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….

Central Banks and Climate Policy

Avoiding a climate catastrophe requires an urgent global effort on the part of households, firms and governments to reduce our reliance on fossil fuels. Like many economists, we support a carbon tax. We also favor generous fiscal support for R&D to substitute for fossil fuels and remove carbon from the atmosphere.

What role should central banks play in this global effort? That is the prime focus of this post. We argue that central banks must preserve the independence needed for effective monetary policy. That implies only a modest role in addressing climate change.

Central banks are involved in both financial regulation and monetary policy. In each case, there are some things that central bankers can and should do to help counter the threat posed by climate change. As financial regulators, they should implement an improved disclosure regime and develop tools to ensure the financial system is resilient to climate risks.

In conducting monetary policy, central bankers should follow a simple, powerful principle: do not influence relative prices. To be sure, it is and should be standard practice to use interest rates to influence relative prices between consumption today and tomorrow. However, central banks ought not influence relative prices among contemporaneous activities. We will see that achieving this form of relative price neutrality may require central bankers to shift the composition of their assets and to alter the treatment of collateral in their lending operations….

Limiting Central Banking

Since 2007, and especially over the past year, actions of public officials have blurred the lines between monetary and fiscal policy almost beyond recognition. Central banks have expanded both the scope and scale of their interventions in unprecedented fashion. This fiscalization risks central bank independence, thereby weakening policymakers’ ability to deliver on their mandates for price and financial stability. In our view, to find a way to back to the pre-2008 division of responsibilities, officials must establish clearer limits on what central banks can and cannot do.

In that division of official labor, it is fiscal authorities that ought to make the unavoidably political choices that directly influence resource allocation. And governments should not conceal such fiscal actions on the balance sheet of the central bank. In a democracy, doing so lacks legitimacy and would become unsustainable….

What's in store for r*?

It is amazing how things we once thought impossible, or at least extremely improbable, can become commonplace. Ten-year government bond yields in most of Europe and Japan are at or below zero. And, for U.S. Treasurys, the yield has been below 1 percent since March.

A confluence of factors has come together to deliver these incredibly low interest rates. Most importantly, inflation is far lower and much more stable than it was 30 years ago. Second, monetary policy remains extremely accommodative, with policy rates stuck around zero (or below!) for the past decade in Europe and Japan, and only temporarily higher in the United States. Third, the equilibrium (or natural) real interest rate (r*)—the rate consistent in the longer run with stable inflation and full employment—has fallen by roughly 2 percentage points since 2008 and is now only 0.5% or lower.

How long will this go on? What’s in store for r*? Focusing on the United States, in this post we discuss the large post-2007 decline in r* that followed a gradual downward trend in prior decades. After considering various possible explanations, we focus on the change in U.S. saving behavior. Around 2008, there was an abrupt increase in household savings relative to wealth and income. Combined with increased foreign demand for U.S. assets, this appears to be a key culprit behind the recent fall in r*.

We doubt that this will change anytime soon….

An Economic Zombie Survival Guide

Everyone surely hopes that zombies will remain confined to the growing list of horror movies. But unless we shut them down, insolvent firms can become economic zombies that suffocate innovation and growth.

As the COVID pandemic continues, policymakers will face some difficult decisions. Many businesses are coming under increasingly severe financial stress. Some, like dry-cleaning establishments that rely on laundering clothing for office workers, have limited prospects even after the pandemic subsides. But there are others that have a bright post-COVID future if they can hold on long enough. Without a way to distinguish these two groups, we face an unpleasant choice of either creating zombies or allowing viable firms to perish.

In our view, the solution to this problem is to reinforce and modify the bankruptcy process. This means ensuring that there are sufficient resources to restructure the debts of those whose expected future profits exceed their liquidation value, while allowing the remainder to close. In the case of large corporations, we can make use of Chapter 11. For smaller firms, if it is not already too late, we need a low-cost mechanism more tailored to their needs.

In the remainder of this post, we discuss these two related issues: zombie firms and the use of bankruptcy procedures to identify and sustain viable firms.

Fed's big stick lets it speak powerfully

The powerful stabilizing impact of the Federal Reserve’s COVID response is visible virtually across U.S. financial markets. What is most remarkable about this is how little the Fed has done to achieve these outcomes. To be sure, the central bank now holds $7 trillion in assets, an increase of $2.8 trillion since early March. Yet, virtually all the increase reflects large-scale purchases of government-guaranteed instruments. What we find astonishing is that the acquisition of risky nonfinancial debt remains tiny.

The point is clear: backed by massive fiscal support, the Fed’s mere announcement of its willingness to purchase corporate and municipal bonds, as well as asset-backed securities, has proven sufficient to stabilize markets despite the worst economic shock since WWII. Put differently, the Fed’s willingness to backstop markets has obviated the need to serve actively as a market maker of last resort.

In this post, we document these developments and then speculate about their implications. For one thing, in a future crisis where the U.S. fiscal and monetary authorities share key goals, people will now anticipate that the central bank will backstop financial markets. Because a central bank is almost certain to intervene when systemic risks rise, these stabilizing powers are welcome.

