A Conversation about Inflation and Monetary Policy
For the past two years, inflation has been high, well above the Federal Reserve's 2% annual target. Price increases have been persistent and widespread due to supply and demand factors associated with the COVID-19 pandemic, including fiscal and monetary policies implemented in response. What should we expect to see in terms of inflation moving forward? The St. Louis Fed hosted a virtual event featuring Fernando M. Martin and Mark L.J. Wright exploring inflation-related topics. Transcript follows video.
Mark Wright: Good afternoon. My name is Mark Wright. And I'm a senior vice president in the St. Louis Fed's Research division. I'm joined by my fellow research colleague, Fernando Martin. Fernando is an economist an assistant vice president here at the Bank. His research interests span much of macroeconomics, monetary economics, banking and public finance. He joined the St. Louis Fed in 2011.
Fernando Martin: I'm glad to be here. Thank you.
Wright: So why don't we start by summarizing where we are with inflation and how we got to this point?
Martin: Excellent. OK. So, in the years before the pandemic, inflation was actually low and stable. If anything, it was a little bit below 2%, which is the Federal Reserve's target for inflation. And then of course in 2020, the pandemic hit. And what happened was the lockdowns came in, people were sent to their homes, economic activity was depressed, consumption and consumption demand dropped significantly. And with that, prices actually initially came down.
So, we ended 2020 actually with inflation even below what inflation needs to be in the years prior to the pandemic.
Then 2021 started and we started seeing an acceleration in prices. Come March 2021, annual inflation — so that means the change in average prices between March 2021 and March 2020 — was a little bit above 2%. And it has remained above 2% ever since.
So, inflation proved to be persistent after that. The year 2021 ended with high inflation. Then we enter 2022, high inflation persists; high inflation is also widespread. 2022 also ended with high inflation numbers. We enter 2023, inflation seems to be moderating some, especially headline inflation. Much of the recent dynamics has been driven by energy prices, which increased a lot in early on in the pandemic. And now, we're coming down to more normal levels.
So, we're still waiting for other prices to come down as well. So that's where we are now with inflation above the Federal Reserve's target of 2% and inflation being high for quite a while.
Wright: You mentioned that inflation has been persistent. The Fed has received some criticism for having used the messaging that inflation was going to be transitory. Why do you think we got that wrong?
Martin: Okay. So, the mindset at the onset of the pandemic was inflation if anything was below the target. And as I mentioned before, prices initially came down. So, it was not obvious during 2020 what would happen afterwards.
Early on in 2021, what we see is shifting consumption patterns. I mean, it started in 2020, but it really strengthened in 2021. And people started substituting away from services and into goods. So, people stopped going to restaurants, going to a theater or going on vacation. And they started buying furniture to work at home or electronics to spend time at home, started baking goods at home. So, you make your own bread instead of buying it at the bakery. So that shifting in consumption patterns, what it did was to create pressures into certain goods.
At the beginning what we saw was certain goods increasing in prices quite dramatically. And that led some to believe that this was a transitory phenomenon. So everyone wanting to buy the same sofa or everybody wanted to buy a webcam. There is only so many sofas and webcams around. So what happens is retailers, they jack up the price.
So, at the beginning what we saw was an increase in certain goods. We remember what happened to things like cars, lumber, etc. And it led to some misdiagnosis of what was actually happening. As time went on, it became clear that this was much more widespread even though it started off in a few goods. But now, it's basically all across the board.
Wright: All right. So, you mentioned cars of course, traditionally used cars are much less expensive than new cars. The moment you drive it off the lot, you lose money.
Wright: At the height of COVID though, you're — as you drove it off the lot, you didn't lose any money at all. Sometimes, it even went up in price in a few strange cases.
Martin: Yes. And that's going to be an excellent example of how the pandemic was an unusual event.
Wright: You mentioned some specific goods. If we drill down deeper into the inflation data, what categories of goods are driving inflation now has it become more widespread?
Martin: I would say that the first set of goods that increase in prices was food. So early on as we substituted away from restaurants to cooking at home, food was the category that increased the earliest. After that came durable goods: things like electronics, furniture, etc.
This is interesting because goods used to decline in price. So, if you buy the same piece of electronic gear over time, you're going to notice that you cannot pay less than you used to pay. So they had a downward trend. That reversed and especially in '21, contributed a lot to the high inflation that year.
After that, what we see is things like housing contributing to inflation. And more generally now, services are contributing to the current high inflation numbers. So now I would say is it's widespread even though the dynamics are not synchronized. So good certainly on increase, now they stabilize.
