Macro Roundup

“…To pay for the full $4.1 trillion of excess spending, the unexpected boost in the price level needs to be larger: in the range of 19%, rather than 11% (though even this larger number assumes, perhaps too optimistically, that the government will not have more spending surges in the future). Starting in July 2022, the required price-level accommodation can be accomplished by 9.4% inflation over one year, 5.7% average inflation over two years, or 3.5% average inflation over five years. All these intervals are followed by 2% inflation. The result for five years is not far from the bond market’s current breakeven inflation rate over a five‑year horizon. That is, the fiscal approach accords with expected inflation rates inferred from five‑year yields on conventional and indexed Treasury bonds. So, a plausible argument is that the surge in federal spending triggered by the COVID-19 shock led to a permanent, unexpected rise in the price level by about 19%. This increase in the price level is a mechanism for financing the extra COVID-related spending. In a reasonable scenario, the CPI inflation rate comes down fairly quickly from its current value of 8.5% and averages around 3.5% over the next five years. While the inflation rate eventually returns to 2%, the upward surge in the price level is permanent….”
Robert Barro, "Understanding Recent US Inflation,"Project Syndicate, August 30, 2022, https://www.project-syndicate.org/commentary/us-inflation-fiscal-policy-likely-culprit-by-robert-j-barro-2022-08

Understanding Recent US Inflation

When considering what caused the sharp increase in the US inflation rate from late 2020 to today, my initial instinct was to focus on aggressive monetary policy, following Milton Friedman’s famous dictum that, “inflation is always and everywhere a monetary phenomenon.” But while monetary policy is important, aggressive fiscal policy may have been more important this time.

From March 2020 to March 2022, the US Federal Reserve kept short-term nominal interest rates at zero while also using quantitative easing to expand its balance sheet from $4 trillion to an eventual $9 trillion. It is now generally acknowledged that the Fed was way behind the curve after late 2020, if not earlier. Because it did not raise its policy rate until the spring of 2022, it failed to keep nominal interest rates ahead of inflation, and thus lost control.

The problem with arguing that monetary policy was the sole source of the recent inflation is that the Fed was similarly aggressive during the Great Recession and its aftermath, from 2008 onward. Short-term nominal interest rates were fixed at zero for what turned out to be a seven-year period (early 2009 to late 2015). The Fed’s balance sheet grew from $900 billion in August 2008 to more than $4 trillion - which seemed like a big number at the time. Yet inflation remained tame - averaging around 2% per year from 2009 to 2019 - and inflation expectations remained anchored at about the same value.

Why were the inflation results so different from 2020 on? An obvious difference between the two periods is the dramatic fiscal expansion that began in the spring of 2020 in response to the COVID-related recession, and which included federal transfers that dwarfed those associated with the Great Recession.

To see how fiscal expansion translates into inflation, start with the volume of federal spending since the second quarter of 2020. The quarterly data up to the first quarter of 2022 show cumulative excess federal spending (above a pre-COVID baseline spending of $5 trillion per year) of $4.1 trillion - or 18% of 2021 GDP. The main spending surges (at annual rates) reflect outlays of $9 trillion in the second quarter of 2020 and $7 trillion in the third quarter of 2020, under President Donald Trump, followed by $8 trillion each in the first and second quarters of 2021, under President Joe Biden.

To assess how inflation responded to this spending, I draw from the “fiscal theory of the price level,” which has been advanced in research by the Hoover Institution’s John H. Cochrane. Suppose the government does not plan to finance any of its additional spending by cutting other spending or raising taxes. If there is no formal default on Treasury bonds, “revenue” must come from inflation above the normal or expected level, which in turn reduces the real (inflation-adjusted) value of outstanding government bonds. Specifically, the inflation above 2% per year since mid-2020 can be thought of as cumulating to an unexpected boost in the price level, and this accumulation of excess consumer price inflation from May 2020 to July 2022 turns out to be about 11%.

The net nominally denominated public debt corresponds roughly to the publicly held part of the debt, which was $21 trillion in mid-2020 - or 91% of 2021 GDP. This concept subtracts from the gross debt the amounts held by federal trust funds and agencies but not the parts held by the Fed - as is reasonable because the Fed’s holdings of Treasury and mortgage-backed securities are roughly balanced by the Fed’s nominal liabilities. (One also could adjust for the federal debt that is CPI-indexed, but this amount is only around 7% of the total.)

