The Money Illusion is back!

Good news — there’s bad news.

The Money Illusion got off to a good start in early 2009. All I had to do is to point to the obvious fact that monetary policy was far off course.

By the mid-2010s, things got boring. I was beating a dead horse.

By the late 2010s, TMI hit rock bottom. Monetary policy became quite reasonable and I pivoted to moronic Trump bashing.

Now I’m back. Even better, I get to play a different role, a scarier bird.

It wasn’t until September 2008 that it dawned on me that monetary policy was clearly too contractionary, even though in retrospect policy had been too contractionary for several months. I assumed the Fed had an effective regime in place. It didn’t.

It wasn’t until late 2021 that it became clear to me that monetary policy was too expansionary, even though in retrospect policy had been too expansionary since mid-2021. I assumed the Fed had an effective regime in place. It didn’t.

[Memo to myself: Don’t assume the Fed has an effective regime in place.]

After FAIT was announced in August 2020, I made a forecast. Here’s the entire post:

The (PCE) price level will be 135.207 in January 2030

Or at least it better be.

Powell says there’s no strict mathematical formula; but it’s pretty obvious to me that the markets and pundits are going to hold the Fed accountable. People think in terms of decades, and this policy was announced in 2020. Thus markets will naturally see this a commitment for inflation to average 2% over the 2020s. Since the PCE price level was 110.917 in January of this year, it needs to be close to 135 in January 2030. A slight miss would not be a problem, but a big miss (say average inflation outside the 1.8% to 2.2% range) would be seen as a policy failure. The Fed would lose credibility.

I also have a post on the speech over at Econlog.

At the time, inflation had been running well below 2% since January. The 10-year TIPS spread was 1.72%, implying about 1.47%/year PCE inflation. Put the two together and the market was expecting the price level to be almost 6% too low at the end of the decade.

At that point I wasn’t too concerned, as I figured that Covid might be distorting markets. But many commenters complained that the Fed’s policy clearly had no credibility, and that they would obviously fail to raise average inflation up to 2%. Little did they know.

In April 2021, the PCE first moved above the 2% trend line from January 2020. The 10-year TIPS spread was 2.33%, implying 2.08% PCE inflation. Everything looked fine. Powell’s policy had worked.

But as I’ve pointed out in previous posts, all macroeconomic policies eventually fail. All of them. Nonetheless, this one failed sooner and more spectacularly than I anticipated.

We are two years down the road and can no longer use 10-year TIPS spreads. The 5-year TIPS spread is 3.48%, implying 3.23% PCE inflation. The 5-year, 5-year forward spread is 2.24%, implying 1.99% PCE inflation for those last three years of the 2020s. So the TIPS markets are expecting an extra 6.1% inflation (all in the next 5 years). But it’s even worse. The actual PCE is already 3.5% above the trend line from January 2020. Thus markets are expecting an extra 9.6% inflation over the 2020s, almost 1%/year. That would represent a major failure of FAIT.

[This is why we need level targeting. Think how much the point estimate of the PCE on January 2030 has changed over the past 18 months—from almost 6% below target to 9.6% above. That’s crazy. And it’s in 2030, so presumably it has nothing to do with Covid or supply bottlenecks]

In retrospect, I paid too much attention to Fed promises to target the average inflation rate. This January, Powell basically admitted that he had abandoned the FAIT policy, when he denied that a period of above 2% inflation needed to be offset by below 2% inflation in future years. Smarter observers like Bob Hetzel focused on how the language used by Fed officials echoed statements made in the 1960s and 1970s, when they also tried to “run the economy hot” to create jobs. (Kudos to Larry Summers and Tim Congdon as well.) I thought that happy talk was empty rhetoric to please the administration. I thought FAIT would be maintained. I was wrong.

The abandonment of FAIT will make the Fed’s job much harder, dramatically increasing the risk of recession. Because this policy was abandoned, inflation expectations have driven NGDP growth much higher in recent months than if markets had anticipated that the Fed would tighten enough to keep long run inflation at 2%. (Think of a loss of credibility as boosting velocity, if you wish.) Because the economy got so hot, it will take a much more contractionary policy than otherwise to bring it back down. It’s not about interest rates, it’s about the policy regime.