So now the price of goods is relatively constant. But the price of services continues to increase. And that's what's giving us inflationary pressures right now.
Wright: The Fed often likes to talk about narrower measures of inflation; we talk about core inflation. Recently, the chair has been talking about core services, less housing. Why is that a useful measure to look at?
Martin: All right. So let's break that down. Typically what you have is what we call a headline inflation number. That's all goods and services. So what we measure is the consumption of households. And then we track prices and that gives you an average price level. You take how much it changed over time, that gives you inflation. So the problem with that is there are some items that are very volatile.
One example of that is energy. Energy depends a lot on the cost of oil, which is trade in international markets. Its price depends on global factors both demand and supply factors. Sometimes it doesn't really reflect domestic factors. So whatever is happening in the U.S. economy. So what we do sometimes is take away the effect of energy just to understand better what the underlying forces are especially because they're very volatile. They go up and they come down.
And you don't want to contaminate the data with that. Another number or item that people take out sometimes is food because it also shows some cyclicality and some volatility. I would say that this time around taking away food is probably a mistake, because food was such an important part in consumption behavior during the pandemic. As I said, we move from eating out to eating in. And it has behaved much more like other goods. I would say you shouldn't take it out right now to understand what's going on. But if you take both energy and food from the price level, you get what's called core prices.
Now, you can break it down even further and say, well goods have this problem that I buy maybe there is a surge in demand. So we all go and buy sofas or buy Xboxes. And then what happens is that there may be a surge in the price, because production cannot respond quickly enough. Whereas services tend to be smoother in their behavior. So we have very predictable patterns in terms of, for example, housing, education, health services, and any other service you can think of. Those are very slow moving.
What has happened recently is that to understand what the underlying trends are and to try to predict where the economy is heading, the Fed has been narrowing down the measures and focusing a lot on what's called "core services excluding housing." And that means you take away the effects of energy and services, and then you take housing out. And you are left with actually a substantial part of expenditures. So this category comprises half of household expenditure. So it's a big part of our monthly expenses. And this covers things like I said, education, health services, if you hire a lawyer or things like that. And there are two reasons why this is important: one is, well, because it's slow moving. So it gives you a good sense of an underlying trend.
But the other is that services rely a lot on labor, so that means that they reflect what's going on with wages. So if you're worried that there might be some price pressure through wages, there's a good way to capture that. And that's one of the reasons the Fed has kind of narrowed its focus on something like a more narrower version of this.
Wright: And sometimes, people talk about the danger of getting into a wage price spiral. You mention these goods depend very much on wages: is this a way of getting a sense of whether we are in such a spiral?
Martin: You would have to look at both things at the same time. So no one measure will help you understand the full picture. And I would say that theoretically, you can have the causality going in either direction, either prices driving wages or wages driving prices. You can think of well, the price of goods and services goes up, so people that work are going to demand higher wages to maintain their consumption habits. So that would be prices, leading to wages.
You can think it's the other way. Maybe there are some reasons for why for example, workers managed to bargain higher wages. And that increases the cost for producers. And they're going to have to pass that on to the final consumer.
In this case, what we observe is that it's really prices leading the way.
So like I said, there was a shift in consumption patterns that led to some increases in prices that eventually became more widespread. But prices have been leading the way. And then wages have been catching up. And actually, they've been keeping pace with inflation. So when you look at real wages, which means you look at how much people get paid and you subtract the effect of inflation, actually, we get positive numbers on average. So wages have kept up. But they have not been rising fast enough to explain the price dynamics.
Wright: Very good. So now, I want to turn to talking about monetary policy. Why don't you tell us a little bit about the tools that the Fed has at its disposal for dealing with high inflation?
Martin: So the primary way in which the Fed conducts monetary policy is through the management of short-term interest rates. So whenever we see the Fed is raising or lowering the rate, what they mean is the overnight rate at which banks borrow and lend to each other. So that's a very short-term rate. But the expectation is that this rate will percolate into other interest rates in the economy. So that's one way of affecting the economy just by the management of short-term rates.
But there's other ways in which you can conduct policy. And one is to affect long term rates directly. So, what we do as consumers is we take loans, like mortgage loans which are very long term, like 30 years or 15 years. And we take car loans which are typically five years. And those are kind of very far from an overnight rate. And sometimes, you want to affect them directly or much quicker than you would affect them if you just focused on the short-term rate.
