Olivier Coibion and Yuriy Gorodnichenko June 7, 2021

The Inflation Outlook: A Return to the 1970s?i

Inflation hit more than 4% in the U.S. in April and the world is holding its breath. After a decade of the Federal Reserve printing trillions and a year of Congress passing multiple historic stimulus packages, are we finally in for a return to the high inflation of the 1970s as policymakers overstimulate the economy?

No. We see the odds of inflation rising persistently and sustainably above 4% in the near future in the U.S. as slim. One reason is that there remains a tremendous amount of slack in the overall U.S. economy. By our estimates, the economy remained shy of full employment even before the pandemic destroyed millions of jobs in one fell swoop. Despite a strong ongoing recovery due to policy support and the reopening of the economy, the latest reading of the employment- population ratio is still lower than at the depths of the Great Recession. We think it would take far more than the Biden stimulus package to decisively close this gap and generate sustained inflationary pressures. A key reason we failed to generate the desired pace of inflation last cycle was that we never achieved a truly tight labor market.

We also think an expectations-driven inflationary spiral is very unlikely to materialize even though measures of inflation expectations have increased. In a new survey of U.S. firms that we describe in a recent paper, the inflation expectations of U.S. firms rose about 1 percentage point in the last six months, as did the expectations of households. However, this recent rise in expectations does not mean that U.S. households and firms have all of a sudden lost faith in the Federal Reserve and are stocking up on canned goods in anticipation of much higher prices in the future. Our research has shown that the inflation expectations of firms and households are anything but anchored. Few Americans, be they CEOs or average Joes, can correctly guess the Federal Reserve’s inflation target of 2%. Households’ expectations are heavily influenced by prices such as gasoline that are easily observed, volatile and most likely to be transitory. Furthermore, our research has shown that the way in which inflation expectations affect outcomes is more complex than the commonly assumed dynamic that they simply become embedded in higher prices through a self-reinforcing cycle. For example, when households revise their inflation expectations upward, they tend to become more pessimistic about the overall economic outlook, which leads them to reduce their purchases of large durable goods.

Global proximity to the zero lower bound on interest rates means that, for the foreseeable future, the primary inflation risk will remain on the downside. Were we to experience an extended period of inflation running somewhat above target (say 3-4%), this should be seen as a sign of success, not as a risk. It would indicate that some of the persistent underutilization of resources and atrophy of productive capacity that has plagued us since the Great Recession would finally be coming undone. Were inflation to rise above these desired levels in a systematic way, then the Fed could quickly take away the punchbowl: this is a relatively straightforward problem for it to fix. But too low inflation is not. While Fed officials can’t quite bring themselves to say out loud that they would welcome a period of 3-4% inflation (even though this is arguably what their average targeting approach calls for), we can: 3-4% inflation for some time would be a sign of an economy that is finally fully recovering and therefore a sign of success.

The Macroeconomics of Inflation The first reason we see low odds of sustained high inflation is that there remains a tremendous amount of slack in the overall U.S. economy. Just before the COVID crisis hit the world, the U.S. labor market was still slowly recovering from the Great Recession. At the end of 2019, the employment-to-population ratio, a popular metric of how scarce labor is, remained below its pre-Great Recession level (Figure 1). Even as the unemployment rate fell to historically low levels prior to COVID, the fact that so many had never returned to the labor force (and were therefore not counted as unemployed) implied that labor markets remained slack and inflationary pressures low. We wrote a paper in 2018 making the case that

March 27, 2017 Julia Coronado [email protected]

2

typical measures of economic slack at the same time were significantly overestimating the strength of the recovery.1 The absence of inflation as the unemployment rate fell further in the subsequent year (amid another “inflation scare” in which inflation failed to materialize) vindicated this view. While some argue that an aging population means employment-to- population ratios will be lower at full employment, we have seen a trend toward rising labor force participation among older workers and focusing only on prime age workers provides an overly optimistic view of slack in our minds.

So the economy remained shy of full employment when the pandemic destroyed millions of jobs in one fell swoop. Despite a strong ongoing recovery due to policy support and the reopening of the economy, the latest reading of the employment- to-population ratio is still lower than at the depths of the Great Recession. In other words, the current state of the labor market is currently worse than it was at the trough of the Great Recession, when the output gap was more than 6 percentage point. At that time, the actual output of the U.S. economy was approximately 1 trillion dollars below its potential, so the current gap is likely significantly larger. We think it would take far more than the Biden stimulus package to decisively close this gap.

Figure 1. The employment-to-population ratio indicates we never reached full employment last cycle

Notes: Data is from FRED. Red vertical dashed lines indicate start and end dates of recessions.