Here’s what I said last July, before I understood that the Fed had abandoned FAIT:

I don’t expect a recession to occur in the next few years, but recessions are almost impossible to predict. It’s more interesting to think about the sort of policy mistakes (were they to occur) that might lead to a recession within a few years.

One mistake would be an excessively tight money policy, which could trigger a recession in 2022 or 2023. That’s possible, but seems quite unlikely at the moment.

A slightly more likely scenario would involve excessively expansionary monetary policy, which drove wage growth to levels inconsistent with 2% inflation over the long run. To get the inflation rate back on target the Fed would then need a tight money policy, which might trigger a recession. . . .

Almost no one wants a recession in 2024. If we get one, it will be due to the misguided policies of people trying to help workers. They would overstimulate, and by 2023 the Fed would be forced to tighten to restore inflation credibility. I don’t think that’s the most likely case; rather it’s the most likely cause of a near-term recession should a recession occur.

Powell will need the skill of that airline pilot who landed the plane in the Hudson River to engineer a soft landing.



26 Responses to “The Money Illusion is back!”

  1. Gravatar of Michael Michael
    19. March 2022 at 13:45

    In many ways this looks like a mirror image of 2008 and the years that followed.

    You spent many years criticizing the Fed for falling short of it’s policy targets.

    Other than being on the other side (failing high instead of low on inflation) is anything different about hoe they are doing policy?

    There is one thing that looks similar to 2008 instead of opposite to it: high commodity prices.

  2. Gravatar of ssumner ssumner
    19. March 2022 at 14:47

    Michael, Yes, but by the second half of 2008 even commodity prices started falling.

    There are differences in the reasons for the policy errors. In 2008 we didn’t yet have AIT. This time we had it, but didn’t adhere to it.

  3. Gravatar of Michael Sandifer Michael Sandifer
    19. March 2022 at 19:27

    The mean expected NGDP growth path was about 5.1% when the year began and fell to about 4.5% two weeks ago, but is back to about 4.78%, after last week, as inflation expectations fell slightly.

    I would be happy at this point if the Fed just started level targeting NGDP at 5%, and given progress made in the approach to imputing NGDP growth expectations in market data, this could be done quite easily immediately, without the need of NGDP futures.

  4. Gravatar of Effem Effem
    19. March 2022 at 19:33

    I think you still fail to appreciate that inflation undershoots will be mild while overshoots will be more serious. The ‘hard money” crowd is right to predict that monetary policy in an age of extreme indebtedness will skew towards excess inflation.

    How else to explain the panic over “deflation” vs the relaxed attitude vs inflation?

  5. Gravatar of dirk dirk
    19. March 2022 at 21:37

    Hey Scott, off topic but I just saw a movie on Criterion I think you would like. It’s “Jazz on a Summer’s Day”. I know you say you aren’t a music guy, and it is technically a music documentary, but the cinematography is astounding.

  6. Gravatar of dirk dirk
    19. March 2022 at 21:57

    I have what might be a dumb question. I apologize, if so.

    If oil prices spike, doesn’t that cause “demand destruction” which would have a similar effect as the FED raising rates?

    I realize that US consumers paying higher oil prices go mostly to US oil companies, and that money mostly ends up in the pockets of other US consumers. But to the extend US consumers are paying more for, say, Saudi oil, doesn’t that amount to demand destruction in the USA?

    Wouldn’t that mean that higher oil prices help fight inflation, as insane as that sounds? Or no? What am I missing?

  7. Gravatar of Matthias Matthias
    20. March 2022 at 01:23

    A few questions for Scott (and anyone else who wants to chime in):

    (1) If the fed runs moderately high inflation for a while, their balance sheet should shrink quite a bit, because demand for fed liabilities will drop? (Though shenanigans with interest on excess reserves might screw with that?)

    (2) Inspired by something like current events:

    Assume an economy runs with an ngdp level target of 10% growth per year, and that’s well established and perfectly credible etc. Now the central banks suddenly announces that they are switching to 4% growth, and will do everything it takes to hit that target (and they have perfect credibility etc).

    Would the economy slide into a recession?

    To attempt an answer of (2) by myself:

    On the one hand, debt, long term leases, employment contract etc will all have been drawn up with 10% ngdp growth in mind. So I would expect lots of bankruptcies and layoffs.