What the Fed also does is buy and sell financial assets, mostly the debt of the U.S. government but also some other assets. And by doing that, it can affect the price of those long-term assets and therefore, the interest rates at those time horizon. So let's say the interest rate on the debt of the government over 10 years or 20 years. And that in turn affects how much you would pay for your mortgage. And right at the beginning of the pandemic, the Fed came in and affected all of it. So it came out, it lowered the short-term rate of course. But it also started a process of buying assets to also lower the long-term rate. And it also opened up a variety of facilities.
So there's more — not so much a monetary policy, but more like financial stability measures to prevent financial problems. So it opened up a lot of facilities resembling what it did during the Great Recession and the financial crisis.
And that was at the beginning. Once things stabilized, what happened is there was a period of time in which interest rates were low. And then as inflation started to increase, what the Fed first did was to affect the long-term rate. So what it did was to stop buying assets at the same pace it was doing before. And that starts affecting long term rates.
So if you look at the mortgage rate or the interest that the federal government pays on its long-term debt is started increasing significantly. So during 2021. Then in 2022, in around March, there was what we call liftoff, which is the short-term rate was raised. And that basically concluded the process of moving away from shorten rates to a more what we call a contractionary monetary policy. And across the board both in the long and in the short end.
But those were the ways in which the Fed initially dealt with the pandemic and then moved into a policy stance that was aimed at curbing inflation.
Wright: So just to dive into that in a little bit more detail. We have a question from our audience. The question is, by increasing the money supply to fund the COVID stimulus, did the Fed have a role in contributing to inflation?
Martin: So that's actually a very good and deep question. If you go back in time when economy started thinking about these things, the economy was a lot simpler. The way we pay for things was more cash based or much more money based. And therefore, the quantity of money was intimately associated with the price level.
And even if you try this in any country, if you all of a sudden doubled the money supply, you're likely going to get a big increase in the price level, perhaps not double but close to that. So there is an intimate relationship between those two.
The way the modern economy works is a bit more complex in the sense that there are many cash equivalents or money substitutes. In particular, the U.S. debt is used as a money instrument in financial markets. And it supports through the way it's used as collateral many operations that in the past would have been taking the form of cash equivalents that were not U.S. debt. So now, measuring the quantity of money is a lot more complicated than it used to be because you cannot just dismiss the federal debt as part of that quantity.
So if one way to rephrase that question is to say the increase in the liabilities of the government contribute to inflation, and the answer to that is yes.
Did the composition affect inflation? That's a harder question to answer. The answer is probably not so much.
I would say a first order effect is the total amount of liabilities of the government, both in terms of how much is actual debt outstanding and how much of that was monetized by the Fed. So once you sum that up, that increased a lot. And that certainly contributed to inflation, where — whether you have it a little bit more on debt or a little bit more in terms of bank reserves. I don't think it's that material this time around. So we refined our older theories to accommodate the way financial markets work in the present.
Wright: You mentioned how liftoff began in March of '22. Since then, how much have we raise rates and what else have we done to combat inflation?
Martin: Like I said, even before that, long term rates were increasing. So much of the contractionary effects of monetary policy began before that by affecting long term rates. And then yes, we started with lift off and interest rates in the short end of the spectrum. So the overnight rates, they went from 0% to basically 5%.
So that's a substantial increase over a very short period of time. So interest rates have increased very fast. And of course, households and banks and other financial actors have had to accommodate to that new reality. But that's where we stand now with both long term rates and short term rates higher than before.
The idea of raising rates to curb inflation is basically what you're trying to do is dissuade consumption. So you're trying to say, well, maybe if rates are higher, you're going to think more about saving rather than spending, so you're going to leave money in the bank perhaps.
Or if you don't have savings then you're not going to take that extra loan to finance consumption because interest rates are very high. So the idea is that for multiple fronts a higher interest rate makes you curb your demand for consumption, that lowers the pressure on prices because demand is lower. And competition basically acts on the other side from the production side to keep pricing in check.
Wright: We have another question from our audience. This one's a little bit of a minefield for you to answer: in your opinion, how high will interest rates go?
Martin: I cannot answer that question.
Wright: But you can talk a little bit about the messaging that the Fed has made so far about that.
Martin: So that's a decision for the FOMC, so the Federal Open Market Committee, to take. I would say that their position now is to be nimble. And manage risk more than anything. So let's put things into perspective. Once we started observing high rates of interest, there was a big risk that inflation would run away. And that we would perhaps get into two-digit territory. So instead of having 6% inflation, we could have had 10%, 15% inflation. So much of the aggressive behavior even at the beginning was designed to prevent that from happening and to signal that the Fed was very serious about combating inflation and bringing it down to 2%.
