Constrained efficient inflation

I haven't had time to do much blogging lately. But I have been studying the recent burst of inflation and thinking of how to interpret what we're experiencing. As is my way, I decided to write down a little model (a dynamic general equilibrium model) to help organize my thinking on this question. Below, I summarize the interpretation stemming from the model (available on request). Because it's a model, it does not capture everything that one might think isimportant. But I think it certainly captures some of the main forces operating on the U.S. economy over the 2020-2022 time period. And if so, then it offers a different take on how to interpret the recent episode of (relatively) high and (hopefully) transitory inflation. I look forward to any feedback. DA

Introduction 

In February 2020, the month before the full effects of the pandemic were felt in the United States, PCE and CPI measures of inflation were running between 1.7% and 2.4%, consistent with the Federal Reserve's official 2% target inflation rate. From March 2020 to February 2021, these measures of inflation declined significantly, with most measures falling below 1% in May 2020, before recovering to somewhere near 1.5% by February 2021. In March 2021, measures of inflation began to rise sharply and significantly. By February 2020, the month prior to the Russian invasion of Ukraine, PCE and CPI inflation rates rose to between 5.4% to 8.0%, with core PCE peaking in that month. Other measures of inflation peaked in the summer of 2022. Inflation has been declining slowly and steadily since then. Most outlooks have inflation declining to between 2% and 3% by the end of 2024.

    If inflation continues along its projected path to settle in at or even somewhat above 2%, then the recent inflation dynamic will be hump-shaped, beginning in 2021, peaking in 2022, and falling significantly in 2023; see Figure 1.

Figure 1

   How should we interpret the hump-shaped inflation dynamic in Figure 1? The answer to this question is critically important because an evaluation of monetary and fiscal policy over this episode requires a proper interpretation of the phenomenon being studied. More than one interpretation is possible, of course. But any useful interpretation will have to rely on theory at some level. The goal of this paper is to develop a dynamic general equilibrium model that can explain the qualitative properties of data in an empirically plausible manner and be used to assess the monetary and fiscal policies employed since March 2020.

An overview of the argument 

    Views on the causes and nature of the "COVID-19 inflation" vary considerably. There is no doubt an element of truth to many of these views and my interpretation below relies on more than one causal factor. 

    Beginning in March 2020, there were the supply disruptions induced by the pandemic. Some sectors of the economy, like leisure and hospitality, were virtually shut down in an attempt to "flatten the curve." Individuals stopped patronizing establishments delivering in-person services. The prime-age employment-to-population ratio fell from 80% to 70% from February to April in 2020 and did not recover its initial level for another two years. Severe disruptions in the global supply chain led to shortages of goods at final destinations. At the time these COVID-19 related shocks had more or less dissipated, additional disruptions emerged with the Russian invasion of Ukraine in late February 2022 along with growing Sino-American tensions. 

         These "supply side" shocks were real and significant. It is not entirely clear, however, how they might be used to understand the inflation dynamic in Figure 1. The intensity of the "supply side" shock likely peaked in 2020, a year in which inflation declined. And the Russia-Ukraine war shock appeared in 2022, after the sharp rise in inflation in 2021. Of course, these observations do not mean that supply disruptions had no effect on the inflation dynamic. But they do suggest that other forces were likely at work. 

         Other important forces were surely at work on the "demand side" of the economy. Exactly what these forces were and how they should be modeled remains an open question. Guerrieri, Lorenzoni, Straub, and Werning (2022) demonstrate how a negative sectoral supply shock in an incomplete markets setting can endogenously result in "deficient demand" (a decline in actual output in excess of the decline in potential output). Although their paper does not focus on inflation dynamics, the mechanism they identify is presumably disinflationary; at least, on impact. 

         Another way in which demand can be affected is through expectations. Developed economies devote significant amounts of time and resources to activities broadly classified as investments, including business fixed investment, residential investment, human capital accumulation, and job recruiting. The contemporaneous demand for goods and services devoted to investment (broadly-defined) surely depends on its expected rate of return. Indeed, there is considerable evidence suggesting that this is the case; see Liao and Chen (2023) and the references cited within. Whether these expectations are driven by news over economic fundamentals (e.g., Beaudry and Portier, 2006) or by purely psychological factors (e.g., Keynesian "animal spirits") matters little for positive analysis. Depressed expectations over the return to investment will depress investment demand whether expectations are formed rationally or not. The manner in which expectations are formed does, however, have implications for monetary and fiscal policy. 

