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.

Robert Lucas and the rational expectations revolution

 

Few economists over the past 50 years had as great an impact on macroeconomics as Bob Lucas, who died Monday May 15, 2023 at the age of 85. When Lucas received the 1995 Nobel Prize in Economics, the Prize committee cited him “for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy.”

Lucas’s 1972 paper, “Expectations and the neutrality of money,” (Journal of Economic Theory 4(2), 103-124) set out a coherent theory reconciling the long-run neutrality of money with the short-run non-neutrality of money. He did so by carefully modeling an informational friction that generated expectational errors in the short-run, errors that, because individual firms and households formed expectations rationally, could not persist. In his model, only monetary policy surprises mattered for the real economy. This result had profound implications for monetary policy. Lucas and Sargent summarized these implications in 1978, noting that policy had to be systematic, stating that “… [equilibrium methods] will focus attention on the need to think of policy as the choice of stable rules of the game, well understood by economic agents. Only in such a setting will economic theory help predict the actions agents will choose to take.” Yet policy must also be unpredictable: “the government countercyclical policy must itself be unforeseeable by private agents...while at the same time be systematically related to the state of the economy. Effectiveness, then, rests on the inability of private agents to recognize systematic patterns in monetary and fiscal policy (Lucas and Sargent 1978).

When expectations are formed rationally, having policy be systematic while also being unpredictable is a contradiction. Whatever systematic rule the central bank chose to follow would come to be understood by the public and would then make no difference for the real economy; it would matter for inflation, but not for output or unemployment. This conclusion became known as the policy irrelevance hypothesis.

Lucas offered empirical evidence for his theory in “Some International Evidence on Output-Inflation Tradeoffs.” (American Economic Review, 1973, 63 (3): 326–34). There he showed that evidence on the slope of the output-inflation tradeoff from a cross-section of countries followed “directly from the view that inflation stimulates real output if, and only if, it succeeds in "fooling" suppliers of labor and goods into thinking relative prices are moving in their favor.”

The development of the new Keynesian approach during the 1990s shifted the focus of the non-neutrality of monetary policy from informational frictions to price and wage rigidities. Today’s models are firmly based on rational expectations, relying on nominal rigidities in the form of sticky prices and wages as the rationale for the potentially significant but ultimately temporary effects of monetary policy on the real economy.

Importantly, the emphasis today is that policy must be be systematic and predictable if it is to be effective. As described by Woodford in Interest and Prices: Foundations of a Theory of Monetary Policy (2003, Princeton, NJ: Princeton University Press), “...the central bank’s stabilization goals can be most effectively achieved only to the extent that the central bank not only acts appropriately, but is also understood by the private sector to predictably act in a certain way. The ability to successfully steer private-sector expectations is favored by a decision procedure that is based on a rule, since in this case the systematic character of the central bank’s actions can be most easily made apparent to the public.” (p. 465, emphasis in original).

While Lucas’s model of monetary non-neutrality has largely been replaced, his impact on current policy discussions is still strong. Discussions of monetary policy, whether in theoretical work or in policy practice, continue to stress the importance of policy credibility and of behaving in a systematic fashion. When central bankers emphasize the important role of inflation expectations, the need to anchor expectations, and that a credible commitment to lower inflation will lessen the unemployment costs of anti-inflation policies, they are channeling the fundamental insights of Bob Lucas.

Wages and inflation

Will faster wage growth lead to higher inflation? Discussions of wage and price spirals are in the news, but by comparing the growth rates of wages and prices, one can lose sight of what is going on with the levels. Real wages – the level of wages relative to the price level – are what matter for those receiving labor income. And what has happened to real wages during the past two years of above target inflation depends very much on which price index one uses to deflate nominal wages.