I think that has been achieved. Another question is, how quickly you return back to something close to the Fed's target of 2%? So now what we're talking about is how to calibrate the speed of going back to 2%. And when you do that calibration, you need to think about other factors, because inflation fighting is not the only thing you should be worried about.
You perhaps can move too fast, and not let financial markets or households adapt to new rates. So you could raise interest rates very quickly, very high. But that probably would be very disruptive and have unintended consequences.
So you perhaps want to do it a bit slower. Now, the question is, have you done enough? And that's still an open question. And when we start talking about the fiscal part of this, perhaps we can revisit, and I can address that part of the question, because there are many confounding factors into how much pressure you want to put into interest rates because of the mechanisms I mentioned before.
But right now, we are in a situation in which things are still unraveling — so things are still moving. And you have to be mindful that you may do too much or you may do too little. So I think the Fed is being very aware that inflation is too high. But it's also aware of the risks of other things that could happen if interest rates are deemed too high for let's say, financial purposes.
Wright: So you mentioned fiscal policy. What role has fiscal policy played in the inflation so far and in terms of getting inflation back to normal?
Martin: Yeah. So I would say that arguably, fiscal policy was a key driver in inflation. So what happened is, as I mentioned before, COVID happened, the lockdowns happened. There is a big depression in economic activity, big drop in consumption, and what happened was well the fiscal authorities or the federal government came out and provided fiscal assistance to households in the form of, for example, sending checks to people.
So this was all designed in a context of high uncertainty. So especially in 2021, we didn't know where this was going or where it would end. The idea here was to protect people's income, to prevent people from going bankrupt for example, because lots of people lost their jobs or didn't have a source of income for quite a while.
The idea was let's arrest that possibility, so and what we ended up having was three rounds of fiscal stimulus or fiscal expansion, which are very, very big in size. So the end product of that on average households ended up with very high disposable income. And that disposable income that excess disposable income has been spent, over time. It hasn't all been spent yet, but it has been spent over time.
And that created what? Well, it turns out that even though consumption dropped at the beginning, it rebounded. And in real terms — so once we take away the effect of inflation, so the effect of prices — in real terms we're actually consuming above the trend that we had before COVID. So maybe this is a good time to illustrate this with a little chart.
And let's go here. So what we have here is real consumption. So again, it's taking away the effect of prices since 2016. And this is monthly consumption. So these are trillions of dollars on the vertical axis. The solid line is real personal consumption expenditure. So this is an aggregate measure of consumption in the U.S. economy.
The dotted line is the pre-COVID trend so from '16 to '19. And as you can see, consumption in the pre-pandemic period is very smooth. It goes. It doesn't deviate from the trend that much. And this is very, very typical of consumption.
Then COVID happens, lockdowns happened. So consumption in real terms - so the amount of stuff that we buy - it goes down dramatically. So it rebounds very quickly. But it remains below the trend for quite a while.
Then it crosses the trend coincidentally in March 2021. Remember, that's the date I mentioned, that's when inflation crossed 2%. And you can see a big surge there in consumption. And it has to remain above trend ever since.
Now, if you were to compare the solid line — so the actual consumption with the dotted line, which is the trend — you have a sense of well, you can add up the difference between those two lines and say, have we consume more than we would have without the pandemic or less? It turns out that we're still a little bit behind.
When I add up all the consumption relative to trend since the pandemic started, we're still a little bit below, about maybe half a month worth of consumption, which is a substantial number. And that's why people sometimes now talk about revenge spending. So they're still thinking that they owe themselves a vacation or they owe themselves a big splurge.
And the reason is accumulated consumption so far has not caught on. If you can look at the same data but in a different way, and this is without taking the effect of inflation out — so these are nominal values.
The red line again is consumption. The dotted line is the trend. And the blue line is income. And this is disposable income.
So we take into account transfers you get from the government and the taxes you pay to the government. And here, you can see also disposable income fluctuating around the trend in the pre-COVID era. And those three spikes that you see in 2020 and 2021, those were the three rounds of fiscal packages and fiscal assistance I was referring to before. And what you can see is that those were pretty sizable, pretty dramatic.
And they explain why when you look at consumption in nominal terms. So when you look at expenditures and just the number of things we buy but the amount of dollars we spend on consumption, you can see that it has remained above trend and substantially.
So when you also make the numbers and you compare the excess income we have and the excess consumption we experience since the pandemic started, you end up with around $400 billion or so excess savings that still need to be spent. And the reason I mention this number is because now we need to put this together with monetary policy. So as I mentioned before by raising rates, what we're trying to do is to dissuade consumption. But at the same time what happened was the fiscal authority sent money to households, which grows disposable income that was spent. So they're kind of moving in opposite directions.