         The analysis below assumes a large "negative sentiment shock" in 2020, consistent with the fear and uncertainty associated with the unfolding pandemic and the dramatic measures taken to shut down parts of the economy. When the outlook on investment returns darkens, investors typically seek safe havens. During the financial crisis of 2008-09, U.S. Treasury securities served as a "flight to safety" asset. The result was plummting bond yields. To the extent that interest rates do not (or cannot) move lower, the demand for safety expresses itself as a decline in capital spending and the price-level. That is, a negative sentiment shock is disinflationary; at least, on impact. Below, I assume that this negative sentiment shock largely reversed itself in 2021, consistent with the appearance and widespread use of COVID-19 vaccines in that year. 

         Now, imagine for the moment, that monetary and fiscal policy remained roughly unchanged from 2019 to today. That is, imagine that the Fed did not lower its policy rate in March 2020 and that the large discretionary fiscal programs (primarily the CARES Act of 2020 and the American Rescue Plan of 2021) had not been implemented.

 Assume that the negative sentiment shock was significantly more powerful than the negative supply shock in 2020, in line with Guerrieri, Lorenzoni, Straub, and Werning (2022). Assume that these two shocks are largely reversed in 2021. Then the supply-demand framework sketched above suggests a large disinflationary impulse and recession in 2020, followed by an equally large inflationary impulse and economic recovery in 2021. Depending on the nature of adjustment costs, employment and inflation should have more or less returned to their pre-pandemic levels by 2022 or shortly thereafter. To a first approximation, this is essentially what happened. However, actual inflation turned out to be much higher and more persistent than can be rationalized by these shocks alone. What is missing?

         What is missing, of course, are the monetary and fiscal policy responses implemented at the start of the crisis. In March 2020, the Fed lowered its policy rate from 150bp to essentially zero where it remained until March 2022. The anticipated monetary tightening began in late 2021 (see the 2-year rate in Figure 2). From March to December of 2022, the federal funds rate rose by over four hundred basis points.

Figure 2

         From 2020 to 2021, the U.S. Congress passed a number of bills described as delivering "stimulus and relief." The two largest bills were the CARES Act, passed in March of 2020, and the American Rescue Plan (ARP), passed in March 2021. In broad terms, these spending packages had the following properties. First, the consisted largely of monetary transfers targeting the bottom half of the income distribution as well as distressed businesses. Second, the spending packages were large--around $2 trillion each--over ten percent of GDP in both 2020 and 2021. Third, the spending packages were not offset by spending reductions in other areas. Nor were surtaxes levied to finance the programs. The programs were financed with net new issuances of nominal securities purchased by the banking sector. That is, the transfers essentially took the form of "helicopter drops" of money; see Figure 3.

Figure 3

    The ultra loose monetary and fiscal policies over 2020-21 exerted strong inflationary pressures. In 2022, the Russian-Ukraine war contributed to headline inflation. The output loss in 2020 contributed to inflationary pressure. The reversal in business sentiment in 2021 contributed to inflationary pressure. 

    The inflationary pressures cited above were offset by strong deflationary pressures in 2020 and 2022. In 2020, there was a strong negative demand shock, resulting in a strong decline in investment with an accompanying movement in the demand for money (the inverse of money velocity); see Figure 4.

Figure 4

     As business sentiment reversed in 2021, the demand for money (safe assets, in general) declined. This turn of events occurred just as the ARP kicked in. Together, these two events generated a strong inflationary impulse in 2021. This impulse was counteracted in 2022 by strongly contractionary monetary and fiscal policies (a sharp rise in the policy interest rate in 2022 and the expiration of the ARP by the end of 2021). 

         The account given above is based on a model that I formalize below. Note that the account is purely qualitative in nature. This is because my model is designed only to flesh out the qualitative effects of a variety of economic forces that seem plausibly important (I am working on a quantitative version of the model with a coauthor). Formalizing the argument above through a simple dynamic general equilibrium model has two benefits. First, it will force me to be explicit about the assumptions I am making to render the verbal interpretation above logically coherent. Second, it will allow me to evaluate monetary and fiscal policies employed in the 2020-22 period. The model can also be used to perform counterf actuals. 

Policy assessment

The model suggests the following assessment.