    On the other hand, despite this turmoil, nominal income in the economy is on a stable path, so those laid off should find new jobs quite quickly? Previously viable but now bankrupt businesses should be able to re-open with the same business model after their debt got wiped out or restructured?

    So we don’t expect total employment or real business activity to shrink too much?

    I am asking about this (simplified) scenario, beucause I wonder whether we could always go from high inflation to a low inflation with ngdp level targeting and expect a ‘soft landing ‘?

    (To be clear, I expect some turmoil from such a transition. Perhaps like Britain had some real turmoil after the Brexit referendum, but did not see a recession.)

  8. Gravatar of Tacticus Tacticus
    20. March 2022 at 03:17

    ‘Almost no one wants a recession in 2024. If we get one, it will be due to the misguided policies of people trying to help workers. They would overstimulate, and by 2023 the Fed would be forced to tighten to restore inflation credibility.’

    Plus ça change *sigh*

  9. Gravatar of Michael Michael
    20. March 2022 at 03:44

    I guess my point would be this:

    In 2008, the Fed had a target (explicit 2% inflation target, right?), and for most of the following decade it approached that target such that it often forecasted itself to miss low.

    In 2022, the Fed has a different target (AIT), and it appears to be approaching that target in a similar way – such that it forecasts itself to miss high.

    Am I wrong to say “different target, same Fed”?

  10. Gravatar of dlr dlr
    20. March 2022 at 05:14

    the bat signal is definitely back out, glad to see you kept your costume. curious if you have any non-consensus takes on lessons from historical soft-landing attempts.

    also, haven’t seen you mention it but there was a recent interesting paper by hillenbrand showing that 100pct of the decline in long term real rates occurred solely during the 3 day window around fomc meetings. it’s a surprisingly thorny possible challenge to long term monetary neutrality. another paper then tried to model this non fundamental real rate idea as a version of the indeterminacy spiral you are very familiar with bc of its application to ngdp futures targeting, albeit one that also includes a determinate anchor:

  11. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    20. March 2022 at 05:55

    Sumner: “Think of a loss of credibility as boosting velocity, if you wish.”

    It’s as Fisher said, rates-of-change in money flows, volume times transaction’s velocity, equal roc’s in P*T. Real output has suddenly collapsed increasing the gap (increasing inflation) between long-term and short-term money flows.

    As Friedman said: “Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.”

    To quote economist John Gurley, “Money is a veil, but when the veil flutters, real-output sputters.”

    The collateral shortages show up with the decline in real output.

  12. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    20. March 2022 at 06:02


    The drop in income velocity, is largely due to the impoundment of monetary savings in the payment’s system, i.e., banks don’t lend deposits. The higher the proportion of savings to transactions deposits, the slower the turnover.

    Then the introduction of higher levels of outside money to inside money, QE forever, further exacerbates the decline in rates and velocity, decreasing real rates of interest.

  13. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    20. March 2022 at 06:54

    “When the Fed started buying $120.0 billion in securities every month, the total amount of securities on the Fed’s balance sheet was around $4.8 trillion. As of March 16, 2022, total securities were about $8.5 trillion.”

  14. Gravatar of Lizard Man Lizard Man
    20. March 2022 at 07:07

    I thought that the most frustrating thing about the Fed following the Great Recession was that they publicly stated that they were happy about the job they were doing and the inflation rate. And there wasn’t really a whole lot of public pressure to change, in spite of lingering unhappiness with the economy. If anything, elected officials were trying to get the Fed to have an even tighter policy with calls to “audit” the Fed’s decisions.

    It seems that this time is different. There are countless mainstream newspaper articles about how bad inflation is and how to deal with it and what it will be in the future, etc., etc. There are numerous articles about the Fed and what they are going to do about inflation in my local paper, so there is talk about the Fed’s failures outside of the economics blogosphere. Politicians seem to be aware of the problem as well, and political reporters seem to be aware that the public isn’t happy about the levels of inflation. All of this seems to be quite distinct from the period following the Great Recession, where little attention was paid to the Fed by the general public, outside of goldbug tea-party types.

    So if I were to guess, the Fed is going to act a lot more quickly to correct their mistakes now than they did during the 2010’s, if only because more people are paying attention.

