View from the Beltway

The Case for Humility

By Owen Ullmann

The experts grapple with understanding .

hen he ran the The hand-wringing infla- Administration is pouring trillions of tion-phobic camp is led by such lu- dollars of fuel on top of an already during his leg- minaries as former U.S. Treasury blazing economy, as Jerome “Jay” endary career, Powell’s Fed is helping to spread the Alan Greenspan: The problem fire around the world with ultra-low Wused to joke that he found economic interest rates and an unabated with models is that they models to be of great use to him as he bond-buying spree. contemplated the Fed’s interest rate are good predictors until By 2022, according to this view, policies. Not, mind you, to predict some unanticipated trend an inflationary spiral will be well un- where the economy was headed, but comes along to make derway, forcing interest rates to jump, to look backwards and explain how the dollar to drop, and the stock and it got where it is. The problem with the models outdated in bond markets to swoon. Early evi- models, he would chuckle, is that they forecasting the future— dence they cite as of mid-June in- are good predictors until some unan- and something unexpected cluded red-hot economic growth in ticipated trend comes along to make the second quarter and soaring price the models outdated in forecasting the always comes along. increases for homes, used cars, food future—and something unexpected products, and commodities, from always comes along. Secretary Larry Summers and, to a lumber to oil—all contributing to Greenspan’s contempt for models lesser extent, former International seems particularly appropriate today Monetary Fund chief Owen Ullmann is TIE’s executive as some of the brightest . They have warned editor and author of Empathy on the planet engage in a high-stakes that the United States is headed to- : The Remarkable Career debate about the future trajectory of ward an inflation explosion unseen of (Public Affairs, inflation in the United States. in half a century because the Biden forthcoming in 2022).

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saw the first rate hikes coming in 2024. Even so, Powell stuck to his belief that On the One Hand… the economy still needed to heal, that inflation would abate in 2022, and that e really don’t have a tem- the Fed had no timetable for curbing “ plate or any experience of a its bond purchases. In a sign of how Wsituation like this. We have skittish investors are about the Fed’s to be humble about our ability to under- changing forecast, the Dow Jones stand the data.” Industrial Average sank more than five hundred points two days later, when St. Louis Reserve Bank President James Bullard said he expects the Fed to start raising rates as soon as the end , Chair, of 2022. But by the following Monday, Federal Reserve Board of Governors the Dow had soared more than five hundred points. So who is right? As the old ad- the highest increases in the consumer in consumer savings itching to go on age goes: Time will tell, but not the price index in more than a decade. a buying spree, but that is offset by a economic models. That’s because, as On the other side is a not-to-wor- labor force that remains weak com- Greenspan would quickly point out, ry coalition led by Powell and U.S. pared to its pre-pandemic state. The too many unanticipated factors are Treasury Secretary Janet Yellen. They labor participation rate as of mid-2021 clouding the crystal balls. That view contend that inflation likely will rise in was still below its level at the start of is being embraced by a growing num- 2021 to as much as 3 or 3.5 percent, 2020, and there were still six million ber of economists, but not Summers, more people out of work than before so far. In 1971, when summoned to the pandemic struck. The former Treasury secretary ar- Camp David, Fed Chair Arthur At its June 16 meeting, the Federal gues that you don’t need to look to the Open Market Committee raised its future, just open your eyes to what is Burns appeared to succumb to forecast for growth and inflation in happening now. “We’ve already seen pressure to lower 2021 and said its zero interest rate pol- inflation statistics far greater than interest rates to help President icy would likely end in late 2023. That anything anybody expected,” he said was sooner than early forecasts that in mid-May. “Everybody was aware Nixon’s re-election, only to unleash runaway inflation a few years later with the help Impossible to Deny of twin oil shocks. That Inflation Looks but then drop back into the 2 percent More Plausible range in subsequent years. They base their projections on the belief that the verybody was aware that there were Covid-19 pandemic which shut down “ a lot of transitory factors. Everybody the U.S. economy for several months Ewas aware that there were short-term in 2020 created price spikes because of bottlenecks. Nobody predicted anything temporary supply shortages, but sup- like recent CPI or average hourly earnings ply and demand will return to balance figures. So, I think you’ve got to say that once the economy returns to normal whatever one thought three months ago, the supply-and-demand patterns as the inflation view has got to look considerably pandemic wanes. more plausible today that it did then.” Former Treasury Secretary Yes, they acknowledge, there is Larry Summers huge pent-up demand and $2 trillion

