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Inflation has been with the United States for a year. It was 8.5 percent in March and trending up. On March 15, the Federal Reserve finally budged the federal funds rate from 0 to 0.33 percent, with slow rate rises to come.
A third of a percent is a lot less than 8.5 percent. The usual wisdom says that to reduce inflation, the Fed must raise the nominal interest rate by more than the inflation rate. In that way, the real interest rate rises, cooling the economy.
At a minimum, then, according to the usual wisdom, the interest rate should be above 8.5 percent. Now. The Taylor rule says the interest rate should be 2 percent (the Fed’s inflation target), plus 1.5 times how much inflation exceeds 2 percent, plus the long-term real rate. That means an interest rate of around 12 percent. Yet the Fed sits, and contemplates at most a percent or two by the end of the year.
This reaction is also unusually slow by historical precedent. In early 2017, unemployment got below 5 percent, inflation got up to and just barely breached the Fed’s 2 percent target, and the Fed promptly started raising interest rates. Inflation batted around the Fed’s 2 percent target. March 2022 unemployment is 3.6 percent, lower than it has been since December 1969. Fear of high unemployment does not explain the Fed’s much slower response.
The 2017 episode is curious. The Fed seems to regard it as a big failure—it raised rates on fear of inflation to come, and inflation did not come. I would expect a self-interested institution to loudly proclaim success: it raised rates on fear of inflation to come, just enough to keep inflation right at target without starting a recession. It executed a beautiful soft landing. The Fed has never before been shy about “but for us things would have been much worse” self-congratulation. Instead, the event sparked the whole shift to the Fed’s current explicit wait-and-see policies.
The Fed’s current inaction is even more curious if we look at a longer history. In each spurt of inflation in the 1970s, the Fed did, promptly, raise interest rates, about one for one with inflation. Not even in the 1970s did the Fed wait a whole year to do anything. Interest rates rose just ahead of inflation in 1974, and close to one to one with inflation from 1977 to 1980. Today’s Fed is much, much slower to act than the reviled inflationary Fed of the 1970s. And that Fed had unemployment on which to blame a slow response. This one does not.
The conventional story is that the 1970s one-to-one response was not enough. A one-to-one pace keeps the real rate constant, but does not raise real rates as inflation rises. Only in 1980 and 1982, when the interest rate rose substantially above inflation and stayed there, did inflation decline. You have to repeat that painful experience, conventional wisdom goes, to squash inflation.
The Fed’s forecasts for the next year, taken from its March 16 projections, are below. (I plot “longer run” as 2030. The Fed’s “actual” is end of 2021 quarterly personal consumption expenditures inflation, 5.5 percent.)
As you can see, this forecast scenario is dramatically different from a repetition of 1980. The Fed believes inflation will almost entirely disappear on its own, without the need for any period of high real interest rates.
An astute reader will notice that above I referred to the “real” interest rate as the nominal interest rate less current inflation. In fact, the real interest rate is the nominal interest rate less expected future inflation. So we might excuse the Fed’s inaction by its belief that inflation will melt away on its own, and its view that everyone else agrees. But the Fed’s projections do not defend that view either. Expected inflation is higher, just not so much as past inflation; real rates measured by nominal rates less expected future inflation remain negative throughout until we return to the long-term trend.
By any measure, in these projections real rates remain negative, yet inflation dies away all on its own. Why?
Various Fed speeches and commentary I have read do not shed much light on this question. Much of the talk about inflation still revolves around a “supply” shock that will go away on its own. To my mind, it’s evident that widespread inflation, including wage increases, comes from demand rather than supply, so I see a large fiscal shock. But a one-time shock, no matter its nature, does not necessarily lead to a one-time inflation. When the shock ends, the inflation does not necessarily end.
Whatever the shock was, the question before us now is this: Suppose the shock is over. (New shocks may come, but one cannot, by definition, predict future shocks.) Inflation is 8.5 percent. The fed funds rate is still very low. Will inflation go away on its own, will it persist, or will it get worse?
It always helps to think first in the simplest terms, and then add complications as needed. If the economy has no frictions—if prices move instantly with economic conditions—and if the Fed does nothing to interest rates, the price level rises proportional to the size of a permanent shock to the fiscal deficit—how much money or debt is issued that will not be eventually repaid. A fiscal shock equal to 1 percent of the debt raises the price level by 1 percent, resulting in a period of inflation. But then the price level stops rising, and inflation stops. The figure below illustrates this simple scenario:
Now, we had a 30 percent shock: the $5 trillion cumulative deficit thus far during the pandemic was almost 30 percent of the $17 trillion in debt outstanding at the beginning of the pandemic. We have seen only about 8 percent inflation so far. But the inflationary fiscal shock is the shock to the discounted sum of deficits and surpluses, not just the shock to today’s deficit. So if people expect most of the deficit to be repaid—if the 30 percent deficit shock comes with a 21.5 percent rise in expected future surpluses—then we have only an 8.5 percent shock to the discounted stream of surpluses, resulting in the 8.5 percent price-level rise we have just seen. And it’s over, at least until there is another shock to deficits, to people’s expectations about that future partial repayment, or to monetary policy.
But prices don’t change instantly—they are “sticky.” How much do sticky prices draw a one-time 1 percent deficit shock out to a long-lasting inflation? Quite a bit.
Inputting a modest value for price stickiness into a standard New Keynesian model produces a graph that illustrates just how much difference price stickiness makes:
The total rise in the price level is the same, 1 percent, but it is spread over time. If this graph is right, we have a good deal of inflation left to go. The first year only produces about 40 percent of the total eventual price-level rise.
With price stickiness, the fundamental story changes. In a frictionless model, we digest the story simply: The government is borrowing or printing money, and people do not expect repayment. They try to get rid of the debt or money, but more sellers than buyers means they just push up prices and push down the value of debt. In the frictionless model, we might say that unexpected inflation, an unexpected one-time price level increase, lowers the real value of outstanding debt, just as would a partial default. But this model with sticky prices still maintains one-period debt, so a slow expected inflation cannot devalue debt in the same way. Instead, there is a long period of negative real interest rates—as we are observing in reality. This period of negative real interest rates slowly lowers the real value of government debt. With sticky prices, even short-term bondholders cannot escape.
That price stickiness draws out the inflationary response to a fiscal shock is perhaps not surprising. Many stories feature such stickiness, and suggest substantial inflationary momentum. Price hikes take time to work through to wages, which then lead to additional price hikes. Housing prices take time to feed in to rents. Input price rises take time to lead to output price rises.
Let’s return to the Fed’s relatively muted response to the inflation the US has experienced thus far, the Fed’s projections that inflation will largely go away on its own without a period of high real interest rates, and its consequent very sluggish interest-rate reaction. Many economists just criticize, but it is more productive to ask: What implicit view of the economy lies behind the Fed’s forecasts? Is that model logically consistent and consistent with data? If one disagrees, one disagrees about how the economy works. Rather than argue about results, it is more productive to examine and argue about assumptions.
To address this question, I consider a simple model and give it two versions: adaptive expectations and rational expectations. Adaptive expectations captures traditional views of monetary policy, and rational expectations captures the New Keynesian view. Their crucial difference lies in the famous Phillips curve, the relation between inflation and unemployment or output. In both models, higher output and lower unemployment come with higher inflation. In the traditional view, higher output comes with more inflation relative to past inflation. In the New Keynesian, rational-expectations view, higher output comes with more inflation relative to expected future inflation.
Fire up each model, starting with 5.5 percent inflation as in the Fed’s March 16 projections. Put in the Fed’s projected interest-rate path, and let’s see what inflation and unemployment rate comes out:
The traditional adaptive-expectations model predicts an explosive inflation spiral, and also an explosive unemployment decline. The New Keynesian model, by contrast, fits the Fed’s inflation and unemployment forecasts well. There is a model that captures the Fed’s views. The Fed is New Keynesian—or, at least, the Fed acts as if it is New Keynesian.
In the traditional model, the inflationary shock we just experienced, whatever its source, together with today’s low interest rate, gives us a large negative real interest rate. That negative rate is itself additional “stimulus”: it raises output and lowers unemployment. Higher output and lower unemployment, however, raise inflation even more, relative to the large past inflation. Higher inflation means an even lower real interest rate, and more inflation still, in a never-ending spiral—until the Fed gives in, raises interest rates to much above inflation, and contains the mess with a large recession.
In the New Keynesian model, we tell the same story, except that the higher output and lower unemployment raise inflation relative to expected future inflation, not relative to past inflation. Given today’s inflation, that means expected future inflation must be lower. Logically, inflation last year was only 5.5 percent, despite low interest rates and a booming economy, because people expect inflation to subside. That minor distinction of how the reference point of inflation enters the Phillips curve changes everything.
We can gain a lot of intuition by asking a related question. Rather than take the interest-rate path as given and simulate inflation and unemployment, let us ask: What interest-rate path would it take to produce the Fed’s inflation forecast? And what unemployment rate does that path produce?
In the traditional, adaptive-expectations version of the model, we need sharply higher, Taylor rule–style interest rates now. Those higher nominal rates create higher real rates, which bring inflation down. They also cause a recession—notice unemployment rising over the 4 percent natural rate. The recession is not so bad, because the simulation starts at last year’s PCE inflation, 5.5 percent, not March’s CPI inflation, 8.5 percent, and not (perhaps) this fall’s 10 percent or more inflation, because the model is incredibly simplified, and because I chose a fairly mild price-stickiness parameter. Serious models can easily deliver a much worse recession.
By contrast, the New Keynesian model says that in order to hit the Fed’s inflation forecast, interest rates can stay low, and indeed a bit lower than the Fed projects. And that path is perfectly consistent with unemployment slowly reverting to the natural rate.
Again, the difference in this little model comes down to whether output and unemployment are related to inflation relative to future inflation, or relative to past inflation. More generally, the issue is if people are forward looking in forming their expectations of the future, or if they mechanically think that the future will look like the recent past. You might guess this would be easy to tell apart in the data, but it isn’t.
The proposition that once the shock is over inflation will go away on its own may not seem so radical. Put that way, I think it does capture what’s on the Fed’s mind. But it comes inextricably with the uncomfortable implication (a “Fisherian” implication, for the late economist Irving Fisher) that if inflation converges to interest rates on its own, higher interest rates eventually raise inflation, and vice versa.
I square this circle by thinking there is a short-term negative effect of interest rates on inflation, which central banks normally use, and a much longer-term positive effect, which they generally don’t know about or exploit. Such a short-term negative effect can coexist with rational expectations, though this little model does not include that negative effect. So relative to my priors, the surprise is that the Fed seems to believe so little in the (short-term) negative effect, and the Fed seems to think the Fisherian long run comes so quickly, i.e. that prices are so flexible.
Why might the Fed have come to this view? Perhaps the clear lessons of the zero-bound era have sunk in. The adaptive-expectations model works in reverse too: If you wake up in mid-2009 with 1.5 percent deflation and a zero interest rate, the adaptive-expectations model predicts a deflation spiral, the mirror image of the inflation trajectory plotted in the first chart on the preceding page. It did not happen. The failure of the deflation spiral to emerge is a hard piece of evidence against the traditional model. The rational-expectations model makes sense of the zero-bound era. Perhaps the Fed has incorporated that experience in its thinking. Perhaps the Fed has also lost faith in the power of interest-rate hikes to lower inflation. Or perhaps the negative effect comes with a recession, which the Fed wishes to avoid, and so the bank would rather wait for a longer-term Fisherian stabilization. That part of 1980 is less attractive for sure!
Amid the chorus of opinion that the Fed is blowing it, let us acknowledge a possibility: the Fed may be right. There is a model in which inflation goes away as the Fed forecasts. It’s a simple model, with attractive ingredients: rational expectations. It survives the zero-bound era, which the traditional model does not do. There is also a model, more likely, in my view, that inflation persists and goes away slowly, because prices are stickier than the Fed thinks. There is also some momentum to inflation, induced by some backward-looking parts of pricing, which could lead to inflation still increasing for a while before the forces of these simple models kick in. But the key point is that inflation may not spiral away as the standard model suggests, even if the Fed is somewhat sluggish to adapt.
If inflation does not spiral away, despite sluggish interest-rate adjustment, we will learn a good deal. The next few years could be revealing, as were the 2010s. Or we may get more bad shocks, or the Fed may change its mind and sharply raise rates to replay 1980, interrupting the experiment.
John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and was previously a professor of finance at Chicago Booth. This essay is adapted from three posts on his blog, The Grumpy Economist, which provide the equations and numbers for the simulations presented here. (See the posts here, here, and here.)
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