The Fed and the Administration: Don’t Believe Your Lyin’ Eyes At the Supermarket Checkout
The basic lesson of Milton Friedman and Anna Schwartz’s majestic Monetary History of the United States is that most major economic disruptions in the history of the US have monetary origins. Since 1913, and the creation of the Federal Reserve, the Fed has been responsible for these monetary shocks. Which is why Friedman advocated rules over discretion, to reduce the degrees of freedom available to the Fed to fuck things up.
For this, with a few exceptions, Fed board members and chairs have hated Friedman, and attempted to devise alternative histories that blame others for Fed f-ups. Current Fed chair Jerome Powell has joined that crew of ankle biters.
The price level has spurt upwards lately, leading to fears of a resumption of 1970s-style inflation. Not wanting to admit that the current price level increases could be harbingers of true inflation (a sustained rate of increase of the price level), Powell is attempting to argue that these recent increases are due to idiosyncratic factors (e.g., COVID-related supply chain shocks) that will not persist. In an attempt to make this case, Powell has engaged in a revisionist history of 1970s inflation.
In a nutshell: it was your fault. Or your parents’/grandparents’ fault. So if inflation happens again, it’s your fault.
The basic story is this. There were supply shocks in the 1970s (e.g., OPEC) that caused price level increases. These caused people to believe (mistakenly, per Powell) that there was true inflation. These inflationary expectations were self-fulfilling: these expectations decreased the demand to hold nominal balances, which increased the velocity of money, which per the PY=MV equation led to an increasing price level, which confirmed inflationary expectations, which kept velocity high, etc., etc., etc.
There is a core of truth to this: expectations matter in inflation. But monetary growth matters too, and money growth in the 1970s was clearly as much of a driver of inflation as a shift in expectations. Indeed, the money growth was likely a cause of the shift in expectations.
Inflation peaked and subsided when the Fed (under Volcker) put the brakes to monetary growth.
Why does this ancient history matter? Because Powell is using it to justify standing pat on monetary policy despite the recent price spurts. Sort of like someone Powell should NOT want to imitate–Arthur Burns, who made very similar arguments in the 1970s. It was exactly the same don’t worry, be happy complacency that Powell expresses today that led Burns–and the country–down the path of inflationary perdition.
Indeed, Powell’s mistaken-inflationary-expectations argument is all the more reason to take aggressive action today to prevent a shift in inflationary expectations. If he really believes we’re all idiots who will confuse one-time price level shocks with true inflation, he should take aggressive action to show credibly that the Fed will not let inflation take hold. Using it to rationalize inaction which will likely exacerbate a shift in expectations is frankly idiotic.
And also like the 1970s, we are seeing a Democratic administration attempt to rationalize and blame. Case in point, Director of the National Economic Council Brian Deese. This oh-so-typical DC cockroach (who scuttled to Black Rock after the end of the Obama administration only to scuttle back to Washington with the ascension of a Democratic administration) was at pains to educate you idiots that what you are experiencing at the grocery story is a figment of your imagination, except when you pass the meat counter:
So I guess vegans should be happy!
This is transparently bullshit on many levels.
First, Deese is literally cherry picking by focusing on fruits and vegetables.
Second, if you look at other ag prices–notably corn, soybeans, and wheat–they have spiked in the last year (although they peaked in the summer and have turned down slightly). The increase in food prices is not limited to meat and poultry.
Here’s corn, for example:
Third, even looking only at meat and poultry Deese’s economics are idiotic and indeed represents another acid flashback to the 1970s.
For one thing, the consolidation in the meat sector occurred years ago, and cannot explain the increase in prices now. Furthermore, firms with market power raise prices above the competitive level, but that is different from causing an upward trend in prices (which is what inflation is). In attempts to deny the true cause of inflation in the 1970s, it was common for liberal politicians and liberal economists to blame “monopolies”: again, this is transparent bushwa, because although monopolies can raise price levels that’s different than causing an increase in the rate of change in the price level.
Indeed, ceteris paribus greater consolidation in the meat sector would tend to reduce input costs (e.g., corn and soy prices): greater monopsony power tends to decrease not increase input prices. That has obviously not happened in the last year. As noted above, corn, soy, and wheat prices have all spurted.
So there’s something else driving food price increases. Deese’s attempt to explain away what your lyin’ eyes see when checking out at the grocery store is pathetically and obviously wrong.
There may be a reason why this is a one time shock rather than a true inflationary trend. But Deese doesn’t provide any such reason, and his risible attempt to provide one seriously undermines his credibility.
And that ultimately is the problem. In the 1970s, the Fed’s and the Carter administration’s attempts to cast blame for price level increases undermined their credibility and contributed to the expectations spiral that Powell laments today. The 70s flashback of just such denial we are experiencing before our very eyes is the strongest indicator that real inflation will return. And with a vengeance, given the far weaker fiscal position of the US government (cf. the fiscal theory of the price level).