Why is this important? Macroeconomists posit that the more slack (underutilization of resources) there is, the lower inflation should be. This relationship is called the Phillips curve. Although there is some debate about the strength of this relationship, Figure 2 below shows, using data from the U.S. and other countries, the relationship between the inflation gap (inflation minus expected inflation) and unemployment (difference between actual unemployment rate and “natural” unemployment rate, that is, the rate of unemployment one would observe if the economy were functioning normally) is actually quite strong. The figure documents a clear negative relationship: more unemployment, less inflation. For inflation to be sustainably high, one needs either a very tight labor market or very high inflation expectations that induce firms to raise prices rapidly. We remain quite far from a tight labor market overall, so that potential source of inflation is still muted. While inflation may sometimes spike due to temporary factors like commodity price changes (e.g. lumber), gasoline pipeline shutdowns, or labor shortages in certain sectors, such spikes are unlikely to be long-lived unless broader labor markets tighten dramatically or inflation expectations start rising sharply.

1 Coibion, Gorodnichenko and Ulate (2018), “The Cyclical Sensitivity in Estimates of Potential Output,” The Brookings Papers on Economic Activity 2018(Fall) 34- 434. 3

Figure 2. The Phillips curve is supported by the data

1

.5

0

-.5

-1

-1.5

Residualized gap,inflation percent -2

-2 -1 0 1 2 3 4 Residualized unemployment gap, percent

Notes: Figure taken from Coibion, Gorodnichenko and Ulate (2019), “Is Inflation Just Around the Corner? The Phillips Curve and Global Inflationary Pressures” AEA Papers and Proceedings 109, 465-469. The unemployment gap is the difference between actual unemployment and a measure of the natural rate of unemployment. The inflation gap is the difference between inflation and expected inflation from surveys. Figure is a binscatter using pooled times series data from 18 countries.

The Complex Role of Inflation Expectations But haven’t inflation expectations risen recently, thereby justifying concerns about inflation risk? It is definitely true that inflation expectations have increased. In a new survey of U.S. firms that we describe in a recent paper, the inflation expectations of U.S. firms rose about 1 percentage point in the last six months, as did the expectations of households.2 But this does not mean that U.S. households and firms have all of a sudden lost faith in the Federal Reserve and are stocking up on canned goods in anticipation of much higher prices in the future. Recent research has shown that the inflation expectations of households and firms are quite insensitive to news about monetary policy or inflation. For example, the announcement of the Federal Reserve’s new Average Inflation Targeting strategy in September 2020 was soundly ignored by the general public.3 Few Americans, be they CEOs or average Joes, can correctly guess the Federal Reserve’s inflation target of 2%.4 The disconnect between what U.S. households and firms believe about inflation and monetary policy and actual inflation and monetary policy is stark. Their inflation expectations are anything but anchored.

What then determines the inflation expectations of U.S. firms and households? Mostly, it is the prices they observe on a regular basis, like the price of gasoline at the local station, milk at the grocery store, or two by fours at Home Depot.5 Figure 3 below plots the historical correlation between the average price of gasoline at the pump and households’ inflation expectations. Gasoline is a small component of what we consume, so its effect on overall prices is not that large. But as the figure shows, it looms very large in the minds of the public when they think about overall prices. As gas prices fell between 2014 and 2016, so did household expectations of inflation, and both rose again in tandem from 2016 to 2018 before falling together in the months prior to the pandemic. In the last six months, prices of certain goods like gasoline or

2 Candia, Coibion and Gorodnichenko, (2021). “The Inflation Expectations of U.S. Firms: Evidence from a New Survey”, NBER Working Paper 28836. 3 Coibion, Gorodnichenko, Knotek and Schoenle (2020), “Average Inflation Targeting and Household Expectations,” NBER Working Paper 27836. 4 Candia, Coibion and Gorodnichenko, (2021). “The Inflation Expectations of U.S. Firms: Evidence from a New Survey”, NBER Working Paper 28836. 5 See D’Acunto, Malmendier, Ospina and Weber, “Exposure to Grocery Prices and Inflation Expectations”, forthcoming in Journal of Political Economy and Kumar, Afrouzi, Coibion and Gorodnichenko (2015), “Inflation targeting Does Not Anchor Inflation Expectations: Evidence from Firms in New Zealand,” Brookings Papers on Economic Activity 2015(Fall), 151-225. 4

lumber have risen very sharply due to a variety of special factors. Not surprisingly, the inflation expectations of both households and firms have again moved in tandem with these price changes. But this rise in inflation expectations is not a harbinger of a sudden loss of confidence in the Fed. As these types of price changes tend to be short-lived, so too will be the effect on the inflation expectations of households and firms. A historical comparison may help: around the start of the 2008 recession, gasoline and other commodity prices shot up and household inflation expectations rose by 2 percentage points as talk of a return to the 1970s picked up.6 But this rise in expectations reversed itself as soon as gas prices fell a few months later. Hence, we also think that an expectations driven inflationary spiral is also very unlikely to materialize.