The unexpected 11% boost in the price level lowered the real value of the net public debt by $2.3 trillion (equivalent to a default on 11% of the debt), which corresponds to effective revenue for the federal government. (Because the increase in the price level was a surprise, it should not have affected the nominal interest rates that the government had to pay on its bonds.)

To pay for the full $4.1 trillion of excess spending, the unexpected boost in the price level needs to be larger: in the range of 19%, rather than 11% (though even this larger number assumes, perhaps too optimistically, that the government will not have more spending surges in the future). Starting in July 2022, the required price-level accommodation can be accomplished by 9.4% inflation over one year, 5.7% average inflation over two years, or 3.5% average inflation over five years.

All these intervals are followed by 2% inflation. The result for five years is not far from the bond market’s current breakeven inflation rate over a five‑year horizon. That is, the fiscal approach accords with expected inflation rates inferred from five‑year yields on conventional and indexed Treasury bonds.

So, a plausible argument is that the surge in federal spending triggered by the COVID-19 shock led to a permanent, unexpected rise in the price level by about 19%. This increase in the price level is a mechanism for financing the extra COVID-related spending. In a reasonable scenario, the CPI inflation rate comes down fairly quickly from its current value of 8.5% and averages around 3.5% over the next five years. While the inflation rate eventually returns to 2%, the upward surge in the price level is permanent.

The bottom line is that, although monetary policy was too aggressive for too long, the likely main culprit behind the recent high inflation was an extraordinarily expansionary fiscal policy.

"...Our most significant finding from correcting the census income calculations wasn’t the overstated inequality between top and bottom earners. It was the extraordinary equality of income among the bottom 60% of American households, regardless of employment status. In 2017, among working-age households, the bottom 20% earned only $6,941 on average, and only 36% were employed. But after transfer payments and taxes, those households had an average income of $48,806. The average working-age household in the second quintile earned $31,811 and 85% of them were employed. But after transfers and taxes, they had income of $50,492, a mere 3.5% more than the bottom quintile. The middle quintile earned $66,453 and 92% were employed. But after taxes and transfers, they kept only $61,350—just 26% more than the bottom quintile. Even these figures don’t tell the whole story. In the bottom quintile, there are on average only 1.92 people living in a household. The second and middle quintiles have 2.41 and 2.62 people respectively. After adjusting income for the number of people living in the household, the bottom-quintile household received $33,653 per capita. The second and middle quintile households had on average $29,497 and $32,574 per capita, respectively. The blockbuster finding is that on a per capita basis the average bottom quintile household received 14% more income than the average second-quintile household and 3.3% more than the average middle-income household...."

Phil Gramm and John Early, "Income Equality, Not Inequality, Is the Problem,"Wall Street Journal, August 29, 2022, https://www.wsj.com/articles/income-equality-not-inequality-is-the-problem-labor-force-participation-income-taxes-transfer-payments-middle-bottom-rich-household-size-census-11661781351

Income Equality, Not Inequality, Is the Problem

Contrary to conventional wisdom, the most dramatic and consequential change in the distribution of income in America in the past half-century isn’t rising income inequality but the extraordinary growth in income equality among the bottom 60% of household earners.

Real government transfer payments to the bottom 20% of household earners surged by 269% between 1967 and 2017, while middle-income households saw their real earnings after taxes rise by only 154% during the same period. That has largely equalized the income of the bottom 60% of Americans. This government-created equality has caused the labor-force participation rate to collapse among working-age people in low-income households and unleashed a populist realignment that is unraveling the coalition that has dominated American politics since the 1930s.

On these pages, we have debunked the myth that income inequality is extreme and growing on a secular basis by showing that the Census Bureau measure of income fails to include two-thirds of all federal, state and local transfer payments as income to the recipients and fails to treat taxes paid as income lost to the taxpayer. The Census Bureau measure overstates current income inequality between the highest and lowest 20% of earners by more than 300% and claims that income inequality has risen by 21% since 1967, when in fact it has fallen by 3%.