There was a recent Krugman wonk bit which spoke to this:
“these expectations decreased the demand to hold nominal balances, which increased the velocity of money, which per the PY=MV equation led to an increasing price level,”
Krugman’s point was that the reason increased M hasn’t led to inflation is that V fell. Because with low interest rates who worries about trying to gain 0.1% in interest by doing something with their cash? A decreased demand to not hold nominal balances perhaps.
OK, I’m fine with that. But the next question then becomes. OK, what happens when interest rates rise – as they will some damn day – and this process goes into reverse in a feedback loop? Which is exactly the bit that Krugman didn’t seem to want to go into. Sigh.
Comment by Tim Worstall — September 9, 2021 @ 2:27 am
Friedman’s fixed money supply growth rule suffers from the fact that in a modern economy not only money, but money substitues (“near money”) perform monetary functions to a varying degree. Thus the rule is cannot be put to practice (like nation building in Afhanistan) which is why it was abandonned during the 70ies when the myriad defintions of money (M1, M2, M3…) failed to adequatly reflect macro economic events.
Of course, a fixed price growth rule is even more absurd, besides well-known measurement problems – discussed for a over acentury now – it also has redistributive effects in non stationary economies with producivity growth.
And what we are witnessing now is the result of such an empty theory: for the Fed has no tools to distinguish between “transitory” and non transitory effects, i.e. given that in the past it has never bothered to distnguisch supply side from monetery effects – the likelyhood of a substantial policy error have never been higher….
Comment by Viennacapitalist — September 9, 2021 @ 2:55 am
Professor, thank you for the article! Casey Mulligan, who is certainly not a Biden supporter, thinks that inflation is largely not a Biden’s fault: https://www.nationalreview.com/2021/08/974676/ Do you agree with him?
Comment by mmt — September 9, 2021 @ 4:15 am
“if you don’t count beef, pork and poultry”: there you are, Americans pay a price for their uncivilised disinclination to eat lamb.
Still, can’t all you chaps sit up trees and shoot passing deer? Venison’s not too bad, especially if eaten as soup.
I suppose people in Florida could eat alligator. Here’s a recipe: “First catch your alligator. …”
Comment by dearieme — September 9, 2021 @ 5:43 am
As in the 70s, the gaslighting is an essential part of the policy: ‘We need to devalue the currency, significantly, but we can’t make it look like we are destroying it – blame the speculators, blame the workers, blame anyone except the people who actually control the printing presses.’
The easiest solution is simply to declare that the Fed/Treasury buys and sells gold at $30,000 per ounce, or some other suitably high number. But you gotta keep that kryptonite out of the discussion, certainly out of people’s portfolios. Hence they wheel out Deese to distract us with meat prices, while the actual business of destroying purchasing power continues apace in the background.
Meanwhile, in Bitcoin world, where there is one rule for monetary policy and zero discretion:
– everything else get cheaper every year;
– Satoshi Nakamoto doesn’t appear every few weeks to gaslight you.
Uncle Milton and Aunt Anna look down from above, and smile.
Comment by Ex-Global Super-Regulator on Lunch Break — September 9, 2021 @ 5:45 am
“Casey Mulligan … thinks that inflation is largely not Biden’s fault”: to this foreigner it has long been apparent that the common American tendency to blame economic problems on the sitting President is foolish.
(i) Presidents don’t control an economy in the way that they (at least in principle) command an army, and (ii) Economies are full of time delays and time lags.
For instance, rather a lot that’s happening now might plausibly be the result of actions of the Fed in Obama’s time, or the result of pandemic panic among state governors, or a zillion other things.
The things to blame His Senility for are, so far, pretty obvious – the capitulation in Kabul, the endless invasion across the Mexican border, and so on.
Comment by dearieme — September 9, 2021 @ 6:12 am
@mmt. Thanks. Glad you liked it.
I don’t blame Biden for what we have experienced so far. The focus of my post, and my concern going forward, is the interpretation of and response to the recent increases in CPI, PPI, and GDP deflator. Powell’s and the administration’s responses fill me with misgivings that they are about to repeat the mistakes of the 70s because they are recycling the same rationalizations.
My other major concern (briefly alluded to at the end of the post) is the impact of the fiscal binge that has occurred (under multiple administrations) and which would become far worse if Biden and the Democrats succeed in implementing even a portion of their spending plans. I am persuaded by the fiscal theory of the price level, and per that theory what is on the table portends massive inflation. Biden would be to blame for that–not what has happened so far.
Comment by cpirrong — September 9, 2021 @ 8:56 am
@dearieme–Many Floridians (and Cajuns and many east Texans) are up to the challenge. West Texans (and others in the South) can substitute rattlesnake.
Ever heard the old Jerry Reed song “Amos Moses”?
Comment by cpirrong — September 9, 2021 @ 8:58 am
‘So there’s something else driving food price increases.’