The Fed’s preferred index for measuring inflation is the personal consumption price index less food and energy prices, called core PCE). The PCE index does a better job of capturing how household substitute away from goods whose prices have risen more than average and away from goods whose prices have risen less than average. The ability to substitute across goods helps to mitigate the effect of inflation on households’ budgets. Eliminating the prices of food and energy, which tend to be volatile, can also give a better picture of future inflation. Using core PCE to deflate the BLS’s series on average hourly earnings yields an estimate of the real wage that is shown in blue in the figure. All data are monthly, seasonally adjusted and obtained from the St. Louis Fed’s FRED database; series are normalized to equal 100 in January 2020. The real wage series based on the core PCE price index suggests wages have kept up with inflation. Real wages spiked during the COVID recession and then dropped in its aftermath, but the measure has remained essentially flat since June 2020.

However, core PCE is not the only way to measure inflation. A more common measure of inflation, so common it is sometimes referred to as headline inflation, is based on the Consumer Price Index (CPI). This index does not do as good a job as the PCE does in incorporating how households shift their spending patterns in response to changing prices. Substituting to cheaper alternatives may cushion the impact of inflation, and this margin of adjustment is better captured by the chain-index PCE inflation measure, but the fact that a household needs to make such a substitution may make the price rise more salient in the household’s assessment of their cost of living. If so, CPI inflation might better capture how households assess the impact of inflation on their living standards. The red line in the figure shows what has happened to the real wage when the CPI is used instead of core PCE. The CPI-based real wage shows a steady decline between June 2020 and June 2022. Since August 2022, the CPI measure of real wages has remained essentially flat at a level approximately 4% below its June 2020 level.

Which measure of real wages might be most relevant for foretelling future wage growth? According to a Gallup Poll (April 6, 2023), inflation remains the top economic concern of Americans in 2023 as it was in 2022, with the fraction of respondents citing inflation as something they worry about “a great deal” coming in at 59% in 2022 and 61% in 2023. The number citing unemployment as something they worry about a great deal was just 32% in both 2022 and 2023.

It seems hard to reconcile how many American are worried about inflation with the stability of the real wage based on the Fed’s preferred price index. The decline in the CPI-based real wage seems much more consistent with the Gallup data. If this is the case, greater pressure for wage growth that is sufficient to boost real wages seems likely.

Bank of Japan IMES Special Trialogue (Part 3)

The Institute for Monetary and Economic Studies (IMES) at the Bank of Japan, to mark its 40^th anniversary, recorded three conversations in October 2022 on central banks, research, and monetary policy in which I participated, together with Athanasios Orphanides (my fellow Honorary Adviser to the IMES) and Deputy Governor Masazumi Watakabe. The third of these conversations, focusing on “An important role of central bank economists for communication”  is now available at https://www.imes.boj.or.jp/en/newsletter/nl202302E1_s3_r.html#t00.

Deputy Governor Watakabe opened the conversation by asking “In what ways do you think central bank research is relevant to or useful for communication purposes?” This is, of course, a key question and goes to the heart of why central banks have research departments.

Athanasios emphasized that a central bank needs to “explain what it is doing and why it is operating in a specific way. But to effectively respond to these public debates, it's very important to have central bank economists who understand academic research and translate that into the language that is understood by the community.”

In my response, I agreed and noted the importance of inflation targeting in facilitating clear communications of policy making by providing an explicit focus, the central bank's inflation objective, around which policy actions can be explained. But I also stressed the importance of not overselling what monetary policy can achieve.

The conversation turned to how central bank economists, through research on their own countries, can help distill and share lessons that as, Athanasios put it, “help identify best practices and build the global regulatory framework.” I noted in this context the important early work on the effective lower bound (ELB) on policy rates by Japanese economists which subsequently became relevant for a much broader set of countries after the global financial crisis. The experiences with attempting to manage expectations at the ELB and, more recently, with increased rates of rates of inflation, even in Japan, have focused attention on the need to better understand inflation expectations. This is an area where research by IMES economists using survey date from, for example, the Tankan survey of several thousand private firms conducted by the Bank of Japan, are making contributions to an important topic of interest to both central bank and academic researchers.

