During the 2010s, I was frequently annoyed by claims that the Fed was “artificially” holding interest rates below their equilibrium level. If interest rates actually were being held below equilibrium for over a decade, then inflation would have quickly risen to a very high level.
In response, some people claimed that through some sort of inexplicable process the inflation that would normally result from easy money was showing up in asset price inflation. And yet I know of no mechanism by which easy money could inflate asset prices without inflating the prices of goods and services. This was a classic example of ad hoc theorizing—a conclusion in search of a model.
Given enough time, however, almost any macroeconomic claim will come true. Today, Fed policy is indeed holding interest rates below equilibrium. I don’t base that claim on the current high rate of inflation (which in principle might be due to supply shocks), rather the evidence for excessively expansionary monetary policy comes from the recent surge in nominal GDP, which most certainly is not caused by supply shocks.
Nominal GDP growth is already well above the pre-Covid trend line, and the consensus forecast of economists is that NGDP will continue growing at over 6% over the next 12 months. That sort of growth in nominal spending is not even close to being consistent with the Fed’s goal of 2% inflation. In that sort of macroeconomic environment, it is difficult to understand how the Fed can justify its zero interest rate policy.
Just as in late 2008, I’m at a loss to understand what the Fed is doing.
BTW, David Beckworth directed me to this tweet:
I find it dispiriting that after everything we’ve experienced since 2008, the Fed still doesn’t understand that they need to focus on NGDP. Of course there’s “one damn thing after another”, just as there was one damn thing after another in the 1970s, when NGDP was growing at 11%/year. With spending growth that rapid, excessive inflation is inevitable. If it’s not oil and cars, it will be rent and restaurant meals, or health care and food. Inflation will always show up when NGDP growth is excessive, it’s just a question of where. Why doesn’t the Fed see that? Are they not paying attention to NGDP?
READER COMMENTS
MarkLouis
Mar 15 2022 at 3:34pm
They either aren’t very good economists or influenced by some large force we’ve yet to adequately identify. My hunch is they are terrified of an asset price collapse on their watch…even if that would just bring valuations back to historical norms. They’d rather impose a regressive inflation tax on the entire country than be the subject of mean looks from the millionaire class.
Matthias
Mar 16 2022 at 11:06pm
What makes you think moderately high inflation (say 5% a year) is a regressive tax?
As far as I can tell, anticipated inflation is mostly a stealthy increase in the capital gains tax. And capital gains tax is mostly paid by people who have capital.
(You can argue that the tax incidence of capital gains tax is not on the people who pay it, but the rest of the economy. Not sure if that’s true, but in any case, it would be a whole separate argument.)
MarkLouis
Mar 17 2022 at 9:00am
Why inflation is regressive:
The 35% of people who don’t own a home have almost certainly fallen far behind and occupy the lower portions of the wealth distribution.
Lower income/wealth cohorts consume 100%+ of their income, which means inflation affects their entire income. If someone spends half their income the burden is not nearly as large (yes, future consumption is hurt but I’d argue that’s far less anxiety-producing).
When inflation is accompanied by low real rates (as ours is), assets disproportionately benefit. And we know asset ownership is HIGHLY skewed to the top of the income/wealth distribution.
raja_r
Mar 15 2022 at 3:48pm
“which in principle might be due to supply shocks”
My econ knowledge is mostly from browsing this site, but wouldn’t supply shocks just affect relative prices? Isn’t inflation “…always and everywhere a monetary phenomenon”?
Scott Sumner
Mar 15 2022 at 6:44pm
No, supply shocks can raise the overall price level by depressing real gdp.
Recall: MV = PY
Don Geddis
Mar 15 2022 at 8:53pm
So what if Y shrinks? Aren’t you implicitly assuming a (mostly) stable money supply? Haven’t you taught us in all these years of your blog that the question that must be raised is “what is the monetary policy reaction function?”
The “always and everywhere” quote comes because M is completely arbitrary, a simple choice of the central bank, and it is the central bank’s job to choose a value for M that is appropriate to whatever are the current conditions in the economy.
I’m of course struggling to “explain” this to you — given that you have taught me pretty much everything I know about macroeconomics and monetary policy. LOL
Scott Sumner
Mar 16 2022 at 12:08pm
You get the same answer holding M constant, holding NGDP constant, or assuming the Fed has a dual mandate.
Yes, if you hold P constant then P doesn’t change. 🙂
Lizard Man
Mar 15 2022 at 6:06pm
6% nominal growth in 2022 would be a lot lower than nominal growth in 2021. That would seem to indicate that the Fed has already begun tightening, and this tightening has been effective. Maybe a pandemic is just a bad time to announce and stick to a new monetary policy regime.
Scott Sumner
Mar 15 2022 at 6:46pm
No, 4% (at most) would be a neutral policy, which means 6% is still highly expansionary. The problems cannot be blamed on the pandemic; they overstimulated the economy.
Lizard Man
Mar 16 2022 at 9:24am
How do you determine what is neutral versus expansionary or contractionary? Output gaps and NAIRU?
