Only monetary policy can stop inflation
Supply-side reforms cannot stop inflation, but . . .
Supply-side reforms can make stopping inflation less painful.
Thus, under a dual mandate, supply-side reforms can nudge the central bank toward a less inflationary policy.
Fiscal austerity (here I’m assuming tax increases and cuts in transfers) cannot stop inflation.
Fiscal austerity doesn’t even make stopping inflation less painful.
But fiscal austerity can lead to tighter monetary policy if the central bank is dumb enough to target interest rates instead of inflation/NGDP.
PS. I have a new piece at The Hill, discussing the risk of recession.
For selfish reasons, I’m sort of rooting for a mini-recession. I’ve never seen one (in America) and had assumed I never would. And with a mini-recession we’d be getting off easy.
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3. July 2022 at 06:17
Imputing the mean expected NGDP growth path in liquid asset prices is necessary, but not sufficient to tell whether we’re currently in recession. That is, unless the drop in expected growth is sufficiently large, but even then, judging the depth of recession in real time is challenging.
We also need to know what the expected real and nominal economic growth rates were for the present quarter prior to the fall in growth expectations. The Fed’s GDPNow seemed reasonably reliable pre-pandemic, but has been anything but since. It says we’re currently in recession, for what it’s worth.
Guessing what will happen with growth going forward couldn’t be more difficult, as additional negative or positive supply shocks could pretty radically change the inflation outlook, in terms of policy implications. And then, the Fed is still very vague about its targeting regime.
3. July 2022 at 06:23
Have not been thinking of it as “getting off easy”——-but now that you have said it, I must agree. I still hope it will be better——I like to believe it is not idiot hope——but it seems like a narrow window. The Fed still has to react—-(as you state re dumbness of targeting I-rates given fiscal austerity)—-and I assume they have to guess to some degree on what to react to——as there must be some forecasting going on.
Plus, as you virtually state, since you hope to get off easy, the Fed track record appears to avoid getting off easy to often. So that is a bummer.
3. July 2022 at 06:27
I’m sort of expecting a recession in 2023 that’s similar to the 2001 recession. In my personal experience I’d call that “mini-recession”–but I hope we don’t have the same persistence in unemployment rates as we did during that period.
All of my predictions about inflation in 2021 turned out spectacularly wrong, so maybe Q42022 through 2024 will be nearly as gruesome as 2007 through 2010.
3. July 2022 at 07:09
If you look at page 15 in “Modern Money Mechanics” you will see that “sells of securities” decrease both the assets and liabilities of “Factors Changing Reserve Balances”
“In concept, the ON RRP facility acts like IORB for a set of nonbank money market participants. Through the ON RRP facility, eligible institutions—money market funds, government-sponsored enterprises, primary dealers, and banks—can invest overnight with the Fed through a repurchase agreement (repo).”
https://libertystreeteconomics.newyorkfed.org/2022/01/how-the-feds-overnight-reverse-repo-facility-works/
Thus, the O/N RRP facility is primarily used by the nonbanks (draining the money stock). So, the FED’s operations are not transparent.
3. July 2022 at 07:27
The money stock can never be properly managed by any attempt to control the cost of credit.
3. July 2022 at 07:49
Since we know that Powell doesn’t understand money and central banking, we can only guess as to when Powell recognizes his huge mistake.
Link: “Turbo Tightening”
https://fedguy.com/turbo-tightening/#more-4493
3. July 2022 at 07:57
Michael, You said:
“It says we’re currently in recession, for what it’s worth.”
No it doesn’t. Recessions are not determined by GDP growth.
David, As I define recession, we’ve had no mini-recessions. In 2001-03, the unemployment rate rose by 2.5%. I view a mini-recession as unemployment rising by less than 2%.
3. July 2022 at 09:02
Scott,
The definition recession, in my mind at least, has long been seasonally-adjusted negative real GDP growth. I don’t consider negative growth in Q1 to be a recession, simply because negative growth in Q1 is not uncommon and normally comes with no increase in unemployment.
So, do you require an increase in unemployment in your definition of recession?