Our most significant finding from correcting the census income calculations wasn’t the overstated inequality between top and bottom earners. It was the extraordinary equality of income among the bottom 60% of American households, regardless of employment status. In 2017, among working-age households, the bottom 20% earned only $6,941 on average, and only 36% were employed. But after transfer payments and taxes, those households had an average income of $48,806. The average working-age household in the second quintile earned $31,811 and 85% of them were employed. But after transfers and taxes, they had income of $50,492, a mere 3.5% more than the bottom quintile. The middle quintile earned $66,453 and 92% were employed. But after taxes and transfers, they kept only $61,350—just 26% more than the bottom quintile.

Even these figures don’t tell the whole story. In the bottom quintile, there are on average only 1.92 people living in a household. The second and middle quintiles have 2.41 and 2.62 people respectively. After adjusting income for the number of people living in the household, the bottom-quintile household received $33,653 per capita. The second and middle quintile households had on average $29,497 and $32,574 per capita, respectively. The blockbuster finding is that on a per capita basis the average bottom quintile household received 14% more income than the average second-quintile household and 3.3% more than the average middle-income household.

It should be noted that while per capita comparisons are widely used, they tend to overstate the effects of household size. Two people living together can achieve the same material well-being for less than they could living separately. The Organization for Economic Cooperation and Development has developed a measure widely used internationally to adjust for household size, and the Census Bureau has a similar adjustment it uses in its supplemental poverty measure. Since the results produced by the OECD and the Census Bureau adjustments are so similar, we simply use the average of the two below.

The nearby chart compares the after-tax, after-transfer incomes of the bottom three quintiles of American households with no adjustment for household size, on a per capita basis, and using the average of the OECD and census adjustments for household size. We found that the average bottom-quintile household has $2,401 (or 6.6%) more income than the second quintile and only $3,306 (or 7.8%) less than the middle-income quintile.

The average second-quintile household earned almost five times as much as the average household in the bottom quintile, because it had 2.4 times as many working-age members working and on average each worker worked 80% more hours. The average middle-quintile household earned almost 10 times as much and had 2.6 times the percentage of its working-age people working, each working twice as many hours. Yet the bottom 60% of American households received essentially the same income after accounting for taxes, transfer payments and household size.

Given the surge in transfer payments since the war on poverty, it isn’t surprising that the percentage of working-age people in the bottom quintile who actually worked plummeted from 68% in 1967 to 36% in 2017. With transfer payments giving recipients about as much for not working as they could earn working, only a mandatory work requirement as a condition for receiving means-tested benefits will bring them back into the labor market. While official statistics don’t count two-thirds of those transfer payments and don’t show the income equality they produce, Americans who work hard to make ends meet are aware of it. Despite Democratic politicians’ efforts to provoke resentment against the rich, when was the last time you heard working people complain that some people in America are rich? The hostility of working people is increasingly focused on a system where those who don’t break a sweat are about as well off as they are.

This justifiable resentment is the economic source of today’s American populism. It is ravaging the increasingly unstable Democratic political alliance between welfare recipients and blue-collar workers. It was already building in the 1980s, with what were then called Reagan Democrats, and it was fully manifested in the Trump blue-collar political base. It is now driving political realignment among Hispanic voters, who are disproportionately middle-income earners.

By eroding self-reliance, worker pride and labor-force participation, government-generated income equality undermines the very foundations of American prosperity. A democratic society won’t knowingly tolerate it.

Paul Krugman, "The Below-Zero Lower Bound,"The Conscience Of A Liberal, March 6, 2015, https://archive.nytimes.com/krugman.blogs.nytimes.com/2015/03/06/the-below-zero-lower-bound/

The Below-Zero Lower Bound

Further to my earlier post on negative interest rates: here’s what may be a simpler way to think about it. When central banks push interest rates on government debt below zero, the effective lower bound is the return on cash held by people who would otherwise be holding that government debt — not people looking to expand their checking accounts. So the liquidity advantages of bank deposits over cash in a vault are pretty much irrelevant. It’s all about the cost of storage.

And really, how high can that cost be? Cecchetti and Schoenholtz argue that given a little time banks or other financial institutions ought to be able to store currency for clients at very low cost — as they say, turning back into the goldsmiths from which banks as we know them evolved — and might even be able to provide some checking-like services on the side.

So it’s not quite a ZLB; but analytically and in terms of policy, a minus x lower bound, where x almost surely less than 1, isn’t all that different.

