Inflation: What Should the Fed Do and How Far Should It Go?

U.S. Federal Reserve Bank

Inflation is about Monetary Policy

Inflation appears to be at the top of everyone’s mind lately. That is understandable given that current inflation rates are at 40 year highs. It is likely to play a major role in determining the outcome of the 2022 mid-term elections, despite the fact that there is much bi-partisan blame to be parceled out for the current high rates of inflation. There are, also, a lot of silly proposals on the table for combating it, e.g. price controls and gas tax holidays. There are also some ideas that may be reasonable policy suggestions, in their own right, but have nothing to do with inflation, e.g. lowering tariffs, allowing Medicare to negotiate some drug prices, or facilitating more domestic energy production.

Milton Friedman, a Noble prize winning economist famous for his work on monetary theory and policy, said that “inflation is always and everywhere a monetary phenomenon.” Things like supply chain problems, higher oil and gas prices, Russia’s invasion of Ukraine, the rapid snap back from the Covid 19 induced recession, and aggressive fiscal policy did play a role. They helped to kick start the current inflation, but in the absence of accommodating monetary policy they would not have caused persistent inflation.

The Theory

In theory, all of the above would have resulted in some things becoming more expensive. Absent monetary accommodation, these price increases would have been accompanied by declining prices for other goods and services. If those price declines did not materialize, because of “sticky wages and prices” we would have seen a recession until the under-employment of labor and other resources forced a relative price adjustment.

Evidence Backing the Theory

Those who think this is just theory should take a look at the inflation rates in Switzerland. The inflation rate in Switzerland (3.4%) is about half that of the rest of Europe (8.6%), yet virtually all of the litany of other factors listed above were present for Switzerland. What is different? Switzerland does not use the Euro and Switzerland’s monetary policy is not controlled by the European Central Bank (the European version of the Fed). Also of note is Turkey, which runs its own, extremely loose, monetary policy and has an inflation rate of 78.6%.

The History: The Fed, The Energy Crisis, and Monetary Policy in the 1970’s

In the 1970’s the Federal Reserve Board attempted to avert a recession, in the aftermath of that decade’s oil price shocks, by expanding the money supply. The idea was to produce just enough inflation so that wages and prices for non-energy intensive goods could decline in real terms (but stay constant in nominal terms) while prices in energy intensive industries could increase in real and nominal terms. Done just right this results in mild inflation and no recession. Sadly, the strategy is nearly impossible to execute properly. The problem is that inflation, once started is devilishly difficult to stop. The result was the “stagflation” of the 1970’s, high inflation and low growth. It was not until Paul Volcker really put the screws to the system, in the early 1980’s, and drove interest rates over 20%, that inflation was finally crushed.

What Should the Fed Do Now?

The policy solution is straight forward, if somewhat distasteful. The Fed needs to reduce the rate of growth of the money supply and quickly raise real interest rates with all of the tools it has at its disposal.

Calculation of Real Interest Rates

Real interest rates are the difference between the nominal interest rate and the expected rate of inflation.

The 10 Year Real Interest Rate

In calculating real interest rates it is important to subtract an estimate of inflationary expectations rather than a historical inflation rate, like the CPI, from current interest rates. The problem with using calculated measures of inflation, like the Consumer Price Index (CPI), is that they are backward looking and the current interest rate is forward looking. If we use the current nominal yield on 10 year Treasuries of 2.9% and the Federal Reserve Bank of St. Louis’ estimate of average inflationary expectations over 10 years of 2.34%, the real 10 year interest rate is 0.56% (2.9 minus 2.34), or nearly zero.

The Short Term Real Interest Rate

If we use the New York Fed’s estimate of 12 month forward inflationary expectations of 6.8%, the real short-term (one year) interest rate is -3.8% based on the current nominal yield on Treasuries of about 3%.

However you look at it, real interest rates, despite recent Fed action, are still either extremely low or significantly negative.

What Should the Target Be?

How high should the Fed push real interest rates? Reasonable people can disagree about the target and the speed for getting there. My own preference would be to see real short-term (1 year) interest rates at about 1-2% and long term (10-30 year) real rates of 3-4%. Getting there will require nominal interest rates in the high single digits or possibly higher. I am not sure what the appropriate speed should be to reach this target but I am sure that it is faster than the Fed is currently moving.

Will this Mean a Recession?

Maybe, but the longer we wait before trying to bring inflation down, the deeper and longer lasting the recession will be. We have already waited too long.

“Price Gouging”: The Futility of Progressive Politics

What is Price Gouging Anyway?

Elizabeth Warren Seizes the Stage Again

Sen. Elizabeth Warren has grabbed the spotlight with another foolish idea: price controls. She calls it “Anti-Price Gouging.”

Why are Price Controls Bad?

Those of you, who are old enough, will remember waiting in line, for hours sometimes, to fill up your gas tank in the late 1970’s. Why did that happen: price controls. What happened when price controls were abandoned: no lines. This isn’t complicated. Anyone who manages to make it to the mid-term exam in the first micro-economics course can explain why. Draw a demand curve and a supply curve. Where they intersect is the market price. Now draw a line horizontally across below the market price at the controlled price. Note the difference between the quantity demanded, at that controlled price, and the quantity supplied. That difference is the shortage you have just created with price controls.

Anti-price gouging has no meaning, unless it means imposing price controls.

Who is Pushing for Price Controls?

Warren wants to combat “price-gouging.” which means she either wants to engage in meaningless political posturing or she wants the FTC to impose price controls. She has some allies in the Senate and House. The legislation is cosponsored by Senators Bob Casey (D-Pa.), Sheldon Whitehouse (D-R.I.), Bernie Sanders (I-Vt.), Ed Markey (D-Mass.), Jeff Merkley (D-Ore.), Tammy Duckworth (D-Ill.), and Dianne Feinstein (D-Ca.). In the U.S. House of Representatives, this legislation is cosponsored by Chairman Jerrold Nadler (D-N.Y.) Rep. David Cicilline (D-R.I.), Val Demings (D-Fla.), Katie Porter (D-Calif.), Ro Khanna (D-Calif.), and Bobby L. Rush (D-Ill.).

If you follow the Centrist Independent Voters Rogues Gallery of candidates (ones we would find it difficult to ever endorse) you will recognize many of these names.

For the purpose of completeness, I will be adding Warren and her co-sponsors to the list, most of them, including Warren, all already there.