3. July 2022 at 11:41
Does anyone still think that interest rates should be a target? I have heard of people who think that (short term) interest rates are the only INSTRUMENT that the Fed has (or at least the only one it should use) to achieve its targets.
3. July 2022 at 12:13
Another leading indicator is Las Vegas casino projects and I remember in March of 2008 multi billion dollar projects started getting cancelled. One I recall is Crown Las Vegas which did finish their Macau project in 2009 while the Vegas project was cancelled. All the major projects in Vegas are still full steam ahead right now.
3. July 2022 at 12:18
Michael, I was referring to the NBER definition, which is the official one.
3. July 2022 at 12:35
I’m keeping an eye on total nonfarm employment. So that goes up every year except when we have a recession with the 2009 low being lower than the 2002/03 low. So if that doesn’t decrease then it won’t be a significant recession.
Btw, the fact Bush got re-elected even with total employment lower in October than in 2000 has to be one of the greatest political con jobs in history…and his approval rating started declining right after his second inauguration and so you know it was all smoke and mirrors.
3. July 2022 at 12:43
Okay, I don’t find the NBER definition useful. I see no reason to say a period of negative growth needs to last at least 3 months. I suspect that 3 months is chosen, due at least in part to the fact that official GDP figures are published quarterly. I already see thinking in terms of quarters as being obsolete.
The distinction concerning unemployment is more important though.
3. July 2022 at 20:20
Scott, ironically enough, if you have central bank that targets ngdp level, supply side policy is the only thing that determines inflation.
3. July 2022 at 20:45
Scott- from your Hill piece…
“ The Fed’s overly expansionary monetary policy in late 2021, which included huge infusions of extra money into the economy, has pushed wage inflation up over 6 percent.”
Please explain how the Fed “infused extra money” into the economy. They bought bonds and lowered short term rates, but the “money” that they swapped for these bonds were placed right back with the Fed in the form of excess reserves and overnight reverse repo. The government, however, dropped trillions of dollars on the economy via grants to businesses (PPP), increased transfer payments, etc. Did the Fed aid this spending? Perhaps, by temporarily providing cheaper financing for the government by being the best bid for treasuries, but they have no authority to compel the government to engage in any fiscal policy (the whole “independence” thing). Take a look at the graph linked below, which shows the gap between retail sales and retail inventories close to the tightest range in the history of the series, right after the PPP money drop. Now, you see that gap starting to widen at a very fast pace, which is certainly disinflationary.
https://fred.stlouisfed.org/graph/?g=RlFy
4. July 2022 at 08:17
Matthias, That’s right.
Nick, I was referring to the monetary base. But M2 also rose sharply, so your assumption about reserve hoarding is wrong.
4. July 2022 at 09:29
From the standpoint of monetary authorities, charged with the responsibility of regulating the money supply, none of the current definitions of money make sense. The definitions include numerous items over which the Fed has little or no control (e.g., M2), including many the Fed need not and should not control (currency).
The definitions also assume there are numerous degrees of “moneyness”, thus confusing liquidity with money (money is the “yardstick” by which the liquidity of all other assets is measured).
The definitions also ignore the fact that some liquid assets (time deposits) have a direct one-to-one, relationship to the volume of demand deposits (DDs), while others affect only the velocity of DDs. The former requires direct regulation; the latter simply is important data for the Fed to use in regulating the money supply.
4. July 2022 at 15:12
Scott – Increased reserves over the period is a fact, not an assumption, however this is beside the point. The increase in M2 was driven by fiscal policy, NOT the Fed. Sum up the cumulative increase in government transfer payments (unemployment insurance) and PPP outlays and compare with the increase in M2. This isn’t that hard. Please stop with the lazy “the Fed just printed a bunch of money” takes while simultaneously failing to refute more evidence based explanations of what caused this “inflation.” Your Hill article had about zero substance to it, unless your purpose was to bloviate about the same false narrative the financial news media has incorrectly been pushing for years about how the Fed is the end all be all when it comes to the economy and inflation.
5. July 2022 at 05:15
Scott, you said, “if the central bank is dumb enough to target interest rates instead of inflation/NGDP.”
