Uneasy Money

Jason Furman has had an admirable career as an economist and policy adviser. He was on the staff of the Council of Economic Advisors in the Clinton administrations, was Assistant Director of the National Economic Policy under Larry Summers in Obama’s first term served as Chairman of the CEA in his second. I am friendly with a really smart economist who worked under Furman for a couple of years at the CEA, and he spoke glowingly about that experience in general and about Furman in particular, both as an economist and as a person. So I’m not anxious to write a critical blogpost about Furman. But a blogger’s gotta do what a blogger’s gotta do.

Following the lead of his former boss Larry Summers, Furman has, for over a year, been an outspoken anti-inflation hawk, calling for aggressive tightening by the Fed to prevent an inflationary wage-price spiral from returning us to the bad old days of the 1970s and its ugly aftermath — the 1981-82 Volcker recession. So, after the January core inflation reports showed an uptick in core inflation in the second half of 2022, Furman responded with an overwrought op-ed (“To Fight Inflation, Fed Tightening Should Go Faster and Further”) in the Wall Street Journal.

The Federal Reserve has said repeatedly that it responds to data and doesn’t set interest rates on autopilot. The data have changed dramatically. The Fed should prove it means what it says by shifting from a 25-basis-point increase at its next meeting to a 50-point increase. It should also shift expectations toward a terminal rate of around 6%.

The Fed should never react too much to any single data point, but when the annualized three-month core inflation rate jumps from 2.9% to 4.7%, the central bank must take notice. When that happens after strong jobs data and faster wage growth, the Fed should plan on action. The expectation that inflation would melt away on its own was always unjustified, but the latest economic data have been especially unkind to team transitory.

Let me first observe that Furman seems to overstate the size of the January increase in core inflation. Core inflation, which excludes volatile food and energy prices from the two broader inflation indexes: the personal consumption expenditures index (PCEI) computed by the Bureau of Economic Analysis of the Commerce Department and the Consumer Price Index (CPI) computed by the Bureau of Labor Statistics of the Labor Department. The two charts below show the 3-month and the 6-month moving averages of the core PCEI and the core CPI. Neither of the 3-month moving averages show a January increase as large as that asserted by Furman.

Yet, Furman is correct that the January increase in core inflation was significant, and also correct to observe that the Fed shouldn’t overreact to a single data point. Unfortunately, he immediately reversed himself by demanding that the Fed respond to the January increase by quickly and significantly tightening policy, because core inflation, notwithstanding the assurances of “team transitory”, has not subsided much on its own.

I can’t speak on behalf of team transitory, but, as far as I know, no one ever suggested that inflation would fall back to the Fed’s 2% target on its own. Everyone acknowledged that increased inflation last year was, at least partly, but not entirely, caused by macroeconomic policies that, during the pandemic and its aftermath, first supported, and then increased, aggregate demand.

But, as I’ve argued in many posts in the past year and a half (here, here, here, here, here, here, here, and here), increasing aggregate demand to avoid a cumulative collapse in output and income was well-advised under unprecedented Covid conditions. Because much of the income supplements provided in 2020-21 were held in cash, or used to repay debts, owing to the diminished availability of spending outlets during the pandemic, rather than spent, increased aggregate demand led not to an immediate, but a delayed, increase in inflation once the economy gradually recovered from the pandemic. Without the macroeconomic stimulus of 2020-21 that became a source of inflationary pressure in late 2021 and 2022, the downturn in 2020 would have been even deeper and lasted longer.

But aside from the underlying macroeconomic forces causing inflation to start rising in 2021, a variety of supply-chain slowdowns and interruptions appeared, just as a Russian invasion of Ukraine was becoming increasing likely, driving up oil and other energy prices well before the actual invasion on February 24, 2022. The transitory component of inflation corresponds to both the delayed spending of cash accumulated from income supplements and other spending undertaken in the pandemic, and to the supply-side problems caused by, or related to both the pandemic and Putin’s war. By the middle of 2022, both of these transitory causes of inflation were subsiding.

That leaves us with a core rate of inflation hovering in the 4-5% range, a somewhat higher rate than I would like, or recommend, as a policy target. Does that mean that further tightening to reduce overall inflation to the 2% target is required? I agree with Furman and others who think it is required, but I disagree that the tightening should be either drastic or immediate, and I find Furman’s rationale for rapid and substantial further tightening deeply misguided.

What makes the current inflation particularly troubling is that all the hoped-for saviors have come and gone without reducing underlying inflation very much. Inflation was supposed to go away after base effects receded, when the economy got over the Delta and Omicron surges, when the ports were unclogged, when timber prices fell, when the fiscal stimulus wore off, when microchips were available, when energy prices came back down again after the Russian invasion. All of that has happened, and yet the underlying inflation rate remains above 4.5% on just about every time horizon and every measure.