Athanasios highlighted the impact of demographics on economic growth as another area in which Japan is at the forefront. He suggested that, as was the case with the ELB, research that draws lessons from the Japanese experience is likely to be of increasing relevance to many other countries.

Policymakers at central banks face many challenges in  implementing successful monetary policy . A strong research staff can help policymakers in meeting these challenges by offering new insights into the effects of monetary and regulatory policies, distilling the latest advances from researchers around the world, and accessing how best to communicate policy actions to the public.

Bank of Japan IMES Special Trialogue (Part 2)

 

The Institute for Monetary and Economic Studies (IMES) at the Bank of Japan recorded three conversations on central banks, research, and monetary policy in which I participated, together with Athanasios Orphanides (my fellow Honorary Adviser to the IMES) and Deputy Governor Masazumi Watakabe. 

On February 27th, I posted a link to the first of the three conversations which covered "Interactions between Central Banks and the Academic Community." The second of the three discussions, which focused on "Art and Science in the Conduct of Monetary Policy" is now available at https://www.imes.boj.or.jp/en/newsletter/nl202302E1_s2_r.html

In this conversation, I stressed that "...monetary policymaking must be based on firm science, but in the application, it's not a cookbook process where you just follow the directions..." The global financial crisis, COVID, and the war in Ukraine are examples of situations in which central banks found themselves facing new and unexpected challenges, and I concluded that "The implications of all those things are uncertain at the time and there is no model that would tell you exactly what you should do. In such cases, you need good people with good judgement."

Athanasios pointed out that, while I had started out by talking about science, I ended up by emphasizing judgement. He went on to argue that "...good public policy must be based on solid analytical foundations and measurement." He concluded that "...judgement is required in the situation when there is not enough data nor information to give clear evidence. In that situation, the policymaker by necessity must combine available pieces of information with his or her personal experience and knowledge and come to a good conclusion."

Dealing with uncertainty requires judgement. Deputy Governor Watakabe suggested an "...analogy is between science and technology, rather than between art and science." He noted that just as engineers have to design systems that are robust in the face of uncertainty, economists at central banks must do the same. "Central bank economists are expected to be good engineers." 

From there, our conversation moved on to discuss the role of expectations and the types of data central banks need as they seek to understand the economy and design policies. 

The third conversation in the trialogue deals with "The Role of Central Bank Research in Communications" and will be featured in a future post.

Bank of Japan IMES Special Trialogue

To mark the 40th anniversary of the Institute for Monetary and Economic Studies (IMES) at the Bank of Japan, I participated in a discussion with Athanasios Orphanides (my fellow Honorary Adviser to the IMES), and Deputy Governor Masazumi Wakatabe that touched on three questions: 1) Interactions between central banks and the academic community; 2) Art versus science in the conduct of monetary policy; and 3) The role of central bank research for communications.

The first of these discussions is now available at https://www.imes.boj.or.jp/index.html?lang=en&page=7&id=#07&src=.\en\newsletter\nl202302E1_r.html. In it, Athanasios and I review the evolving relationship between academics and central bank economics, focusing on the U.S. experience. In my comments, I noted how much this relationship has changed since I began my professional career almost 50 years ago. In the 1970 and 80s, standard models stressed that policy surprises were what mattered for the real economy. Any systematic, predictable monetary policy was irrelevant for business cycle behavior. These models were not well posed to offer guidance on how systematic monetary policy could contribute to stabilizing the real economy. That changed with the adoption of the new Keynesian model, which provided a common framework for academic and central bank researchers to contribute to policy-relevant issues.

In his comments, Athanasios stressed that “…research is essential for understanding what has gone wrong in the past. Sometimes it takes decades to understand why some major economic disasters happened and research is what guides us to improve policy.” He used the Great Depression as an example, noting that it took two decades after the publication of Milton Friedman and Anna Schwartz’s Monetary History of the United States before it was recognized in the profession as the best explanation and understanding of what had gone wrong with Federal Reserve policy during the Great Depression.

