If we believe what its chairman is saying, the Fed does not seem to know what inflation is. The Wall Street Journal of Friday wrote (Nick Timiraos, “Powell Says Supply-Side Constraints Have Worsened, Creating More Inflation Risk,” October 22, 2021):
“Supply-side constraints have gotten worse,” Mr. Powell said Friday at a virtual conference. “The risks are clearly now to longer and more-persistent bottlenecks, and thus to higher inflation.”
The economic definition of inflation is a sustained or persistent (not transitory) increase in the general price level as the Journal hinted to just before the quote above, but it is not clear if it was paraphrasing Mr. Powell. What is pretty sure is that inflation cannot be caused by mere “supply-side constraints,” except if those increase over time. Suppose that production (GDP) decreases by 5% in one year, that it stays at this new level, and that the Fed keeps the money supply constant (and that people do not demand more money in preference to other assets). We would then expect an increase of 5% in the general price level, but this would be only a one-year affair: the higher prices would stay at their new level and would not continue to increase by 5% every following year. For this increase in the general price level to be sustained, production would have to continue to decrease by 5% every year. Or the Fed would have to continue increasing the money supply by the same proportion every year.
From February 2020 through August 2021, while production dipped and recovered, the money supply (measured by M2) increased by 34% (see chart). This is equivalent to an annual growth rate of 21.8% and no end is in sight. No wonder why so many economists expect the annual rate of inflation to continue to increase—until the Fed stops boosting the money supply. Note that “long and variable lags” are involved, as Milton Friedman is reported to have said.
Blaming inflation on “supply-side constraints” looks like a cover-up by the Fed, which previously tried to make us believe that its money creation in response to federal deficit financing could not cause inflation, contrary to what economic theory predicts and history frequently confirmed. A Wall Street Journal op-ed by Steve Hanke of John Hopkins University and The Monetary Bathtub Is Overflowing,” October 21, 2021
We are not in Germany after WWI, Zimbabwe, or Venezuela, but it would be prudent to recall that some roads lead there which are paved with good intentions.
According to the WSJ,
Mr. Powell said it would be important for the central bank to stay flexible in the months ahead. The central bank will “need to make sure that our policy is positioned for a range of possible outcomes.”
This reminds me of what I heard from a politician in the 1970s—if my memory serves, it was California governor Jerry Brown: “What we need are flexible policies for an ever-changing world.” Useless at best, dirigiste at worst!
READER COMMENTS
Thomas Lee Hutcheson
Oct 25 2021 at 8:33am
This is probably WAY overthinking a remark.
Clearly no one that talks about “inflation” means persistent in perpetuity. I take Powel to be saying something like that he expects (given where the values of monetary policy instruments are set and maybe will be set) he expects measured inflation to be greater than the target for average inflation of 2% of the PCE for several more months and then come back down. Of course, the model he is implicitly using to make that prediction may be wrong. And you may not agree with how the Fed has set and will set the values of its policy instruments. (I’m getting a little more worried that market expectations for 5 and 10-year inflation have risen well above 2% PCE recently and I think the Fed should already be dialing back its bond buying.) But it’s a perfectly reasonable statement.
“What we need are flexible policies for an ever-changing world.” What other kind of policies could one have?
Jon Murphy
Oct 25 2021 at 10:57am
Policies that allow for a wide range of behaviors and encourage problem-solving.
An example: Thou Shalt Not Kill. Not particularly flexible. But allows for a wide range of different behaviors that can adapt to changing situations.
Pierre Lemieux
Oct 25 2021 at 11:26am
Jon: You are right that this is an important idea, much emphasized by Hayek but ignored by many economists. If I may quote my review of his The Road to Serfdom (1944) in the current issue of Regulation:
Thomas Lee Hutcheson
Oct 25 2021 at 7:12pm
I don’t think there has been much change in the murder environment, so not much need for keeping the rules up to date. [Although many people would say that regulations around abortion service providers are an exception.]
