by Mish Shedlock, Mish Talk:
The Benefits of Running Hot
In a headline that seems like it could be from The Onion or the Babylon Bee, please consider Chicago Fed president Charles Evans On the Benefits of Running the Economy Hot
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In his speech Evans frequently refers to “r*” defined as the “equilibrium (or natural) real interest rate, or the rate consistent with full employment of the economy’s productive resources”
Let’s now tune in to his thoughts. It was relatively lengthy speech by Evans. Here are the key snips.
It is an understatement to say that our current situation is complex: two years of Covid-19 distress; global supply chains in disarray; strong fiscal, monetary, and financial support; and 7-1/2 percent annual CPI inflation in the U.S.
But monetary policy is not the only game in town. Fiscal and regulatory policies will be crucial complementary tools in many cases—such as when aggregate demand is far too weak or financial excesses loom large. Importantly, these situations are more likely to arise in a low r* environment—when the proximity of the effective lower bound (ELB) reduces monetary policy capacity and investors’ views about potential returns may be at odds with the economy’s fundamentally lower average rate of return.
My view is that as long as the U.S. and global economies are in a low r* world, nominal interest rates will remain low and we will experience episodes close to or at the ELB. Unless the FOMC is to jettison our responsibility to promote maximum employment and price stability, the financial stability burden should be primarily on financial regulators.
Our present monetary policy setting is wrong-footed against the current, sharp increase in inflation. That is for sure. But the sources of these large relative price increases may be different from more typical cyclical inflation episodes. Furthermore, by my reading, underlying inflation appears to still be well anchored at levels consistent with the Fed’s average 2 percent objective, and so—unlike in the Volker and Greenspan eras—no extra monetary restraint is needed to bring trend inflation down. So I see our current policy situation as likely requiring less ultimate financial restrictiveness compared with past episodes and posing a smaller risk to the employment mandate than many times in the past.
As a monetary policymaker, I would cheer continued vibrancy for all segments of the labor market and hold off on potentially unnecessary policy restrictiveness until inflation began rising to levels that were incompatible with average 2 percent PCE inflation over time.
Indeed, as you can see from this chart [lead chart], we have been fighting this low inflation battle for nearly my entire tenure as Chicago Fed President. Even with the recent spike, the price level today is still 2-3/4 percent below a 2 percent trend line starting at 2007, when I got the job. It’s about 1-1/2 percent below a 2 percent trend line starting from 2012, when we formally adopted the 2 percent target. And this gap actually increased some during the “hot period” identified in the conference paper and shaded red on this chart.
This brings me to our current high inflation situation. Despite all the typical Evans dovishness I’ve just expounded, I agree the current stance of monetary policy is wrong-footed and needs substantial adjustment.
But how this plays out will be key for my monetary policy decision-making over the year. “Careful monitoring” will continue to be the watchwords.
So, to conclude, how should one come down on the question of whether running the economy hot is foolish—or when does it become foolish? Of course, the answer is it depends. It depends on how strong the relationship between growth and inflation is today, the dynamics of inflation expectations, the level of r*, and the associated proximity of the ELB. Or, if you don’t believe in Phillips curves, the question is largely moot because you aren’t going to worry about high employment generating inflation.
With regard to the policy situation today, I still see current inflation as largely being driven by unusual supply-side developments related to the Covid-19 shock. But inflation pressures clearly have widened in the broader economy to a degree that requires a substantial repositioning of monetary policy. What that repositioning ultimately will look like will depend a good deal on the same factors that enter the running-hot calculus.
Make Up for Past Insufficient Inflation
It’s economic illiteracy to believe inflation is not running hot and has been for a long time.
Every person on the Fed is guilty of not understanding what inflation is. They are also all guilty of ignoring Fed-sponsored clear asset bubbles.
The Fed dunderheads do not count housing, crypto mania, or obvious stock market bubbles in their definition of inflation.
The fact is, we are currently in one of the four biggest bubbles of all time, the other three being 1929, the DotCom bubble in 2000, and the housing bubble in 2007.