Uneasy Money

Larry Summers continues to lead the charge for a quick, decisive tightening of monetary policy by the Federal Reserve to head off an inflationary surge that, he believes, is about to overtake us. Undoubtedly one of the most capable economists of his generation, Summers also had a long career as a policy maker at the highest levels, so his advice cannot be casually dismissed. Even aside from Summers’s warning, the current economic environment fully justifies heightened concern caused by the recent uptick in inflation.

I am, nevertheless, not inclined to share Summers’s confidence in his oft-repeated predictions of resurgent inflation unless monetary policy is substantially tightened soon to prevent current inflation from being entrenched into the expectations of households and businesses. Summers’s’ latest warning came in a Washington Post op-ed following the statement by the FOMC and by Chairman Jay Powell that Fed policy would shift to give priority to maintaining price stability.

After welcoming the FOMC statement, Summers immediately segued into a critique of the Fed position on every substantive point.

There have been few, if any, instances in which inflation has been successfully stabilized without recession. Every U.S. economic expansion between the Korean War and Paul A. Volcker’s slaying of inflation after 1979 ended as the Federal Reserve tried to put the brakes on inflation and the economy skidded into recession. Since Volcker’s victory, there have been no major outbreaks of inflation until this year, and so no need for monetary policy to engineer a soft landing of the kind that the Fed hopes for over the next several years.

The not-very-encouraging history of disinflation efforts suggests that the Fed will need to be both skillful and lucky as it seeks to apply sufficient restraint to cause inflation to come down to its 2 percent target without pushing the economy into recession. Unfortunately, several aspects of the Open Market Committee statement and Powell’s news conference suggest that the Fed may not yet fully grasp either the current economic situation or the implications of current monetary policy.

Summers cites the recessions between the Korean War and the 1979-82 Volcker Monetarist experiment to support his anti-inflationary diagnosis and remedy. But none of the three recessions in the 1950s during the Eisenhower Presidency was needed to cope with any significant inflationary threat. There was no substantial inflation in the US during the 1950s, never reaching 3% in any year between 1953 and 1960, and rarely exceeding 2%.

Inflation during the late 1960 and 1970s was caused by a combination of factors, including both excess demand fueled by Vietnam War spending and politically motivated monetary expansion, plus two oil shocks in 1973-74 and 1979-80, an economic environment with only modest similarity to the current economic situation.

But the important lesson from the disastrous Volcker-Friedman recession is that most of the reduction in inflation following Volcker’s decisive move to tighten monetary policy in early 1981 did not come until a year and a half later, when with the US unemployment rate above 10%, Volcker finally abandoned the futile and counterproductive Monetarist policy of making the monetary aggregates policy instruments. Had it not been for the Monetarist obsession with controlling the monetary aggregates, a recovery could have started six months to a year earlier than it did, with inflation continuing on the downward trajectory as output and employment expanded.

The key point is that falling output, in and of itself, tends to cause rising, not falling, prices, so that postponing the start of a recovery actually delays, rather than hastens, the reduction of inflation. As I explained in another post, rather than focusing onthe monetary aggregates, monetary policy ought to have aimed to reduce the rate of growth of total nominal spending from well over 12% in 1980-81 to a rate of about 7%, which would have been consistent with the informal 4% inflation target that Volcker and Reagan had set for themselves.

The appropriate lesson to take away from the Volcker-Friedman recession of 1981-82 is therefore that a central bank can meet its inflation target by reducing the rate of increase in total nominal spending and income to the rate, given anticipated real expansion of capacity and productivity, consistent with its inflation target. The rate of growth in nominal spending and income cannot be controlled with a degree of accuracy, but rates of increase in spending above or below the target rate of increase provide the central bank with real time indications of whether policy needs to be tightened or loosened to meet the inflation target. That approach would avoid the inordinate cost of reducing inflation associated with the Volcker-Friedman episode.

A further aggravating factor in the 1981-82 recession was that interest rates had risen to double-digit levels even before Volcker embarked on his Monetarist anti-inflation strategy, showing how deeply embedded inflation expectations had become in the plans of households and businesses. By contrast, interest rates have actually been falling for months, suggesting that Summers’s warnings about inflation expectations becoming entrenched are overstated.

The Fed forecast calls for inflation to significantly subside even as the economy sustains 3.5 percent unemployment — a development without precedent in U.S. economic history. The Fed believes this even though it regards the sustainable level of unemployment as 4 percent. This only makes sense if the Fed is clinging to the idea that current inflation is transitory and expects it to subside of its own accord.

Summers’s factual assertion that the US unemployment rate has never fallen, without inflationary stimulus, to 3.5%, an argument predicated on the assumption that the natural (or non-accelerating- inflation rate of unemployment) is firmly fixed at 4% is not well supported by the data. In 2019 and early 2020, the unemployment rate dropped to 3.5% without evident inflationary pressure. In the late 1990s unemployment also dropped below 4% without inflationary pressure. So, the expectation that a 3.5% unemployment rate could be restored without inflationary pressure may be optimistic, but it’s hardly unprecedented.

Summers suggests that the Fed is confused because it expects the unemployment rate to fall back to the 3.5% rate of 2019 even while supposedly regarding a 4%, not a 3.5%, rate of unemployment as sustainable. According to Summers, reaching a 3.5% rate of unemployment would be possible only if the current increase in the inflation rate is temporary. But the bond market seems to share that view with the Fed given the recent decreases in the yields on Treasury bonds of 5 to 30 years duration. But Summers takes a different view.

In fact, there is solid reason to think inflation may accelerate. The consumer price index’s shelter component, which represents one-third of the index, has gone up by less than 4 percent, even as private calculations without exception suggest increases of 10 to 20 percent in rent and home prices. Catch-up is likely. More fundamentally, job vacancies are at record levels and the labor market is still heating up, according to the Fed forecast. This portends acceleration rather than deceleration in labor costs — by far the largest cost for the business sector.

