The FT recently ran an article by Philipp Hildebrand entitled, “The old inflation playbook no longer applies”, which warned against the Fed adopting an excessively hawkish policy:
The Covid-19 shock and subsequent economic restart brought on supply constraints of a magnitude greater than for decades. Inflation has risen to levels not seen since 1982. Yet, far from running hot overall, the economy has not even reached its estimated potential level of output and employment.
We therefore find ourselves in a fundamentally different situation from the one Paul Volcker faced when he became chair of the US Federal Reserve in 1979. Then, the economy was running hot and the aim was to drive inflation that had become embedded out of the system.
I still have vivid memories of the 1970s. At the time, we were told that the problem was “supply shocks”. We were told that the economy was running below potential and hence the problem could not be excess demand. (It clearly was excess demand.) Economists aren’t very good at estimating the economy’s potential, and it is a big mistake to have the Fed target real variables such as an output gap.
Contrary to Hildebrand’s claim, the economy is probably now operating above potential, given the drop in potential caused by Covid. Many economists miss this fact because they rely on the assumption that potential should rise by a couple percentage points each year. By that criterion, we are slightly below potential. But Covid has clearly reduced potential output. If Covid goes away or even becomes a minor issue, then potential might quickly rise back up to the trend line. Or it might not.
In fact, the old inflation playbook still does apply. Here’s my playbook:
1. If inflation rises sharply at a time of modest NGDP growth (as in 2008), then a more hawkish policy is not needed.
2. If inflation rises sharply at a time when NGDP growth is excessive (as in 2022), then a more hawkish policy is needed.
Some people were hawkish in the 2010s and are hawkish in 2022. Some people were dovish in the 2010s and are dovish today. Wise owls were dovish in the 2010s and are hawkish today.
Don’t be a permahawk or a permadove.
Note that there is also much I agree with in Hildebrand’s article:
Needless to say, central banks should take their foot off the gas this year by removing the extremely accommodating stance of monetary policy and return rates to a more neutral setting. The resumption of activity — unlike a normal recovery — doesn’t require stimulus to be maintained. But what they should not do at this juncture is slam on the policy brakes, deliberately to destroy activity.
So I differ not so much with his policy conclusions than how he gets there. I’d like to see 3% to 4% NGDP growth over the next few years to restore Fed credibility. I fear that nominal growth will be considerably higher. Still, there are much worse problems, and we had them in the 2010s, in the 1970s, in the 1930s, and in the 1890s. Be thankful for that.
HT: Julius Probst
READER COMMENTS
Oscar Cunningham
Jan 29 2022 at 3:11pm
Basic question: what does it mean for the economy to operate above potential? Isn’t that a contradiction in terms?
Scott Sumner
Jan 29 2022 at 4:31pm
“Potential” is a hard to define concept, but it is related to a situation where nominal wages and prices are in equilibrium, at least in aggregate. At that point, a sudden rise in AD can cause the economy to operate above potential (defined that way), although obviously it’s not above potential in the sense of everyday language.
In the late 1960s, for instance, the economy was clearly above potential.
Dylan
Jan 29 2022 at 6:25pm
I’d also like some clarification on this. The whole issue as taught in my high school history was that the late 70s were a time of “stagflation” that the economy was running way below potential, yet we still had excessive inflation. I suspect that, like much of what a person learns in high school, this isn’t quite accurate…but what parts are wrong? 2021 seems a lot better economy wise than in ’78 or ’79.
Scott Sumner
Jan 29 2022 at 9:13pm
From 1971 to 1981 RGDP rose by over 3%year. That’s normal. The problem was 11% NGDP growth, which is why inflation averaged 8%. The problem was almost 100% excessive aggregate demand.
That’s not to say there weren’t some supply problems, but they played a minor role in the high rate of inflation.
Dylan
Jan 30 2022 at 5:09am
I was thinking of the high unemployment and high inflation combo we had during the later 1970s. If there was such excessive aggregate demand, why was unemployment so stubbornly high? Was there a way to bring down inflation without causing even worse unemployment?
Scott Sumner
Jan 30 2022 at 1:02pm
The natural rate of unemployment was much higher in the late 1970s than today. Unemployment is not a good indicator of whether AD is at an appropriate level.
Thomas Lee Hutcheson
Jan 31 2022 at 6:31am
Sure, just as the Fed’s “price stability” needs to be interpreted as a non-zero inflation target, “full employment” need to be thought of as employment of all resources, not just labor.Is your view that the labor unemployment (a high “natural rate of unemployment”) of the ’70s was an institutional framework that prevented a decline in the real wage?
Scott Sumner
Feb 1 2022 at 1:14pm
It’s possible that it had some impact on the real wage, hard to say how much.
Dylan
Jan 30 2022 at 8:36am
This piece in the Economist from 2010 outlines what I think of as the fairly standard description of the 1970s stagflation and the “Volker recession of the early 80s” at least as I recall them from history classes and various economics classes I’ve taken. I’ve read you enough to know that there are parts of the standard story that you disagree with, but not enough to know why you’ve failed to sway the bulk of mainstream macro-economists to your view?
Scott Sumner
Jan 30 2022 at 1:06pm
I’m not sure that that article is the consensus view among well informed economists. Bernanke has stated that Fed policy caused the Great Inflation, and I suspect that many other top macroeconomists agree with him. He’s pretty mainstream.
Dylan
Jan 30 2022 at 1:31pm
Is that a more recent evolution of the thinking? Like I said, the Economist piece reflects my understanding of things as I was taught in school in the late 90s. Do you think this is no longer the way that the topic would be taught in high school and intro economics classes? I feel like you’d have a much better read on that given your position than I do from mine.
Scott Sumner
Feb 1 2022 at 1:17pm
I believe it’s a mixed picture. The better the macroeconomist, the more likely he or she will have an accurate view of the 1970s. Frederic Mishkin’s Money and Banking textbook was number one in the field when I was teaching, and it shares my basic view of inflation.
Andrew_FL
Jan 30 2022 at 9:26am
Being dovish for an entire decade at a time seems pretty permadove to me
Scott Sumner
Jan 30 2022 at 1:00pm
It was mostly the first part of the decade where a more dovish stance was obviously appropriate. Less so later in the decade.
Colin Haller
Jan 30 2022 at 2:06pm
I’m not entirely convinced that the “old playbook” has a coherent understanding of what causes the price level, and even less convinced that its “solution” does what it says on the tin.
Oh, you can cause a recession by raising interest rates, but as a “solution” that is reminiscent of “in order for the village to be saved it had to be destroyed” …
Scott Sumner
Feb 1 2022 at 1:18pm
That’s why high inflation policies are bad—they lead to recessions. So don’t do it.
Thomas Lee Hutcheson
Jan 31 2022 at 6:19am
But doesn’t the Fed need a model of how real variables respond to alternative monetary actions in order to chose which action to take? Is knowing how to maintain exactly whatever NGDP target one set enough? The “old inflation” playbook, trying to keep both inflation on target and the real economy at full capacity still applies. And the Fed is applying it pretty successfully, although it did misjudge the magnitude of the supply constraints last summer and was a tad late in anouncement of dialing back bond purchases.
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