  15. Gravatar of Rodrigo Rodrigo
    20. March 2022 at 07:07

    By increasing their inflation forecasts is the fed not saying they have a new implicit inflation target? Meaning the market will not and should not price in a more contractionary pivote in the future as it would if they kept true to a 2% inflation target? What I am trying to ask is if the fed now has a new inflation target of say 2-4% is policy actually to expansionary if they can manage to keep inflation expectations from rising any further? You will probably respond that the fed should hit its targets but since 2008 they have not been in much of a hurry to do so. They are more concerned with keeping rates on a steady path because they believe this promotes stability and rather let the outcome fluctuate. Obviously this is less than ideal but the real question is can this approach of playing the long game with inflation work? Will at some point if they keep raising quarter points be enough to achieve a new stable trend growth of 2-4% inflation without the need of a recession?

  16. Gravatar of ssumner ssumner
    20. March 2022 at 08:35

    Michael Sandifer, You said:

    “I would be happy at this point if the Fed just started level targeting NGDP at 5%,”

    If they announced such a policy that would be fine. If they did so unannounced it would likely lead to recession. And let’s face it, they aren’t going to announce such a policy.

    Effem, All these political theories are 100% ad hoc. They can’t even explain the 2010s. A few years ago I was told that we had lowflation because creditors had all the political power.

    Dirk, Thanks for the film tip. I’m skeptical that higher oil prices are deflationary. The best argument for that claim would be that they trigger contractionary monetary policy.

    1. The balance sheet is mostly determined by IOR.
    2. That’s a good question. The more people expect slower future NGDP growth, the less cost it has. The big problem is wage stickiness, so it’s never costless. It’s easier to bring NGDP growth back down if it’s only been rising fast for a short period, as expectations are not yet baked in.

    Michael, Yes, that difference is accurate.

    dlr, Thanks, I’ll take a look.

    Lizard, But will they take the correct actions? So far there is no indication they will do so. They haven’t even begun tightening.

    Rodrigo, Anything is possible in that regard, but the policy you suggest is far more likely to lead to missteps (recession) than a simple 2% AIT.

  17. Gravatar of Daniel Daniel
    20. March 2022 at 08:44

    Scott, I pretty much agree with you! My last comment over at Econlog was that the Fed is paying attention but behind the curve. I think they’re paying more attention than in 2008, so hopefully policy doesn’t deviate as badly for as long.

    But one big assumption you’re making is that the Fed is targeting the average inflation rate in the 2020’s. What if they’re targeting the average inflation rate from 2015-2025? Or from 2010-2030? Or from 2005-2035? What if they’re level targeting (if average means they’re targeting trajectory that has a particular mean rate) but also believe in the economy’s fundamentals more than Beckworth’s neutral GDP implicitly does (the forecasts that underlie it are in part affected by the Fed’s overly tight policy of the 2010’s)?

    Asking all these questions indicates the Fed hasn’t communicated itself clearly (they were clear they wanted FAIT to be vague, ugh), which is a problem in itself. But given the potential disparate answers, it also doesn’t necessarily mean the Fed is extremely off course, and hopefully that bodes well for their ability to tighten without sending us into recession. Of course, the safest way to achieve that is to arrest the inflation rate but let the price level remain above-trend until the underlying exponential trend catches up and we find ourselves on course again. That means no sub-2% inflation but definitely lower inflation than we’re seeing now, which is exactly what the Fed seems to want.

  18. Gravatar of Ram Ram
    20. March 2022 at 08:45

    An interesting question is how to interpret stock market reactions to Fed announcements in this environment. If the Fed makes an announcement, like a quarter point bump in the policy rate target, and the stock market rallies, this could be a negative, rather than positive response, simply because if the announcement leaves the market viewing policy as too expansionary, then they will expect dollars to be devalued relative to everything else, including stocks. The TIPS spread has been making clear for a while that the Fed’s AIT regime has lost credibility, but if we see policy change in a way that actually does narrow the spread, then we might see stocks sell off in a big way, not because of a recession forecast but just because of a revaluing of stocks relative to dollars under the new policy. So it will be hard to tell when the stock market is forecasting recession versus deft tightening in this environment. The only tell will be whether the TIPS spread is consistent with the on-target NGDP growth, and perhaps long bond nominal rates as well.

