Prices are rising at the highest rates in 40 years. The Federal Reserve’s overly expansionary policy is the main culprit. Yet the Fed has taken only minimal actions to address this issue. After more than a year of inaction, the Federal Open Market Committee (FOMC) finally started raising interest rates. It increased its federal funds rate target by 25 basis points in March, 50 basis points in May, 75 basis points in June, and another 75 in July.   However, these rate increases were too late and too small to stem the current wave of inflation. The FOMC will need more drastic actions to get inflation down and signal to the public that it is taking inflation seriously. They should also seize this opportunity to implement long-term policy reforms. Consumer price inflation Over the past year, the consumer price index (CPI) has risen by 9.1 percent, while the personal consumption expenditures price index (PCEPI) is up 6.3 percent. Americans face ever rising prices for regular living expenses like food, gas, housing, and clothing. Fed officials have come to accept monetary policy as a major cause of recent high inflation. Auto computer chip and raw material shortages played a role in the early stages of recovery and high oil prices have contributed more recently. However, price increases have been widespread. Core PCEPI inflation, which excludes food and energy prices, is far above the Fed’s long-term target of two percent. The inflation problem appears to be persistent, not “transitory” as Fed officials had previously claimed. Despite the recent rate hikes, inflation remains elevated. The FOMC projects inflation will be above target through 2024. Financial markets’ implied expectations of future inflation have declined over the last month, but still suggest inflation will exceed 2.5 percent per year over the next five years. The Fed’s inaction The widespread and persistent price increases appear to be a symptom of monetary policy. Why didn’t the Fed respond sooner to the threat of inflation? First, Fed officials relied too strongly on their technical models, which predicted that inflation was transitory. They failed to learn from their mistakes in the Great Recession of 2007-2009, when overreliance on faulty models prevented the FOMC from cutting interest rates fast enough, which amplified the magnitude of the recession. Second, the FOMC adapted the interpretation of its mandate in ways that allowed more inflation. It changed from an inflation target of two percent per year to an average inflation target of two percent over time (so they claimed), which delayed its response to high inflation. It reinterpreted its full employment mandate to be more inclusive and promised not to raise interest rates until the economy reached this expanded conception of maximum employment. In addition, Fed officials prioritized nonmonetary goals like inequality, climate policies, and emergency lending to nonfinancial companies, diverting its attention from the core task of keeping inflation low. Third, the Fed monetized the fiscal deficit on an unprecedented scale. On its own, debt-financed government spending has little effect on total spending. The additional government spending enabled by newly issued bonds tends crowd out private sector spending, as businesses and consumers face higher interest rates. When the Fed monetizes those bonds, however, the new money boosts total spending and, with it, prices. In response to the pandemic, Congress increased fiscal spending by $5 trillion. The Fed purchased around $3.4 trillion in U.S. Treasury bonds. In other words, the Fed monetized roughly 68 percent of the debt required to finance the fiscal policy response.   What can be done? In the short run, the Fed must address the inflation problem. Increasing interest rates may not be enough. The Fed should adopt a monetary policy rule in order to increase their credibility and minimize uncertainty about their policies. As Scott Sumner and others have argued, a nominal spending rule might be the most effective way to achieve neutral, predictable monetary policy. In the long run, the Fed should get back to basics. Fed officials must prioritize monetary stability over political objectives such as inequality and climate policy. To simplify its operations, the Fed should consider returning to the pre-2008 corridor system of monetary policy. Thomas L. Hogan is senior research faculty at the American Institute for Economic Research. He was formerly the chief economist for the U.S. Senate Committee on Banking, Housing, and Urban Affairs. (0 COMMENTS)