What is the lever to be pulled for monetary policy to target inflation/NGDP if it’s not the interest rate lever? Or is it the interest rate lever too, but with a different goal in mind compared to current Fed policy?
5. July 2022 at 10:31
What? You think the price of money is the effective funds rate? That’s the price of reserves.
5. July 2022 at 12:00
just one question, how will monetary policy solve a supply chain crisis? the problem isnt just money, its that we cant even produce goods, as we did back in 2019. as an example, new car sales have plunged, supply of new cars at dealers is about 1 million, where the average at this time of year, is closer to 3 million, and since supply is so low, new car prices are much higher, as the starting pointing is MSRP, and goes up from there (to almost the MSRP) and even used cars a few years old (going up to almost a decade), can be selling at new car MSRP (from when they were originally sold). how does it address the chip shortage? or the lack of materials ?
5. July 2022 at 12:01
how does monetary policy a supply crisis (or broken supply chain)?
5. July 2022 at 14:19
Nick, The Fed moves last. When fiscal and monetary move in opposite directions, monetary almost always wins. The Fed determines NGDP, not Congress.
Chris, They can get rid of IOR and use the monetary base as the policy instrument.
wdw, You asked:
“how does it address the chip shortage? or the lack of materials?”
It won’t.
5. July 2022 at 17:14
It appears there is some trade-off between hitting employment and inflation targets. How can we compare the damage each causes? Losing a job feels worse than inflation, but at what point does inflation become a bigger concern?
5. July 2022 at 19:02
The Fed has one policy instrument…. buying and selling assets (and the associated expectations with respect to that action.) Everything else is mostly just talking, talking, talking by people who don’t understand monetary policy.
5. July 2022 at 21:49
The NBER definition of a recession is that it is a recession if they say it is. 2 consecutive quarters negative GDP growth was a long time standard definition. That is, until 2000, and the NBER said that there were enough other factors to indicate a recession that they were calling one despite the fact that there were not consecutive quarters of negative growth.
6. July 2022 at 05:34
@dtoh – you wrote: “The Fed has one policy instrument…. buying and selling assets (and the associated expectations with respect to that action.)”
I think that setting the interest rate on reserves is also a policy instrument.
I’d also count setting reserve requirements as a policy instrument that the Fed has, but with that in abeyance I understand not counting it.
6. July 2022 at 08:52
Scott,
Any thoughts on recent market movements? Commodities are wayyy down, almost to pre invasion levels. Actually since their peak commodities are down 20% like stocks but have really tanked in the last week. Gasoline is set to fall to <$4 a gallon at current futures prices. The 5 year TIPs spread is now 2.46% and the 5 year, 5 year forward is about 2%. Equities and 1-10 year interest rates are pretty steady/down slightly. The 2 and 10 year yields are "inverted" but essentially the same.
It almost looks like markets are forecasting a "mini recession".
6. July 2022 at 10:17
Thrawn, I think the tradeoff is largely illusionary, at least in the long run. (There is a short run tradeoff.)
dtoh, As Brent suggested, IOR is also a policy tool, although I wish they’d get rid of it.
Doug, The NBER has always looked at multiple factors, but it’s true that recessions almost always involve 2 consecutive negative quarters. Even more reliable is a 2% increase in unemployment, which works 100% of the time.
Cameron, A bunch of indicators suggest that NGDP expectations are falling.
I’m reluctant to forecast a recession, mini or otherwise, as it’s very difficult to do.
7. July 2022 at 06:55
The contraction of the E-$ market has been going on since 2007. It was accelerated by Basel III’s LCR, and Sheila Bair’s assessment fees on foreign deposits, which changed the landscape of FBO regulations. It helped make E-$ borrowing more expensive, less competitive with domestic banks (the exact opposite of the original impetus that made E-$ borrowing less expensive, when E-$ banks were not subject to interest rate ceilings, reserve requirements, or FDIC insurance premiums). And now Powell has eliminated required reserves.
All prudential reserve banking systems have heretofore “come a cropper”. The E-$ market is following that historical precedent.
