How does the economy work? New Fed document suggests no one really knows
It has long been a central tenet of mainstream economic theory that public fears about inflation tend to come true.
Now, however, a cheeky and even gleeful withdrawal from that idea has emerged from an unlikely source, a senior Federal Reserve adviser named Jeremy B. Rudd. His 27-page article, published as part of the Fed’s Finance and Economics Talk series, has become what goes for a viral sensation among economists.
The article takes issue with the idea that people’s expectations of future inflation matter a lot to the level of inflation experienced today. This is particularly important at this time, in trying to determine whether the current inflationary surge is temporary or not.
But Rudd Paper is part of something bigger. It reflects a broader overhaul of fundamental ideas about how the economy works and how policymakers, especially within central banks, try to manage things. This shift also included debates about the relationship between unemployment and inflation, how deficit spending affects the economy, and much more.
Indeed, many of the key ideas underlying economic policy during the Great Moderation – the period of relatively stable growth and low inflation from the mid-1980s to 2007 which also appears to be a highlight for overconfidence. of economists – increasingly look to be incomplete at best, and wrong at worst.
This is glaring proof that macroeconomics, despite the thousands of very intelligent people over the centuries who have tried to figure it out, remains, to an uncomfortable degree, a black box. The ways in which millions of people bounce off each other – buying and selling, lending and borrowing, intersecting with governments, central banks and businesses and everything around us – is such a complex system that no human fully understands it.
“Macroeconomics behaves as if we were doing physics after the quantum revolution, that we really understand at a fundamental level the forces around us,” said Adam Posen, president of the Peterson Institute for International Economics, in an interview. “We are really at the level of Galileo and Copernicus”, understanding the basics of how the universe works.
“It takes more humility and acceptance that not everything fits into one model yet,” he said.
Or to put it less politely, as Mr Rudd writes in the first sentence of his article, “The traditional economy is full of ideas that ‘everyone knows’ are true, but which are in fact nonsense. blatant. “
One of the reasons for this, he postulates: “The economy is a complicated system which is inherently difficult to understand, so propositions like these” – the blatant nonsense in question – “are all that saves us from nihilism. intellectual “.
And from that starting point, an economist at the world’s most powerful central bank has indeed said his own employer has focused on the wrong things for the past decades.
Mainstream policymakers, including Mr Rudd’s bosses at the Fed, believe that inflation is largely self-fulfilling – that what people expect future inflation to look like has the ability. to determine the price increase in the short term.
In the common saying, the Great Inflation of the 1970s began because people came to believe that inflation would continue to soar. Soaring gasoline prices were not just a frustrating development, but a harbinger of things to come, so people had to demand higher increases, and businesses could feel confident charging prices. higher for almost everything.
In this story, the Fed’s great achievement in the early 1980s was to break this cycle by restoring the credibility that it would not allow sustained high inflation (but at the cost of a severe recession).
This is why today’s discussions of the inflation outlook often spend a lot of time focusing on things like what bond prices suggest inflation will be in five or 10 years, or how people answer survey questions about what they expect.
Mr Rudd argues that there is no solid evidence that conventional history of the 1970s describes the actual mechanism by which inflation takes place. He says there is a simpler explanation consistent with the data: that businesses and workers arrive at prices and wages based on conditions they have experienced in the recent past, not abstract future predictions.
For example, when inflation has been low in the recent past, workers might not demand an increase as they would in a world of high inflation; after all, their existing paychecks are going about as far as they used to be. You don’t need a theory about inflation expectations to do this.
Some economists who favor the idea that central bankers have too fetishized precise measures of inflation expectations are not ready to reject the idea entirely.
For example, Mr Posen, a former Bank of England policymaker, argues that there remains a simple and difficult idea to dispute about inflation expectations backed by many antecedents: if people are wary of the monetary system of a country, inflationary shocks can skyrocket. The credibility of economic policy is important. But this is not the same as assuming that a bond market survey or measure of what will happen to inflation in the distant future is particularly useful for forecasting the near future.
“It was a noble lie that has become an essential part of the catechism of global monetary policy, according to which long-term inflation expectations are not only interesting but are a decisive determinant of real-time inflation,” said said Paul McCulley, a Pimco alumnus. chief economist, commenting on Mr. Rudd’s article.
This is not the only way the basic tenets that underpin economic policy are shifting under the feet of economists.
In particular, for years central bankers believed that there was a close relationship between the unemployment rate and inflation, known as the Phillips curve. During the 2000s, however, this relationship seemed to weaken and become a less reliable guideline on how to define policy.
Likewise, interest rates and inflation have fallen around the world, for reasons that researchers are still trying to fully understand. This involved a lower “neutral interest rate”, or a rate that neither stimulates nor slows the economy, than was generally believed to be the case in the mid-2010s.
In many ways, the Fed’s policies just before the pandemic were aimed at incorporating these lessons and embracing sustained, lower interest rates – and the possibility of lower unemployment – that many in the mainstream thought was reasonable. a few years earlier.
In the area of fiscal policy, certain preconceived ideas have also been overturned in recent years. It was believed that large public debt issuances risked spiking interest rates and crowding out private sector investment. But during this period, huge budget deficits were associated with low interest rates and abundant credit for businesses.
All of this makes for a difficult time for central bankers and other policymakers. “If you are a decision maker and you don’t have a solid confidence in the parameters of the game you are managing, it makes your job a lot more difficult,” said McCulley.
But if you’re tasked with crafting an economic policy that affects the lives of millions of people, you can’t just shrug your shoulders and say, “We don’t know how the world works, so what are we supposed to do? You review the available evidence and make the best judgment possible.
And then, if you think it turns out you’ve got something wrong, post a sassy post to try to get it right.