Incidentally, Milton Friedman and James Tobin were the first two Honorary Advisers to the IMES. I stepped down as an Honorary Adviser in December; Markus Brunnermeier of Princeton University took on the role in January. A complete list of all the Honorary Advisers since 1982 can be found at the Institute's web site at https://www.imes.boj.or.jp/en_about.html

Confusing the price level and the inflation rate

Isn't it annoying when the price level and the rate of inflation are confused? Or when bringing down the inflation rate is confused with reducing the price level? See my recent (Feb. 20, 2023) letter in the FT: https://www.ft.com/content/e7fff27b-0c10-47a7-b9a0-d6470b80c68c. (Subscription may be needed.)

In memory of Ben McCallum

Bennett T. McCallum died December 28, 2022. Ben was a major contributor to macro and monetary economics, with important publications spanning 40 years. While his work touched on many topics, his papers on equilibrium determinacy in rational expectations models, monetary policy, interest rate rules, and the importance of robustness in designing policy rules were, I think, his most important. He offered insights into the theoretical implications of general equilibrium monetary models under rational expectations as well as practical guidance to the evaluation of policy rules.

My first interaction with Ben was when he was a discussant of the paper I presented at the 1982 Federal Reserve Bank of Kansas City Jackson Hole Symposium. Far from filling the large meeting room just off the Jackson Lake Lodge's lobby as it does now, in 1982 the whole event was held downstairs in modest room that felt like a basement.

It is interesting to look back at the 1982 Symposium and see what has changed and what has remained the same in terms of the featured topics. On the first day, Alan Blinder presented "Issues in the Coordination of Monetary and Fiscal Policy," and John Taylor presented "The Role of Expectations in the Choice of Monetary Policy," topics still discussed today.  The next day I offered a paper on "The Effects of Alternative Operating Procedures on Economic and Financial Relationships,"  Ed Kane presented "Selecting Monetary Targets in a Changing Financial Environment," and Ben Friedman presented "Using a Credit Aggregate Target to Implement Monetary Policy in the Financial Environment of the Future.” The second day papers reflected the debates of the time over instruments and targets for monetary policy. Nowadays it is taken for granted that central banks employ a short-term interest rate as their policy instrument and that targets should be for goals such as inflation, not for alternative definitions of reserves or monetary aggregates.

In looking back over Ben's discussion of my 1982 paper, I was struck by his concluding comments: "...recommending the use of equilibrium models is not the same as asserting that the behavior of the economy is well-described by flexible-price equilibrium models. As Taylor's (1982) paper for the conference points out, these models are difficult to reconcile with the data. What is needed is an extended equilibrium analysis that explains the existence and nature of nominal contracts and thus predicts how they will respond to changes in policy…The virtue of the equilibrium-analysis program is that it provides a particular form of analytical discipline, i.e., it encourages one to think carefully about the behavior of individual agents and about the way in which the actions of many such agents interact. This discipline is valuable...."

Recall that 1982 was the year Kydland and Prescott published "Time to build and aggregate fluctuations,” (Econometrica, 50:1345-1370), providing the foundation for real business cycle analysis based on equilibrium modeling approaches. Ben stressed that the use of equilibrium models did not preclude introducing nominal rigidities that both facilitated the study of monetary policy rules and helped to fit business cycle data. Since the early 1980s, economists in the new Keynesian tradition have made great strides in extending our understanding of the role of nominal rigidities. However, the profession has been less successful in addressing Ben’s call for explaining the existence of such rigidities.

Here is a very short and selective set of some of Ben’s important papers; the titles give a good sense of some of the topics he worked on:

McCallum, B.T. 1981. “Price Level Determinacy with an Interest Rate Policy Rule and Rational Expectations.”  Journal of Monetary Economics 8:319-329.