Contrary to the FED’s accountants, RRPs drain both reserves and the money stock. They should be a subtraction from both the FED balance sheet’s assets and liabilities – not just a swap in liabilities (regardless of term limits as the operations are constantly rolled over). If you look at page 15 in The Federal Reserve Bank of Chicago’s “Modern Money Mechanics” you will see that “sells of securities” decrease both the assets and liabilities of “Factors Changing Reserve Balances”
Also a subtraction in PG. 305 in my 1963 Money and Banking book. PG 366, 382, & 398 in my 1958 Money and Banking book.
The Keynesian economists at the FED don’t know a credit from a debit. And they don’t care about the money supply, just the level of interest rates or R *. Otherwise, they would separate in their accounting, bank from nonbank sells of securities (like they did in the 70’s, with RPDs, reserves for private deposits).
7. July 2022 at 10:17
I’ve been slightly confused by John Cochrane’s recent post on the impact of Fed policy on inflation. John seems to be saying that the Fed’s rate changes won’t have immediate effects—and worse, that we’re going to have persistently high inflation for the next several years even if the Fed continues to act aggressively. I’m not sure I buy this, because we are seeing some softening of prices as a consequence of Fed policy and inventory rebuilding–in spite of Comrade Putin’s War.
Cochrane, and a few others, have been predicting/rooting for Stagflation Part II because of decades of fiscal profligacy, the pandemic helicopter money, loose Fed money, a collapse in morality, etc…
It’s probably not worth much, but the Hypermind bets have been going down recently. I’d buy that for a dollar.
7. July 2022 at 12:14
Scott,
IOR is just a way to way to buy or sell more assets.
And to be a little more specific, the policy tool is actually to get the overall banking system to buy or sell assets.
7. July 2022 at 12:26
agree of course NGPD level targeting would minimize the employment/growth loss of recession
but we’ve never seen this combined level of stimulus and supply restriction across the OECD
historically large consumer cash positions from stimulus and falling productivity have proven an explosive combination
falling why? look at the common OECD policies — energy, food (look at the Dutch right now, to say nothing of Sri Lanka), COVID mandates, sanctions… all restricting supply
and remember, Fed was still worrying about inflation in late 2007 even as the financial markets were collapsing… let’s hope they’ve learned something
7. July 2022 at 12:30
btw as much skepticism as we hear of Fed’s ability to end the inflation, few seem willing to place large bets against the 5YF
https://fred.stlouisfed.org/series/T5YIFR
CBs hold all the cards in that poker game, if they’re willing to play them
7. July 2022 at 16:44
dtoh, I don’t think you know what terms like “instrument” or “tool” mean. If you do, then your comment doesn’t make any sense to me.
7. July 2022 at 22:05
Marcus Nunes has an excellent new post that argues that the Fed’s goal should not be to return NGDP to it’s pre-pandemic growth path:
https://marcusnunes.substack.com/p/its-a-kind-of-magic
What was particularly interesting was his graph showing that RGDP growth path began falling below it’s decades-long trend mean just as the Volcker Fed started to tighten monetary policy. Coincidence? Maybe, but it certainly fits the narrative I’ve been pushing for years, and the stock market very much agrees. Money has been too tight since the end of the Great Inflation. Yes, inflation needed to come down, but not as quickly as it did. And yes, economies take longer to heal from nominal shocks than most economists seem to think.
Remember, when there’s genuine significant secular stagnation, or expected secular stagnation, as in Japan, lower real interest rates do not correlate with higher stock price multiples. That happens when growth is expected to recover. In the longer run, higher multiples are replaced by higher NGDP growth rates.
I use the word “correlate” here, instead of “cause”, because stock prices are primarily determined by the expected mean NGDP growth path.
8. July 2022 at 05:04
“For selfish reasons, I’m sort of rooting for a mini-recession. I’ve never seen one (in America) and had assumed I never would. And with a mini-recession we’d be getting off easy.”
Probably the first time I’ve ever agreed with, Scott.
I hope the economy collapses. Maybe then, the woke thugs in academy and govt will leave people and markets alone. Maybe then, the federal government will stop waging wars.
In fact, I would extend my hatred even further. I want farmers to stop producing food. Just produce enough for themselves, and let the democrats in the city starve to death until they agree to stop using the Federal government as a bludgeoning stick, and until they stop intervening in state and community affairs.
