There has been a heated debate lately about whether inflation is transitory or not. I think I caught this discussion a little late, but for various reasons, it took me quite a while to finalize this post, and I see no reason not to share it now. Note that most of the post was written almost two months ago, and I only made a few additions to it due to a few posts shared recently.
While the US economy is recovering from the recession, we have seen the CPI grown by 0.6%, 0.9%, and 0.5% in the last three months. We’ve seen many pundits seem extremely concerned about persistent inflation. However, we also had many convincing data to think that inflation will be transitory and not worry about it. Despite the many dramatic changes experienced during the pandemic, market and consumer expectations remained quite moderate. The unemployment rate is 5.2%, indicating that the economy still needs to make necessary improvements to reach full employment. It is reasonable and realistic to predict that aggregate demand will decrease (due to the decrease in government support) in 2022, but will reach normal levels once the supply bottleneck is over.
The Fed’s new framework, FAIT, requires short-term above-trend inflation to offset periods of below-trend inflation and maintain a sustainable 2% inflation. However, the Fed has communication problems in explaining its new framework to the public, which created uncertainty about the future path of monetary policy. Moreover, it seems that many pundits still haven’t internalized and understood FAIT. Calls for tightening and doomsday scenarios started flying around as PCE inflation caught the pre-March 2020 trend. In fact, these concerns stem from fundamental confusion: pundits simply do not realize that the inflation we are experiencing is due to the supply shocks from the pandemic.
First of all, I think it’s essential to understand what “transitory inflation” means. According to the generally accepted definition, what we mean by temporary inflation is that inflation, which is higher than the trend, will return to normal level soon. But this seems too obscure to me, and I believe we can make a better definition. It is clear that the Fed is capable of “stopping” both supply-side and demand-side inflation and returning it to normal levels. So the main debate should not be whether the Fed can fix the problem or have something to do, but whether more or less AD would be helpful. The Fed has always had this capability, and we have enough examples not to doubt it. Therefore, whether inflation is transitory depends entirely on what the Fed does in the future. It would be more useful to think of transitory inflation as returning inflation to normal levels without triggering higher unemployment than the current rate. Indeed, this is very similar to the difference between a cold and the flu. If you only have a cold, you can regain your health in a short time if you drink herbal tea, keep yourself warm and rest. But if you have, for example, the flu or pharyngitis, you will have to take antibiotics, and you will suffer from a high fever for a while.
Joey Politano has a fascinating post exactly about that. In here, Joey says:
“In 2007, 2015, and 2018 the Federal Reserve preemptively tightened policy out of misplaced fear of oncoming inflation, only to reverse course later and loosen monetary policy in order to support the economy. If the Federal Reserve does not learn from these prior experiences and stick to their new commitment to create policy-driven transitory inflation they will deal irreparable damage to both their credibility and to the economy. Today’s inflation is transitory, and policymakers should not react to it by pre-emptively tightening monetary policy.”
The Fed is learning from its past mistakes. That’s why we got FAIT last year. It’s not ideal, but it’s a good step in the right direction, and Powell has given us a pretty reasonable policy so far. That’s exactly why the Fed should not make the same mistake.
It is inevitable that “how should a good monetary policy be” arises from all these. In my view, good monetary policy triggers higher employment, leads to a steady increase in nominal wages and income, increases investment and productivity, stabilizes financial and macroeconomic variables, and lowers inequality. But I’m not sure how reasonable it is to target inflation or employment to achieve these. Congress gave the Fed a dual mandate, which can be summarized as maximum employment and stable prices. However, I think that indexing monetary policy to inflation or employment may fail to achieve the above. Of course, it can still do all of these, but I’m not sure that each of them can be reached at an ideal level. Maximum employment is not clearly defined, and we do not have a clear sense of how many jobs can be created by monetary stimulus without destabilizing prices. This does not mean that maximum employment or price stability can be ignored; the Fed should certainly strive to achieve the dual mandate. Rather, it looks like the Fed needs a more precise model to achieve it.
If high inflation is an indicator of excessive AD, then it is more reasonable to focus on NGDP rather than inflation. Similarly, I think the best way to reach maximum employment is to aim for steady growth in NGDP. What could be the definition of maximum employment other than a period when NGDP growth is stable over a long period, and the unemployment rate remains relatively constant over the years? Consequently, in order to achieve dual mandate, the Fed should not target both for monetary policy. The outcomes of a good monetary policy are likewise indicators of whether a monetary policy is good or not.
