Yesterday, Fed Vice Chair Lael Brainard gave a speech, "What Can We Learn from the Pandemic and the War about Supply Shocks, Inflation, and Monetary Policy?" It starts an important conversation.
I realize this is against economic orthodoxy, but I find it insane that most believe the cure for “inflation” (i.e. higher prices) is for the Fed to raise prices. Raising the FFR raises the cost of funding, which forces companies to raise prices to maintain their margins. Interest expense is a real line item on any company’s income statement, and is also incorporated in higher storage costs for inventories. Huge CPG companies like PEP and Unilever reported double digit price increases in 3Q, despite declining sales volumes (i.e. demand). And an industrial production company that sells commodities on the forward or spot markets automatically raises prices for forward contracts when rates are higher, to incorporate the opportunity cost of selling on spot, pocketing the cash and buying t-bills to get a risk-free return. Rate hikes might “work” to cure inflation simply because they are regressive fiscal policy: basic income for people with net savings, tax hikes for people who are net borrowers (Claudia, you did a phenomenal job pointing out in a post I think last year how rich people get hosed by low rates and inflation, whereas poor people benefit from low rates and modest inflation). I’ve spoken w management teams who are shocked the Fed has raised this aggressively. How can four straight rate hikes be consistent with “stable prices?!”
Please acknowledge inflation shock was the sanctions. Not the Putin did it lame refrain. Russia had a legimate security concern from US arming, training UA since Victoria Nuland's coup 2014. US intent has been to destabilize Russia using Ukraine.
Due to COVID and Ukraine? Right. Due to the stupid reactions we chose to have to both events is more like it. Which made it far worse in both cases.
A disease with tiny, tiny IFR doesn’t cause this dislocation without lockdowns & mandates. And the war in Ukraine was a predictable outcome of US/UK foreign policy in the region for the past few decades.
I disagree with your foreign policy and less with the COVID response, but neither is relevant to the discussion of monetary policy. A shock is a shock.
At a first pass monetary policy would appear rather simple. Create money until you see inflation, then stop. If you follow that, you will have nearly full employment with low inflation since serious unemployment would have to lower prices, which would cause you to print more money.
The pandemic is unusual because it was a demand shock. Literally people all decided not to spend money and at the same time supply closed down. Closing down supply didn't cause inflation because nothing was being spent.
This creates a problem, when you turn everything back on, how do you do it? Let's say previous demand/supply was 100. Now it has been 50 for a few months. If you assume demand will return by increments of 10, you will plan:
Month 1: 60
Month 2: 70
Month 3: 80
Month 4: 90
Month 5: 100
But suppose demand returns by 15 in month 1, so demand is now 65 rather than 60? Well in the very short term you can't do much of anything. You'll tap inventories, maybe have shortages, there might be complaints about fast food places not being able to find anyone to work, etc. So there will be some price increases and that will be good because the price increases signal that demand is coming back faster and action should be taken.
But is demand surging over the long run supply curve? No it isn't. Some things have changed, for example more people working from home long term and I still today see more people using drive thrus at fast food than sitting inside. The supply curve may have shrunk a bit because of these changes, and then the war acts as a traditional supply shock.
The model for this, I think, is actually after WWII. The US experienced a rather brief but serious surge of inflation back in 1948. On one hand you had a lot of supply getting freedup. Rations were being relaxed, factories were allowed to switch back to consumer goods, there was a lot of war surplus goods you could buy cheap if you wanted*, and many GI's were back in the workforce looking for work. You also had demand racing back and also demand for new things. Houses in the suburbs, cars, etc. Inflation was, though, transitory and necessary.
* A story I remember reading in the Pacific, GI's were told they could have a jeep if they wanted. Just had to pay a small fee to ship it back to the states. Few GI's wanted one so thousands of perfectly good jeeps were simply pushed off ships into the ocean.
Brainard raises two issues that I do not think she very well distinguish: a) Has the baseline level of shocks in relation to the baseline relative price flexibility when some prices scarcely can fall. Can we expect larger “extraordinary” shocks like COVOD and Putin’s war. [COVID was two different kinds of shock, supply and relative shifts on the recovery.]
The first suggests a higher average target, greater than 2%.
The second suggests more upward flexibility around that target. But it also raises the stakes on being able to identify in any given case how much above target inflation and for how long the Fed should try to engineer.
The explanation that ARA was not (indeed could not be in a regime of Fed targeting) a source of inflation was excellent!!!