McCallum, B T. 1983. “On Non-Uniqueness in Rational Expectations Models: An Attempt at Perspective.” Journal of Monetary Economics 11 (2): 139–68.

McCallum, B.T. 1986. “Some Issues Concerning Interest Rate Pegging, Price Level Determinacy, and the Real Bills Doctrine.” Journal of Monetary Economics 17 (1): 135–60.

McCallum, B.T. 1988. “Robustness Properties of a Rule for Monetary Policy.” Carnegie-Rochester Conference Series on Public Policy 29: 173–204.

McCallum, B.T. 1999. “Issues in the Design of Monetary Policy Rules.” In Handbook of Macroeconomics, edited by J Taylor and M Woodford, 1483–1530. Vol. 1C, Amsterdam: Elsevier North-Holland.

Inflation surges in perspective

 

This week’s FOMC statement and Chair Powell’s press conference rightly stressed the progress that has been made in controlling inflation, and the U.S. does seems to be past the peak of the inflation surge of 2021-2022. Powell was correct, however, in stating that it is too early to claim victory. To offer some perspective, this post looks at other inflation surges over the past 50 years.

Figure 1 shows U.S. inflation over the period 1960 to 2022 as measured by the percent year-over-year change in three different price indices: the consumer price index (CPI), the personal consumption index, the personal consumption index (PCEPI) less food and energy prices (PCEPILFE), and a measure of the prices of sticky goods and services prices constructed by the Federal Reserve Rank of Atlanta (it also excludes food and energy prices). All data is obtained from the St. Louis Federal Reserve Bank’s FRED database. https://fred.stlouisfed.org/.

The figure suggests four inflation-surge episodes, three of which occurred between the late 1960s and the early 1980s, a period that encompasses the Great Inflation. The first two surges were quickly followed by another and larger upward surge in inflation. After the third surge, which peaked in June 1980, CPI and Sticky CPI inflation started rising again, reaching a second peak in Sept. 1981, but thereafter all four inflation measures continued to fall as the economy entered the period of the Great Moderation.  

The fourth surge in inflation that stands out is the one in 2021-2022. 

The second figure isolates the four inflation surges. The mid-1970s and late 1970s cases (in the upper right and lower left panels) are the most interesting from today's perspective. Both were associate with oil shocks. In both cases, CPI inflation, which includes food and energy prices, dropped relatively quickly. In the case shown in the upper right panel, inflation fell, but not back to its starting level, before rising again, leading into the inflation surge seen in the lower left panel. 

The question now is whether the current inflation surge, seen in the lower right, will follow the pattern of the early 1980s, with inflation eventually stabilizing around a low level, or whether it might be 1976 again, with only a temporary decline, followed by an uptick in inflation. And even if there is no uptick, will it decline to rates similar to when the surge started, as with the first surge in 1970 (upper left panel), stabilize at the Fed's 2% target, or halt at a higher rate, perhaps around 4% as some have advocated?  

In his opening remarks at the press conference following the FOMC meeting February 2, 2023, Chair Powell stated that, in the fight to bring inflation down, the Fed has "...covered a lot of ground, and the full effects of our rapid tightening so far are yet to be felt. Even so, we have more work to do. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy." Inflation over the next year will depend critically on the credibility of that statement.

As a sidenote, the Sticky Price CPI index doesn't look very sticky. Despite the fact it is meant to measure the prices of good and services that do not change frequently, and excludes food and energy prices, it is only in the recent episode that it lagged appreciably behind the other measures as inflation initially rose. It also has not yet peaked (as of January 2023).  

Role of money at the lower bound

Roberto Billi, Ulf Söderström and I just reviewed the proofs for our forthcoming JMCB paper, "The role of money in monetary policy at the lower bound."  In the paper, we reconsider the merits of strict money growth targeting (MGT) relative to conventional inflation targeting (IT) and to price level targeting (PLT). We evaluate these policies in terms of social welfare through the lens of a new Keynesian model and accounting for a zero lower bound (ZLB) constraint on the nominal interest rate. Although MGT makes monetary policy vulnerable to money demand shocks, MGT contributes to achieving price level stationarity and significantly reduces the incidence and severity of the ZLB relative to both IT and PLT. Furthermore, MGT lessens the need for fiscal expansions to supplement monetary policy in fighting recessions.