In addition, the way in which inflation expectations matter is not just through the pricing decisions of firms, i.e. the Phillips curve. Our recent research has used randomized control trial methods and quasi-experiments to study whether exogenously induced changes in inflation expectations (meaning that we provide information on inflation to a randomized subset of people to alter their beliefs relative to those of a control group) affect firms’ employment and investment decisions. The short answer from this research is that they do: inflation expectations affect firms along a variety of margins including pricing, investment, employment, and financial positions.7 The same is true for households: changes in inflation expectations lead households to adjust their monthly spending. Some of these channels push in the opposite direction of the usual Phillips curve logic. For example, when households revise their inflation expectations upward, they tend to become more pessimistic about the overall economic outlook, which leads them to reduce their purchases of large durable goods like cars, refrigerators, etc.8 This reduced demand would therefore tend to slow price growth. Inflation expectations of financial market participants also feed into longer term interest rates as well as the prices of other financial assets so rising inflation expectations could result in a tightening in financial conditions. The effects of inflation expectations on economic outcomes are therefore more complex than the commonly assumed dynamic that they simply become embedded in a self-reinforcing cycle.

Figure 3: Household inflation expectations are heavily influenced by gasoline prices

6 See for example Paul Krugman’s 2008 article: “A Return of That ‘70s Show?” New York Times June 6th, 2008. 7 Coibion, Gorodnichenko and Kumar (2018), “How Do Firms Form Their Expectations? New Survey Evidence” American Economic Review 108(9), 2671-2713 and Coibion, Gorodnichenko and Ropele (2020), “Inflation Expectations and Firm Decisions: New Causal Evidence,” Quarterly Journal of Economics 135, 165-219. 8 Coibion, Georgarakos, Gorodnichenko, and Van Rooij (2019), “How Does Consumption Respond to News about Inflation? Field Evidence from a Randomized Control Trial,” NBER Working Paper 26106 and Coibion, Gorodnichenko and Weber (2019), “Monetary Policy Communications and their Effects on Household Inflation Expectations,” NBER Working Paper 25482. 5

Source: Data is from FRED. Red vertical dashed lines indicate start and end dates of recessions.

But what about the trillions of dollars that the Fed has printed through quantitative easing? Ultimately, this has to debase the currency through high levels of inflation, right? Again, the answer is no. When short-term interest rates are at zero, as they have been for most of the last decade, the historically tight relationship between money and prices breaks down. What we have learned from the experience of Japan, the U.S., the U.K. the Euro-Area and many other countries over the last decade or two is that, when constrained by very low interest rates, modern central banks are not powerless and can still resort to tools like quantitative easing and forward guidance but that the power of these tools is limited. One can see this from the experience of the last decade: all these central banks have repeatedly and systematically undershot their inflation targets despite adopting a wide range of tools and strategies to try to get around the low interest constraint. Stimulating an economy in a low inflation environment is a lot harder than slowing down an overheating economy in a high inflation environment.

What this means is that, for the foreseeable future, the primary inflation risk will remain on the downside. Were we to experience an extended period of time with inflation running somewhat above the target (think 3-4%), this should be seen as a sign of success, not as a risk. Such an outcome would help achieve an average inflation target of 2% after years of undershooting this target. It would indicate that some of the persistent underutilization of resources and atrophy of productive capacity that has plagued us since the Great Recession would finally be coming undone. Were inflation to rise above these desired levels in a systematic way, then the Fed could quickly take away the punchbowl: this is a relatively straightforward problem for it to fix. But too low inflation is not. While Fed officials can’t quite bring themselves to say out loud that they would welcome a period of 3-4% inflation (even though this is arguably what their average targeting approach calls for), we can: 3-4% inflation for some time would be a sign of an economy that is finally fully recovering and therefore a sign of success. It should not be seen as a risk but as an objective. Preemptive tightening like the Fed did in 2017, the ECB did in 2011 or the Bank of Japan did in the mid-2000s would be a repeat of previous mistakes. So for now, let’s all hope for some sustained moderate inflation and the associated economic growth that leads firms to increase their productive capacity, that brings people back into the labor force and finally back into jobs that ensure a rising standard of living for all.

i Olivier Coibion is a Professor of Economics at The University of Texas at Austin. He received a BA in Economics and Political Economy from the University of California at Berkeley (1999) and a PhD from the University of Michigan at Ann Arbor (2007). He works on macroeconomic topics, including monetary policy, how agents for their expectations, inflation measurement, commodity prices, inequality, the efficacy of stimulus payments, and policy communication. Prior to joining UT Austin, Olivier worked at the International Monetary Fund, the Council of Economic Advisers, the Brookings Institution, and the College of William and Mary. He is also affiliated with the National Bureau of Economic Research.

Yuriy Gorodnichenko is a Quantedge Presidential professor at the Department of Economics at the University of California, Berkeley; and has affiliations with the National Bureau of Economic Research; Institute for the Study of Labor (IZA); Federal Reserve Bank of San Francisco; Review of Economics and Statistics; Journal of Monetary Economics. He has presented their work on inflation expectations at the Fed’s Jackson Hole Symposium and participated in the research conference hosted by the Chicago Fed as part of the Fed’s Policy Review.

MPP does not provide investment advice and is not investment manager or an expert network. The information presented represents the views of the author and is not intended to be, and should not be considered, investment, tax, or legal advice.