So what happens is monetary policy is having a calming effect on consumption. But there is so much disposable income still on the table, that we still need to wait for the full effect of monetary policy to materialize. Because at least on the aggregate, it's not like everybody needs a loan to make - to pay for a vacation - they can rely on this excess savings I'm referring.
And I want to be very careful about this. I'm talking about averages. We're talking about aggregate. There is, of course, differences across households. There's a lot of households for which they don't see any excess savings. And there's other households, that see perhaps much more than the average household sees.
Wright: I think you made a good point there, which is that I mean, there were a lot of things that this fiscal expansion was designed to solve. And in fact, if we went back to the Great Recession, the consensus was that the government didn't spend enough. Perhaps they may have spent a little bit more than they needed to this time, but they didn't want to make that same mistake again.
Martin: Right. And you always learn from the past. That's a great point. So a parallel that people draw is also not just to the Great Depression but also the financial crisis and the Great Recession where — and this goes back to the earlier question on did the monetizing of the debt create the current inflation? And we also monetize — or the Fed — so we, so the Federal Reserve monetize the debt during the Great Recession as well.
And we didn't see inflation materialize in the same way as we saw it today. And there are many reasons for why these two events are very different. So in particular during the financial crisis, there was a big demand for very safe assets. So people started moving away from risky investments into safe assets. So there was a big demand for U.S. treasuries, bank reserves, etc.
And not just in the U.S., but globally. There's a big demand for U.S. — the U.S. dollar denominated assets. What happened this time around is that this is more of a textbook example of what people call a helicopter drop where the old example was printed a bunch of money, you gave it to people, people went and spend it and of course, prices increase.
Here is a bit more subtle where we live, we send checks to people those checks were financed with government debt. So the government issued treasuries. And around half of that debt was bought by the Federal Reserve. So it was transformed into reserves.
But like I said before, maybe perhaps the number you have to focus on is the total liabilities of the government, both the Federal Reserve and the Treasury, not just one of the two agencies. But from an economist point of view, when you see those big spikes in the blue line in disposable income, that looks like a more classic helicopter drop. And you shouldn't be surprised that you see inflation materialize after that.
Wright: OK. We have another question from our audience. This is going to take us a little bit back to that drilling down into inflation discussion earlier. So the question is, my bill at restaurants and in the grocery stores feel like they have gone up close to 50%. Is that increase here to stay or will these prices go down if inflation is lowered?
Martin: Excellent question. And probably everybody has a that in their minds. So we touched a little bit on this earlier on when we were breaking down average prices into their components. And what I have here is another chart, also starting in 2016, and where I break down the average price level into three big components.
And one of the ones mentioned here is food. What you see here is that early on in the pandemic, you see this inflection point. And people can see, you see this little increase or big increase in prices, because people were moving away from eating at restaurants and into producing food at home. So there was an immediate pressure into food prices, because of the splurge in demand.
And that persistent. You can see that it never came down. And then in 2021, it continues increasing in such a way that when you look at food prices today, they are — the numbers that what they mean is — that relative to the current basis year, which is 2012. So food prices are around 130 which means that 30% higher than in 2012. When you compare it to the pandemic food prices used to be around 105.
So we're talking 20% to 25% increase in let's say, 20% increase in food prices since the pandemic started for food. Now you can see that the price of food has stabilized. Is it going to come down or not? That's a very good question. In particular, because food is produced globally, so it will depend also on global factors like production factors. You would expect some return to normalcy. But the thing is given that all the prices went up and wages went up you shouldn't expect your restaurant bill to go back where it used to be before the pandemic. So, and this is perhaps a good point to make, which is when we talk about inflation what we talk about is a generalized increase in prices that goes on over time.
So that's what we talk about 2% inflation. So price is going up over 2%. But we also talk about movements in prices. So we also say OK, the price level jump to say so — and you can see here that prices are higher than they used to be.
Now, we can go back to 2%. But that doesn't mean that the price is going to go back to where it was. Because now, we're at a much higher price level and maybe now food starts increasing at 2%. But that means it's going to start increasing at the normal pace, something like 2% per year. But it doesn't mean it's going to come down where we're used to it.
So I wouldn't expect at least in the short run for food prices to go down where they used to be. Other things, it's a good question. If you go to electronics, electronics used to decline over time. So you can see like this red line actually has a downward trend. Those are goods in general. But that decline is being driven especially by things like yeah, electronic goods but mostly durable goods.