But to be clear, I was talking about things like monetary policy instruments and suppose that Brown was thinking about that kind too.
Jon Murphy
Oct 26 2021 at 9:57am
I know you were. So was I. The value of general rules is because they are fairly inflexible (like all rules are), but sufficiently general that they allow a broad range of behavior. “Thou shalt not kill” is merely an example of such a rule.
alvincente
Oct 26 2021 at 1:18pm
Picking a nit, Jon: “Thou Shall Not Kill” is not actually in the bible, it is not one of the ten commandments, although it is indeed a common mistranslation. Plainly in a part of the Pentateuch that is full of rules requiring killing, there would not be a rule prohibiting it. The actual Hebrew word translates to “murder” rather than “kill.” And contrary to your claim about rules being inflexible, what is murder is open to interpretation like other rules – rules are flexible because there are almost always different ways to interpret them.
Jens
Oct 27 2021 at 3:25pm
Do you consider “Love your neighbor as yourself” a good rule under your stated conditions ? I think it is fairly inflexible and covers a broad range of behavior. But – since it is not formulated negatively – it also does not allow the norm addressee so much to adjust his behavior to comply with the wording, but to avoid the meaning. The prohibition to kill, for example, “allows” – ceteris paribus – any form of physical (and even more so mental) abuse that does not lead to death. This is somewhat different with the commandment to love.
Pierre Lemieux
Oct 25 2021 at 11:04am
Thomas: I did not say it was persistent “in perpetuity.” I tried to capture the idea that, in any useful and standard definition of inflation, there is a time component, an idea of on-going, self-sustaining phenomenon. The general level in price rises by X% a year or, in the worst case, the rate of inflation increases. Some definitions use more euphemistic terms such as “upward movement” to say the same. Most Fed economists would know that (even if their management wants to ignore it); I think it is implicit in standard economic definitions. Just three examples:
“More precisely, inflation is defined as ongoing increases in the overall price level.” (Cleveland Fed, Inflation 101, https://www.clevelandfed.org/our-research/center-for-inflation-research/inflation-101.aspx, their emphasis)
“Inflation is the increase in the prices of goods and services over time.” (Board of Governors of the Federal Reserve System, <a href="https://www.federalreserve.gov/faqs/economy_14419.htm"What is inflation and how does the Federal Reserve evaluate changes in the rate of inflation?)
“Inflation can be defined as the overall general upward price movement of goods and services in an economy.” (Bureau of Labor Statistics, <a href= https://www.bls.gov/bls/inflation.htm Overview of BLS Statistics on Inflation and Prices")
Thomas Lee Hutcheson
Oct 25 2021 at 7:24pm
I don’t think inflation can be “self sustaining.” Of course any change has a time dimension, but I read those definitions as pointing to most prices changing together instead of huge changes in relative prices over time.
That said, I’d prefer that Powell had just said that the inflation seen recently and which may persist for several more months should not lead people to doubt the Fed’s intention to maintain average inflation at 2% PCE.
Pierre Lemieux
Oct 26 2021 at 10:55am
Thomas: You are right that “self-sustaining” is misleading if it is not understood as “politically self-sustaining.” The underlying monetarist theory is that (ongoing) inflation cannot continue, or a one-time increase in the general price level cannot persist, if not accommodated by the central bank’s money creation. For the same reason, trade unions cannot create inflation. Once inflation expectations have set in, inflation is useless for the state, and only an increase in the rate of money creation and inflation can fill in the public coffers.
Jose Pablo
Oct 28 2021 at 9:04am
“What we need are flexible policies for an ever-changing world.”
That’s a terrible one. Particularly when there are the “original flexible policies” the one changing the world.
