No end in sight for the debate over inflation

The debate over the Biden’s administrations proposed stimulus I discussed a few weeks ago is still going. If you wanted to keep up to date, here are some useful links:

The debate still hinges around three technical questions:

  • How large is the output gap? This is the gap between what an economy can theoretically produce, and what it is producing today. Think of the gap as representing idle factories or unemployed workers. The larger the gap, the more stimulus can be applied before you hit ‘supply limits,’ and cause inflation.
  • How effective will the stimulus be? Stimulus does not automatically create the demand which fills the output gap. Instead of buying a new TV, people might save the money they receive, or use it to pay down debts. Those who are concerned expect most of the stimulus to be spent, those who are more sanguine, the opposite.
  • How will inflation behave if it arrives? Both camps agree there is likely to be some inflation, but they disagree over how it will evolve. Those in favour of the stimulus as it stands expect inflation to steadily increase, perhaps even to 2% or 3%. They see this as a good thing, given inflation has been below target for almost a decade. There is little risk of it getting out of control because the Fed can always raise rates in the last instance.

    Pessimists are concerned that if inflation starts growing, it could quickly get out of control. Instead of growing to 2% or 3% and stabilising, expectations might change, causing inflation to continue higher. If the Fed has to react by rapidly raising rates, it could have negative consequences for the financial sector and the wider economy.

This says nothing about the politics around the stimulus. Biden does not want to run the risk of delivering an underpowered stimulus as Obama did after the GFC.


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Macro economists argue over higher inflation (again)

Prominent macro economists are divided over whether the Biden administration’s proposed $1.9 trillion stimulus bill is likely to stoke inflation and curb future investment.

In a Washington Post op-ed on Friday, former United States Secretary of the Treasury, Larry Summers, argued that the $1.9 trillion stimulus bill risked overstimulating the economy and stoking inflation. Summers argued the program, mostly short-term spending to counter the effects of the COVID-19, could also consume political and economic space required for the long-term investments.

“The Biden plan is a vital step forward, but we must make sure that it is enacted in a way that neither threatens future inflation and financial stability nor our ability to build back better through public investment,”said Summers.

On Saturday, former IMF Chief Economist, Olivier Blanchard, backed Summers in several tweets.

Critics argue their fears are overblown. Counter-arguments fall broadly into three categories: firstly, inflation is less responsive to employment than it once was, secondly, it is difficult to estimate what constitutes excess stimulus, and, thirdly, that long-term investments could pay for themselves.

Inflation is less responsive to employment than it once was

Summers op-ed comes at a time when a vocal minority of economists are warning of higher inflation due to the combination of loose monetary policy, fiscal stimulus, and household’s pent-up savings.

In contrast, Nobel Prize winner Paul Krugman argues that stimulus is unlikely to cause unsustainable inflation. His argument hinges on the Phillips curve, the supposed inverse relationship between inflation and unemployment which has guided macroeconomic policy making since the 1960s. For decades, economists thought targeting low unemployment with stimulus would only accelerate inflation, as in-demand workers bargained for higher wages, and raised prices.

Krugman points to new research which suggests that the Philips curve is actually “flat,” and low unemployment is unlikely to significantly increase inflation. As long as the Federal Reserve keeps inflation expectations stable, there is little risk a “hot” economy will generate inflation by itself.

Markets show no sign of expecting higher inflation. According to David Beckworth, Senior Research Fellow at Mercatus, “Markets have skin in the game and have already priced in a large Biden relief package. And yet, no evidence of overheating as far as the eye can see.”

Others, like Slate’s Jordan Weissmann, argue that the structural conditions for inflation are weaker now than in the past. Global supply chains, alternatives to oil, weak unions, and independent central banks mean low unemployment is unlikely to translate into higher wages and prices quickly.

The difficulty in estimating the output gap

In a recession, government stimulus hopes to close the “output gap” between what economies can hypothetically produce – “potential output” – and reality. Theoretically, too much stimulus could exceed potential output and lead to inflation as companies scramble to meet outsized demand.

But for sceptics, measures of potential output are notoriously unreliable; it cannot be observed directly, only retrospectively. The Congressional Budget Office, which produces these estimates, has been wrong before. As a result, Summers’ critics treat his claim that the proposed stimulus will be excessive with caution. “Nobody actually knows what our potential output really is,” said Weissman.

Self-financing long-term investments

During Biden’s Presidential campaign, a $2 trillion dollar plan was announced to accelerate the transition to clean energy. For summers and others, the size of the COVID-19 package will exhaust the economic capital needed for those long-term investments.

Others have responded by arguing investments into climate, transport, and infrastructure pay for themselves. “Compared with other major infrastructure projects in U.S. history, and these projects will give back more than they cost,” said economist Noah Smith in a recent Bloomberg column

These debates take place in the shadow of the Obama administration. In 2009, concerns about debt led the administration to downsize its post-financial-crisis stimulus. For some, the slow recovery cost Obama control of the House in 2010.

