This essay is also available on Medium.
Major General Grant
My dear general …
I am writing this now in gratitude for the almost invaluable service you have rendered to the country. I would like to say one more word. … When you turned northeast of the Big Black, I feared it was a mistake. Now I want to personally acknowledge that you were right and I was wrong.
July 13, 1863
(Letter sent acknowledging Grant’s successful capture of Vicksburg, Mississippi)
I often remind myself of this quote. Even if I’m not Abraham Lincoln, if Lincoln could admit he was wrong, then I should be able to too. When inflation accelerated last year, I argued that it was likely due to transient factors that would soon pass. It didn’t happen. This essay sets out the basic arguments I advanced then, the data that has come since then, what I did wrong and the potential implications for the future of monetary policy.1
In the summary of economic projections (SEP) for September 2021, I estimated that inflation would be 4.2% for 2021 and 1.8% for 2022. Actual inflation for 2021 ended up being by 5.8% and this week I just raised my forecast to 4.5% for 2022 PCE inflation for the 12 months to January was 6.1% (Figure 1).
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What happened and why were my inflation predictions wrong?
I argued that the job offer has been held back by a combination of fears of COVID-19, higher unemployment benefits, and childcare problems triggered by school closures. While we didn’t see an immediate increase in labor supply when schools reopened and unemployment benefits ran out in the fall, we still saw extraordinarily strong employment growth, around 582,000 per month over the past six months. also with Delta and Omicron waves.
So the job offer materialized. However, I expected this increase in workers to ease the pressure on businesses, supply chains and wages. As more workers returned to work, temporary inflationary pressures eased. This has not happened with wage growth rising to around 5% and companies continuing to struggle to find all the workers they need (Figure 2).
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I also expected supply chains to eventually resolve on their own when COVID-19 was brought under control, workers returned, and companies adapted. While large companies warned us that supply chains would be under stress throughout 2022, there have been fewer improvements at this point than I hoped to see. For example, US automotive assemblies in February were still 25% below the February 2020 level.
And now there is a substantial risk of new disruptions in China, which could further challenge global supply chains: COVID-19 cases have erupted in Hong Kong and are now steadily increasing on the mainland. Many experts have said that Omicron is so contagious that China sticking to its zero-COVID-19 policy would require large lockdowns, which we are now seeing with the announcement of such measures for 17 million people in Shenzhen. Unfortunately, the Chinese government has not authorized the distribution of Western vaccines, which are much more effective than current domestic ones, while they wait for their scientists to develop their own mRNA vaccine.
The shocking invasion of Ukraine makes almost all of these problems more difficult with the soaring prices of oil and other commodities and tremendous geopolitical and economic uncertainty, as well as the terrible human suffering of the Ukrainian people.
Moving on to consumption: I hypothesized that the artificially high level of consumption of goods we saw during the pandemic would rebalance towards services when the economy reopened and normal activity resumed once the virus began to regress. The virus has retreated in the United States, workers are returning to their offices, and service activity has increased, but I’m surprised the consumption of goods hasn’t retreated. That is, while consumption of services is climbing towards its pre-COVID-19 trend, consumption of goods remains high above its trend (Figure 3). This is one of my biggest surprises.
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Unless Congress passed a further fiscal stimulus, we had some confidence in how long it would take for the stimulus to flow through the economy and was, by definition, temporary. I focused not only on the timing of government transfers to households and businesses, but on what was happening to household budgets. We knew that household budgets were much stronger than before the pandemic, because the COVID-19 aid packages were much larger than the income lost to the pandemic. But I expected those excess savings to be spent pretty quickly, especially for low-income families.
Household saving rates have fallen back to around pre-pandemic levels, but households do not appear to be saving (Figure 4). So how are they funding their high levels of consumption? It appears that they are financing it with current revenues (Figure 5). This suggests to me that this robust economic activity and associated high inflation may be sustained and may in fact not be transient.
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State governments tell a similar story. It is true that there have been massive transfers from federal to state government in COVID-19 aid packages, and some of that money has yet to be spent. But many state governments are also now generating surpluses, in some cases record surpluses, from normal tax collection. This too does not appear to be a transitory phenomenon which is simply the shift from one-time spending on COVID-19.
The good news is that long-term inflation expectations appear to be well anchored to the strong inflation credibility of the Federal Open Market Committee (FOMC), as financial markets indicate that they expect inflation to return to our target (Figure 6 ).
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Making sense of high inflation
So how do I put it all together? The first explanation is that these supply and demand imbalances are actually still transient, but will simply take much longer to normalize than I expected (and longer than we can tolerate without running the risk of destabilizing inflation expectations). The second explanation is that massive fiscal and monetary intervention in response to COVID-19 has shifted the economy towards a balance of greater pressure and inflation, with people earning more and spending more than before. We know that the wealth effect is a real phenomenon and both the stock market and house prices have risen about 30% from pre-pandemic levels; even households that do not own shares or houses have more solid balance sheets on average than before the pandemic. Perhaps this is leading people to be safer and simply spend more. In any case, the FOMC must act to bring the economy back into balance.
Implications for monetary policy
We know that monetary policy operates with a delay, but forward guidance can have an immediate effect. The FOMC has already made a profound shift in the past six months with its guidance on the path of the federal funds rate and the budget, and I believe the SEP we have just released is sending a strong signal that further strengthens our commitment to achieving the our inflation target. The first excursion we announced this week proves that we will follow our lead with action.
Over the past six months, I have made major changes to my projected path for federal funds rates. For example, in September, my SEP submission had the federal funds rate from 0 to 0.25 percent by the end of 2022. I increased it from 0.50 to 0.75 percent in the December 2021 SEP and then l ‘I increased again from 1.75 to 2.00 percent in the most recent SET. My estimate of the neutral nominal rate remains at 2.00 percent, where I have had it for several years.
If my first explanation of persistent high inflation mentioned above is correct (which will still prove transient but will take much longer than expected), then I believe the FOMC will have to remove the accommodations and become slightly above neutral as inflationary dynamics they relax. However, if my second explanation above is correct (that the economy is in a balance of high pressure and high inflation), then the FOMC will need to act more aggressively and bring politics into a restrictive position to bring the economy back. back to a balance consistent with our 2% inflation target. Over the course of this year, as we move towards what I anticipate will be a neutral political stance, we will gain information that will help us determine how far we may need to go.