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
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.
The Buffett Indicator is a valuation multiple used to assess how expensive or cheap the aggregate stock market is at a given point in time. It was proposed as a metric by investor Warren Buffett in 2001, who called it “probably the best single measure of where valuations stand at any given moment”, and its modern form compares the capitalization of the US Wilshire 5000 index to US GDP. It is widely followed by the financial media as a valuation measure for the US market in both its absolute, and detrended forms.
For more on the Buffett Indicator, please see Jill Mislinski’s excellent post Market Cap to GDP: January Buffett Valuation Indicator on Advisor Perspectives.
The current stock market bubble exceeds all of the others. The Fed’s QE and lose money is what fueled the bubble in 2000, 2007, and now.
Evans in effect is praising the benefits of bubbles, and he still wants the Fed to make up for alleged lack of inflation.
Evans mentions inflation expectations and the Phillips Curve, both totally discredited economic theories.
Fed research papers discredit both of them!
On October 1, 2021, I noted A Fed Economist Concludes the Widely Believed Inflations Expectations Theory is Nonsense.
Well Anchored Nonsense
Please recall my August 31, 2020 post The Fed’s Stupidity is Still Well Anchored.
Former Fed chairs Janet Yellen and Ben Bernanke were both big Phillips Curve advocates despite the fact the theory never worked even according to Fed studies.
- August 29, 2017: Fed Study Shows Phillips Curve Is Useless: Admitting the Obvious
- January 15, 2019: Yet Another Fed Study Concludes Phillips Curve is Nonsense
I commented: “The Phillips Curve isn’t dead, it was never alive to begin with.”
Amusing Fed Research Paper Comments
- It is far, far better and much safer to have a firm anchor in nonsense than to put out on the troubled seas of thought. John Kenneth Galbraith (1958).
- Few things are harder to put up with than the annoyance of a good example. Mark Twain, The Tragedy of Pudd’nhead Wilson (1894)
Those comments are from the Fed’s own study on inflation expectations.
In Search of the Effective Lower Bound
Evans mentioned the Effective Lower Bound as well.
ELB is the point at which lower interest rates no longer benefit the economy and cutting them further damages it.
I discussed ELB on September 25, 2019, In Search of the Effective Lower Bound
There certainly is an ELB, and given the bubbles the Fed blew, I suggest we are below the ELB and have been for some time.
Why Two Percent?
The last three Fed presidents, Jerome Powell, Ben Bernanke, and Janet Yellen, have all been hell bent on achieving two percent inflation over time.
None of them have any idea what inflation is nor have any of them ever provided any rationale for two percent.
Evans is arguing for more than two percent still believing his own BS regarding the need to make up for lack of past inflation.
Historical Perspective on CPI Deflations: How Damaging are They?
A Bank of International Settlements (BIS) study show routine price deflation is a benefit. Central banks have not caught on.
Please consider Historical Perspective on CPI Deflations: How Damaging are They?
Key BIS Findings
- Concerns about deflation – falling prices of goods and services – are rooted in the view that it is very costly. We test the historical link between output growth and deflation in a sample covering 140 years for up to 38 economies. The evidence suggests that this link is weak and derives largely from the Great Depression. But we find a stronger link between output growth and asset price deflations, particularly during postwar property price deflations. We fail to uncover evidence that high debt has so far raised the cost of goods and services price deflations, in so-called debt deflations. The most damaging interaction appears to be between property price deflations and private debt.
- Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive.
- Once we control for persistent asset price deflations and country-specific average changes in growth rates over the sample periods, persistent goods and services (CPI ) deflations do not appear to be linked in a statistically significant way with slower growth even in the interwar period. They are uniformly statistically insignificant except for the first post-peak year during the postwar era – where, however, deflation appears to usher in stronger output growth. By contrast, the link of both property and equity price deflations with output growth is always the expected one, and is consistently statistically significant.
The Fed is hellbent on producing damaging inflation.
In the real world deflation boosts output. Falling prices make things more affordable and improve standards of living.
In one of the more accurate statements ever made by any Fed president, James Bullard, St. Louis Fed president recently stated “I think the inflation we are seeing is very bad for low and moderate-income households. Real wages are declining. People are unhappy. Consumer confidence is declining. This is not a good situation.”
Bullard is no hero. He failed to dissent in any recent Fed meetings.
Asset Bubble Burst Coming
The Fed blew another enormous asset bubble, the biggest in history.
Payback is coming and the BIS described it well. The “link of both property and equity price deflations with output growth is always the expected one, and is consistently statistically significant.”
S&P 500 – What is the Pain Threshold for the Fed and Traders?
How big a stock market crash is coming?
I discuss likely targets in S&P 500 – What is the Pain Threshold for the Fed and Traders?
Thank the Fed for the carnage that is about to happen.
Finally, if you think the Fed is just following the markets, please think again. That’s not the case at all.
For discussion please see my Fed Uncertainty Principle.
But it’s not just the Fed, fiscal stimulus and unproductive debt from decades of overspending by Congress is also to blame.
Your best defense against this insanity is to buy gold.