Paul Krugman, "How Negative Can Rates Go?," March 3, 2015, The Conscience Of A Liberal, https://archive.nytimes.com/krugman.blogs.nytimes.com/2015/03/06/the-below-zero-lower-bound/

We now know that interest rates can, in fact, go negative; those of us who dismissed the possibility by saying that people could simply hold currency were clearly too casual about it. But how low? Evan Soltas is getting some attention with an interesting attempt to find the true lower bound on interest rates; David Keohane cited a similar, more detailed estimate a month ago.

But it seems to me that all such estimates that I’ve seen involve a misconception. (Maybe it’s me, so I’m happy to stand corrected.)

In both the Soltas and Keohane pieces, there’s a discussion of storage costs for currency, which are not as trivial as one might have assumed. But they go on to say that the real lower bound comes from the fact that bank deposits are more useful than currency in a safe, because you can write checks and all that. Basically, in the modern world deposits are actually more liquid than cash, at least for most transactions that don’t involve controlled substances or concrete overshoes.

But you need to think about the incentives for holding a dollar in one form or the other at the margin, and I think that changes the story.

In normal times, we invoke the convenience of money — its extra liquidity — to explain why people hold money at zero or at any rate low interest rates when there are other safe assets offering higher yields. We think of money demand as determined by people increasing their holdings up to the point where the opportunity cost of holding money, the interest rate on other safe assets, equals its utility from increased liquidity.

Once interest rates on safe assets are zero or lower, however, liquidity has no opportunity cost; people will saturate themselves with it. That’s why we call it a liquidity trap! And what this means is that the marginal dollar of money holdings is being held solely as a store of value — the medium of exchange utility is irrelevant.

This in turn should mean that the usefulness of deposits is irrelevant in trying to find the true lower bound. The marginal holder is simply looking for a store of value, and the only question should therefore be storage costs.

And I am pinching myself at the realization that this seemingly whimsical and arcane discussion is turning out to have real policy significance.

Paul Krugman, "How To Think About QE2 (Wonkish),"The Conscience Of A Liberal, October 23, 2010, https://archive.nytimes.com/krugman.blogs.nytimes.com/2010/10/23/how-to-think-about-qe2-wonkish/

How To Think About QE2 (Wonkish)

Still on the run, so no long posts. But with all the talk about further quantitative easing by the Fed — QE2, for quantitative easing, the sequel — I think it’s worth sharing one way of thinking about what’s on the table — and why you shouldn’t be too optimistic about its effects. This isn’t original, although I don’t know who deserves the credit.

So, here it is: in effect, QE2 amounts to a decision by the US government to shorten the maturity of its outstanding debt, paying off long-term bonds while borrowing short-term. This should drive down long-term interest rates. But how much?

How do we get to this view? Think first of the Fed’s balance sheet. The Fed’s liabilities are the monetary base — currency in circulation, plus bank reserves. Those bank reserves are essentially short-term borrowing: the Fed pays a small interest rate on them, which is comparable to the interest rate on Treasury bills. More broadly, in a near-zero-rate world, cash — an official liability that pays no interest — is essentially equivalent to T-bills — another official liability that pays more or less no interest.

What happens when the Fed buys long-term government securities? If we consider the Fed and Treasury as a consolidated entity — which, for fiscal purposes, they are — then what happens is that some long-term federal debt is taken off the market, and paid for by issuing more short-term debt in the form of monetary base. It’s just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

So the question to ask is, how much do we think federal management of its maturity structure matters for the real economy? I think if you put it that way, most people wouldn’t be terribly optimistic.

Anyway, my jet-lagged thought for the day.

Paul Krugman, "QE Truthers,"The Conscience Of A Liberal, February 12, 2015, https://archive.nytimes.com/krugman.blogs.nytimes.com/2015/02/12/qe-truthers/

QE Truthers

Everyone knows about the infamous open letter warning Ben Bernanke not to engage in quantitative easing, lest he cause inflation and currency debasement; many are also familiar with the remarkable unwillingness of that letter’s signatories to admit, after more than four years of low inflation and a rising dollar, that they were wrong. But not many people seem to know about an opinion piece by John Taylor and Paul Ryan, released at about the same time, that is even more revealing about the GOP’s monetary madness.

