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.