For example: policies that depress the interest rate and causes an increase in asset prices …
… that increase inequality (which as everybody knows is “the most terrible thing on Earth”) so “flexible policies” are required to increase redistribution and control prices …
… but price control and taxes depress investment and growth so new “flexible policies” are required to spur growth for example by investing in infrastructure …
… but infrastructure investments increase deficit that need to be financed thru new taxes or/and new debt so, “flexible policies” are required to …
And so, on
Sounds familiar?
Craig
Oct 25 2021 at 2:35pm
Inflation is, always and everywhere, a monetary phenomenon — Friedman. Powell knows this. Here’s the problem, he really doesn’t have a choice, he can’t come out and say, “Uh, listen folks, we’re gonna be running inflation over 5%” No, he can’t do that because then the bond market would roll over and the stock market would crash. So, he has to lie, he has to say that the Fed will defend the dollar and that the Fed won’t tolerate inflation over 2%….well, at least such that some average of inflation is 2%. But that is looking a little shaky right about now. Indeed the Fed is simply jawboning the market. JP is simply a negative real yield bond salesman. What he’s doing is criminal if you ask me, but nobody asks me, right?
With the recent debt ceiling debate, they again toyed with the idea of the trillion dollar platinum coin. Yellen dismissed it as a gimmick, but how is QE itself not a gimmick, how exactly?
I even ask myself who would buy 10 years at 1.6-1.7% and 30 years at 2.11% at all? If you guaranteed inflation were 0% I wouldn’t buy that. Still somehow I seem to underestimate the amount of faith that exists in the US and the US dollar. Why? I don’t know, but it still somehow exists.
At the end of the day, one can’t ignore the money creation. Still there do seem to be supply chain issues as well. There doesn’t seem to be much question that international governments have engaged in policies which will result in reduction of supply, generally, particularly as global logistics built for ‘just in time inventory’ meet a world where dozens of cargo ships sit off the coast of Long Beach.
It is now said that the Fed will announce the taper in the early part of November. We’ll see if that is true, but if the taper is announced, let’s remember that the Fed will still be maintaining an extremely dovish stance. Indeed, the Fed will simply be creating less money than it had been until the taper ends at which point interest rates will still be ‘pre-liftoff’ at 0%
It should be noted that the Fed is currently buying $80bn worth of treasuries per month which I believe is approximately 57% of all issuance. So as the Fed tapers the government is going to need to find somebody to buy all those bonds as they float the idea of trillions more in spending.
Craig
Oct 25 2021 at 2:41pm
“We are not in Germany after WWI, Zimbabwe, or Venezuela, but it would be prudent to recall that some roads lead there which are paved with good intentions.”
Indeed, they’re playing with fire here. From my point of view, I’m retired, the US is simply not a place where I would even consider starting another business. Too much leftism and the money isn’t sound enough.
“From February 2020 through August 2021, while production dipped and recovered, the money supply (measured by M2) increased by 34% (see chart).”
Note your subsequent reference to Hanke and I’ve read a lot about Hanke’s thoughts on inflation. He feels that inflation of 6-9% is ‘baked in the cake’ based on the current rate of growth, not in M2, but in the measures of Divisia M3/M4, measures of the broad money supply made at the Center for Financial Responsibility.
Time will tell the tale of course but right now the inflation rate > yield on the 10 year bond and that isn’t going to last forever.
Joanna
Oct 25 2021 at 7:21pm
Good stats…as to remark I thought the same. Argentina here we come all to make the consumer short term happy and Congress multi-rich. This is not a prudent course of affairs.
rsm
Oct 25 2021 at 9:49pm
《the price level and rate of inflation are literally indeterminate. They are whatever people think they will be. They are determined by expectations, but expectations follow no rational rules. If people believe that certain changes in the money stock will cause changes in the rate of inflation, that may well happen, because their expectations will be built into their long term contracts.》
Fischer Black, “Noise”
Why can’t the Fed sell inflation swaps to manipulate market breakevens? Why shouldn’t the Fed pay inflation as interest on individual CBDC accounts, to directly encourage individual savings in inflationary times?