The Biden administration wants to avoid a similar situation by going big straight out the gate. Summers’ role in rejecting proposals for a larger stimulus package in 2009 have made him a target for a new generation of progressive economists. Expect these debates to continue.


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The FOMC meets and, among other things, we discover Jerome Powell has been vaccinated

The FOMC met for the first time in 2021 yesterday. The committee has maintained its accommodating policy stance as the economic recovery slows in the US.

Chair Powell hanging on for dear life like the rest of us

As at the last meeting, the Fed expects to keep this in place for some time:

With regard to interest rates, we continue to expect it will be appropriate to maintain the current 0 to ¼ percent target range for the federal funds rate until labor market conditions have reached levels consistent with the Committee’s assessment of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.


The Q&A session with Chair Powell had a few interesting nuggets:

  • He addressed the ‘burst of inflation’ hypothesis (discussed by me here), arguing that any inflation this year is likely to transient and minor“we think its very unlikely that anything we see now results in troubling inflation.” And, even if it did appear, “we’re going to be patient. Expect us to wait and see, and not react.”
  • With the ongoing Gamestop frenzy (expect a write up soon…), there were lots of questions about markets, macro-prudential regulation, and ultra low-interest rates. He reminded everyone that with 9%-10% unemployment, the Fed will continue to prioritise jobs over hedge fund tears.
  • One of the striking parts of the Fed’s language in recent years has been the recurring emphasis on employment, jobs, and minorities. Inflation increasingly feels like a side-show. This conference was no different, Chair Powell discussed joblessness in almost emotive terms.

We’re not just going to look at the headline numbers. We’re going to look at different demographic groups, including women, minorities, and others. We’re not going to say we’ve reached full employment, which is our statutory goal, until we have reached maximum employment. Which you haven’t if there are lots of pockets of people not participating or not employed in the labour market.

We want an economy where everyone can take part, can put their labour in, and share in the prosperity of our great economy.

I’m much more worried about falling short of a complete recovery and losing people’s careers and lives that they’ve built because they don’t get back to work in time. I’m more concerned about that, not just to their lives, but to the US economy. I’m more concerned about that than about the possibility – which exists – of higher inflation. Frankly we’d welcome slightly higher, somewhat higher, inflation. The kind of inflation that people like me grew up with seems far away, unlikely, in the domestic and international context we’ve been in for some time.

This shift in emphasis was partly forced on the Fed. Persistently low inflation despite falling unemployment shone a spotlight on the full employment side of the Fed’s mandate. Its similar elsewhere; as central banks took on on ever larger roles in economic management following the GFC, they needed to maintain legitimacy with a public concerned about joblessness and inequality, not inflation.

From my own analysis of language in all central banking speeches between 01/2007-01/2020

This language creates precedent which could constrain, or influence future Fed decisions, or at the very least, how they are presented and framed. This could have long-term consequences. It is said that the experience of inflation in the 1970s/80s shaped the minds of a generation of economists and policy makers. The Fed’s new attitude and language may have a similar effect on its institutional culture. Might there be a dovish, employment bias, for years to come?

Are we crying wolf over inflation?

The FT has just published an op-ed from one Professor Jeremy Siegel of Wharton. In it, he predicts that the US is going to experience “an extremely inflationary economy in 2021,” where “inflation will run well above the Fed’s 2 per cent target, and will do so for several years.”

This is a contrarian position. The Federal Open Market Committee – the body at the Fed which sets monetary policy – does not project inflation reaching 2% until 2022. Professor Siegel joins the vocal minority warning about inflation.

December 2020 FOMC projections

Professor Siegel bases his argument on an old proposition: the Quantity Theory of Money (QTM). Simplified, it argues that the price level is a function of the quantity of money in an economy. If the quantity of money increases faster than output, all other things being equal, prices will rise.

The QTM has motivated previous inflation warnings. After the Global Financial Crisis, some warned that Quantitative Easing (QE), with its massive expansion of the money supply, would cause runaway inflation. The opposite happened, and the major macroeconomic puzzle of the last decade has been falling, not rising, prices.

Professor Siegel argues this time is different (always a red flag). QE created trillions in reserves, but it turned out banks were happy to sit on them, and not make loans, in part because the Fed began paying interest on excess reserves. Today, thanks to the stimulus checks, grants to local government, and the Paycheck Protection Program, money is “going directly into the bank accounts of individuals and firms.” Where before money wound up in bank vaults, this time it will get into the hands of private sector individuals and be spent.

As part of QE, banks exchanged their bond holdings for reserves, and then sat on them

Is that really the case though?

Siegel’s argument rests upon a distinction between the money held by banks as excess reserves, and the money now in consumer bank accounts; growth of the former had little or no effect on inflation, but growth in the latter will.

