether the economy is short of its maximum employment or not. Unemployment rates that are at historically low levels as seen recently do not require a monetary policy response when inflation forecasts remain consistent with inflation goals. However, the Fed’s poor ability to forecast inflation makes such a strategy problematic.

Besides reviewing its policy strategy, the FOMC should examine its tactics. In 2021 it argued the shocks to inflation were temporary, justifying its failure to react. However, as I discussed in "Implications of a Changing Economic Structure for the Strategy of Monetary Policy", a paper presented at the Federal Reserve Bank of Kansas City’s 2003 Jackson Hole Symposium, better outcomes can be achieved by acting as if inflation shocks will not be temporary. When faced with uncertainty about the persistence of exogenous shocks, it is better to over-estimate the shock’s persistence, not underestimate if as the FOMC did, as it was consistently surprised when shocks failed to fade away. In that same paper, I showed that a central bank seeking a policy that is robust to uncertainty about shock persistence should act as if the shock will be more persistent than it really believes. That is, even if the policymaker’s forecast is that an inflation shock will quickly dissipate, policy should be designed as if the shock will persist.

Determining exactly what policy framework should replace the 2020 one requires care review. It is time to start undertaking that review.