Random Observations for Students of Economics
Recently, I had the opportunity to speak with Boston University economist Larry Kotlikoff and some BU students and faculty. You can listen to the conversation here at his podcast. You can also subscribe to Larry's substack here.
I am not attending the ASSA meeting in person this year, but I will participate via zoom in a session on Efficient and Effective Course Preparation. It is today from 2:30 to 4:30 CST at the Hilton Riverside, Grand Salon A Sec 3 & 6. The panel is also being streamed live. Click here for more information.
My recent paper for Brookings is now published. You can access the final version by clicking here.
Last week, Eric Budish of the University of Chicago gave a great lecture on cryptocurrencies at Harvard. You can watch it by clicking here.
I thought I might explain my fear that the Fed is in the process of tightening too much. Let me begin, however, with two points of agreement with the monetary hawks.
First, I agree that monetary and fiscal policymakers are partly to blame for the recent inflation surge. In fact, I warned about overheating in a February 2021 column in the New York Times.
Second, I agree that some significant amount of monetary tightening is in order. That is especially true because fiscal policymakers are doing little to help contract aggregate demand. Instead, actions like student loan forgiveness are doing the opposite. The so-called Inflation Reduction Act is a feckless political smokescreen.
The question is, how much monetary tightening is in order? This question is hard, and anyone who claims to know the answer for sure is not being honest either with you or with themselves. The reason it is hard is that monetary policy works with a substantial lag. It is no surprise that the recent Fed tightening hasn't had much impact on inflation yet. That is no reason to think the Fed needs to tighten a lot more. The Fed made the mistake of waiting for inflation to appear before starting to tighten. It would be a similar mistake to wait for inflation to return to target before stopping the tightening cycle.
The Taylor rule suggests one way to calibrate the problem. This rule of thumb says that the real interest rate needs to rise by 0.5 percentage points for each percentage point increase in inflation. The yield on the 5-year TIPs, which incorporates recent and near-term expected changes in monetary policy, has risen by 330 basis points over the past year. According to the Taylor rule, that would be appropriate if inflation had risen by 6.6 percentage points. Has it?
The answer depends on what measure of inflation one looks at. If you look at the CPI, then yes, the inflation surge could justify such a large tightening. But some of that inflation surge was due to temporary supply-side events. (Team Transitory was wrong, but not entirely wrong.) Wage inflation has increased only about 3 percentage points. By this metric, which can be viewed as a gauge of ongoing inflation pressures, a smaller monetary tightening would be appropriate.
A related issue is whether the normal real interest rate, sometimes called r*, is higher than the Fed previously thought. It might be. But I am inclined to think that there are long-run structural changes that explain the decline in real interest rates, as I explained in a recent Brookings paper. Those forces are likely to keep r* low in the years to come.
Another data series that I keep an eye on--though it is out of fashion these days--is the money supply. M2 surged before the large increase in inflation. Economists who watch the money supply, like Jeremy Siegel, were among the first to call the inflation surge. Yet over the past year, M2 has grown a mere 3.1 percent.
Finally, another factor is that the monetary tightening is occurring worldwide. Standard monetary rules like the Taylor rule do not explicitly incorporate the international linkages. But perhaps they should. Some of upcoming contraction of the U.S. economy will be attributable to the policies of foreign central banks. It is hard to say how much.
So, if I were one of the Fed governors, I would recommend slowly easing their foot off the brake. That means when the next decision comes and they debate an increase of, say, 50 or 75 basis points, choose the smaller number.
At this point, a recession seems a near certainty due, in part, to the Fed's previous miscalculations that led monetary policy to be too easy for too long. There is nothing to be gained from making the recession deeper than necessary. The second mistake would compound, not cancel, the first one.
From his famous AEA presidential address, still relevant more than a half century later:
I appreciate every new adoption of one of my textbooks, but this one, facilitated by my publisher Cengage at the request of my friend Patrick Moynihan of the Haitian Project, is especially heartwarming.
When I was young, Paul Krugman was one of my favorite economists, and I would try to read everything he wrote (which was a lot!). At some point, however, roughly coinciding with his becoming a regular New York Times columnist, he switched from writing as an economist to writing more as a political pundit. I then lost interest. His political commentary struck me as repetitive and slightly unhinged: "Conservatives are stupid, conservatives are evil, yada, yada, yada."
Yet his column in yesterday's paper caught my eye. It's titled "Is the Fed braking too hard?" I have been pondering this question myself, and my instincts tell me the answer may be yes. Paul makes the case well.
Anyway, I am here to recommend the Krugman column, which is something I did not expect myself to be saying.
Update: David Papell and Ruxandra Prodan reach a similar conclusion about current monetary policy.
"Europe's lower inequality levels cannot be explained by more equalizing tax and transfer systems. After accounting for indirect taxes and in-kind transfers, the US redistributes a greater share of national income to low-income groups than any European country."
I will be speaking at he 18th Annual Economics Teaching Conference sponsored by the National Economics Teaching Association (NETA) and Cengage, to be held Thursday evening the 27th and Friday the 28th of October in Atlanta. For more information, click here. Space is limited, so if you are interested, register early.
This paper from the Bank of England is interesting. A tidbit:
Inflation rates across firms have become more dispersed and skewed since the start of the pandemic. We find that average price inflation is positively correlated with the dispersion and skewness of the distribution.
In calendar year 2022, enacting the bill would have a negligible effect on inflation, in CBO’s assessment. In calendar year 2023, inflation would probably be between 0.1 percentage point lower and 0.1 percentage point higher under the bill than it would be under current law.
Of course, Piketty's thinking is very different from mine. Words like supply, demand, comparative advantage, and the mutual gains from trade are almost entirely absent from his book. Instead, we hear a lot about political power and exploitation of the weak by the strong. In Piketty's worldview, the standard undergraduate textbook in economics is largely a non sequitur. So is Adam Smith's The Wealth of Nations.
This new book purports to summarize the key points of the massive volumes that Piketty has previously written. What I found most interesting, therefore, was what was not included. Piketty does not mention "the central contradiction of capitalism," to use the phrase from his book Capital in the 21st Century. In that earlier book, we were told that r>g leads to an "endless inegalitarian spiral." For reasons I explained here, I always thought that this claim was absurd.
Why is this major theme from the earlier book omitted in this new one? Has Piketty tacitly recanted? It is hard to say.
I am the Robert M. Beren Professor of Economics at Harvard University. I use this blog to keep in touch with my current and former students. Teachers and students at other schools, as well as others interested in economic issues, are welcome to use this resource.