This raises the question of why money in a consumer bank account is more likely to be spent than bank reserves? Siegel suggests that liquidity requirements, and the interest the Fed pays on excess reserves, explains the tendency of reserves to accumulate. But if so, why should it be any different with consumers, who, as we all know, also receive interest.

The Fed started paying interest on reserves, and regulators imposed liquidity requirements that could be satisfied with these reserves. The banks easily absorbed the extra reserves created by the Fed and quantitative easing led to only a modest increase in lending.

But, why is money sometimes stashed under the proverbial mattress, and other times not? It seems unlikely the answer is directly related to how many notes are under the pillow. It is not enough to simply increase the money supply, you need people to want to spend it.

In fairness, the QTM does acknowledge this. In addition to the price level, the quantity of money, and a measure of real output, it includes a variable called the “velocity of money,” a measure of how often it changes hands.

M = quantity of money, V = velocity, P = price level, T = a measure of real output

High velocity looks like this. I pay you $100 for a bicycle, you use it to (under)pay your neighbor’s son to paint your house, and he spends it taking his girlfriend to a gauche mini-golf bar. In a low velocity world, I buy your bicycle, and you stash the money between the pages of your untouched copy of War and Peace. A healthy economy looks more like the former than the latter.

The problem is, if velocity is subject to unpredictable changes, then there can be no fixed relationship between quantity and the price level. Instead we must look to a third (or fourth or fifth) variable to explain why velocity changes. But, if one wants to posit a stable relationship between quantity and price level, as Professor Siegel does, then velocity must be relatively static in the short to medium term. Otherwise, price is conditional on the quantity of money, which is conditional on velocity, which is conditional on some other unknown. At best we could say the quantity of money is a necessary condition of inflation.


The point is to be skeptical of mechanistic explanations, especially ones first developed in the 18th century. The money supply is broadly correlated with inflation, but that does not mean they are causally related. Even if they were, it would not necessarily tell us the direction or magnitude of the effect.

Correlation or causation?

Let us also look skeptically on theories which avoid falsification tests and rely on verification. QTM theorists can always find historical episodes to verify their arguments. In fact, the allure of the “more money = more inflation” argument is that it is right eventually; at some point there will be inflation, and it is more than likely it will follow an increase in the money supply, if only because the money supply is usually increasing.

To paraphrase Paul Samuelson, inflation hawks have predicted 9 of the last 5 inflationary episodes. Despite this, the opinion pages of major newspapers always seem to find room for them.

It is unclear what would constitute a falsification of their hypothesis. Inflation failed to rise after the GFC, and a series of ad hoc explanations were provided. If inflation fails to increase in 2021, is that a definitive rejection of the QTM, or will more ad hoc explanations be appended to explain it away?

For the second time this week, I am reminded of the Marxists, who, when confronted by the failure of history to match their deterministic predictions (when is the revolution?), could always respond “not yet.”

We remain waiting.

September FOMC meeting

The Federal Reserve had its September Board meeting yesterday (Australian time). Apart from the time difference, the most frustrating thing is the Fed appears to host the press conference video themselves, and there is no button to adjust playback speed.

The press conference and statement offered some useful clarifications on the big announcements made last month at Jackson Hole (see forthcoming piece – hopefully this week!)

There were a lot of questions about how the Fed’s new average inflation targeting approach would work, how far above 2% would inflation be allowed to go and for how long?

With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent

So what will policy be like in the meantime?

The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time

Low for loooooooong baby! Remember inflation has barely touched 2% over the last decade. The projections of Board members show no one thinks inflation will reach 2% before 2022/3. The median projection for unemployment is 4% in 2023, but the range goes all the way up to 7.5%. The Fed has already issued a mea culpa for raising rates in 2018 when unemployment dropped below 4%, so it is unlikely they will do so again. All this adds up to low rates for the next few years, barring something extraordinary.

Preemptive tightening in the face of unemployment is officially dead and buried.

We view maximum employment as a broad-based and inclusive goal and do not see a high level of employment as posing a policy concern unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals

Powell acknowledged the new normal; low interest rates are now part of the furniture.

In turn, well-anchored inflation expectations enhance our ability to meet both our employment and inflation objectives, particularly in the new normal in which interest rates are closer to their effective lower bound even in good times

Aside from all the technical announcements, two short sections caught my eye:

As I have emphasized before, these are lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. We can only create programs or facilities with broad-based eligibility to make loans to solvent entities with the expectation that the loans will be repaid

Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources. (is monetary policy not?)

Firstly, it is simply not true that the Fed cannot grant money to particular beneficiaries. Legality aside, it is certainly possible operationally. It would be politically momentous, sure, but lets not kid ourselves about what Central Banks can and cannot do.

Secondly, the second paragraph implies that monetary policy, unlike fiscal policy, is not one of society’s collective resources. Again, I disagree. The money supply is a collective resource, and even if its creation and control currently sits outside day-to-day political control, that is a choice. It is neither inevitable nor eternal and we do ourselves a disservice when we blithely reify the specific institutional arrangements we happen to have today.