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higher gasoline prices and car pric- es and food prices and all this stuff, Theory Shortage which in some sense should funda- mentally be temporary, will somehow don’t believe that there is a working the- break into the public consciousness in “ ory of inflation that is relevant to 2021 a way that invokes more of an infla- I that allows for more or less confident tionary psychology. decisions by the Fed in real time.” “And if that happens, then it gets a little tougher because the thing that really made the 1970s so bad was the conviction by the public that the Fed was not going to do anything about in- flation and there would be no stability. , former member, I don’t think that’s going to happen. I Federal Reserve Board of Governors think the Fed has enough credibility. I think we’ll see that the Fed might be a little tighter than the markets think. that there were a lot of transitory fac- I have no clue as to what happens to The people who predicted inflation tors. Everybody was aware that there inflation and rates, because it is in a when the Fed launched QE [quantita- were short-term bottlenecks. Nobody part of the space we have not been tive easing] in 2009 were kooks. This predicted anything like recent CPI or in for a very long time. Uncertainty is different. An inflationary spiral is average hourly earnings figures. So, I about multipliers, uncertainty about not impossible. It’s not crazy, but the think you’ve got to say that whatev- the , uncertainty about odds are quite against it going to 3 per- er one thought three months ago, the the dovishness of the Fed, uncertainty cent for very long.” inflation view has got to look consid- about how much of the $1.9 trillion Former Fed Governor Daniel erably more plausible today that it did [Biden relief] package will turn out Tarullo said he finds the inflation out- then.” to be permanent, uncertainty about look hazy because “I don’t believe that In contrast to true believer the size and the financing of the [pro- there is a working theory of inflation Summers, Blanchard, who expressed posed] infrastructure plan. All I know that is relevant to 2021 that allows his worries about inflation in February, is that any of these pieces could go for more or less confident decisions was more circumspect just a month wrong.” by the Fed in real time.” Tarullo, who later. In his February article for the In doubting the accuracy of infla- served on the Fed Board from 2009 Peterson Institute for International tion forecasts, Blanchard is in good to 2017 and now teaches at Harvard Economics, where he is a senior fel- company. A former top policymaker Law School, said output gap analysis low, Blanchard wrote: “The issue is at the Fed, who has studied inflation- is hampered by uncertain estimates of whether the current relation between ary trends for decades, admitted great what the gap is, and the Phillips curve inflation and unemployment would uncertainty about the outlook. “We is no longer a reliable predictor. “The hold, and there are good reasons to haven’t had this kind of experience be- Fed, as with most central banks, is worry. The history of the Phillips fore and the main reason, frankly, that now highly reliant on expectations the- curve is one of shifts, largely due to the nobody can be really perfectly sure is ory,” he explained. “Intuitively, I think adjustment of expectations of inflation that we don’t understand the inflation expectations play a role, but talk about to actual inflation. True, expectations process that well,” said the former offi- something that is under-theorized. have been extremely sticky for a long cial, who asked to remain anonymous How do expectations get established time, apparently not reacting to move- in order to speak candidly. and how do they change? That is the ments in actual inflation. But, with “In particular, the conventional really important point. If we believe such overheating, expectations might view, which I personally believe with inflation expectations provide this in- well de-anchor.” a large standard error, is that inflation credible anchor, what’s the mechanism Then, in a March 24 article on expectations are really critical but we by which they do it? There’s never re- the great inflation debate in the New don’t understand inflation expecta- ally been a great account of it.” York Times, he is quoted as saying, tions very well,” he continued. “So, As a risk manager, Tarullo would “I shall plead Knightian uncertainty. it is possible that the combination of have scaled back Biden’s relief

40 THE INTERNATIONAL ECONOMY SUMMER 2021 THE MAGAZINE OF INTERNATIONAL ECONOMIC POLICY 220 I Street, N.E., Suite 200 View from the Beltway Washington, D.C. 20002 Phone: 202-861-0791 • Fax: 202-861-0790 www.international-economy.com [email protected] package, say, to $1.3 trillion, just to be on the safe side. “If you know you’re vulnerable, you want to be Forecast Wasteland careful because you don’t want to create a circumstance in which some ormer Fed Governor Jeremy Stein, secondary exogenous event some- who now chairs Harvard’s econom- how changes the minds of central Fics department, said he and his col- bankers, foreign exchange guys, leagues “need to be super humble because asset managers around the world,” nobody knows a thing about how to forecast he said. “Psychology can shift over- inflation.” night. Underlying conditions may not change from day one to day two, but the world may look at those same con- ditions very differently on day two.” Jeffrey Frankel, a member of President ’s Council of Economic Advisers who now teaches super humble because nobody knows “Remember, we do have both an un- at Harvard’s Kennedy School, noted a thing about how to forecast infla- precedented crisis and an unprece- that inflation predictions have been tion. And even if they did, now is a dented fiscal response. So, I think it’s flawed going back a decade, when particularly unusual time given all the a real open question about how the inflation first remained higher than fiscal and the rebound of the economy is going to proceed in the expected given the level of unem- economy. If you put a gun to my head near term. I think it’s a real debate, ployment, and then remained stub- and said, ‘Give me your forecast for and it’s a fair debate to be having cer- bornly lower than predicted even as inflation three years forward,’ I would tainly. I personally am very attentive unemployment kept falling. “The have moved it up a little bit, 20 or 30 to the risks on both sides.” entire history can be explained by the basis points, to 2.3 or 2.5 percent, Some former Fed governors are Phillips curve being flat, that varia- nothing that if you woke up from a in the Summers camp, convinced tions in output and employment just long sleep and found it, you would be that inflation is already accelerating don’t have as big of an effect on in- terribly concerned by.” and can’t be easily reversed. Hoover flation as they used to,” he concluded. A current Fed governor who Institution Visiting Fellow Kevin Likewise, former Fed Governor would not talk on the record also Warsh, who was on the Fed board Jeremy Stein, who now chairs admitted to real uncertainty about during the 2007–2009 housing crash Harvard’s economics department, the inflation outlook. “I think the and subsequent , has told said he and his colleagues “need to be jury is still out,” the official said. colleagues that he considers Powell to have embarked on a “radical” pol- icy of allowing inflation to build up without taking into account the long Not Worried at All lag time for interest rate moves to take effect. ’m not worried about a return to Larry Lindsey, who served on the “ the 1970s. We designed our new board in the and then became I framework for director of the National Economic the very different world we live in Council for President George W. now.” Bush, agrees with Summers that it’s impossible to ignore the accumulat- ing evidence of inflation building when you look at all the data com- , vice chair for ing in and listen to anecdotal reports supervision, Federal Reserve from company executives. “It’s hap- Board of Governors pening, and it’s a problem,” he said. “The issue of whether inflation is