While the framework we employ is a stylized, but common, New Keynesian model, our findings suggest a productive avenue for future research will be to explore the re-introduction of money into monetary policy in a wider class of model environments.

Here is a link to the current draft of the paper. The final JMCB version should be available soon.

The Fed's maximum sustainable employment mandate

The Federal Reserves has a dual mandate, assigned to it by Congress, that calls for it to promote maximum employment and price stability. One objective of such mandates is to provide performance measures that can be used to judge whether the Fed is doing a good job. To be used for such a purpose, however, it must be possible to measure what maximum employment and price stability mean.

In the case of price stability, few think it should be interpreted literally – that some accepted index of prices should remain constant over time. Instead, price stability is normally taken to mean a low and stable rate of inflation. In 2012, the policymaking committee of the Federal Reserve, the Federal Open Market Committee, or FOMC, defined 2% inflation as the rate consistent with its mandate.

The FOMC has not been as clear in operationalizing the objective of maximum employment. In fact, they have moved to make it increasingly opaque. The FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy was revised in August 2021 to define the employment goal as “a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors. . . Consequently, it would not be appropriate to specify a fixed goal for employment; rather the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level, recognizing that such assessments are necessarily uncertain and subject to revision.”

In short, the FOMC has said it doesn’t know how to measure one of its key objectives. One does have to sympathize with the FOMC – labor markets are complex, employment depends on business cycle factors but also on factors that influence labor force participation decisions, structural shifts arising from changing patterns of work (home or in the office), technological innovations that shift the types of skills demanded in the workplace, and many other factors. However, by being unable to offer guidance on this key policy objective, in contrast to the 2% inflation target, the public faces a more difficult problem in predicting Fed policy. For example, while inflation is currently well above its 2% target does the FOMC see current employment as too high or too low?

The figure shows the unemployment gap in blue (unemployment minus 4% -- 4% because that is the median projection among FOMC participants of longer-run unemployment) and the inflation gap (measured by the personal consumption price index less food and energy minus 2%). Throughout 2021, inflation exceeded the Fed's target, suggesting the need for tighter monetary policy, but at the same time, unemployment was above 4%, suggesting the Fed should not tighten. But while the unemployment gap was clearly falling, it was the dramatic rise in inflation in excess of 2% that was the chief development. By December 2012, the unemployment gap had entered negative territory, while the climb in the inflation gap, after looking like it might be pausing over the summer of 2021, jumped significantly in the Fall. Only in March 2022 did the FOMC decide to raise its policy rate.    

Since Spring 2022, the unemployment rate gap has remained roughly constant with the unemployment rate around 3.6%. Inflation peaked in February at 5.4%, ending the year at 4.4%. 

These gaps shows the economy at a moment of time. Just looking at the figure suggests the Fed still needs to focus on bringing inflation down. That will lead to some increase in unemployment, but the FOMC projections already suggest unemployment is below the level viewed sustainable. Current gaps reflect the consequences of the Fed's past policies, including its delay in responding to the surge in inflation seen in the figure. Because policy affects the economy with a lag, the Fed must be forward looking; policy decisions will depend on the FOMC's forecasts of the future path of unemployment and inflation. 

Last year, inflation was central problem the Fed had to address. In December 2022, the FOMC projections indicated members expected 2023 would end with 4.6% unemployment and core inflation at 3.5%. If these projections pan out, the economy will end this year both unemployment and inflation still too high. Fed actions will reflect the FOMC's assessment of the trade-offs between these two goals. Thus, understanding the Fed's actions will require more clarity on how it will balance the competing goals of ensuring both gaps return to zero. 