1. Cutting the policy rate in March 2020 was appropriate only to the extent that there were forces driving a declining output below potential. A strong deflationary pressure is not sufficient to identify an "output gap," because rationally-pessimistic forecasts are deflationary. One would have to make the case that investors became overly-pessimistic. Or that sectoral shocks somehow led to deficient demand (Guerrieri, et. al., 2022). These are difficult arguments to make because "potential" is unobservable and prior to the arrival of the vaccines, a gloomy sentiment did not seem irrational. 

2. The fiscal transfers associated with the 2020 CARES Act were desirable. The policy mostly redistributed purchasing power (at a time when total output was declining) from high to low-income persons (the latter group being disproportionately affected by the shutdowns). Without the CARES Act, the economy would have likely experienced a significant deflation (benefiting those with wealth in the form of money/bonds). Hence, the desired redistribution was financed through an inflation tax. A temporary income or consumption tax might have been used instead. In this sense, inflation was at least in part an efficient tax (or constrained efficient, better ways of financing the desired transfers were available).

3. A case could be made that the 2021 ARP was desirable ex ante. A case could be made that it was undesirable ex post. Either way, the model suggests that the ARP was implemented at precisely the time investor sentiment had returned to normal. Essentially, 2021 saw a large increase in the supply of money and a large decrease in the demand for real money balances. Both effects served to drive inflation higher. 

4. Strong disinflationary policies were enacted at the beginning of 2022. First, fiscal policy became highly contractionary (by ceasing the ARP). Second, the Fed began to raise its policy rate aggressively. These disinflationary policies were partially offset by the inflationary consequences of growing geopolitical tensions. 

         My own assessment of monetary and fiscal policy over this period of time (based in part on my model) is as follows. First, the Fed should not have lowered its policy rate in March 2020 (its emergency lending programs worked as needed). Conditional on having lowered the policy rate (forgivable, in light of the weak inflation numbers), the Fed should have begun tightening sometime in 2021 (consistent with the recommendations of those economists who favor NGDP targeting). Second, despite all its warts, the CARES Act was essential and did what it needed to do. Third, desirability of the ARP is better weighed in political, rather than economic, terms. It was a redistribution policy. It was financed through an inflation tax. It might have been financed in some less-inflationary way. But a tax in some form would have been unavoidable. 

         The policies and programs put in place by our elected representatives to meet the economic challenges inflicted on us by the pandemic were designed to redistribute purchasing power. If those policies were widely viewed as desirable, then it seems strange to blame inflation (or some other tax) for inflicting economic hardship. Inflation was mainly a symptom of the solution to a problem inflicted on humanity by nature. This is the sense in which one can describe the recent inflationary episode as "constrained efficient inflation." 

PS. If the hump-shaped inflation pattern continues to play out, it will be judged by economic historians as a "transitory" inflation. There is nothing in the model which suggests that a recession is necessary for the transitory part. A helicopter drop of money creates a transitory inflation. This is textbook economics. 

There's No Free Lunch or: How I Stopped Worrying and Learned to Not Hate Inflation

Remember when the Fed's most pressing policy concern was missing their 2% inflation target from below for most of the decade following the financial crisis of 2008-09?  The concern never failed to puzzle me in all my time at the St. Louis Fed. I once let out how I really felt:

All those years I was expecting low inflation and low interest rates to make the political opposition to ever-higher deficits melt away. As I recall explaining to my colleagues at the time "Either we'll get the biggest free-lunch of all time (increased government spending and/or tax cuts) or we'll get inflation." The inflation was inevitable, to my of thinking. I just didn't know when it would return. I certainly did not see the point of encouraging it! 

Well, inflation returned. But not exactly for the reasons I was expecting. What happened? 

Shocks

What happened was COVID-19 and the Russia-Ukraine war. These two shocks were large, disruptive, and persistent. A great many people died. Large parts of the economy were shut down with the hope of slowing the spread of the virus so as not to overwhelm our limited ICU capacity. The leisure and hospitality sector was crushed, and other sectors as well. There was a massive (and highly unusual) reallocation of production and consumption away from services to goods--a phenomenon that has not fully reversed to this day. We learned about the delicate and interconnected nature of global supply chains. People modified their behavior in dramatic ways. Work-from-home seems here to stay. And then, of course, as if a global pandemic was not enough, Russia invaded Ukraine in early 2022, leading to the usual sickening consequences of war: death, destruction, and displacement--as well as energy disruptions and food shortages that reverberated across the global economy. 