8. July 2022 at 05:15
re: “Money has been too tight since the end of the Great Inflation” and “RGDP growth path began falling below its decades-long trend”
That’s how the plumbing is programmed. And that’s looking at history. Those slowing numbers were predicted by 1961.
Princeton Professor Dr. Lester V. Chandler, Ph.D., Economics Yale, theoretical explanation was: 1961 – “that monetary policy has as an objective a certain level of spending for gDp, and that a growth in time (savings) deposits involves a decrease in the demand for money balances, and that this shift will be reflected in an offsetting increase in the velocity of demand deposits, DDs.”
Thus, the saturation of DD Vt (end game) according to Corwin D. Edwards, professor of economics. [Edwards attended Oxford University in England on a Rhodes scholarship and earned a doctorate in economics at Cornell University. He spent a year teaching at Cambridge University in England in 1932. He taught at New York University in 1954, the Chicago School from 1955-1963, the University of Virginia, and the University of Oregon from 1963-1971.]
Edwards: “It seems to be quite obvious that over time the “demand for money” cannot continue to shift to the left as people buildup their savings deposits; if it did, the time would come when there would be no demand for money at all”
Chandler’s conjecture was correct from 1961 up until 1981. The S-Curve” hybrid dynamic damage (sigmoid function) in money velocity, was completed by the first half of 1981.
Professor emeritus Leland James Pritchard (Ph.D., Chicago Economics 1933, M.S. Statistics) never minced his words, and in May 1980 pontificated that:
“The Depository Institutions Monetary Control Act will have a pronounced effect in reducing money velocity”.
Why? In short, because banks don’t loan out deposits. Deposits are the result of lending. All bank-held savings are lost to both consumption and investment, indeed to any type of payment or expenditure.
8. July 2022 at 05:38
Nunes: “The 1990/91 recession permanently lowers the level of RGDP”
The DIDMCA of March 31st 1980 turned 38,000 nonbanks (the CUs, MSBs, and S&Ls) into banks. To survive, “the nonbanks had to act like banks”.
So, you had another decline in Vt (“the failure of 1,043 out of the 3,234 savings and loan associations (S&Ls) in the United States from 1986 to 1995”).
The rate-of-change in bank debits to deposit accounts went negative for the first time since the GD in 1990-1991 period. I.e., savings flowing thru the nonbanks never leaves the payments system, increasing the velocity of circulation, but not the supply of money.
8. July 2022 at 05:54
“Gurley-Shaw thesis was based on the implications of the rapid growth of financial intermediaries in the post-War II period. Gurley and Shaw were particularly inspired by the work of Raymond Goldsmith which showed that while all financial intermediaries grew rapidly during the first half of the 20th century, the claims of non-bank intermediaries increased much more than the demand deposit claims of the commercial banks, thus causing the commercial banks to diminish in importance among all intermediaries.”
The U.S. Golden Age in Capitalism was 2/3 financed by velocity. Today we have the opposite dynamic. And when the FED tightens, it creates disintermediation of the nonbanks.
The FED’s Romulan cloaking device (payment of interest on interbank demand deposits), has exceeded the level of short-term interest rates which was explicitly illegal per the FSRRA of 2006.
As George Selgin pointed out: “The 2006 Financial Services Regulatory Relief Act gives the Fed permission to pay interest on reserves. The IOR rate was always higher than “the general level of short-term interest rates” which is imposed in the Law. “A Legal Barrier to Higher Interest Rates,” The Wall Street Journal, Sept. 28, p. A13.
The IOR, @ 1.65% is still above 1mo Treasury Daily Interest Rates. Therefore, the banks are able to outbid the nonbanks for the shortest-term collateral. That pushes interest rates below zero. This artificial demand forces the nonbanks to place temporary funds in the O/N RRP facility @ 1.55%.
8. July 2022 at 06:37
The economic engine is being run in reverse. Lending by the banks is inflationary (increases the volume and turnover of new money). Whereas lending by the nonbanks is noninflationary (results in the turnover of existing money). Why do you think velocity disappeared?