Here’s your answer tom “who’s responsible”? and “what is to be done” [(c) V.I.Lenin]
https://edition.cnn.com/2021/09/08/opinions/economy-weakening-goldman-sachs-covid-filipovic/index.html
Relevant quote:
The people who are refusing the vaccine and refusing to mask up aren’t just killing themselves and infecting their neighbors. They’re destroying the American economy.
Comment by Tatyana — September 9, 2021 @ 10:29 am
@Viennacapitalist. Rules vs. discretion goes beyond the specific rule that Friedman advocated in the 60s and 70s. An imperfect rule is likely far superior than allowing the likes of Jerome Powell (or Arthur Burns) run amok with discretion.
The issue of near money has been clarified to a considerable degree. In the early-1980s Gene Fama showed elegantly that base money (cash in circulation plus reserves) is relevant for determining the price level. The issue then becomes the demand for base money.
The 1970s debate revolved around the stability of the demand for money. Friedman’s argument for a quantity rule was based on his belief that this demand was highly stable. Hence, controlling supply of money would ensure price stability.
It is clear that Friedman’s confidence on this issue was misplaced. The availability of private liabilities (e.g., checking accounts, savings accounts) and the costs and risks attendant thereto impact the demand for base money. Similarly, the availability of non-bank private liabilities (e.g., shadow bank liabilities) and substitute means of payment (credit cards, and now crypto) affect the demand for base money. So do things like the drug trade–a big driver of the demand for cash!
Thus, the demand for base money is not constant, and there are shocks to the demand for base money that can lead to changes in the price level (and real activity). So as with the gold standard, there can be monetary shocks that arise from the demand side that can have price level (and output) implications. (I note that the Fed affected the demand for base money by paying interest on reserves.)
So if a simple Friedman quantity rule is problematic, what rule is superior? A Taylor Rule worked pretty well until the zero bound was hit. A nominal GDP target (advocated by Scott Sumner) has a Hayekian feel and considerable appeal.
No rule is or will be perfect. But some of the rules on offer are far superior to giving unlimited discretion to central banks.
Insofar as separating transient from permanent shocks is concerned, this is in essence a signal extraction problem. Price indices (e.g., CPI) are noisy measures of the price level. This is a problem perfectly suited to signal extraction techniques (e.g., Kalman filtering) but to my knowledge this technology has not been widely employed. Instead, central banks have relied on arbitrary exclusions of goods and services to calculate “core inflation” and the like. The problem is (as the article re Burns that I linked to) that this gives central banks way too much discretion to define “core” and they end up choosing definitions that meet their policy desires and confirm their biases. A Kalman filter (or particle filter) approach would provide much more rigor in the identification of transient shocks driven by idiosyncratic relative price changes (e.g., shocks to oil prices due to supply shocks) vs. true changes in the price level.
Comment by cpirrong — September 9, 2021 @ 4:24 pm
@ Prof
I was not aware of the Fama Paper, sounds interesting and will have a look at it (although solving for the demand vor base money is far more complex than it sounds, precisely due to the demand shocks that you mention and which occur with frightening frequency).
If I remember correctly, Friedman assumed an increasing demand for money due to demographics – hence the need for increasing supply – and constant velocity. Now it is true that velocity had been constant in the two decades prior to the 70ies, but ever since Henry Thornton (1802) it has been known to monetary theorists in Europe (ignored later by quantity theorits in the US, ie. Mr Fisher and his intellectuel heir Mr Friedman) that velocity fluctuates to a significant degree…
Certainly a rule based system appers superior to what we have know (with Fed members insider trading the markets) and NGDP targeting theoretically perfect (as it would start introducing producitivty aspects into monetary policy), I am still at odds to understand how this would work in practice, given that there are even more substantial short term measurement problems with NGDP than with the CPI, as witnessed by the substantial revisions that follow every quarterly estimate. Further (and this touches Fama as well) there is not necessarily a direct crelationship between Money stock and Money income (which in book determines the price level)- base money was not scarce in the great depression but due to high money demand money incomes contracted. Mr Sumner and the Fed can only influence the base money stock…
And of course, once the rule becomes entrenched it will start to be gamed by demagogues an entrenched elites (GDP definitions can change, etc)…
Your filtering proposals might work and warrant their own post we could debate. I did not mean to say that it is impossible to distinguish, just that the intellectual debate on how to best approach the problem has been missing for the better part of the last 4 decades….
Comment by Viennacapitalist — September 10, 2021 @ 12:13 am
I guess I’m eating ramen and Rice Crispies with, maybe a can of beans thrown in once in awhile. I’m gonna get some chickens and a pig and put them in the backyard, that should bust up the monopolies.
Where do they find these idiots? Austin and that other clown general, this guy, winkin, Blinken and nod (that would be Biden), your mom over at the CDC and Uncle Tony saying,”don’t look at this hand. Pay attention to the other one. Daszak and I were only goofin around.”
Comment by Donald Wolfe — September 10, 2021 @ 4:28 pm