Adverse supply shock

To improve Fed policy, improve communications

Since May 2021, we have criticized the Federal Reserve’s lagging response to surging inflation. In our view, both policy and communications were inadequate to address the looming challenge. Early this year, we argued that the Fed created a policy crisis by refusing to acknowledge the rise of trend inflation, maintaining a hyper-expansionary policy well after trend inflation reached levels far above their 2% target, and failing to articulate a credible low-inflation policy.

Against this background, we commend the FOMC for its recent efforts. Not only is policy moving quickly in the right direction, but communication improved markedly. In particular, despite the increasing likelihood of a near-term recession, Chair Powell made clear that price stability is necessary for achieving the second part of the Fed’s dual mandate. We suspect that the combination of the Fed’s recent promise to make policy restrictive, along with its improved communications, is playing a key role in anchoring longer-term inflation expectations.

In this post, we focus on central bank communication and its link to policy setting. By far the most important goal of communication is to clarify the authorities’ reaction function: the systematic response of central bank policy to prospective changes in key economy-wide fundamentals—usually inflation and the unemployment rate.

To anticipate our conclusions, we argue for two changes to the FOMC’s quarterly Summary of Economic Projections to better illuminate the Committee reaction function. First, we encourage publication of more detail on individual participants’ responses to link individual projections of inflation, economic growth, and unemployment to the path of the policy rate. Second, we see a role for scenario analysis in which FOMC participants provide their anticipated policy path contingent on one or more adverse supply shocks that present unappealing policy tradeoffs (for example, between the speed of returning inflation to its target and the pace at which the unemployment rate returns to its sustainable level)….

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Trend inflation: How wages and housing are sustaining momentum

While annual inflation may have peaked, it remains at levels we last saw in the early 1980s. Indeed, our preferred measure of the medium-term inflation trend– the six-month annualized change in the trimmed mean personal consumption expenditure price index—is up by nearly 5 percent. Fortunately, policymakers now realize the severity of the situation and are raising interest rates quickly as they work to catch up. Fed fund futures anticipate a rate of at least 3½ percent by yearend—the most rapid increase in more than 40 years. Will this be enough?

In this post, we address this question. Our conclusion is that policymakers will have to act more aggressively than financial markets anticipate if inflation is to decline to the Fed’s 2-percent target within two years. The reason is that inflation has substantial forward momentum arising from two sources. First, a tight labor market combined with elevated short-term inflation expectations appear poised to drive wage inflation higher. Second, there is the continuing impact of increases in prices of housing, both for owners and renters. So, while energy prices as well as other temporary drivers of the current high inflation are fading, and long-term inflation expectations remain reasonably contained, inflation is currently poised to remain well above 2 percent….

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Can vacancies plunge without a significant rise of unemployment?

The primary objective of central bankers is to maintain low and stable inflation. While this task was never easy, the recent bout of large, adverse supply shocks—from the pandemic to the Russian invasion of Ukraine—combined with massive demand stimulus (both fiscal and monetary) made the task of securing price stability far more difficult.

Our favored indicator of the inflation trend, the Dallas Fed’s trimmed mean PCE price index, rose at a 4.4% annual rate over the past six months, and seems to be accelerating. Furthermore, while activity has slowed, the U.S. labor market remains extraordinarily tight: there are nearly two vacancies for each person who is unemployed—well above the peaks of the early 1950s and the late 1960s.

Against this background, a large, recession-free disinflation seems highly unlikely to us (see our recent post). In theory, a plunge of vacancies could cool a very hot labor market without raising unemployment (see, for example, Waller). In practice, however, the behavior of the relationship between vacancies and unemployment since 1950—what is known as the Beveridge Curve—suggests that this is very unlikely (see Blanchard, Domash and Summers).

That is the subject of this post….

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