I did not get the difference between the “old thinking” and the “new.” The need to allow prices to rise NO MORE THAN enough to respond to an extraordinary large negative supply shock seems implicit in FAIT. It of course means that at some point after the shock the Fed will need to bring the “temporary” inflation back to target.
I agree that the Fed appears to be over-reacting (“not muted”) to its earlier failure to start tightening sooner. I wish Brainard had made reference to TIPS, which it looks to me sent and is now sending the correct signal about inflation management. What TIPS makes very clear is that the risks of de-anchoring are very low. “Listen to the people?” “Vox TIPSi, vox populi.”
She's starting a conversation and not ending it. I disagreed with some of her points. The failings of the old thinking is a sole reliance on monetary policy to contain inflation, an obsession with inflation expectations, and reliance on other unmeasurables like potential output. That's my argument, not hers.
Reliance on "potential out put"? Agree. Don't do it. 1.0
Expectations. Important but look at the data like TIPS, not exclusively at ones worry beads. 0.5
Monetary policy to control inflation? What else? Of course there are a gazillion supply side things to do -- Jones Act, more high skilled immigrants, port modernization, lower structural deficits, trade liberalization, etc., etc. -- but they only work in the longer run. 0.0
* I really DO know I am an outside amateur even if my attitude doesn't show it. :)
I understand this as probably good advice taking account of political realities. And I guess I would not rule out in principle a microeconomic intervention -- shock absorber -- that would prevent a cascade of relative price adjustments that would require more above target inflation to accommodate.
I am a "let the Fed go it alone"-er but in the sense that it really does not help for Congress and the Administration to try to manage macroeconomic aggregates. I think fiscal policy should stick to growth and redistribution and let -- and demand that -- the Fed manage the outcome of those decisions
But my "a shock is a shook" comment was directed at labeling the gasoline price rise as a result of the "sanctions," not "Putin's war."
I realize this is against economic orthodoxy, but I find it insane that most believe the cure for “inflation” (i.e. higher prices) is for the Fed to raise prices. Raising the FFR raises the cost of funding, which forces companies to raise prices to maintain their margins. Interest expense is a real line item on any company’s income statement, and is also incorporated in higher storage costs for inventories. Huge CPG companies like PEP and Unilever reported double digit price increases in 3Q, despite declining sales volumes (i.e. demand). And an industrial production company that sells commodities on the forward or spot markets automatically raises prices for forward contracts when rates are higher, to incorporate the opportunity cost of selling on spot, pocketing the cash and buying t-bills to get a risk-free return. Rate hikes might “work” to cure inflation simply because they are regressive fiscal policy: basic income for people with net savings, tax hikes for people who are net borrowers (Claudia, you did a phenomenal job pointing out in a post I think last year how rich people get hosed by low rates and inflation, whereas poor people benefit from low rates and modest inflation). I’ve spoken w management teams who are shocked the Fed has raised this aggressively. How can four straight rate hikes be consistent with “stable prices?!”
You have some good company here in the form of Warren Mosler.
Please acknowledge inflation shock was the sanctions. Not the Putin did it lame refrain. Russia had a legimate security concern from US arming, training UA since Victoria Nuland's coup 2014. US intent has been to destabilize Russia using Ukraine.
fully disagree.
Due to COVID and Ukraine? Right. Due to the stupid reactions we chose to have to both events is more like it. Which made it far worse in both cases.
A disease with tiny, tiny IFR doesn’t cause this dislocation without lockdowns & mandates. And the war in Ukraine was a predictable outcome of US/UK foreign policy in the region for the past few decades.
fully disagree.
I disagree with your foreign policy and less with the COVID response, but neither is relevant to the discussion of monetary policy. A shock is a shock.
That's incorrect. A shock is not a shock.
As climate change accelerates, I expect supply disruptions to also accelerate. So this is a prescient speech.
Lots of discussion on goods vs services demand. But where does residential real estate demand/inflation fit in?
Of course, she could have covered more ground. Clearly supply disruptions due to Covid hindered the supply of new homes. Good point.
At a first pass monetary policy would appear rather simple. Create money until you see inflation, then stop. If you follow that, you will have nearly full employment with low inflation since serious unemployment would have to lower prices, which would cause you to print more money.
The pandemic is unusual because it was a demand shock. Literally people all decided not to spend money and at the same time supply closed down. Closing down supply didn't cause inflation because nothing was being spent.