Scott Sumner
Mar 16 2022 at 12:10pm
Whether you assume an average inflation target or a NGDP level target, policy is too expansionary. There are good arguments for either assumption, but the implications are the same.
Roger Sparks
Mar 15 2022 at 7:01pm
Some (disputed) economic principles:
New money is created when banks lend.
Higher interest rates discourage new lending.
Money is destroyed when bank loans are repaid.
Inflation is caused by increasing supplies of money.
Money can be reused.
Only the first user spends newly created money.
Newly created money is rapidly spent.
Now, it seems to me that we would not see a general inflation if we carefully only reused the money we already had. Money supply, as measured by bank deposit accounts, should be a very steady number. The covid shock should have been a supply shock concentrated in identifiable clusters, accompanied by a buying shock concentrated in identifiable clusters.
Our economy is not ONLY reusing money; it is highly dependent upon a continuous stream of newly created money. The rate of new money delivery was amplified during the pandemic far beyond the rate of delivery for most of the past 70 years or so.
Using the principles listed, we can break NGDP into two parts: NGDP funded by reused money and NGDP funded by new money. Changes in NGDP (reused money) would also result from changes in the velocity of spending, which would respond to factors such as tax changes, advertising, and weather events.
It seems to me that the rate of new money creation is the root of the high inflation we see today. Rapid NGDP growth is to be expected.
The problem I see is how supply chains, especially those with long time requirements (such as agriculture) can adjust to some sort of a steady-state condition with predictable demand and prices.
Everett
Mar 20 2022 at 1:22pm
As indicated by MarkLouis above the lower income people are another source of rapidly spent money. Whereas the higher income people typically redirect their income into lower velocity “investments” which are also money sinks not counted by the CPI (general inflation).
So could the dramatic ramp up in “investments” in the past 6 years or so (stock market and cryptocurrencies) be a velocity sink that effectively made it looks like rates weren’t artificially low?
Roger Sparks
Mar 15 2022 at 7:06pm
Sorry, the number list of principles and the proper paragraph spacing did not survive uploading.
Michael Rulle
Mar 16 2022 at 9:44am
I have given up on formatting too. It never survives uploading. I thought maybe it was designed to keep responses shorter—which for me would be a good thing!
Jacob
Mar 15 2022 at 7:45pm
“Are they not paying attention to NGDP?”
Correct, they are not (sadly).
Hugh D'Andrade
Mar 15 2022 at 10:03pm
Your book “The Money Illusion” explains the mistakes made by the Federal Reserve which were the major cause of the Great Depression, the Great Inflation, and the Great Recession. Your recent writing point to major mistakes made by the Federal Reserve which have been a major cause of the current inflation. During all this time the Fed been run and staffed by exceptionally intelligent and well-intentioned people. The Fed has unparalleled amounts of relevant data. So why do these people continue to make serious mistakes? If you say because they have the wrong model, I ask why do they consistently use the wrong model? What am I missing?
Scott Sumner
Mar 16 2022 at 12:11pm
Monetary policy is hard. In fairness, their mistakes tend to get smaller with each iteration.
Mark Bahner
Mar 16 2022 at 7:02pm
The Beatles hoped so.
Chris Gardner
Mar 16 2022 at 6:08am
The Fed increased the money supply by 45% in 2 years. It’s right there on FRED site. Then that fire hose of money was shoved into stimulus checks and PPP money, much of it to people who didn’t need it. How on earth is anyone mystified or surprised with rampant inflation?
For months Powell said it was transitory. Then said they’re retiring that word.
Quit blaming supply chain, oil companies, meat Packers, other corporations, or “Putin’s price hike.”.
Thomas Lee Hutcheson
Mar 16 2022 at 8:09am
Any guesses about why the Treasury has not created more intermediate term TIPS? I’d think a 1,2,3, and 7 year TIPS would be useful.
Scott Sumner
Mar 16 2022 at 12:11pm
I believe these exist in the secondary bond market.
Daniel
Mar 16 2022 at 11:07am
A positive NGDP gap wasn’t really noticeable until Q3 2021, which we didn’t know until November. The Fed announced a faster taper in December. The NGDP gap for Q4 2021 was clear, which we didn’t know until February. The Fed will announce a rate hike today. They’re behind the curve, but I’m thinking they’re paying attention.
Scott Sumner
Mar 16 2022 at 12:13pm
They continued QE right up until this month.
But the biggest mistake was their abandoning AIT, which caused them to lose credibility. That cannot be excused with “policy lags”.
Mark Louis
Mar 16 2022 at 2:47pm
Abandoning a new mandate so quickly is a real challenge for the economics profession. It’s no longer enough to have an opinion on what the Fed should target. You also need an opinion on under what conditions the Fed will actually maintain their stated strategy.
Joe
Mar 16 2022 at 11:10am
> I was frequently annoyed by claims that the Fed was “artificially” holding interest rates below their equilibrium level
Are you claiming that interest rates would have been exactly the same if the Fed did nothing? Because that’s what “artificial” means to me.
Can someone point me to an article where Scott clearly defines “artificial” and defends his position?