This is not, of course, the only thing that happened. We also had policy responses. 

Policy: What was needed

I want to limit attention to economic policy here (health policy is another matter). The COVID-19 shock disrupted some sectors of the economy more than others. Some sectors, like leisure and hospitality were virtually shut down. But in many other parts of the economy, people were able to work from home. Since not many people purchased pandemic-insurance, a large number of Americans were in for a whole lot of economic hurt. Most of those adversely affected were in the bottom half of the income distribution. What could and should have been done?

I should like to think that most Americans would have been in favor of a social insurance program that supported those most in need; i.e., targeted transfers for as long as the pandemic remained disruptive. Most people would have recognized that this is the right thing to do. And even those few who seemingly do not care much for their fellow Americans might have recognized how redistribution would have been desirable, perhaps even necessary, to maintain social cohesion. We should not have wanted a replay of what happened in the last crisis, where the financial sector was bailed out while American many households were largely left flailing in the foreclosure winds that blew in the aftermath of 2008-09. 

How might such a program be financed? A consumption tax would have been one way. Imagine a "transitory" 5% federal sales tax to fund a targeted transfer program. The program parameters could, in principle, be calibrated in a manner that requires little or no adjustment in the deficit. Ideally, such an emergency program would have already been put in place. (As far as I know, there is still no such plan in place--a significant policy failure, in my view.)

How might things have played out with such a policy, given the sequence of shocks that unfolded? To a first approximation, my guess is "probably not much different." With the balanced-budget policy described above, inflation would have almost surely been lower. Imagine shaving 300-500bp off the "inflation hump" we've experienced so far:

We would almost surely still have had some inflation stemming from supply disruptions and energy costs (associated with the war). But inflation would have been less pronounced. Naturally, rather than complaining about high inflation, people would instead have been complaining about high consumption taxes. ("They told us they'd be transitory!") There's no such thing as a free lunch. 

Under this higher-tax/lower-deficit policy, most Americans would have felt worse off relative to 2019. The blame for this feeling, however, properly lies with the shocks and not the policy response. Yes, work-from-home types would not have received transfers and they would have been paying more for goods and services. This is the nature of redistribution, which I believe most people would have supported. 

Policy: What we got

To a large extent--and all things considered--we pretty much got what was needed: a set of redistributive policies with transfers targeted (mostly) to the bottom half of the income distribution (yes, yes, we can talk at length about how things could have been done better). Except that there was no surtax to fund the transfers. Our representatives in Congress chose to deficit-finance the programs. The resulting large quantity of treasury paper had to be absorbed by the private sector at a time supply was constrained and interest rates were not permitted to rise (I'll get to monetary policy in a moment). How does one not expect some additional inflation in this case? So, instead of a "transitory" consumption tax, we got a "transitory" inflation tax. There's no free lunch. 

By the way, by "transitory" I mean to say that inflation is expected to revert to target, instead of remaining elevated or even increasing. In the fall of 2020, I expected a "temporary" inflation (see here) because I thought the supply disruptions and CARES Act were not permanent. Inflation turned out to be higher and more persistent than I expected. But the supply disruptions have largely alleviated and the ARP expired at the end of 2021 (though the RUS-UKR war continues). Up until recently, I remained optimistic that--absent further shocks and with responsible fiscal policy--inflation would make its way back down to target in 3-5 years without a recession. I'm not as optimistic today, but let me return to this below. 

What about monetary policy? Well, I was very pleased with the way the Fed calmed financial markets in March 2020, as I expected it would.

Well done, Fed. But what about monetary (interest rate) policy?

Well, to be honest, monetary policy seemed a bit bonkers. Lowering the policy rate in response to recession engineered by a manufactured shutdown did not make much sense to me. My view was more in line with Michael Woodford's, as expressed here in his 2020 Jean Monnet lecture. What was needed was insurance, not stimulus. And this insurance needs to be delivered through fiscal policy. 

My own view is that many economists could not resist interpreting the severe decline in output as reflecting a conventional "output gap." To be fair, there may very well have been a decline in aggregate demand in the first half of 2020. The economic outlook at the time was very uncertain, which likely increased the desire for precautionary savings. Remember, monthly inflation rates for March, April and May of 2020 were negative. The monthly inflation rate only became positive in June 2020 (5.4% annualized rate), though it remained fairly subdued for most of  2020. 