Of course, this discussion was all based on the assumption that 4% unemployment is what the Fed considers to be the rate associated with their mandate of maximum sustainable employment. Understanding the Fed's decisions in balancing the two components of its dual mandate would be aided it it could be as clear about its interpretation of maximum sustainable employment as it is about its interpretation of price stability.  

 

Super active fiscal policy (December 2022)

I have been investigating the role of super-active fiscal policies, policies that increase government spending or cut taxes as debt levels rise in joint work with Roberto Billi. We find that such polices can outperform standard inflation targeting when monetary policy is occasionally constrained by the zero lower bound. Our most recent version of Seemingly irresponsible but welfare improving fiscal policy at the lower bound extends the analysis to consider deviations from rational expectations in the form of cognitive discounting. 

Using a standard New Keynesian model subject to an occasionally-binding zero lower bound on the monetary policy interest rate and a model-consistent measure of welfare, we show that such seemingly irresponsible fiscal rules can improve economic welfare. While sensible fiscal policy and active monetary policy performs best away from the ZLB, the fiscal rules we analyze significantly reduce the time spent at the ZLB and produce overall welfare gains. 

Super-active fiscal policies are most effective with a high debt target and when debt is short-term. However, when private expectations are characterized by cognitive discounting, the performance of super-active fiscal rules deteriorates. 

Roberto and I wrote a SUERF policy brief in April 2022 was summarized our results from an earlier version of this paper that did not consider deviations from rational expectation.

The Fed Pivots: Goodbye Soft Landing – Hello Disinflation (Sept. 2022)

I've decided to post some thoughts on monetary policy. So to start things off, this post is something I wrote in September 2022 after last year's KC Fed Jackson Hole Symposium. Chair Powell's speech at Jackson Hole was short but significant. It marked  a clear pivot in Fed policy towards dealing with the surge in inflation the US was facing. Four months later, in January 2023, the Fed has moved significantly, and speculation is that next week's FOMC meeting (Jan 31-Fed 1, 2023) will see a slowdown in the rate of interest rate increases. 

So, while the following reflects events from last year, it offers a starting point for this new blog.

Last week’s monetary policy symposium at Jackson Hole WY gave international central bankers an opportunity to dust off their inflation fighting credentials – gone was any talk of soft landings and inclusive economic expansions, in were pledges to bring down inflation and, in the words of US Federal Reserve Chair Jerome Powell, “to keep at it until we are confident the job is done.”

 This new language brings to mind October 6, 1979, when Federal Reserve Chairman Paul Volker called a special Saturday meeting of the FOMC, the Fed’s policy committee, to adopt new policies procedures to fight inflation. These led to skyrocketing interest rates, the Fed’s policy rate peaked at 19.1 percent in June 1981, and two back-to-back recessions. Ultimately, though, the Volker-led Fed broke the back of inflation and ushered in the low inflation and economic stability the US enjoyed between 1985 and the financial crisis of 2008.

Today, the U.S. is experiencing inflation rates not seen since the early 1980s, and surveys find that inflation is a major concern of American households. The Pew Research Center’s April survey found that 93 percent of American households described inflation as “a very big” or “moderately big problem.” This isn’t surprising. Despite Fed protestations during 2021 that the surge in inflation was temporary, year-over-year headline inflation in July was 8.5 percent, and inflation has exceeded the Fed’s 2 percent target for 17 straight months. For many people, gains from economic expansion have been eaten away by rising prices.

At Jackson Hole, Powell made clear that, like Volcker, he is now committed to reducing inflation. He also highlighted a lesson from the past – delay in reacting makes the cost of reducing inflation higher. It is unfortunate that the Fed has only now remembered this lesson. The FOMC waited until March 2022, when inflation was over 6 percent, before slowly beginning to raise interest rates. Its response has hardly been one of shock and awe; it has taken five months to boost rates to 2.5%. In 1979 the Volcker FOMC caused rates to rise roughly the same amount in just a month. Volcker’s dramatic actions came when inflation had averaged over 8 percent during the previous five years. Inflation is not as ingrained now as it was then, but simply waiting in the hope that inflation would quickly recede was always going to be a risky strategy.