Capt. J Parker
Mar 16 2022 at 11:54am
One reason might be that there is no shortage of material in the press that says inflation has to do with a whole bunch of things other than growth other than monetary factors. Here’s the latest example I’m trying to get my head around:
https://www.wsj.com/articles/inflation-high-forecast-economist-goodhart-cpi-11646837755?st=of10d5ti86p784m&reflink=desktopwebshare_permalink
The thesis of Goodhart and Pradhan seems to be that inflation is profoundly affected by real supply. Since 1980 massive growth in the global working age population and cheap manufactured goods form China made it easy to control inflation. Hence the low interest rates and easily hit 2% inflation target in the years prior to 2008.
Now that that the boom in cheap labor and cheap imports form China has peaked inflation will be “harder to control” according to Goodhart and Pradhan. Massive debt accumulation adds to the difficulty. Is this why the Fed seems so cautious about raising rates?
Here is a condensed version of Goodhart and Pradhan’s arguments:
https://www.suerf.org/docx/f_fa99ccdbea597263a88f27075bd6eb49_17385_suerf.pdf
Whenever I feel like disagreeing with Uncle Milton I lie down until the feeling goes away. So, this is really surprising stuff to me especially given that Goodhart is reputed to be a monetary economist. I think what is being said here is that yes, you can tighten the money supply to control inflation but, doing that in today’s global economy and not causing a Volker recession is a lot harder than it used to be but, Goodhart and Pradhan never explicitly say that. It’s always just “oh boy, inflation is going to be harder to control.”
Rodrigo Escalante
Mar 16 2022 at 3:46pm
Did JPOW stick the landing?
Michael Sandifer
Mar 16 2022 at 6:01pm
The implicit mean NGDP growth path in the S&P 500 index indicates a rate of roughly 4.5%, coming into this week. This is slightly above the Fed’s max forecast for NGDP growth out through 2024. So, the Fed is likely somewhat looser than it realizes.
But, is this a cause for concern? While even small differences in inflation rates can have significant real consequences, I still don’t see a cause for concern.
Michael Sandifer
Mar 16 2022 at 6:07pm
In other words, while the Fed has a poor history when it comes to soft landings, I do not assume history will repeat itself, though it’s obviously a danger. I see no reason to further limit inflation right now, but if the Fed wants to do so, it should be easy to do so without causing a recession.
vince
Mar 16 2022 at 8:11pm
Scott Sumner wrote:
Are you suggesting that easy money doesn’t help asset prices?
Scott Sumner
Mar 17 2022 at 2:06pm
I didn’t comment on that issue at all. I’ve discussed that in other posts. It’s complicated.
vince
Mar 17 2022 at 8:57pm
I should have said asset price inflation, not “help asset prices.” I’m sure there are many scenarios in which easy money leads to asset price inflation.
Let’s say the economy is at full employment but Fed doesn’t know it. It buys Tbills. The Tbill sellers invest in stocks. The stock sellers buy other stocks in a spiral that sends up stock prices. None of the money supply increase was spent on goods and services.
The Fed sees that unemployment didn’t go down. It repeats.
Knut P. Heen
Mar 18 2022 at 11:00am
I argued along the same lines the last time this was discussed. Cantillon effects which changes the relative prices between assets and consumption goods for a while until the new equilibrium has been reached. The new money reach the asset markets first, circulates among investors for a while before it eventually trickles down to the consumers causing a lag between inflation in asset prices and consumer goods prices.
From January 1st 2020 to December 31st 2021, the S&P500 increased by close to 50 percent. It is difficult to believe that the fundamentals or the expectations about the future improved that much during the pandemic. One possible explanation is simply that the value of money fell during the pandemic and that other prices are more sticky than asset prices. If that is correct, we should expect the sticky prices to start increasing soon too.
Scott Sumner
Mar 18 2022 at 2:30pm
In some cases, easy money reduces asset prices, as during the Great Inflation of 1966-81, when high inflation hurt stocks and bonds.
As for Cantillon effects, it’s not so much how the money is injected, it’s the fact that financial asset prices are more flexible than goods and services prices. Even if the new money were given directly to consumers, say via social security payments, financial asset prices would respond more quickly than goods prices.
vince
Mar 18 2022 at 3:01pm
Offsetting inflationary easy money in the 70s was fear and uncertainty, for example that a 1981 monetary policy might become necessary.
Knut P. Heen
Mar 21 2022 at 7:21am
I am pretty sure that the price of heroin would increase much more than stock prices if we gave money to heroin addicts only.
There is a problem with measuring consumer goods prices. The shelf price is the ask price, not the market price. If people switch to buying goods with a higher shelf price, the market price has changed while the shelf price stay constant. This can happen in many ways. Buying a lot of soap when the soap sells at a discount vs. buying less soap at the discount and more at the normal price. Buying the same soap at a discount store vs. a normal store. Certainly, the prices of gasoline and electricity fluctuates a lot.
The poor stock market performance during the 1970s was due to other reasons, high oil prices for example. Inflation redistributes income from fixed-price suppliers like bondholders and labor to stockholders provided the corporation adjust their prices to inflation.
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