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If we’re wrong, we know how to bring inflation down,” namely phase out the It’s All About Validation $120 billion monthly bond purchases and start raising interest rates sooner t’s happening, and it’s a problem. The than planned. “Ultimately what drives “ issue of whether inflation is sustainable inflation is people’s expectations Ihas to do with whether or not it’s vali- about what they’re going to need in dated now.” the way of wages, which then feeds into prices, which then feeds into wages,” Quarles said, “and if that cy- cle starts, that’s really what drives the Larry Lindsey, former director, National kind of inflation spiral that gets diffi- Economic Council, and former member, cult for the Fed to control. And I think Federal Reserve Board of Governors those are imperfectly measured.” Fed Chair Powell put the quan- dary about the course of inflation sustainable has to do with whether percent at some point during 2022, more succinctly following the June or not it’s validated now. Secretary despite his concerns that the size of 16 FOMC meeting: “We really don’t Yellen and Chairman Powell are say- Biden’s relief package and a recent have a template or any experience of ing we may get some inflation but it’s unexpected acceleration of wage a situation like this. We have to be going to be short-lived. Yet they’re growth “could make above-target in- humble about our ability to under- doing everything in their power to flation more persistent than we cur- stand the data.” validate that inflation. And once it rently expect.” The Fed certainly should be hum- gets into inflation expectations, then “I don’t want to overstate my con- ble considering its dubious track re- the cat is out of the bag.” cern; I’m not worried about a return cord over the decades. In the 1930s, The current Fed leadership re- to the 1970s,” Quarles continued. it tightened lending during the depth mains unconvinced. Fed Vice Chair “We designed our new monetary pol- of the , which made Randy Quarles said in a speech to the icy framework for the very different the downturn even worse. In 1971, on May 26 that world we live in now, which involves when summoned to Camp David, he expects inflation to run close to 2 an equilibrium for the economy with Chair Arthur Burns appeared to suc- slow workforce growth, lower po- cumb to White House pressure to A former top policymaker tential growth, lower underlying in- lower interest rates to help President flation, and therefore lower interest Nixon’s re-election, only to unleash at the Fed, who has studied rates. One of those differences is that runaway inflation a few years later inflationary trends for decades, the kinds of wage-price spirals that with the help of twin oil shocks. In admitted great uncertainty characterized inflation dynamics in the early 1980s, Chair the 1970s have not been present for had to reverse policy sharply and about the outlook. a long time. … The best analysis we virtually overnight, when it became “We haven’t had this kind currently have is that the rise in in- clear the Fed had tightened too much of experience before and flation to well above our target will and was putting the economy in be temporary. But those of us on the grave danger. More recently, Powell the main reason, frankly, FOMC are economists and lawyers, himself has been criticized for one that nobody can be really not prophets, seers, and revelators. too many rate hikes in December perfectly sure is that we We could be wrong, and what hap- 2018, which forced the Fed to start pens then?” cutting rates in 2019. don’t understand the inflation His answer: If inflation overshoots Humility is in order, indeed. process that well,” said or undershoots the ’s Perhaps, as Greenspan wisecracked, the former official, who asked long-term 2 percent goal, “the Fed has Powell and Co. will construct a new the tools to address inflation that runs inflation model—to explain in later to remain anonymous too high, while it’s more difficult to years what they did right or wrong in to speak candidly. raise inflation that falls below target. 2021. u

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