Projecting how increases in rent and home prices that have already occurred will affect reported inflation in the future is a tricky exercise. It is certain that those effects will show up in the future, but those effects are already baked into those future inflation reports, so they provide an uneasy basis on which to conduct monetary policy. Insofar as inflation is a problem, it is a problem not because of short-term fluctuations in prices in specific goods, even home prices and rents, or whole sectors of the economy, but because of generalized and potentially continuing long-term trends affecting the whole structure of prices.

The current number of job vacancies reflects both the demand for, and the supply of, labor. The labor-force participation rate is still well below the pre-pandemic level, reflecting the effect of withdrawal from the labor force by workers afraid of contracting the COVID virus, or unable to find day care for children, or deterred from seeking by other pandemic-related concerns from seeking or accepting employment. Under such circumstances, the re-allocations associated with high job-vacancy rates are likely to enhance the efficiency and productivity of the workers that are re-employed, and need not exacerbate inflationary pressures.

Presumably, the Fed has judged that current aggregate-demand increases have less to do with observed inflation than labor-supply constraints or other supply-side bottlenecks whose effects on prices are likely self-limiting. This judgment is neither obviously right nor obviously wrong. But, for now at least, it is not unreasonable for the Fed to remain cautious before making a drastic policy change, neither committing itself to an immediate tightening, as Summers is proposing, nor doubling down on a commitment to its current accommodative stance.

Meanwhile, the pandemic-related bottlenecks central to the transitory argument are exaggerated. Prices for more than 80 percent of goods in the CPI have increased more than 3 percent in the past year.With the economy’s capacity growing 2 percent a year and the Fed’s own forecast calling for 4 percent growth in 2022, price pressures seem more likely to grow than to abate.

This argument makes no sense. We have, to be sure, gone through a period of actual broad-based inflation, so pointing out that 80% of goods in the CPI have increased in price by more than 3% in the past year is unsurprising. The bottleneck point is that supply constraints have prevented the real economy from growing as fast as nominal spending has grown. As I’ve pointed out recently, there’s an overhang of cash and liquid assets, accumulated rather than spent during the pandemic, which has amplified aggregate-demand growth since the economy began to recover from the pandemic, opening up previously closed opportunities for spending. The mismatch between the growth of demand and the growth of supply has been manifested in rising inflation. If the bottleneck theory of inflation is true, then the short-term growth potential of the economy is greater than the 2% rate posited by Summers. As bottlenecks are removed and workers that withdrew from the labor force during the pandemic are re-employed, the economy could easily grow faster than Summers is willing to acknowledge. Summers simply assumes, but doesn’t demonstrate, his conclusion.

This all suggests that policy will need to restrain demand to restore price stability.

No, it does not suggest that at all. It only suggests the possibility that demand may have to be restrained to keep prices stable. Recent inflation may have been a delayed response to an expansive monetary policy designed to prevent a contraction of demand during the pandemic. A temporary increase in inflation does not necessarily call for an immediate contractionary response. It’s too early to tell with confidence whether preventing future inflation requires, as Summers asserts, monetary policy to be tightened immediately. That option shouldn’t be taken off the table, but the Fed clearly hasn’t done so.

How much tightening is required? No one knows, and the Fed is right to insist that it will monitor the economy and adjust. We do know, however, that monetary policy is far looser today — in a high-inflation, low-unemployment economy — than it was about a year ago when inflation was below the Fed’s target and unemployment was around 8 percent. With relatively constant nominal interest rates, higher inflation and the expectation of future inflation have led to dramatic reductions in real interest rates over the past year. This is why bubbles are increasingly pervasive in asset markets ranging from crypto to beachfront properties and meme stocks to tech start-ups.

Summers, again, is just assuming, not demonstrating, his own preferred conclusion. A year ago, high unemployment was caused by the unique confluence of essentially simultaneous negative demand and supply shocks. The unprecedented coincidence of two simultaneous shocks posed a unique policy challenge to which the Fed has so far responded with remarkable skill. But the unfamiliar and challenging economic environment remains murky, and premature responses to unclear conditions may not yield the anticipated results. Undaunted by any doubt in his own reading of an opaque situation, Summers self-assurance is characteristic and impressive, but his argument is less than compelling.

The implication is that restoring monetary policy to a normal posture, let alone to applying restraint to the economy, will require far more than the three quarter-point rate increases the Fed has predicted for next year. This point takes on particular force once it is recognized that, contrary to Powell’s assertion, almost all economists believe there is a lag of about a year between the application of a rate change and its effect. Failure to restore policy neutrality next year means allowing two more years of highly inflationary monetary policy.

All of this suggests that even with its actions this week, the Fed remains well behind the curve in its commitment to fighting inflation. If its statements reflect its convictions, this is a matter of serious concern.

The idea that there is a one-year lag between applying a policy and its effect is hardly credible. The problem is not the length of the lag, but the uncertain effects of policy in a given set of circumstances. The effects of a change in the money stock or a change in the policy rate may not be apparent if they are offset by other changes. The ceteris-paribus proviso that qualifies every analysis of the effects of monetary policy is rarely satisfied in the real world; almost every policy action by the central bank is an uncertain bet. Under current circumstances, the Fed response to the recent increase in inflation seems eminently sensible: signal that the Fed is anticipating the likelihood that monetary policy will have to be tightened if the current rate of increase in nominal spending remains substantially above the rate consistent with the Fed’s average inflation target of 2%, but wait for further evidence before deciding about the magnitude of any changes in the Fed’s policy instruments.