This creates a problem, when you turn everything back on, how do you do it? Let's say previous demand/supply was 100. Now it has been 50 for a few months. If you assume demand will return by increments of 10, you will plan:
Month 1: 60
Month 2: 70
Month 3: 80
Month 4: 90
Month 5: 100
But suppose demand returns by 15 in month 1, so demand is now 65 rather than 60? Well in the very short term you can't do much of anything. You'll tap inventories, maybe have shortages, there might be complaints about fast food places not being able to find anyone to work, etc. So there will be some price increases and that will be good because the price increases signal that demand is coming back faster and action should be taken.
But is demand surging over the long run supply curve? No it isn't. Some things have changed, for example more people working from home long term and I still today see more people using drive thrus at fast food than sitting inside. The supply curve may have shrunk a bit because of these changes, and then the war acts as a traditional supply shock.
The model for this, I think, is actually after WWII. The US experienced a rather brief but serious surge of inflation back in 1948. On one hand you had a lot of supply getting freedup. Rations were being relaxed, factories were allowed to switch back to consumer goods, there was a lot of war surplus goods you could buy cheap if you wanted*, and many GI's were back in the workforce looking for work. You also had demand racing back and also demand for new things. Houses in the suburbs, cars, etc. Inflation was, though, transitory and necessary.
* A story I remember reading in the Pacific, GI's were told they could have a jeep if they wanted. Just had to pay a small fee to ship it back to the states. Few GI's wanted one so thousands of perfectly good jeeps were simply pushed off ships into the ocean.
I agree it's very complicated. That's why it is important that Brainard elevated these challenges.
Brainard raises two issues that I do not think she very well distinguish: a) Has the baseline level of shocks in relation to the baseline relative price flexibility when some prices scarcely can fall. Can we expect larger “extraordinary” shocks like COVOD and Putin’s war. [COVID was two different kinds of shock, supply and relative shifts on the recovery.]
The first suggests a higher average target, greater than 2%.
The second suggests more upward flexibility around that target. But it also raises the stakes on being able to identify in any given case how much above target inflation and for how long the Fed should try to engineer.
The explanation that ARA was not (indeed could not be in a regime of Fed targeting) a source of inflation was excellent!!!
I did not get the difference between the “old thinking” and the “new.” The need to allow prices to rise NO MORE THAN enough to respond to an extraordinary large negative supply shock seems implicit in FAIT. It of course means that at some point after the shock the Fed will need to bring the “temporary” inflation back to target.
I agree that the Fed appears to be over-reacting (“not muted”) to its earlier failure to start tightening sooner. I wish Brainard had made reference to TIPS, which it looks to me sent and is now sending the correct signal about inflation management. What TIPS makes very clear is that the risks of de-anchoring are very low. “Listen to the people?” “Vox TIPSi, vox populi.”
She's starting a conversation and not ending it. I disagreed with some of her points. The failings of the old thinking is a sole reliance on monetary policy to contain inflation, an obsession with inflation expectations, and reliance on other unmeasurables like potential output. That's my argument, not hers.
I'm with you on 1.5 of the three. :) *
Reliance on "potential out put"? Agree. Don't do it. 1.0
Expectations. Important but look at the data like TIPS, not exclusively at ones worry beads. 0.5
Monetary policy to control inflation? What else? Of course there are a gazillion supply side things to do -- Jones Act, more high skilled immigrants, port modernization, lower structural deficits, trade liberalization, etc., etc. -- but they only work in the longer run. 0.0
* I really DO know I am an outside amateur even if my attitude doesn't show it. :)
See my post on other options: https://stayathomemacro.substack.com/p/dont-make-the-fed-go-it-alone-on Congress and the White House have a role to play. Also this on gasoline prices: https://stayathomemacro.substack.com/p/congress-and-the-white-house-must note, they did many of these and more.
I understand this as probably good advice taking account of political realities. And I guess I would not rule out in principle a microeconomic intervention -- shock absorber -- that would prevent a cascade of relative price adjustments that would require more above target inflation to accommodate.
I am a "let the Fed go it alone"-er but in the sense that it really does not help for Congress and the Administration to try to manage macroeconomic aggregates. I think fiscal policy should stick to growth and redistribution and let -- and demand that -- the Fed manage the outcome of those decisions
But my "a shock is a shook" comment was directed at labeling the gasoline price rise as a result of the "sanctions," not "Putin's war."