EEA-ESEM Panel: Macroeconomic Consequences of the Pandemic
Blog: MacroMania
Abstract
I was recently asked whether I'd like to share my thoughts on monetary policy in a post-pandemic world. Sure, why not? Thanks to Jan Eckhout for thinking of me. The panel was hosted by the European Economic Association last month and moderated by Diane Coyle. I was honored to speak alongside Ricardo Reis and Beata Javorcik, both of whom provided riveting presentations. For what it's worth, I thought I'd provide a transcript of my remarks here. Lunch Panel EEA-ESEM CopenhagenAugust 25, 2021I want to focus my discussion on the U.S. economy
and from the perspective of a Fed official concerned with the challenges the
Fed may face in fulfilling its Congressional mandates in a post-pandemic world.
First, to provide a bit of context, let me offer
a bit of history on policy and, in particular, on what I think were some
policy mistakes. Let me begin with the 2008-09 financial crisis, which is
something I think most people would agree should never have happened. Whether a sufficiently aggressive Fed lender-of-last-resort operation would have averted the crisis remains a open question. Even if it had been successful, such an operation would have had costs. It may, for example, have elicited
an even greater political backlash than we saw at the time--and who knows how this
may have manifested itself as undesirable changes to the FRA. As well, such an
intervention may have just pushed mounting structural problems down the road.
In particular, while it's now clear that some private sector lending practices
needed to change, it's not clear where the incentive to do so would have come
from absent a crisis. In any case, the crisis happened. How was it managed?
The ensuing recession was deep and the recovery
dynamic very slow. The prime-age employment-to-population ratio did not reach
its pre-pandemic level until 2019, a full decade later. Nevertheless, on the
whole, I think the Fed followed an appropriate interest rate policy. There were
one or two times the FOMC exhibited a little too much enthusiasm for
"normalizing" policy, but I think the slow recovery dynamic had more to do with
insufficient fiscal stimulus—especially at the state and local level—rather
than a consequence of inappropriate monetary policy. The evidence for this can
also be seen by the fact that inflation remained below the Fed's 2% target for
most of the time the policy rate was close to its ELB. The Fed has interpreted
this low inflation episode as partly a monetary policy mistake, something its
new AIT regime is designed to address. But my own view is that persistently low
inflation—and the low money market yields that go along with it—have more to do
with the supply and demand for U.S. Treasury securities. This is something the
Fed does not have very much direct control over.
I know many people are skeptical of fiscal
theories of the price-level, but in virtually every economic model I know, a
fiscal anchor is necessary to pin down the long-run rate of inflation. Monetary
policy—specifically, interest rate policy—can, of course, influence the
price-level, so monetary policy can influence inflation dynamics. But it can do
so only in the "short run." Interest rate policy alone cannot, in my view,
determine the long-run rate of inflation, at least, not without appropriate
fiscal support.
Now, I know many of you may be asking how I can
think fiscal policy has very much to do with inflation given how rapidly the
debt has risen since the financial crisis and again with the C-19 crisis, all
with little apparent pressure on long-run inflation expectations and on
long-term bond yields. We should, however, keep in mind that an observed change
in the quantity of an object may entail both supply and demand considerations.
And one can easily point to several forces that have contributed to increases
in the global demand for UST securities in recent decades. For example, the
growing use of USTs as collateral in repo and credit derivatives markets
beginning in the 1970s and accelerating through the 1980s. The growing demand
for USTs as a safe store of value from EMEs. The evaporation of private-label
safe assets during the financial crisis that left a gaping hole for USTs to
fill. Next, we had a large increase in the regulatory demand for USTs coming
out of Dodd-Frank and Basel III. The Fed's SRF and FIMA facility should further
enhance the demand for USTs. On top of all this, we've witnessed an emergent
class of money funds called "stablecoins" that are further contributing to the
demand for USTs. These forces have been disinflationary, leading bond investors
to revise down their expectation of the future path of policy interest rates.
It is interesting to ponder a counterfactual here. In particular, think of what
may have transpired absent an accommodating U.S. fiscal policy. We may very
well have experienced the mother of all deflations. If this is correct, then an
elevated debt-to-GDP ratio, given a relatively stable inflation and interest
rate structure, reflects an elevated real demand for outside assets. The
problem is not that the debt-to-GDP ratio is going up. The problem is what
disruptions might occur if it goes down
owing to a sudden and unexpected inflation.
The recent rise in inflation is concentrated in
durable goods, and I think is mostly attributable to ongoing supply-chain
issues associated with the pandemic. This effect is likely to reverse itself,
the way lumber prices recently have. Some of what I think is temporarily high
inflation may not reverse itself, leading to a permanently higher price-level. In
this case, households will worry whether their wages will keep pace with the
higher the cost of living. There is even the possibility—though I think less
likely—that the rate of inflation itself will remain elevated and that
inflation expectations will rise well above the Fed's 2% target. This may
happen, for example, if the traditional bipartisan support for fiscal anchoring
in the new generation of Congressional representatives is perceived to wane, or
if the global demand for safe assets slows. If either or both of these things happen
and are persistent, then the Fed may find itself faced with what Sargent and
Wallace phrase an "unpleasant monetarist arithmetic." That paper, which was
published exactly 40 years ago, warned how tightening monetary policy without
fiscal support might actually make inflation go higher rather than lower.
The implications for U.S. monetary policy are
quite interesting should an event like this unfold. A determined Fed may try to
fight inflation by raising its policy rate. The result is likely to be a temporary
disinflation and recession. Should fiscal policy remain unaltered, the
logic provided by Sargent and Wallace implies that inflation will return even
higher than before as the deficit must increase to finance a larger interest
expense on the debt. The best the Fed can do in this case is to lower its
policy rate, announce a temporarily higher inflation target, and hope that the
fiscal authority gets its house in order. The notion that a Volcker-like policy
would lower the long-run rate of inflation depends on fiscal capitulation. This
capitulation to some extent did happen under Volcker, although keep in mind he
had considerable Congressional support from both sides of the aisle. I do not
think this type of political support is something one can count on, especially
given today's political climate. So, you may want to buckle up, as we may be in
for some interesting times ahead.Related Readings:Is it Time for Some Unpleasant Monetarist Arithmetic? Link to blog post. Link to paper.
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