The Fed Is Skating To Where The Puck Was: Comparisons To Volcker's 1980s Inflation Are 'Conceptually Wrong,' Says This Economist

Unbeknownst to many, the gift for the 43rd anniversary of marriage is entertainment; to stretch it further, this fall marks the 43rd anniversary of a pivotal event in the history of the Federal Reserve and the U.S. economy. While it may be more like watching a horror movie, the Fed has provided the markets with a lot of entertainment this year.

Paul Volcker, then-Chairman of the Fed, took decisive action on Oct. 6, 1979, to tame the Great Inflation, a period of out-of-control inflation that had been eroding economic strength since the mid-1960s.
Read more: Inflation Is Still Running Hot As US Producer Prices Rise: What You Need To Know

The U.S. economy would have continued to decline without his audacious change in monetary policy and his resolve to stay with it through many difficult years. Volcker laid the groundwork for the protracted economic expansions of the 1980s and 1990s by abandoning the shortsighted policies of his predecessors.

At the Federal Reserve Board building in Washington, D.C., where current chair Jerome Powell is battling to control inflation that is on the verge of reaching 40-year highs, Volcker's powerful words still reverberate through the halls some 43 years later.

In an August address in Jackson Hole, Wyoming, Powell echoed Volcker's strategy: the Fed will tolerate a recession as the cost of battling inflation.

“We must keep at it until the job is done,” Powell said, invoking the title of Volcker’s 2018 autobiography, “Keeping At It.”

But, the inflation of 2022 is different from what it was in the 1980s, and, according to economist Paul Krugman, the “hardliners” who want the Fed to keep tightening are relying on arguments that “seem to be conceptually wrong.”

Krugman laid out his argument to his 4.3 million Twitter followers on Wednesday, saying that The Great Inflation period of the 1980s was riddled with expectations, and these days, all available evidence says that inflation expectations are still anchored, which means that analogies with the Volcker disinflation are all wrong.

Also Read: Fed Minutes Warn Investors Interest Rates May Be Higher For Longer

What does that mean?

People's expectations of inflation's long-term value serve as its anchor. The anchor is lost if expectations consistently shift, or if they diverge from the central bank's aim.

According to data, the anchor may have begun to drift as early as 1967, and this may have been seen long before policymakers identified the problem. This method's efficacy for measuring the inflation anchor in real time was confirmed by using predicted data from Brazil, Turkey, South Africa, and the U.S. in the 1970s and in 2021.

Economic theory attributes a particularly important significance to expectations as the cause of inflation. Any inflation rate is consistent with the same real results and welfare, according to the long-run classical dichotomy. In order to control inflation, the Fed must largely control the expectations of the public, which are impacted by regulations, regimes of policy, and monetary standards.

“First, there's the argument that the continuing tightness of U.S. labor markets says that we still haven't tightened enough,” Krugman noted, “this seems odd given what I thought was a universal view that monetary policy works with substantial lags.”

It’s true — there are five recognized lags in Monetary Policy, and Data Lag is one of them.

Policymakers are unaware of the precise timing of economic events.

An economic shift that begins at the beginning of the month typically manifests itself in the middle of the following month. Therefore, there is a 1.5-month data lag.

Research on forward-looking statistics continues to suggest that inflation is heading lower in the upcoming quarters, despite the fact that backward-looking inflation measures present a perplexing image.

The majority of economic statistics that have been made public over the previous few months reflect a winding down of many of the factors that increased inflation in the wake of COVID. Some recognize that the delay between changes in the supply and demand equation and a decline in the rate of inflation has been painfully slow, and others think these developments will lead to a reduction in price pressures in the upcoming year.

The Fed's preference for backward-looking inflation data over more comprehensive, forward-looking economic data is the main cause for concern.

For instance, at the board meeting on June 15, the Fed officials' median projection was that the Fed funds rate would be 3.4% by the end of 2022. Compare that anticipation to the meeting on Sept. 21, where the prediction for the end of the year was a rate of 4.4%.

Now take into account that the Fed thought it would raise rates by a total of 25 basis points for the entire year of 2022 one year ago. The conclusion is that the Fed, rather than paying attention to what forward-looking reports are suggesting, is using lagging data to make reactionary choices.

The Fed is skating to where the puck was, borrowing a phrase from the great Wayne Gretzky.

“We know that the strong dollar will take a while to hit trade flows; mortgage rate rises are clearly having a big effect on housing, but construction employment has yet to decline,” Krugman wrote, “surely much of the impact of the tightening so far lies in the future?”

Data from the BLS shows that the CPI rent index lags a full year behind rents paid by new tenants, which means that core inflation is likely to stay high because of big rent rises in the past, “that isn't a reason for tight monetary policy!” Krugman said. “If new-tenant rents are leveling off, which seems to be happening, this says that conventional measures of core inflation are about the past, not a good indicator of whether the economy is overheated now.”

The economist noted that it's possible that the Fed hasn’t tightened enough, but, “that’s a quantitative question, and hard to answer in this strange new economic environment. But the hardliner arguments I'm hearing seem to rest on dubious logic.”
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Photo: Courtesy of Commonwealth Club and Rafael Saldaña on flickr