There are actually multiple revelations in that article. For one thing, it attacks not just QE2, which was about to commence, but QE1 — the Fed’s intervention during the chaotic post-Lehman period — which is generally considered to have been quite effective. Their evidence to the contrary? “QE1 failed to strengthen the economy, which has remained in a high-unemployment, low-growth slump.” Also, when I stepped outside this morning, it was cold, so I put on a coat — but it didn’t work, because it was still cold.

But the truly amazing thing is the conspiracy theorizing. The article is titled “Refocus The Fed On Price Stability Instead Of Bailing Out Fiscal Policy”, and the text matches that theme:

This looks an awful lot like an attempt to bail out fiscal policy, and such attempts call the Fed’s independence into question.

So Ryan and Taylor were accusing the Bernanke Fed of deliberately betraying its mandate in order to help out Obama by monetizing deficits — or at least doing everything they could to convey that message to readers. And that’s one heck of a conspiracy theory, given that the Fed never said anything along those lines, insisting all along that it was intervening to support the economy and to defend price stability against the threat of below-target inflation — a defense of its actions completely borne out by events.

Furthermore, think about it — suppose that you believe that the Fed’s actions were staving off what would otherwise have been a fiscal crisis. That’s supposed to be a bad thing? Were Ryan and Taylor casting envious glances at the euro area, where the ECB’s failure to do its job as lender of last resort provoked a series of near-catastrophic speculative attacks until Mario Draghi stepped up to the plate?

Anyway, keep this and other such episodes in mind. Rand Paul by no means has a monopoly on monetary crazy, conspiracy theories very much included.

Also, did I mention that Jeb Bush seems to be getting his economic ideas from his brother’s 4% growth project, which is led by inflation truther Amity Shlaes?

Paul Krugman, “Quantitative Easing and Monetary Aggregates,”The Conscience Of A Liberal, February 26, 2015, https://archive.nytimes.com/krugman.blogs.nytimes.com/2015/02/26/quantitative-easing-and-monetary-aggregates/

Quantitative Easing and Monetary Aggregates

I haven’t had time for the broader discussion of cognitive closure, but one more thing about Meltzer and all that: I get especially annoyed when economists who have been wrongly predicting inflation say that it’s not their fault — who could have known that banks would just sit on all those reserves? The answer is, anyone who had paid attention should have known that would happen.

Let me quote myself, from my 1998 — yes, 1998 — paper on the liquidity trap: “The point is important and bears repeating: under liquidity trap conditions, the normal expectation is that an increase in high-powered money will have little effect on broad aggregates, and may even lead to a decline in bank deposits and a larger decline in bank credit.”

I presented data from the 1930s that seemed to confirm that point; a few years later Japan gave us another experiment, when it tried quantitative easing. Here’s how it went, with the monetary base and M2 both shown with January 2001=100:

So theory and experience both predicted exactly the sterility of monetary base expansion that we saw in practice. And, you know, that’s the kind of successful prediction that is supposed to change peoples’ minds: if you’re that wrong about how an experiment turned out, and someone else made a prediction you considered foolish but turned out completely right, you’re supposed to concede that just maybe, possibly, they were on to something.

The fact that essentially nobody on that side of the debate has budged in the slightest tells us that whatever it is they’ve been doing, it’s not scientific research.

Publication selectivity in favor of reporting growth-enhancing effects of corporate tax cuts explains most of the evidence supporting the growth impact of corporate tax cuts, "...The empirical literature on the impact of corporate taxes on economic growth reaches ambiguous conclusions: corporate tax cuts increase, reduce, or do not significantly affect growth. We apply meta-regression methods to a novel data set with 441 estimates from 42 primary studies. There is evidence for publication selectivity in favour of reporting growth-enhancing effects of corporate tax cuts. Correcting for this bias, we cannot reject the hypothesis of a zero effect of corporate taxes on growth. Several factors influence reported estimates, including researcher choices concerning the measurement of growth and corporate taxes, and controlling for other budgetary components. The unweighted sample mean of all standardised coefficients amounts to −0.02. Fig. 2, however, reveals that there is considerable dispersion in the results: the minimum standardised coefficient is −0.29 and the maximum is 0.16; the standard deviation is 0.08. The funnel has a familiar shape, often found in the literature: the most precise estimates, which can be seen at the top of the funnel plot, are close to the vertical zero effect line. Moreover, the bottom of the funnel is somewhat asymmetric with a stronger mass of imprecise estimates located on the left side (representing the common-sense growth-enhancing effects of corporate tax cuts), which could be an indication for publication selection bias...."