And you can see that now that red line is flat meaning that goods prices have stabilized. So you shouldn't expect them to continue increasing as they did before. Now the open question is, are they going to go back to the trend of the declining trend they had pre-COVID? That's a good question. I would foresee that probably yes, just because of the underlying process of technological improvement and competition that was driving the decline in prices before in durables should persist after this process is resolved.
So you should expect things like electronics to at some point start trending down in the way they used to. But you shouldn't expect a sudden drop in electronics prices. So I would say perhaps a bit more gradual.
Wright: So, as you pointed out on the plot, food - food and - food prices have gone up by about 25% since before the pandemic. The person who was commenting said that their bills had gone up about 50%. That's of course, entirely possible because this is measuring an average person. And depending on what people consume, they can have higher or lower inflation rates.
Martin: Yes. Correct. Plus, this is food in premises not so — at your own home, not in a restaurant. So what happens in restaurants is that the factors are a bit more complex, because it's not just the price of one input, which is food. Now, you have to factor in the energy that you spend.
I mean, operating a restaurant consumes much more energy. You have industrial ovens instead of like a household oven. And you have also personnel that you have to pay. And we all know that there has been a shortage in certain areas of workers.
So, and wages have gone up in those sectors. Remember, we said why are core services important as a measure of underlying inflation is because they reflect wages. When you look at the restaurant bill, a big chunk of that bill is actually the wages that go into providing that meal, not just the waiter but everyone involved in the supply chain that leads up to what you're consuming on premises. So the fact that wages have been increasing has also created pressures for certain products to remain high. Yeah. I wouldn't expect restaurants to lower their prices anytime soon.
Wright: Sadly, sadly, I feel the same. So we have another question from our audience. Does the war in Ukraine influence inflation at all?
Martin: Yes, in a very direct way. And that's for food and energy prices. So Ukraine is a big agricultural producer. And you can see part of the surge in food prices.
The war contributed a bit to it. I wouldn't say it's the main driver. But it did contribute to that. The war also contributed to a temporary surge in energy prices at the beginning. And now, we're actually having the opposite effect, which is as energy prices return back to normal, that contributes to a decline in overall inflation as well.
So you get both effects. You get inflation last year was perhaps higher than it would have been in the absence of the war. The decline in inflation is also today faster, had the war not occurred. So I would say it contributes more to having to high inflation and then to rapid inflation fall.
And that's why sometimes it's a good idea to take for example, the effect of energy out of this, to sift out or to filter out these effects. But it was a - I would say it's a temporary contributor to inflation. It's not going to be… I would say, the more permanent factor has been fiscal policy.
Wright: You were talking earlier about how important it is that we learn from past mistakes in economic policy, both fiscal and monetary policy. We have a question from our audience on that as well: what impact does the 1970s stagflation have on the current actions of the FOMC?
Martin: OK. That's an interesting question. So there's no direct linkages in the sense that the economy is very different from the way it used to be. But it's a good reminder of how things can go.
So in the '70s inflation, which was much higher, maybe another plot is illustrative for that, just for perspective. So this is expanding the time horizon a little bit more. So I go all the way back to 1960.
This is measuring annual inflation. I'm taking away the effect of energy, again, just to clean that out. And you can see at the right end of the graph, you can see the current inflation episode. And towards the left, you can see the '70s.
And you see two big spikes during the '70s. And there's two lessons to be drawn: first of all, it's much worse than today. So the episode in the '70s was much more costly for everyone involved than the current one. So even though inflation is much too high, we are not at the levels we were in the '70s. And the other one is that there is a double spike. So inflation does spike, it comes down. People generally thought OK, the problem is over. And perhaps, there was a complacency around that. And then it came back, for a variety of reasons.
I mean, they were oil shocks like back there played a big role into that. But the main thing there was that inflation did go up again. And that was very much in the mind of policymakers this time around.
So, to prevent something similar happening — again, when you become too complacent, you think you are on the way to going back to your target. And then something else happens that brings you back up.
And you have to go back to where you were before. So that's always in the mind of the policymakers today. So to try to prevent that double whammy of inflation.
The other thing is that because inflation was much higher than it is today, the Fed had to jack up interest rates much more than it did today. That created a big recession, a very costly recession, and unemployment did go up to historical highs.
And that's also the reason why a lot of commentators today say, well, in order to bring inflation back down, you're going to have to engineer a recession. It's because of that historical lesson that the interest rate has to increase high enough to create a big drop in consumption, a big increase in unemployment, so basically a recession.