One author who has been quick to notice the gains in income for black and Hispanic people is Manhattan Institute senior fellow Jason L. Riley. In his fact-filled and beautifully terse 2022 book, The Black Boom, Riley, shows that incomes for every demographic and every part of the income distribution grew during Trump’s first three years. My independent check of the data shows that Riley is right. Each year the US Census reports comprehensive survey data on incomes of various ethnic groups. Its latest report shows that between 2017 and 2019, median income for black households rose from $40,594 to $46,073, a rise of 13.5 percent over just two years. Adjusted for inflation, the increase was a respectable 8.8 percent. For Hispanic households, median income rose from $61,372 in 2917 to $68,703 in 2019, an 11.3 percent increase; inflation adjusted, the increase was 7.3 percent. How does that compare with progress for white households over those same two years? Their median income rose from $65,273 in 2017 to $72,204, an increase of 10.6 percent. Adjusted for inflation, their median income rose by 6.1 percent. Notice something interesting: black and Hispanic household incomes rose by a higher percentage than white household incomes. This is from David R. Henderson, “The Roots of Black Economic Progress,” Defining Ideas, July 28, 2022. Another excerpt: On February 10, 2017, less than one month into the Trump presidency, Joe Kernen and Becky Quick interviewed me on CNBC’s Squawk Box about economics under the Trump administration. My fellow interviewee, Tony Crescenzi of Pimco, was pessimistic about future growth rates. He argued that the labor force would grow by less than 1 percent and that productivity would grow by less than 1 percent, causing overall economic growth to be less than 2 percent annually. While I granted his arithmetic, I challenged his data. Predicting productivity growth, I pointed out, is necessarily forward looking. I asked, “What if we get all kinds of deregulation that frees things up and you get more productivity?” Read the whole thing. (0 COMMENTS)

Imagine you were on a ship crossing the ocean. The captain said he hoped to reach New York, but didn’t have any great confidence as to whether the ship would achieve that destination. In contrast, he told you exactly how he planned to adjust the steering wheel over the next 3 hours. How would you feel?Personally, I’d rather the captain express a high level of confidence as to the destination, but also exhibit a willingness to change the steering wheel setting as necessary to offset wind and waves.Over the past year, I’ve often been critical of the Fed. The so-called “flexible average inflation target” has ended up creating more confusion than clarity. The exact meaning of the 2% inflation target is now unclear. In 2021, the Fed provided forward guidance on interest rates and QE, leading to a policy that was too expansionary for the conditions of the economy. They should have provided much more clarity about where they wanted the future price level to be, and much more willingness to make interest rate targets and QE be “data dependent”.Today, I’d like to praise Jay Powell for his comments at yesterday’s press conference. He was forceful in his statements that the Fed would do whatever it takes to get inflation back to 2%. (Of course I’d still prefer NGDP level targeting.)  More importantly, he suggested that future interest rate movements would be data dependent. I suspect this is why the markets responded positively to the press conference.The media often focuses on whether Fed statements are hawkish or dovish. I focus more on whether they are effective in achieving the Fed’s goals and reducing policy uncertainty.  By that criterion, yesterday was a modest step forward. PS.  And no, we did not have a recession in the first six months of 2022. (0 COMMENTS)

The first tranche of Marshall Plan funds helped West Germany reform its currency and jump-start a surprisingly rapid economic and political revival. Integral to the Marshall Plan was the Truman administration’s elimination of German debt and reparations. As a result, real output increased by 18.5 percent in 1948 and leveled off at an average increase of 8 percent a year during the first half of the 1950s. The above is a quote from David L. Roll, “The 11-Minute Harvard Speech that Rebuilt Postwar Europe,” Wall Street Journal, Saturday/Sunday, June 4-5, 2022. It’s based on Roll’s book titled George Marshall: Defender of the Republic. Roll missed most of the cause of the German recovery and economic expansion. It wasn’t the Marshall Plan, as Tyler Cowen laid out cogently in his 1985 book chapter titled “The Marshall Plan: Myths and Realities” and in a 1986 article based on that chapter in Reason. The latter is titled “The Great Twentieth-Century Foreign-Aid Hoax,” Reason, April 1986. So what did cause what has come to be known as the German economic miracle? I tell the story in some detail in “German Economic Miracle,” in David R. Henderson, ed., The Concise Encyclopedia of Economics, Liberty Fund, 2008. The short version: currency reform, ending price controls, and substantially cutting marginal income tax rates. The picture above is of the person who, more than anyone else, deserves credit for the German economic miracle: Ludwig Erhard. (0 COMMENTS)

Ludwig Wittgenstein pointed out that many words don’t have a simple precise meaning, but instead refer to a set of concepts with a sort of family resemblance. I thought of this when reading a twitter exchange, which was triggered by a recent post I did over at TheMoneyIllusion: There are a number of different ways that one could address this question.  For simplicity, I’ll focus on a fiat money system, as I’d probably define monetary policy slightly differently under a gold standard.    Monetary policy occurs: 1. When a monetary authority . . . 2. uses a set of monetary policy tools . . . 3.  or signals intentions to make future use of policy tools . . . 4.  to impact the supply and/or demand for the medium of account, . . . 5.  which impacts nominal aggregates such as the price level and NGDP.   Later I’ll return to the question of whether only actions by the monetary authority (such as a central bank) should count.  For now, let’s look at the other parts of my definition. In the US, the monetary base (cash plus reserves) is the medium of account.  The Fed has traditionally had three policy tools that impact base supply and demand, but those tools have changed over time: Policies affecting the supply of base money:  Open market operations and loans to banks. Policies affecting the demand for base money:  Reserve requirements and interest on reserves (IOR). That’s four tools, but prior to 2008 IOR did not exist and today reserve requirements do not exist.  So mostly three tools. Basically, the Fed adjusts the supply of base money by the purchase and sale of assets, as well as loans of base money.  Demand is impacted via changes in IOR.   More supply of base money is expansionary, ceteris paribus, and more base demand is contractionary.  But, and this is important, policy is not necessarily expansionary when the base is increasing, and it’s not necessarily contractionary when higher IOR is tending to increase base demand.  Lots of other things matter, by far the most important of which is signals about the future path of policy, that is, the future use of the three major policy tools. You could make an argument that monetary policy should refer not just to actions taken by the monetary authority that impact the supply and demand for base money, but also to any other action that impacts the purchasing power of money. Thus, suppose Bill Gates were to shift $50 billion of his wealth from stocks to US currency placed in safe deposit boxes?  That increases the demand for base money, doesn’t it?  Why not consider his action to be monetary policy?   David Andolfatto makes a related point in response to Nick Rowe: I can give you two reasons why I don’t think it’s useful to expand the definition of monetary policy beyond the monetary authority: 1. The behavior of the monetary authority is a very important part of government policymaking.  It is useful to have a term that applies to monetary actions taken by this specific institution, and have other terms (currency hoarding, fiscal policy, etc.) for actions taken by other entities that might impact the value of money. 2.  As a practical matter, I don’t think that currency hoarding by Bill Gates would impact the value of the dollar.  I suspect that the Fed would respond by injecting enough extra base money to offset the effect that Gates’ action might otherwise have on the value of money.  In the same way, I suspect that the Fed would roughly offset the effect of more fiscal spending on prices and nominal spending.  And if it didn’t, I’d still call that passivity an “expansionary monetary policy”.  (A good example is the Fed’s expansionary policy during 2021, which was discretionary, not forced by fiscal policy.)  I do not believe this monetary offset argument applies in countries like Zimbabwe.  But even in those cases (of fiscal dominance), the first reason I provided is sufficient for having a special term to designate policies of the monetary authority that impact the supply and demand for base money.  I’d prefer to call deficit spending in Zimbabwe “fiscal policy”, while acknowledging that it would likely impact inflation. PS.  Here’s another tweet by Andolfatto: I’m not sure how much weight anyone puts on my views, but I will say that Milton Friedman would have certainly viewed that definition as being wrong.  (Although I suppose it could technically be correct if one were to define monetary policy as policy affecting both the path of interest rates and the path of the natural interest rate.) (0 COMMENTS)

A story in this morning’s Wall Street Journal follows up on the EU government’s actions in the face of “Russia” (i.e. Putin’s Russian state) cutting gas supplies to European customers. The article contains some some confused statements and some sound points from a narrow economic viewpoint, but that is not what I want to focus on. (See my more mainstream post of yesterday on the same topic.) I will  instead underline what I think is a general result of in the economic analysis of politics. The WSJ writes (“Europe Agrees to Cut Gas Consumption as Russia Crimps Supplies,” July 26): “Governments haven’t done a good job at preparing the public for these kinds of demand-saving measures,” said Natasha Fielding, analyst at Argus Media. I wonder where Ms. Fielding has been living or what she has read about the past century or century and a half—and longer if we want to reach to Alexis de Tocqueville’s premonitions about the soft tyranny of future democratic regimes. Governments have done whatever they could without open violence, and often with sanctimonious open violence, to accustom individuals to being dependent upon, trustful of, and addicted to their political and bureaucratic masters. “Citizens” often tell pollsters that they mistrust the current government in power, but they deify the state as it should be and as it would be if and when the democratic crowd or the plebiscitic strongman espouses their own views and interests. The failure to see how free-market prices could resolve heightened scarcity in the gas market is only an example among zillions. (0 COMMENTS)

  I promised last month to post Casey Mulligan’s and my op/ed in the Wall Street Journal after the 30-day waiting period was over. Here it is.   Biden is Practically Engineering a Recession His regulatory and tax agendas seem designed to negate the good things the economy has going for it. By David R. Henderson and Casey B. Mulligan June 22, 2022 4:27 pm ET Most discussion about the possibility of recession focuses on the Federal Reserve’s monetary policies. But there are also factors on the supply side of the economy that may tip the U.S. economy into a recession. Among them are the tax and regulatory policies of the Biden administration. A recession is sometimes defined as a decrease in employment. Other times it is defined as a reduction in real gross domestic product for two quarters or more. Strong labor-force and productivity growth are supply-side factors that make a recession less likely, as is recovery from the pandemic. But increased regulation and increased taxation of capital—two Biden administration policy priorities—are supply-side headwinds that make recession more likely. Adult population growth is normally an economic tailwind. But it has fallen substantially, from above 1% between 1980 and 2018 to about 0.4%. President Trump’s restrictive policies on even legal immigration are partly to blame for this decline. President Biden has done little to reverse those policies. Recovery from the pandemic has also been a tailwind. It will continue to lift employment, but most of the recovery in employment has already occurred. Workers lost skills and capital laid idle during the pandemic. These are recovering, though strictly from an accounting point of view, their recovery won’t be fully recognized in the growth data. GDP and productivity levels were exaggerated during the pandemic as many goods were unavailable or low in quality in ways the GDP data didn’t capture. Even though public-school teachers stayed home, for instance, national accountants assumed that they were as productive as ever merely because they continued to be paid. As they get back to traditional teaching, this won’t be officially recognized as economic progress for the same reason the pandemic regress was never acknowledged. In normal years, workers’ productivity rises by about 1%. That alone is a strong economic tailwind causing GDP growth, making recession by the reduced GDP definition less likely than otherwise. Unfortunately, Mr. Biden’s economic policies will likely cause productivity growth to fall. A 2020 analysis by one of us (Mr. Mulligan) and three co-authors concluded that Mr. Biden’s economic agenda would cause full-time equivalent employment per capita to be 3.1% lower than otherwise and real GDP per capita to be 8.5% lower than otherwise. If that effect were spread over five years, the reductions relative to the baseline growth would be 0.6% and 1.7% a year, respectively. That by itself makes a recession likely in one of those five years. Mr. Biden’s regulatory agenda seems to be going ahead as expected. The good news is that the Senate rejected David Weil, the president’s nominee to the Labor Department’s Wage and Hour Division. But Mr. Biden’s mask mandates offset that good news by disrupting hiring and employee retention when supply chains are already strained. His regulatory agenda will likely cause employment growth to fall by 0.2 percentage point a year and real GDP growth to fall by 0.7 point a year. Although Mr. Biden’s Build Back Better bill would increase taxation of capital, it’s unlikely to pass. High inflation, however, is increasing taxation of capital without any action by Congress. Mr. Biden is almost certain to let temporary capital-taxation provisions in the 2017 tax cut law expire. The effect will be to reduce growth of real GDP by about 0.4 percentage point a year. The combined effect of increased regulation and increased taxation of capital is a reduction in employment growth by about 0.25 percentage point a year and of real GDP growth by about 1.1 points a year. Taxation of labor is a wild card. The $300 weekly unemployment bonus created an implicit tax on work: If you got a job, you lost the bonus. Because that bonus expired last summer, the implicit tax rate on work fell. Unfortunately, when economies enter recessions, politicians of both parties, wanting to “do something,” typically expand unemployment benefits. If that happens this time, it could easily and quickly reduce employment by 1% or more. On the other hand, various federal health-insurance subsidies are about to expire. Letting them die will encourage work. Viewed only from the demand side, a recession seems reasonably likely. Unfortunately Mr. Biden’s supply-side policies seem tailor made to encourage one. Mr. Henderson is a research fellow with Stanford University’s Hoover Institution and editor of the Concise Encyclopedia of Economics. Mr. Mulligan, an economics professor at the University of Chicago and a fellow with the Committee to Unleash Prosperity, was chief economist for the White House Council of Economic Advisers, 2018-19. (0 COMMENTS)

In a recent piece in the WSJ, Elizabeth Warren criticizes the views of Larry Summers: Despite these warnings, the Fed chairman still has cheerleaders for his rate-hiking approach. Chief among them is Larry Summers. “We need five years of unemployment above 5% to contain inflation—in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment,” the former Treasury secretary recently told the London School of Economics. You read that correctly: 10% unemployment. This is the comment of someone who has never worried about where his next paycheck will come from. My views are closer to those of Summers than to Warren.  Nonetheless, I’m a bit surprised by his unemployment estimates.  If they were based on a “Phillips curve” type model, then I’d view the estimates with a great deal of caution. It’s true that unemployment often rises during periods when the rate of inflation is brought down.  But the higher unemployment is not directly caused by lower inflation (that would be reasoning from a price change.)  It depends why the inflation rate has declined.  The real problem is not lower price inflation; high unemployment is more closely linked to a decline in NGDP growth, or a decline in wage inflation, or a decline in inflation expectations. While the US CPI inflation rate recently reached 9.1%, the (5-year) expected rate of inflation has remained relatively low—mostly in the 2.5% to 3.5 % range.  And the PCE index targeted by the Fed runs about 25 basis points lower, on average. In contrast, even expected inflation rose to near double digit levels at the end of the 1970s.  Thus it should be far less costly to reduce inflation today than it was back in the 1980s. Wage inflation is also running at excessive levels (roughly 6%), but that’s also nowhere near as bad as CPI price inflation, or as bad as wage inflation in the 1970s. If you look at the fed funds futures market, investors seem to anticipate short-term rates rising to 3.4% by yearend, and then falling back to slightly below 3% in late 2023.  That sort of yield curve inversion often precedes a recession, but it also indicates that investors expect the recession to be relatively mild.  If unemployment actually were expected to average 7.5% over two years, then interest rates would almost certainly fall to zero in late 2023. Of course those are just market forecasts; reality almost never turns out exactly as expected.  So a major recession is possible.  But at the moment, investors seem to be pricing in a fairly mild recession, perhaps because inflation expectations never reached the levels of the late 1970s.  Indeed, inflation expectations are even below the levels of the late 1980s, after 8 years of Paul Volcker’s monetary restraint. All policy failures are relative. PS.  If I see one more reporter say that two falling quarters of GDP is a “technical recession” I’ll shoot myself.  The US labor market was booming in the first two quarters of this year.  The correct view is that, as a rule of thumb, two quarters of falling GDP is usually accompanied by a recession. (0 COMMENTS)

Economist John List of the University of Chicago talks about his book, The Voltage Effect, with EconTalk host Russ Roberts. He discusses what determines scalability and argues that the only good ideas that count are those that scale. Along the way, he draws on his experiences as chief economist of Uber and Lyft to peer […] The post John List on Scale, Uber, and the Voltage Effect appeared first on Econlib.

Natural gas deliveries to Europe from Russian state corporation Gasprom have already been reduced and further reductions are expected as winter approaches. It is a way for the Russian government to pressure European governments into dampening their political and military support for Ukraine. The European Union government is advancing a rationing plan to face the reduced supplies (“Brussels Asks EU States to Slash Gas Use by 15% Starting Next Month,” Financial Times, July 20, 2022): Brussels has asked EU countries to cut their gas use by 15 per cent and set out emergency plans ahead of winter when it anticipates severe disruption to gas supplies from Russia. If supply drops by 15%, the use of gas (by consumers and intermediate users) must also decrease by 15%. The question is who will bear the burden of this reduction, that is, how demand will be rationed. Some economists don’t like using the term “ration” when the process is done through market prices; it does, however, emphasize that everything in our finite world has to be rationed one way or another. But we may use the term “allocate” as a synonym. There exist basically two ways to ration something: through market prices or by diktat from some political authority—politicians or government bureaucrats in our societies. (I neglect traditional or religious rules like in primitive societies.) Political allocation can only be arbitrary, whether it is egalitarian or not, and even if it hides behind a formal rule of law. It is arbitrary for two reasons: first, the authorities are likely to favor themselves or their most useful political clienteles; second, even if the authorities are composed of perfect altruists, they don’t have the information of time and place that is dispersed among the minds of all the participants in the economy (see F.A. Hayek, “The Use of Knowledge in Society,” American Economic Review, 1945). Automatic allocation by prices is preferable because each user is thereby incited to take into account the value of gas (our illustrative case) for other users. The individuals who will finally get the gas or what is made with it (say, home heating or metal objects made with gas-produced electricity) are those who are willing to pay the most for it. If you are among those, you pay for the gas more than the value of which you are depriving others. It is true that some users may be willing to pay more because they have higher incomes, wealth, or financing capabilities. But this is not necessarily the case: when you buy a car and the steel and aluminum that goes into it, you outbid billionaires who would otherwise have ordered bigger private yachts; if no car were produced, their yachts would cost less. Mutatis mutandis when you buy a Cohiba. In a sense, the allocation of gas will remain efficient if political authorities give tradeable ration coupons or equivalent cash subsidies to some users who could not otherwise “afford” the stuff. A consumer will buy a thousand cubic feet of gas for (say) $12 only if it is worth more than what he can otherwise get for $12. (There will be of course a transfer from general taxpayers to gas consumers and some consequent deadweight loss, and this fact should not be ignored.) The EU plan seems to recognize the efficiency of some price allocation in the case of industrial users of gas. If I understand the plan correctly, after some EU allocation of the reduced supply among member countries, industrial buyers could obtain their gas through national auctions or, what amounts to the same in an opportunity-cost sense, by bidding down the subsidy they could receive from the government (presumably for having to sell the gas at lower prices than they paid for it): Market-based measures can mitigate the risks to society and the economy. For example, Member States could launch auction or tender systems to incentivise energy reduction by industry. And, from another EU document: One recommended measure consists of national or joint auctions or tender systems by which Member States incentivise a reduction of consumption by large consumers (mostly industries). Those industries best placed to reduce demand would voluntarily offer to do so. Depending on design, they could receive financial compensation in return. If some measure of rationing by market price are envisioned for industrial users, the allocation to household consumers and other “protected customers” will remain purely political. Since it is the government who will decide who are these “protected consumers” (households, hospitals, non-large consumers, and other politically preferred clienteles) to benefit from protected supplies and capped prices, political factors will determine resource allocation. Along these lines, mandates for temperature or hourly thresholds would still be possible. So-called “public” places (venues and businesses open to the public) can be subject to forced consumption cuts. As usual, much dirigisme and economic planer’s conceit mars the EU plan. The more you read it, the more you realize that. Although less inefficient than if no market mechanism at all is used, the system will still be inefficient. Consider an individual consumer who would prefer to consume a bit less gas to heat his home (he has warm duvets for the night) in order to keep some money for patronizing well-heated restaurants, bars, theaters, or concert halls. On a free market, it is easily done: he consumes less gas—by buying less or by selling his ration coupons—and uses the money to spend on these other activities he considers more important. In a government allocation system like the one envisioned by the EU government for “protected consumers,” our individual consumers’ more expensive gas consumption at home is subsidized and he may not choose to apply these subsidies to his preferred consumption activities instead. Besides being arbitrary, the “prioritization” of—that is, discrimination in—subsidies and interventions is very opaque. The rationally ignorant voter will have no idea that the rationing system decreases the supply, and jacks up the prices, of some goods he would prefer to buy instead of subsidized heating. Rationing gas among all users should be done through market prices. If there must political tampering with market allocation to protect poorer households, it should be done by tradeable ration coupons or simply and preferably by cash subsidies.  Unfortunately, this is not how politics work under a mostly unlimited democracy (“totalitarian democracy,” as Bertrand de Jouvenel would have said) where politicians must satisfy the most vocal clients and organized interests, while pretending to run the economy “from a societal perspective” (whatever that means). Expect a mess, generated jointly by the governments of Russia, the EU, and individual EU countries. (0 COMMENTS)