Sebastian Gecherta and Philipp Heimberger, "Do corporate tax cuts boost economic growth?"European Economic Review, August 2022, https://www.sciencedirect.com/science/article/pii/S0014292122000885

“…The "Model-based Inflation" bar in the chart above presents an estimation of the U.S. CPI inflation rate over the 2019-21 period, which was calculated to be 9.18% from Dec. '19 to Dec. '21, annualized. The actual observed inflation during this period is 8.47%, so the model-calibrated rate is very close. “Backed-out AD shock” explains roughly 60% of model-based inflation, driven by fiscal stimulus and other aggregate demand factors. “Sectoral demand shock” driven by change in households’ consumption patterns across sectors accounts for very little, so the remaining 40% is primarily explained by “Sectoral supply shock,” with fifty-eight out of sixty-six sectors supply-constrained. In the absence of any new energy or other shock, it is therefore possible that the ongoing easing of supply bottlenecks will cause a substantial drop in inflation in the near term…”

Julian di Giovanni, 'How Much Did Supply Constraints Boost U.S. Inflation?,"Federal Reserve Bank Of New York, August 24, 2022, https://libertystreeteconomics.newyorkfed.org/2022/08/how-much-did-supply-constraints-boost-u-s-inflation/

How Much Did Supply Constraints Boost U.S. Inflation?

What factors are behind the recent inflation surge has been a huge topic of debate amongst academics and policymakers. We know that pandemic-related supply constraints such as labor shortages and supply chain bottlenecks have been key factors pushing inflation higher. These bottlenecks started with the pandemic (lockdowns, sick workers) and were made worse by the push arising from increased demand caused by very expansionary fiscal and monetary policy. Our analysis of the relative importance of supply-side versus demand-side factors finds 60 percent of U.S. inflation over the 2019-21 period was due to the jump in demand for goods while 40 percent owed to supply-side issues that magnified the impact of this higher demand.

The Debate

The U.S. has witnessed near historic inflation since the economy began to re-open in 2021 following the COVID-19 lockdowns, as seen in the chart below. There have been several factors put forth to explain this inflation outburst and its persistence, which have been difficult for policymakers to disentangle and have led to an active debate by leading economists. Some analysts have focused on the importance of supply chain constraints, while others point to demand as driving the jump in inflation. Meanwhile, some economists argue that a combination of supply and demand factors are necessary to generate the inflation we are currently witnessing. Our work belongs to the last camp.

Arriving at a definitive understanding of the relative importance of demand and supply drivers of inflation is difficult without providing some formal structure that can be taken to the data. In the recent work referenced above, we take a step in this direction by building on the work of others to quantify the effects of the pandemic on inflation over the period spanning both the collapse and recovery phases of the economy. This framework not only allows us to examine the cumulative impact of the pandemic from 2019:Q4 to 2021:Q4, before the Russia-Ukraine war’s “energy/food shock” on inflation, but also to decompose the contribution of demand- and supply-side factors underlying the observed inflation.

The model allows for the observed limited factor mobility. That is, since everyone was exposed to the same health-related shock at a global level, it was difficult for firms to reallocate labor between sectors and/or switch and substitute suppliers in the short run, leading to shortages in labor and in other inputs. Furthermore, besides demand effects being present at the aggregate level—due to accommodative fiscal and monetary policy—the composition of demand also changed as consumers substituted from services to goods. The model incorporates these aggregate and sectoral demand effects, which can further amplify the impact of supply-side constraints on inflation due to the resulting supply-demand imbalances.

Taking the Model to the Data

We calibrate a closed-economy version of the model to match the observed U.S. inflation over the 2019-21 period, along with doing a similar exercise for the euro area. The model implies that inflation is a function of aggregate demand shocks, changes in hours worked, and productivity by sector. The changes in hours worked capture both demand and supply shocks, while changes in productivity/technology are sectoral supply shocks.

We assume that sector-level technological changes were zero over the 2019-21 period and use the observed inflation rate along with sectoral hours worked to back out the implied aggregate demand shock. The computed aggregate demand shock captures several possible demand drivers, such as changes in households’ preferences for consumption in the present vs. future as well as expansionary effects of fiscal and/or monetary policy.