Heading into 2020, the Fed's policy rate was around 1.6%. Was it really necessary to lower it any further? Especially in light of the fiscal transfers taking place throughout 2020?  But apparently, in the minds of some, perhaps even most, the economy needed "stimulating." 

In any case, it seems clear now, in retrospect at least, that the cut should probably not have happened or, conditional on happening, should have been quickly reversed once the financial panic had subsided. The main effect of interest rate policy according to many was an undesirable asset-price boom (stocks, bonds, and real estate). The increase in private sector wealth coming from higher asset valuations surely added some fuel to the inflationary fire. 

 

We can now see how that Fed-induced wealth effect is being undone. The rapidity of the rise in the Fed's policy rate is wreaking havoc on wealth portfolios. This is not a huge concern to the extent the policy is just reversing an undesirable asset-price inflation. But to the extent that these assets sit on bank balance sheets, to the extent these positions are not hedged against duration risk, to the extent that depositors are skittish, and to the extent that capital buffers are running low, then the banking system--or at least parts of it--are subject to runs. We are seeing this play out now in the United States. 

Where are we heading?
 

I fear we may be in a bit of a pickle. One reason is China. To be more precise, the risk of the U.S. entering a long and costly proxy war with China. Let's hope it doesn't happen. But I can't help thinking of Rome vs. Persia. I'm not sure about the Persian perspective, but my reading of history suggests that the late Roman Empire devoted considerable resources to defending its eastern frontier against its great rival. Such a fiscal strain requires taxes (or inflation). 

 

If the Sino-American proxy war scenario fails to materialize, then I think we stand a reasonable chance of getting out of this decade without a recession, but with inflation hovering above target for the indefinite future. The Fed might want to sell this as part of its "symmetric" inflation targeting regime. After all, we tolerated undershooting the target inflation rate for a decade (see here). In my view, much will depend on the course of fiscal policy--the deficit, in particular--in relation to the global demand for U.S. Treasury securities (see here). Needless to say, these are very difficult objects to forecast. (In fact, there's no point in forecasting them -- we should just make contingency plans instead.)

There is a chance that the Fed overdoes its policy tightening and starts to "break things." Given the recent events in the U.S. banking sector, the FOMC would, in my view, be wise to pause and see how things play out. This is not an issue of "financial dominance." It is based on the deflationary impulse induced by the recent bank failures. I expect all banks to redouble their efforts to repair their balance sheets. This means a fear-induced tightening of lending standards and slower loan growth beyond what one might consider to be a normal reaction against higher policy interest rates. 

 

If the Fed does pull a Paul Volcker, then we'll get a sharp recession. Inflation will come down--temporarily, at least. Where inflation goes from there will depend, as always (in my view), on fiscal policy. 

 

If the proxy war scenario does come to pass, then get ready to pay the necessary taxes. And remember: wars are typically inflationary. In fact, an inflation tax may not be a bad way to finance a part of this endeavor. The U.S. would effectively be collecting a greater amount of seigniorage on its U.S. Treasury securities held abroad. And why shouldn't our allies be prepared to shoulder some of the expense? (There are other ways, of course.) A proxy war may or may not be worth fighting. Either way, remember: there ain't no such thing as free lunch. 

 

As for monetary policy in a period in which the government has a set objective and wants to deficit-finance its spending, I'm afraid the Fed will just have to learn how to stop worrying and "love" inflation (in case you're unfamiliar with the reference, see here). Raising interest rates sharply can break things and create disinflation. But without fiscal reform, the respite on inflation is likely to be temporary. In fact, inflation is likely to reemerge even higher than before since the Treasury will now have to issue paper at an even faster pace, first, to cover the shortfall created by the recession, and second, to cover the higher interest expense of the debt. This is a version of Sargent and  Wallace's "unpleasant monetarist arithmetic," see here and here. Need I add that creating a recession is no way to win a proxy war. 

 

How will U.S. policy evolve to meet our many challenges? No one knows how the future will unfold. Perhaps we can take some comfort in Winston Churchill's observation: "You can always count on the Americans to do the right thing--but only after they've tried everything else." Alas, the quote is apocryphal. Nevertheless, I am hopeful that we will "do the right thing" eventually (and before it's too late).