At the same time, the central bank’s backstop is a source of potentially serious moral hazard. We suspect that investors are now counting on Fed stimulus to support equity and bond prices (and possibly bank loans) even as household and business insolvencies rise. Yet, in a market economy, it is shareholders and creditors who ultimately must bear these losses. Indeed, were the U.S. equity market to plunge by 40 percent in the remainder of 2020, that by itself would pose little threat to the financial system, and ought not trigger large corporate bond (let alone equity) purchases by the central bank….

Stress tests lack COVID-scale stress

In recent months, the Federal Reserve acted aggressively to support nearly all parts of the U.S. economy. Unprecedented monetary policy actions, both in size and scope, served to maintain market function and the flow of credit. And, while we have misgivings about the Fed’s CARES Act-driven moves to support the nonfinancial sector, we applaud Chair Powell and his colleagues for their quick and decisive actions (see our previous posts here, here and here). This, together with fiscal policy support for individual households and small firms, has kept an awful situation from becoming far worse—at least for now.

But, the Fed’s responsibility extends beyond monetary policy to the regulatory and supervisory arenas: it is obliged to maintain the safety and soundness of the banking system (and, to some extent, of the broader financial system). On this score, and in stark contrast to its actions in 2009, the Board of Governors has come up significantly short. Without full disclosure of the latest stress test results, suspicions will linger about the ability of the largest banks to provide credit to healthy borrowers if the COVID recovery falters. (See our earlier post for details.)

In this post, we examine the results from the Fed’s 2020 assessment of bank capital adequacy published on June 25. Based on the COVID-related sensitivity analysis—for which individual results are unavailable—one-quarter of the 33 banks tested fall below the regulatory minimum in the worst of the three cases. The fact that we can only guess which banks those might be creates suspicion regarding many banks….

An Open Letter to Randal K. Quarles, Federal Reserve Vice Chair for Supervision

Dear Vice Chair Quarles,

Nearly three years ago, we wrote an open letter congratulating you on your nomination as the first Vice Chair for Supervision on the Board of Governors of the Federal Reserve System. In that letter, we highlight the central mission of ensuring the resilience and promoting the dynamism of the U.S. financial system.

Today we write to express our profound disappointment regarding the plans (expressed in your June 19 speech on “The Adaptability of Stress Testing“) to limit the disclosure of this year’s large-bank stress tests. In our view, failure to publish the individual bank results from the special COVID-19 related “sensitivity analysis” weakens the credibility and effectiveness of the Fed’s stress testing regime.

Consequently, we urge you to reverse course and to announce this week the individual bank sensitivity results, along with the aggregates. To put it bluntly, the point of a supervisory stress test is disclosure. Anything short of full transparency leaves potentially destabilizing questions unanswered.

The Fed's Crystal Ball: Looking Beyond the COVID-19 Recession

Over the past 75 years, no one has seen anything like the COVID-19 shock to the global economy. Nor have we seen anything like the swift, broad and massive fiscal and monetary expansion that followed.

In the United States, the economic rebound has started. As states and municipalities relax the lockdown, businesses closed by the virus are gradually reopening and employment is rising. But, there remains tremendous uncertainty about the speed and extent of the recovery.

This was the backdrop for the Federal Open Market Committee’s (FOMC) release last week of its June Summary of Economic Projections (SEP)—the first SEP since December. Unsurprisingly, attention usually focuses on the FOMC’s interest rate projections: with the exception of two participants, the Committee does not anticipate an interest rate increase over the forecast horizon to the end of 2022.

In this post, we concentrate on the Committee’s projections for the real economy. Our conclusion is that these contain two elements of optimism. First, while the recession is clearly the worst since the 1930s, FOMC participants believe that the recovery will be roughly twice as fast as the one from the GFC. Second, their projections are that longer-run economic growth will match the pre-COVID pace. That is, in contrast to the GFC experience, COVID-19 will not usher in a slowdown in trend growth. Compared to the FOMC, we believe there is room for disappointment, especially with regard to the longer run.

Fiscal Space Has Limits, Too

In the battle against the economic impact of COVID-19, governments around the world are pulling out all the stops. In advanced economies, leading central banks have pushed interest rates to zero or below. And, a recent IMF estimate puts the combination of discretionary spending and automatic fiscal stabilizers (including unemployment insurance and progressive income taxation) at $9 trillion―more than 10 percent of global GDP.

With bond yields low or negative, the limits to monetary policy are clear (see our pre-COVID post). How large is the scope for additional countercyclical fiscal policy? With sovereign yields so low, the cost of additional financial expansion looks to be minimal, at least for now (see, for example, Blanchard).

Nevertheless, each time public debt-to-GDP ratios ratchet higher—as they did in the 2007-09 crisis and are now doing again—the question of “fiscal space” reemerges. When the next economic shock hits, will governments again be able to provide relief and stimulus on the scale required to meet society’s needs?

In this post, we highlight recent fiscal developments in advanced economies, and review the factors affecting the sustainability of their high and rising levels of debt. To foreshadow our conclusion, the fact that many countries’ fiscal positions were precarious even before the COVID crisis does not weaken the current case for stimulus. But, doubts about fiscal space are growing. So, it is important that governments find a way to make a credible commitment to future fiscal consolidation when their economies have returned to full employment. Failure to do so could threaten confidence both in government finances and in economic performance….

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Money, Banking, and Financial Markets