Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Wednesday, September 29, 2021

EEA-ESEM Panel: Macroeconomic Consequences of the Pandemic

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 Copenhagen
August 25, 2021

I 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.