What makes Furman’s inflation anxiety particularly annoying is that, while he and others had been warning that, unless the Fed sharply tightened, inflation would accelerate — possibly to double-digit levels — he continues to hyperventilate about runaway inflation, even as headline inflation over the past year has dropped substantially, and core inflation has also fallen, albeit by much less than headline inflation. Having learned nothing from his earlier exaggerated warnings about inflation, Furman is now using a one-month uptick in inflation as a pretext for continued inflation alarmism and tight-money advocacy.

The Fed’s tightening over the past year prevented core inflation from accelerating even as the transitory factors that had raised inflation to the highest levels in 50 years gradually dissipated, causing the sharp decline in the volatile non-core items in the CPI and PCE indexes. The argument between team transitory and team non-transitory was never an all or nothing dispute, but a matter of emphasis.

Many of those opposed to rapid and severe tightening understood that responding too aggressively to temporarily high inflation carries risks of its own, potentially plunging the economy into a recession because of an exaggerated estimate of the inflationary threat, an underrated risk that is one of the 1970s lessons that many, including Furman and Summers, seem to overlook, but a risk of which the events of the past two weeks have provided an unwelcome and frightening reminder.

The modest decline in core inflation over the past year was accompanied by a gradual decline in the rate of NGDP growth since the first quarter of 2022 from over 11% to about 7%. For inflation to decline further toward the 2% target, a further modest — and ideally gradual — decline in NGDP growth to about 5% will be necessary.

Whether the decline in NGDP growth is possible without further monetary tightening is unclear, but it’s unlikely that the effects of monetary tightening over the past year have yet been fully absorbed by the economy, so it seems reasonable to postpone any decision about monetary tightening until at least the preliminary Q1 GDP report is released in about six weeks. And given the heightened risk to the banking and financial system, any increase in rates would be foolhardy.

If total domestic spending is increasing at a rate faster than 7%, further increases in interest rates might be warranted, but the current inversion of the yield curve suggests that an increase in short-term rates is presumptively inadvisable (see my posts on yield-curve inversion here and here). If long-term rates are below short-term rates, notwithstanding the incremental risk associated with holding securities of longer duration, the relatively low yield of longer-term securities suggests either that the liquidity premium on money is abnormally high (a symptom of financial distress), or that there is an expectation of sharply declining yields in the future. In the former case, a lack of liquidity and increasing default risk drive up short-term rates; in the latter, the longer-term outlook suggests that the inflation rate, or the profit rate, or both, will decline. So the watchword about policy changes should be: caution.

After that warmup, Furman, in diagnosing “underlying inflation, goes from being annoying to misguided.

Fundamentally, much of the economy’s underlying inflation had nothing to do with base effects or microchips or timber prices.

Correct! But let’s say that the underlying inflation rate really is, as Furman suggests, 5%. That would be 3% above the target rate. Not trivial, but hardly enough to impose the draconian tightening that Furman is recommending.

Furman continues with, what seems to me, a confused and confusing rationale for monetary tightening.

[Underlying inflation is] a product of extremely tight labor markets leading to rapid wage gains that passed [sic] through as higher prices. These higher prices have also led to faster wage gains. Some call it a “wage-price spiral,” but a better term is “wage-price persistence,” because inflation stays high even after the demand surge goes away.

This passage is beset by confusions, explicit or implied, that require unpacking. Having started with a correct observation that the economy’s “underlying inflation had nothing to do” with increases in any particular price or set of prices, Furman contradicts himself, attributing inflation to “rapid wage gains” that got passed through “as higher prices,” which, in turn, led to “faster wage gains.” That this ancient fallacy about the cause of inflation would be repeated by a former CEA chair, now a professor of economic policy at the Kennedy School at Harvard, is, well, dispiriting.

What’s the fallacy? An increase in one price – presumably, including the wage paid to labor — can never explain an increase in prices in general. To suggest otherwise is to commit the “fallacy of composition,” or something closes to it. (See “Fallacy of Composition”) An increase in wages relative to other prices could just as well be associated by wages remaining constant and all other prices falling; there is no logical necessity for wage increases to entail increases in other prices.

Of course, Furman might not be asserting a logical connection between wage increases and price increases. He might just be making an empirical observation that it was rising wages that initiated a series of price increases and an unending process of reciprocal wage and price increases. But even if wage increases did induce subsequent increases in other prices, that observation can’t account for an inflationary process in which wages and prices keep rising endlessly.

To account for such a continuing process, an explanation of why the process doesn’t eventually reach an endpoint is needed, but missing. There must be something that enables the inflationary process to conintue. That additional factor is, of course, the monetary or macroeconomic environment that determines aggregate demand and aggregate spending. Furman obviously believes that the process can be halted by monetary or macroeconomic policy measures, but, focused solely on wages, he ignores the role of policy in initiating and maintaining the process.

Other, related, confusions emerge in Furman’s next paragraph.

Wage growth is currently running at an annual rate of about 5%. Sustaining such wage growth with 2% inflation would require a large increase in productivity growth or continually falling profit margins. I’d root for either outcome, but I wouldn’t bet on them. Falling wage growth could bring down inflation, but in an economy with nearly two job openings for every person looking for work, don’t expect it to happen. Instead, the most probable outcome is that if the unemployment rate doesn’t rise, wages will continue to grow at that pace, which historically is associated with about 4% inflation.