  19. Gravatar of Rajat Rajat
    20. March 2022 at 17:12

    An interesting question is what will you do if an impending or worsening recession coincides with a Trump (re-)election? Sounds like we might get twice as many posts as we’ve become accustomed to!
    Seriously, since we’re now in the realm of expert piloting rather than (inflatable) autopiloting, although you don’t give investment advice, I’m wondering if it might be time to lighten the equities weighting of my pension fund portfolio. Just one question: Not being a bonds person, I don’t follow your point about not being able to use the 10-yr TIPS spread and the implicit market prediction of 1.99% PCE inflation for the last 3 years of the decade. How do you derive that?

  20. Gravatar of Michael Sandifer Michael Sandifer
    20. March 2022 at 17:54


    I agree that adopting 5% NGDPLT at this point, without an explicit commitment, would likely lead to a recession, ceteris paribus. This would be due to the unexpected overheating, and the lagged wage adjustment.

    I also agree that the Fed is not likely to adopt NGDPLT soon, given that they just changed their policy regime recently, and that I can’t think of a single FOMC member who thinks they would know how conduct such a policy. As far as I know, none of them are aware of how to impute the expected mean NGDP growth path in stock prices, nor do any of them support the idea of setting up an NGDP futures market.

  21. Gravatar of ssumner ssumner
    21. March 2022 at 08:29

    Daniel, In many ways it’s worse than 2008. In that year, inflation and NGDP gave mixed signals. Now they are both screaming that policy is too expansionary.

    You said:

    “What if they’re targeting the average inflation rate from 2015-2025?”

    Three problems:

    1. That would be really dumb.
    2. They’ve given no indication they are doing that.
    3. Even if they were, there’d be no reason for their implied forecast of the 2030 price level to vary by more than 15 percent points. Indeed it should not really vary at all over the past 12 months.

    Ram, Yes, it’s not easy to read stock market responses to policy, as stocks respond to both nominal and real changes, as you say.

    Rajat, There is only 8 years left, and the market forecast of inflation changes year to year. That’s why I use the five year TIPS, and then the 5-year, 5-year forward TIPS. The latter is a better estimate of the missing two years at the end of the 10 year.

    I won’t offer investment advice. 🙂

  22. Gravatar of ChrisinVa ChrisinVa
    22. March 2022 at 07:49

    Scott, I’ve been waiting for this day! I sought out a book on macroeconomics way back in November 2021 because I was worried about inflation. By good luck, I found The Money Illusion. I had already been worried about inflation for several months at that point, and I wanted a better understanding of what the Fed actually does. Since then I’ve been following your blog occasionally, waiting for you to go into full battle mode on this inflation. It has been a long wait.

    Your description of “sticky” prices and “sticky” wages really hit home with me, as my salary has not increased since March of 2021, but prices have taken off in that time. My company is expected to give across-the-board salary increases later this month, but they already admitted that the increases were budgeted in June 2021, when company officials “believed” the rhetoric about inflation being short-lived. So now I am looking at up to 2 years with no meaningful COL adjustment, and prices rising near double-digits year over year.

  23. Gravatar of luigi luigi
    22. March 2022 at 11:48

    Sorry, but the Austrian School destroys Sumner’s NDGP targeting all day, every day.

    I’ll take a 90 year old Mises brain over a thirty year old Sumner brain any day of the week. In fact, I might even take a dead mises brain over a live Sumner one.

    But I suppose since americans have reserve currency status you can keep fudging numbers, and play the psuedoscience game for short while longer.

    at the very best, monetary economists will be placed in the trash bin of history. at the worst, they will be remembered as tyrannical thugs who destroyed republics.

  24. Gravatar of ssumner ssumner
    22. March 2022 at 17:06

    Thanks Chris.

    Luigi, LOL, Hayek favored NGDP targeting. You know that, don’t you?

  25. Gravatar of James A James A
    22. March 2022 at 23:31

    “ Effem, All these political theories are 100% ad hoc. They can’t even explain the 2010s. A few years ago I was told that we had lowflation because creditors had all the political power.”
    They did, and then came Trump. And debtors are now in charge. 100% ad hi , but still factual.

  26. Gravatar of ssumner ssumner
    25. March 2022 at 10:20

    James, But Trump is gone. So Obama is a creditor guy and Biden is a debtor guy?

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