 The Fed can’t do anything about its slow start in fighting inflation, but there are three things it can do now to win the battle. First, if fighting inflation is the Fed’s priority, stick to it, and keep inflation at the forefront of how policy is communicated to the public. It is important to continue to avoid discussions of engineering a soft landing or prioritizing short run economic expansion. At this late date, these topics raise questions about the Fed’s commitment to fighting inflation. Everyone wants the smallest possible hit to the economy, but even those who might benefit most if a slowdown is avoided may also be the ones most hurt by the failure to control inflation as their limited budgets are stretched further and further.

Second, conducting monetary policy in the face of great uncertainty is a challenge, but there are lessons from the past here too. When uncertain about whether shocks to inflation are temporary or persistent, I argued at Jackson Hole almost 20 years ago that it is better to overestimate the persistence of inflation shocks, just the opposite of what the Fed did. One can hope that inflation quickly subsides, but it is best to plan for “temporary” shocks to inflation to end up persisting. Just as in fighting wildfires, it is best to respond quickly and strongly even to small fires to avoid the risk unpredictable winds convert a small fire into an inferno.

Third, clarify the Fed’s policy framework. Doing so would begin by admitting that the 2020 policy review and subsequent adoption of average inflation targeting was a mistake. With an inflation target that was no longer clearly defined and an employment goal the Fed itself described as “not directly measurable,” the new policy framework made the Fed less accountable. And, as others have pointed out, the Fed adopted a framework appropriate for a low inflation environment of the previous decade just as the global economy entered a high inflation environment.

 In 1978, Volcker’s predecessor G. William Miller was asked whether the Fed was responsible for the U.S.’s then 8 percent inflation. He responded, “I take the 5^th,” appealing to the U.S. Constitution’s protection against self-incrimination. (FOMC Transcript 9/19/1978, p. 17) Last year at Jackson Hole, Powell downplayed the Fed’s responsibility for inflation. At this year’s Jackson Hole, Powell firmly took on the mantle of Volcker, emphasizing that it is the Fed’s responsibility to ensure low average inflation. It remains to be seen which former Chairman’s legacy will guide policy over the next year.

Inflation Surges and Monetary Policy (BOJ-IMES Keynote May 2022)

In May 2022, I delivered a keynote address at the Annual Conference of the Bank of Japan's Institute for Monetary and Economic Studies. the title was "Inflation Surges and Monetary Policy". It was published in the BOJ's Economic and Monetary Studies, vol. 40, Nov. 2022 and can be found at https://www.imes.boj.or.jp/research/abstracts/english/me40-4.html.

Here is the abstract: Similarities between the 1960s and 1970s raise concerns that central banks are repeating mistakes that led to the Great Inflation. Two explanations for this earlier period of inflation, that it was due to shocks and special factors or that it was the result of political pressures on monetary policy, seem particularly relevant today. Major central banks such as the Federal Reserve and the ECB have been slow to react to the surge in inflation due to COVID-19 and the war in Ukraine. I investigate the consequences of policy delay and the impact of a more aggressive reaction, conditional on policy being delayed. In assessing the persistence of inflation shocks and in dealing with uncertainty about inflation dynamics, policymakers seem to be ignoring lessons from the literature on monetary policy in the face of model uncertainty.

One interesting finding was that in a standard new Keynesian model, delay in responding to an inflation shock could lead to increased volatility of interest rates, but the impact of delay on output and inflation was relatively small. I interpret this as a reflection of the policy of forward guidance. As long as the private sector knows the Fed will eventually respond, delaying by a couple of quarters makes little difference. As usual, therefore, the credibility of the central bank is key. Too much delay, however, can lead to instrument instability.