So I would say that the big lessons from the '70s that is in the minds of many people, both policymakers and commentators, because it creates a blueprint for what could happen. Not necessarily what will happen. But what could happen.
And again, I will remind you that this time around inflation has not surged as much as it did in the '70s. And the labor market is dramatically different from the way it used to be in the '70s. So as I mentioned before, unemployment shot up back in the day. Whereas now, we're having historically low unemployment rates. So the labor market dynamics is very different. So there are important similarities, but also important differences. So the economy is not the same. It's much... we have a much more nimble economy now, much more flexible. Financial markets are way more developed. The global economy is much more integrated than it used to be. So even though there are some similarities, there are some important differences that you need to take into account.
Wright: You almost answered one of the questions from our audience, which was: will the Fed succeed in bringing inflation back down and avoid a recession? And I guess all of this discussion is built up in the concept of the Phillips curve. So maybe you want to tell our audience a little bit about what Phillips curves are and what they mean.
Martin: OK. Yeah. Yeah. These are all excellent questions. So the Phillips curve you are referring to is it's essentially an empirical relationship between inflation and unemployment or between inflation and economic activity. And the idea is that it suggests that there might be a tradeoff between inflation and unemployment that perhaps the way to bring inflation down, is at the cost of higher unemployment. And it's a trade that policymakers have to face.
Now, maybe it's time for another chart. This is one way to draw the Phillips curve. And what you have on the horizontal axis is the unemployment rate. And what you have on the vertical axis is the annual inflation rate.
Again, taking away the effect of energy. So it's much more compressed than the headline number. And I divided the data in two time periods. So the blue dots are the pre-pandemic period. Let's say the period between '94 and 2009, a period characterized by inflation, low and stable around the 2% target.
And what you can see is that the dots are all over the place. So the average inflation is around 2%. But unemployment was so all over the place. Why because we had multiple recessions in that period and unemployment always spikes up during recessions. So what you see is periods of very low unemployment, periods of very high unemployment, but inflation remains more or less around 2% or at least most of the time. So that led people to believe that this tradeoff that I was referring to had disappeared. So that's what people refer to as a flat Phillips curve, that you have a very credible inflation target and then unemployment moves for other reasons. So that trade off doesn't exist anymore.
The red dots in the chart basically trace what happened once COVID hit until the latest data point. And we start around the middle of the chart. And then we go all the way here.
And what you can see is that now until it went to where we are today, you trace this with a negative relationship meaning inflation goes up and unemployment goes down. There's the more traditional relationship that some people have in their heads that trade was mentioned, that you get high inflation with low unemployment and vice versa — high unemployment with lower inflation.
So where we are now is kind of a complete transformation of the Phillips curve, that went from flat to vertical. So we are now is in this cluster of points where inflation moves around as we are trying to bring it down from its peak. But unemployment remains very low and steadily so, so we move from flat to vertical.
So again, no trade off. So but just in a different way. So instead of having unemployment bounce around and inflation being constant, what we have now is a period in which inflation spiked, and then since it's been trending down and unemployment has remained low. The only reason why we have that negative tradeoff, is because we had a period in which we were recovering from — so we were transitioning from the pandemic period into something closer to where we are now. But once that process ended, so the red lines are just to be clear, they start in 2021. So they avoid the first year of the pandemic. So once we started having high inflation rates where we had this unemployment trending down, inflation trending up, we reached peak inflation, we've been trending down inflation for a few months - but unemployment remains very low.
And that reflects a very healthy labor market where there is actually a very large — on the aggregate, not across sectors — but on the aggregate, what we see is a very high demand for workers that is not being perhaps adequately satisfied. And what that means is that if you are looking for a job, you're likely to find a job very quickly.
And that means that there are not many unemployed at any given time. And that contributes to a low unemployment rate. Now, when people are worried about the future what they say is that well, is this going to change?
So and for this to change, what you need to start seeing is layoffs. So if at some point, you may think, well, the effects of high interest rates are going to impact consumption even more than they are impacting it today. And at some point, it's going to impact production. And then firms are going to start laying off workers.
And that's going to lead to unemployment. And you should expect something of this nature to occur. I mean, you want demand to go down in order to arrest increase in prices. So this baked into the mechanism.
The question is, how far is it going to go? Again, we're starting from a point in which unemployment is so low and the labor market is so tight that there is a long way to go until we start seeing high unemployment numbers. And therefore, something that looks like a recession or a deep recession, like we had in the '70s or in the '80s. So we're still far off from that. It doesn't mean that maybe we get another shock that drives us there.