Pierre Lemieux
Oct 26 2021 at 11:45am
rsm: Interesting comment! Although mob movements happen, expectations cannot remain irrational. Expectations of different individuals have to be consistent. Some expectations will push against others and rational ones must ultimately prevail.
As for your last question, here are three hypotheses. (1) The Fed does not do this because its expectations are irrational. (2) The Fed does not do this because it is not in the interest of politicians and bureaucrats (“Leviathan”). (3) People save in order to spend later, so money created now and spent to bribe people to save is likely to create inflation in the future; inflationary expectations are thus generated.
rsm
Oct 26 2021 at 8:27pm
《Expectations of different individuals have to be consistent.》
Argument from authority?
《 (3) People save in order to spend later, so money created now and spent to bribe people to save is likely to create inflation in the future; inflationary expectations are thus generated.》
So what? If I know that rent next month will remain the same portion of my income as this month, what do nominal prices even matter?
In this 1978 paper by Fisher and Modigliani https://www.nber.org/papers/w0303 , are they hard-pressed to find that full indexation results in anything more serious than menu costs (which can be automated away)?
Michael Sandifer
Oct 26 2021 at 12:08am
Should you trust your intuition over forward-looking indicators, such as the 5 year inflation breakeven?
https://fred.stlouisfed.org/graph/?g=Idjq
That indicator shows longer-run inflation expectations spiking this month, but the expected level is still not that high. Have to subtract 30 or 40 basis points or so to translate into expected PCE inflation.
Craig
Oct 26 2021 at 9:02am
Well so much for inflation expectations being ‘anchored at 2%’ as JP might be wont to say, no? But I digress. Inflation expectations are important, but whether they are 2% or 2.95% or 4% as you indicate: “but the expected level is still not that high”
BUT all of those numbers are above the current yields for 5 year, 10 year, etc. Part of the reason for that is that the Fed itself is intervening in those markets and buying those assets making bond prices higher than they otherwise would be.
I think another thing people are overlooking is that if the Fed decides to tighten that its first step, tapering, isn’t really a tightening, its just slightly less dovish. Its still a relatively large amount of money creation until it completes the tapering timeline at which point the rates will still be at 0%.
Craig
Oct 27 2021 at 9:19am
If supply chain disruptions are truly the elephant in the room then shouldn’t the trade numbers be decreasing. Right now in the news there are obviously reports of dozens of container vessels sitting off the coast of Long Beach.
Ok, fair enough, I’m not saying that isn’t happening, but the trade numbers show:
Deficit:
$73.3 Billion
+4.2%°
Exports:
$213.7 Billion
+0.5%°
Imports:
$287.0 Billion
+1.4%°
So the US is both exporting and importing more in September.
Capt. J Parker
Oct 28 2021 at 12:58pm
Greenwood and Hanke might be right but their article in the Journal left a lot to be desired. The path of M2 by itself isn’t very informative. Even looking at M2/GDP doesn’t tell you too much. From 2008 till now, M2 as a percent of GDP increased by over 30% with no inflation. During the “great inflation” of the 70s and early 80s M2 as a percent of GDP didn’t really change that much. In fact, M2 proved so unhelpful to the task of keeping prices stable that the Fed under Greenspan stopped worrying about M2 altogether and started targeting the inflation rate instead.
https://fred.stlouisfed.org/graph/?g=Ijt8
The recent massive increase in M2 by itself looks bad but, so did the massive increase in M1 in 2008-2009. The Fed knew better than the inflation hawks then. The Fed may still know better now.
Craig
Nov 1 2021 at 3:47pm
Well I think somebody like Hanke might point to the Center for Financial Responsibility’s measure of M3/M4 the Divisia measure of the broad money supply. Indeed post 2008 money creation by the Fed led to little inflation, but if looking at M3/M4 those measures actually went negative.
Comments are closed.