8. July 2022 at 08:19
A lot of this article is very curious (admittedly, from my perspective). Not “deeply wrong, oh my!”, or something like that, but it raises some serious questions:
1) Are we sure there’s enough support for the narrative that the economy is super overheated at a high rate and will continue to do so? Isn’t it possible a lot of the indicators of inflation that we’re looking at are lagging indicators, and of course reflective of potential inflation-spiral-type stuff, but lagging nonetheless and not great for predicting the future? For example, wages have been going up, but it’s clear that much of the fuel for the growth in tech has been removed and that QT would nudge things further in that direction.
It seems like this is also sort of what is referred to by the “reason to be humble” section. A lot of tech companies’ hiring and high-wage tech departments just haven’t gotten the memo yet that the ride is over.
2) Related: is wage growth really that serious of a problem? Why is this a main factor that the Fed seems to want to hit hard, particularly since it has been notoriously stagnant in the face of gentler inflation and shrinkflation and lower-quality products? Wages are obviously a concern when you say lacking GDP growth may not sustain wages, but there’s a fair concern that this would be a consequence of the Fed raising interest rates further. Prices have been rising since the GFC but millennials have gotten shafted for a decade. Kneecapping wage growth at this time seems like it would hit them hard, which in turns might be bad for the economy and carry political risks in terms of populism (especially if bailouts start coming again).
3) Again, wages and employment: the article raises the question of why the harm of “layoffs” is greater than the harm of wage growth getting pounded on the runway before takeoff. If money for wage growth dries up, doesn’t this also result in a lack of competitive hiring and many of the same effects as a higher unemployment environment? It’s not obvious to a layman.
Some of this might be related to the curious situation of “the big tech companies” or whatever and their spending habits. Until now they’ve been practically allergic to taking profits, but while they’ve been eager to invest money in stuff and stock buybacks and whatever, they’ve been relatively hesitant to invest in human capital until now (and it’s gotten a lot of sensationalist attention).
There’ve been many writeups on “woe is me, I sent out 5 million automated recruitment spam messages on linkedin demanding 15 years of experience in a technology that’s 10 years old for slightly higher mediocre pay, and no one is responding. No one wants to work! Job openings aren’t filling up!” So it’s hard to take these concerns seriously. In what scenario does the employment market actually get to be finally tested so we can see what labor is worth, particularly as prices and assets have risen for so long without commensurate wage increases? Or did I miss it?
8. July 2022 at 08:20
Ricardo, You said:
“Probably the first time I’ve ever agreed with, Scott.
I hope the economy collapses.”
Idiot.
8. July 2022 at 11:05
Daniel, Overheating is fundamentally a nominal concept, too much NGDP growth (although it does produce a tight labor market). Your comment mostly focuses on real issues such as real wages and employment. Those are important issues, but it’s important not to confuse them with nominal problems.
Higher real wages require supply side reforms (which I support); you cannot artificially create long term prosperity by printing money.
8. July 2022 at 12:39
‘if the projected unemployment rate is much lower than u* (the non-accelerating inflation rate of unemployment), that’s a reason to raise interest rates”
The unemployment rate is always going to be “too low”. See: “The Great Demographic Reversal” by Charles Goodhart and Manoj Pradhan.
10. July 2022 at 07:53
Link: https://www.wsj.com/articles/inflation-surge-earns-monetarism-another-look-11655906400
“Indeed, some economists have suggested the Fed should target a stable growth rate of nominal demand (more precisely, nominal gross domestic product) instead of inflation because it doesn’t require a judgment on whether excess demand or supply disruptions are pushing up prices. With such a target, the Fed would have begun tightening monetary policy sooner, said David Beckworth, an economist at the Mercatus Center, a think tank.”
10. July 2022 at 09:52
See: June 03, 2022 “Understanding Bank Deposit Growth during the COVID-19 Pandemic”
https://www.federalreserve.gov/econres/notes/feds-notes/understanding-bank-deposit-growth-during-the-covid-19-pandemic-20220603.htm
“the deposits may leave the banking system if the holder of the deposits exchanges…them in the Federal Reserve’s Overnight Reverse Repurchase (ON RRP) facility.”