But for now, we are we're far from that point. So I would say what people call a soft landing, which is a situation in which inflation goes slowly back to 2% without creating a major disruption in economic activity is still plausible, is probably the most likely scenario. If you get a recession, you might get a very mild one.
A deeper recession is always possible. But for people to be talking about that, we need other things to happen so, personally, I would have to see things like massive layoffs to occur before I start saying, oh a recession is likely in the horizon, at least in the short term. Five years out, who knows?
Wright: Yeah. So we started raising rates over a year ago and raise them quite rapidly by our standards. And yet, unemployment has just stayed where it is. So this leads into one of the questions we got from our audience: the Fed talks about long and variable lags in seeing the impact of its actions? So how long are those lags and how much longer might we have to wait for it to see it kick in?
Martin: Yeah. So the idea of long and variable lags again comes back to theories that were developed back in the day. So you have to go back to the '60s where the economy worked in a very different way. And as I was mentioning when I was describing the '70s, it was not an economy that was as nimble as the modern economy.
And the idea there is that it would take time for monetary policy to have real effects, just because you would affect interest rates, it would take time for households and firms to engage in credit operations, and for those to materialize into investment and consumption behaviors. So you would wait several months until you see the impact of a decision being taken today.
I would say that right now, the economy works in a different way. Financial markets incorporate news much faster than they used to. So, and the Fed has been telegraphing its policy before it actually takes action. That's what we normally call forward guidance.
So it's not like one day the Fed wakes up and says, "we're going to raise interest rates." They've been saying that for a while. Interest rates are going to rise in the future at some point right. Or we're going to start lowering rates, et cetera, et cetera.
So and those expectations about what's going to happen in the future incorporated today. And they're reflected by prices today. So the price of financial assets is reflecting what people expect is going to happen in the near future and sometimes even in the long future. The economy already responds much faster. As I was mentioning before, long term rates move much quicker much sooner than short term rates reflecting in part not just what the Fed was doing but also the expectation of what the Fed was going to do come lift off. So the impact was felt way before that.
So when you think about long and variable lags, you have to take into account that the actions are also having an impact way before they occur because people anticipate them. So the economy is much more nimble. It anticipates things. It prices policy much quicker than it used to be. So I would say the argument for long and variable lags is much narrower than it used to be. Things happen at a much higher frequency than it used to.
The one case you can make is that the COVID shock was so unprecedented that there is a lot of uncertainty about where the economy is going to settle down after all these processes end up. So as I mentioned before, there are still things that haven't unraveled completely. So households on average still have excess savings that hasn't died out. So as those things peter out, the economy or take work from home. For example, where are we going to end up? Who knows.
Firms went really heavy on that, then they moved away from it a little bit. Where are we going to end up is still an open question. So as the economy kind of settles down, we're going to have a much better idea of where the economy settles but also about how monetary and fiscal policy connect with the economy. Because you need to understand what's going on to understand the effects of your particular policy.
And that's why the Fed always says things about, "we're going to let the data speak." Because they also want to understand what's the relationship between their actions and the outcomes that we see in the economy. And that's contaminated by all this adjustment that is coming out of a very big very unprecedented event.
Wright: So I think we have time for one last question. Hopefully, you've got a short answer handy for it. What role do corporate profits play in our current situation with inflation?
Martin: Well, this goes perhaps back to the wage spiral question. So what happens is — think about it the following way — suppose there is a big surge in demand for particular set of goods.
Let's say we all go out and buy computers or furniture. There is so much being produced. It's very hard for firms to adjust production if the increase in the demand is very high.
So the natural outcome of that is what they're going to increase the price. And if they increase the price, given that the costs are more or less fixed in the short term, what happens is profits go up. So it's only natural that if the phenomenon of high prices comes from the demand side, you're going to see initially an increase in profits. That's only natural.
Then what happens? Well, workers start seeing that they're spending more on restaurant bills, on education, on health care, et cetera, so they're going to start asking for higher wages. So that raises the cost of producers, which are rose their profit margins. So that effect does die off with time.
Wright: All right. Well, we're coming up to the top of the hour. So it's time to close. Fernando, thanks for talking to us today. And we both like to thank you, our attendees, for watching and participating today.
Please stay connected with us through social media or sign up to be notified about our blogs, newsletters or future events. With that, thanks again for joining us today.
Martin: Thank you.
Wright: Thank you.
This conversation was inspired by two May 2023 articles that Fernando Martin authored, which appeared on our On the Economy blog: