How 10 Prominent Economists Think About Overheating

on Mar24
by | Comments Off on How 10 Prominent Economists Think About Overheating |

I shall plead Knightian uncertainty. I have no clue as to what happens to inflation and rates, because it is in a part of the space we have not been in for a very long time. Uncertainty about multipliers, uncertainty about the Phillips curve, uncertainty about the dovishness of the Fed, uncertainty about how much of the $1.9 trillion package will turn out to be permanent, uncertainty about the size and the financing of the infrastructure plan. All I know is that any of these pieces could go wrong.

We would have to see the Fed’s preferred gauge of core P.C.E. inflation sustained at a rate above 3 percent for several years and importantly matched by wage growth with measures of inflation expectations rising before I worry about the Fed losing its grip on its stable price mandate. Bond yields would need to be sustained well north of 4 percent in this scenario. It is strange to me that for years economists pined for a better mix of monetary and fiscal policy and now we have it and there is a narrative among some that it has to end in disaster. I am more optimistic about the macro outlook than I have been in a long time and am far more focused on how quickly the labor market returns to health than any threat from inflation.

The Federal Reserve’s inflation target has been that inflation should average — not ceiling, but average — 2 percent per year using the P.C.E., 2.5 percent per year using the core CPI. Had inflation in fact matched that average since the beginning of the Great Recession, the core CPI would now be 296 on a 1982-84=100 basis. It is actually 270.

If the Fed had hit its inflation target, the price level now would be 9.6 percent higher than it is. When the cumulative excess of C.P.I. core inflation over 2.5 percent per year reaches +9.6 percent, come and ask me again whether Federal Reserve policy is excessively inflationary. Until then, we certainly have other much more important economic problems to worry about than the risks of excessive and damaging inflation.

I think there is a fair amount of consensus that the economy will grow strongly beginning in the fourth quarter of 2021 and that inflation will rise. I also believe, although there is less consensus here, that the level of economic activity will temporarily rise above its sustainable level for a time and inflation will rise above the Fed’s target. If you want to call that overheating, I think that isn’t in and of itself problematic. In fact, I think making up for some lost economic activity is beneficial. And, the Fed has said it welcomes a rebound in inflation.

So where would I be concerned? Is this just a matter of degrees? In isolation, there isn’t a credible prediction of temporary overheating or inflationary pressure that worries me. For example, I think we can increase labor force participation well above its sustainable level for several quarters. Same with capacity utilization. I don’t think anyone will be too surprised to see massive airfare inflation. Instead, I worry if we start to see signs that people, businesses and financial markets are responding to the level of overheating as if it were permanent. On one dimension, that could suggest a harder landing. For example — I would worry about a significant jump in the quit rate.

I would worry about a housing construction boom or a commercial real estate boom. I would worry about a significant increase in leverage across the economy. That all suggests pain for people when the economy cools. On another dimension, if financial markets start to view the overheating as being too permanent, we could see inflation expectation rise to worrying levels — well above the Fed’s target. For example, I think we need to keep a close eye on the five-year, five-year forward inflation expectation rate. The Cleveland Fed has a nice roundup of inflation expectation measures.

I would worry about the Fed’s credibility if longer-term expectations remained stubbornly above where they were in 2019 by, say, one-half percentage point. Which is to say, the economy has benefited from the Fed being credible about its policy direction. If it’s lost, regaining that credibility would exact a toll. Still, everything I see in terms of underlying economic strength, households’ resources, and the fiscal support in train points to a several-quarter-long surge in the economy. We — policymakers, households, businesses — need to appreciate its temporary nature and adjust accordingly.

The most obvious indicator is that they predict sustained and rising inflation from an overheated economy. You should see prices rising rapidly, and it’s not called a NAIRU for nothing — it should start accelerating. It should be in wages and prices, and it shouldn’t be temporary. It should be 3, then 4, then 5 percent and so on. Basically they are predicting a 1970s repeat, so just go look at how inflation accelerated in the 1970s.

So B, this means more than just what is the inflation rate one year from now. Up and then back down is perfectly consistent with the Yellen/Powell view. If you are impatient to get an idea before having to wait four years, you would expect this to show up in the TIPS implied inflation expectations. Compare the five-year TIPS to the 10-year TIPS, and it will tell you whether they expect a heavy, sustained inflation. Right now the five-year is 2.5 percent, and the 10-year is 2.3 percent, so they don’t expect high inflation and they don’t expect rising, sustained inflation. It’s as simple as that.

C, the implicit implication of their view is that the labor market in particular will overheat. For that to happen we should see a big rise in the labor force participation rate back to recent normal levels, at the least, and the unemployment rate down below the 3.5 percent range it got to under Trump (without inflation).

But D, it should count somewhat in their favor if the Fed had to jack up rates so quickly/stiffly that it created a tough recession without a soft landing. That might prevent actual inflation from happening and negate their hypothesis in the technical sense, but they would still be right in spirit even without the actual inflation. Caveat to D, if we have a bubble going on and the bubble pops and that causes a recession, that has nothing to do with their theory and they should not get credit for that. It’s basically just the 2001, 2008 style recession again.

Ultimately we’re worried about an outcome in the real economy, which is rapid growth in 2021 followed by a significant reversal in 2022 or 2023 with anything like a recession, negative growth or a sizable increase in the unemployment rate. Much of what we call “overheating” is mostly a concern insofar as it triggers that outcome. But some more proximate measures:

Inflation in the second half of 2021 or the four quarters of 2022 at an annual rate of 2 to 2.5 percent would be desirable; 2.5 to 3.5 percent would cause more worries than it objectively should, but those worries could create self-fulfilling problems; and above 3.5 percent would create a substantial risk of macroeconomic reactions that create genuine instability and problems in the economy.

The 10-year nominal interest rate going above 3 percent in 2021 should give us some pause, and going above 4 percent should raise the possibility of a meaningful course correction for fiscal policy. Finally, not a proximate measure, but a fear (and this is not my central guess), is that overheating could happen without a large decline in the unemployment rate. If, for example, people don’t return quickly to the labor force and it takes a while for the unemployed to find jobs, then you could have overheating even with an unemployment rate of 4.5 or 5 percent. That would be the worst scenario because it would really discourage policy activism for some time to come. Not my main prediction and maybe a risk worth taking, but is the gnawing fear that keeps me up at night.

I would say the economy is overheated if G.D.P. rises above potential G.D.P. (as estimated by, say, C.B.O.), and core inflation (P.C.E. price index excluding food and energy) rises above 3 percent over a 12-month period. (Inflation has not broken that threshold anytime during the past quarter century.)

Such an overheating could be temporary. I would say we have an ongoing overheating problem if, in addition, five-year break-even inflation — a gauge of inflation expectations — rises above 3 percent.

To have overheating you need to start getting a spiral. There’s not a magical number. It’s not that if you’ve gone over 5 percent inflation you’re overheating. To me, overheating is inflation starts picking up, and it keeps going. Inflation is a slow-moving dynamic, especially in core. You see it’s up a couple of tenths of a percent, then another couple of tenths, then starting to move up half a percent if things really start to get out of control. When it keeps going and keeps getting worse, you’re overheating.

It would speed up. It would have to be persistent. If by the end of next year we were looking at consistent prints of 3 percent, and it had started — we’re at 1.5 now — if it had climbed to 2.6 by the end of the year, then kept going up next year and was heading toward 3 by the end of 2022, with the unemployment rate completely recovered, OK, maybe we’re pushing the economy too hard. It’s time to ease up on the accelerator and tap the brakes.

It’s the spiral that matters. It could happen, but it would take a while and not only do we know how to disrupt a wage-price spiral — we know what it looks like.

I think there’s a one-third chance that inflation expectations meaningfully above the Fed’s 2 percent target will become entrenched, a one-third chance that the Fed will bring about substantial financial instability or recession in order to contain inflation, and a one-third chance that this will work out as policymakers hope.

In the first scenario, we have a Vietnam-like experience where inflation expectations ratchet upwards due to macroeconomic policies, and inflation expectations, broadly defined, become unanchored.

In the second scenario, we have an experience like most of the recessions prior to 1990, when expansions were murdered by the Fed with inflation control as the motive. This was the case three times in the 1950s, at the beginning of the 1970s, in 1975, 1980 and 1982. In the past it has proven impossible to generate a soft landing. I can’t think of a time when we have experienced a big downshift without having a recession.

In the successful scenario that is the aspiration of policymakers, we would enjoy a period of very rapid growth, followed by a downshift to moderate growth, with inflation expectations remaining anchored in the 2 percent range.

I have a separate view on what would be good for the economy and on what the Fed might be able to tolerate.

Trend inflation (measured by some sort of a moving average, let’s say — but that does not include March and April due to base effects) of 2.5-3 percent would be a policy victory. By “inflation” I mean the year-over-year change in the monthly core P.C.E. Aberrant, transitory months spikes are nothing to worry about from an economic perspective. But if that average starts to creep above 3 percent, then I would start to worry, regardless of the behavior of market-based inflation expectations.

If market-based inflation expectations on the five-year break-even go above 3 percent and expectations using five-year, five-year forward go above 2.5 percent, then I would start to worry, regardless of the behavior of actual price inflation, as measured in the previous paragraph.

My big concern is that the Fed won’t be able to hold firm in the environment I characterize in my first paragraph, especially if you add evidence of financial market bubbles into the mix. So in that sense, I am more worried about a policy mistake than I am worried about a de-anchoring of expectations.

Source link

Previous postWhy Finance Gurus Switched Their Bait From Millions to Thousands of Dollars Next postHow 10 Economists Think About the Economy Potentially Overheating

Chicago Financial Times

Copyright © 2024 Chicago Financial Times

Updates via RSS
or Email