In a previously quoted passage, Furman asserted that wage increases caused underlying inflation. But that was not what actually happened in the current episode. Since January 2021, just before the current inflation started, prices started rising before wages, and until the last six months or so prices have been rising faster than wages, causing real wages (i.e. adjusted for the purchasing power) to fall.

It’s one thing to say that wage increases cause the prices of things made by workers to increase; it’s quite another to say that wage increases cause the price of the things made by workers to increase faster than wages increase. By blaming current inflation on the current increase in wages, Furman is, in effect, calling for permanent real-wage cuts. Since wage increases cause “inflation persistence,” Furman proposes a restrictive monetary policy to reduce the overall demand for labor and the rate of increase in nominal and real wages.

Real wages (adjusted for the CPI) were barely higher in Q4 2022 than in Q4 2019 even though real GDP in Q4 2022 was 5.1% higher than in Q4 2019 and per-capita real GDP was 4.1% higher in Q4 2022 than in Q4 2019. If inflation is (in my view mistakenly) attributed to a distributional struggle that labor is clearly losing, then it’s obvious that it’s not wages that are to blame for inflation.

Furman makes another astonishing claim in the next paragraph.

Monetary policy operates with long and variable lags. Given that most of the tightening in financial conditions was already in place 10 months ago and, if anything, the real economy and demand have strengthened in recent months, it would be foolish to sit and wait for the medicine to work.

How long and variable the lags associated with monetary policy really are is a matter of some uncertainty. What is not uncertain, in Furman’s view, is that most of the tightening had occurred 10 months ago (May 2022). The FOMC began raising the Fed Funds target exactly a year ago in March 2022. How Furman can plausibly assert that most of the effect of the Fed’s tightening were in place 10 months ago is beyond me. The Table below shows that 10 months ago (May 2022) the effective Fed Funds rate (St. Louis Fed) was still only 0.77% and has since risen to 4.57% in Feburary.

Below is another table with the monthly average yield on constant maturity 10-year Treasuries, showing that the yield on 10-year Treasuries rose from 2.13% in March 2022 to 2.90% in May (reflecting expectations that further increases in the Fed Funds rate were likely). But the rate on 10-year Treasuries rose from slightly more than 2% to nearly 4% between March 2022 and October 2022, with rates fluctuating since October in a range between 3.5 and 4%.

So I can’t understand what Furman could was thinking when he asserted that most of the Fed’s tightening of financial conditions were already in place 10 months ago. The real economy has indeed strengthened, but that strengthening reflects the unusual economic circumstances in which both the real economy and monetary policy have been operating for the past three years: the pandemic, the partial shutdown, the monetary and fiscal stimulus, the supply-chain issues that initially obstructed and hobbled the return to full employment even as unemployment was falling to a record low rate of 3.5%.

Dramatic evidence that the effects of the tightening since January had not been fully absorbed by the economy was provided within days after Furman’s op-ed by the failure of SVB and Signature Bank and only days ago by the rescue of Credit Suisse. And there is no assurance that these are the last dominoes to fall in the banking system or that other effects attributable to the increase in rates will not emerge in the near future.

Furman also overlooks the permanent withdrawal of workers (mostly but exclusively babyboomers nearing retirement age) from the labor force during the pandemic. Despite a rapid decrease in unemployment (and increase in employment) since the summer of 2020, and total employment in February 2023 exceeded total employment in 2020 by only 1.9%. The labor-force participation rate has dropped from 63.3% in February 2020 to 62.5% in February 2023.

With fewer workers available as businesses were responding to increasing demand for their products, competition to hire new workers to replace those that left the labor force is hardly surprising. However, a largely transitory burst of inflation in the second half of 2021 and the first half of 2022 outpaced a perfectly normal increase in nominal wages, causing real wages to fall. But it would be shocking – and suspicious — if normally functioning market forces didn’t drive up nominal wages sufficiently to cause a real wages to recover given the increased tightness of labor markets after a significant negative labor-supply shock.

For Furman to suggest that a market adjustment to a labor-supply shock causing an excess demand for labor should be counteracted by tight monetary policy to reduce the derived demand for labor is extraordinary. There may be – and I believe that there are — good reasons for monetary to aim to bring down the growth of nominal spending from roughly 7% to about 5%. But those reasons have nothing to do with targeting either nominal or real wages.

In fact, lags are precisely why the Fed should do more now—considering it will take months for whatever the central bank does next to have a meaningful effect on inflation.

Furman seems to envision a process whereby wage increases are necessarily inflationary unless the Fed acts to suppress the demand for labor. That is not how inflation works. Inflation depends on aggregate spending and aggregate income, which is what monetary and macroeconomic policy can control. To subordinate monetary policy to some target rate of increase in wages is a distraction, and it is folly to think that, with real wages still below their level two years ago, it is the job of monetary policy to suppress wage increases.