Armed with the implied aggregate demand shock, the growth rates of sectoral hours worked, and the observed change in the composition of sectoral consumption (that is, an increase in consumption in the goods sector and a fall in consumption in the service sector), we then use the model structure to decompose the relative importance of supply and demand shocks in driving inflation. Crucially, the model structure allows us to explain why observed employment may have been below its “normal” level, and what sectoral dimensions of the data are crucial explaining this outcome—for example, a shortage of workers or a lack of demand given changes in preferences and/or the aggregate demand shift

U.S. Results

The first bar in the chart below presents our estimation of the U.S. CPI inflation rate over the 2019-21 period, which was calculated to be 9.18 percent from December 2019 to December 2021, annualized. The actual observed inflation during this period is 8.47 percent, so the model-calibrated rate is very close. The next three bars decompose the drivers of inflation. Notice that the sum of these bars is 10.5 percent, which is slightly higher given the nonlinear interactions between sixty-six sectors. The aggregate demand shock (“backed-out AD shock”) explains roughly 60 percent of model-based inflation. The remaining 40 percent of the model-based inflation is primarily explained by sectoral supply shocks (“sectoral supply shock”), while the change in households’ consumption patterns across sectors (“sectoral demand shock”) accounts for very little. The bottom line of this decomposition is that supply constraints magnified the impact of higher demand in inflation. Consequently, most sectors in the U.S.—fifty-eight out of sixty-six—were supply-constrained. This result is consistent with other research that shows that expansionary fiscal policy has increased the share of sectors classified as supply-constrained.

The current debate on whether the Federal Reserve can engineer a soft landing needs to disentangle the drivers of U.S. inflation. Our work shows that inflation in the U.S. would have been 6 percent instead of 9 percent at the end of 2021 without supply bottlenecks. Our quantitative results clarify why some pundits were wrong to predict a transitory surge in inflation, while others were right in predicting high inflation, but for the wrong reasons. Put differently, fiscal stimulus and other aggregate demand factors would not have driven inflation this high without the pandemic-related supply constraints. In the absence of any new energy or other shock, it is therefore possible that the ongoing easing of supply bottlenecks will cause a substantial drop in inflation in the near term.

President Biden’s new student loan forgiveness plan includes three major components. We estimate that debt cancellation alone will cost up to $519 billion, with about 75% of the benefit accruing to households making $88,000 or less. Loan forbearance will cost another $16 billion. The new income-driven repayment (IDR) program would cost another $70 billion, increasing the total plan cost to $605 billion under strict “static” assumptions. However, depending on future IDR program details to be released and potential behavioral (i.e., “non-static”) changes, total plan costs could exceed $1 trillion.

Junlei Chen and Kent Smetters, “The Biden Student Loan Forgiveness Plan: Budgetary Costs And Distributional Impact,”Penn Wharton Budget Model University Of Pennsylvania, August 26, 2022, https://budgetmodel.wharton.upenn.edu/issues/2022/8/26/biden-student-loan-forgiveness

The Biden Student Loan Forgiveness Plan: Budgetary Costs And Distributional Impact

President Biden’s new student loan forgiveness plan includes three major components. We estimate that debt cancellation alone will cost up to $519 billion, with about 75% of the benefit accruing to households making $88,000 or less. Loan forbearance will cost another $16 billion. The new income-driven repayment (IDR) program would cost another $70 billion, increasing the total plan cost to $605 billion under strict “static” assumptions. However, depending on future IDR program details to be released and potential behavioral (i.e., “non-static”) changes, total plan costs could exceed $1 trillion.

Key Points

We estimate that President Biden’s proposed student loan debt cancellation alone will cost between $469 billion to $519 billion over the 10-year budget window, depending on whether existing and new students are included. About 75% of the benefit falls to households making $88,000 or less per year.

Loan forbearance for 2022 will cost an additional $16 billion.

Under strict “static” assumptions about student borrowing behavior and using take-up rates within existing income-based repayment programs, the proposed new IDR program will cost an additional $70 billion, increasing total package costs to $605 billion.

However, depending on future details of the actual IDR program and concomitant behavioral changes, the IDR program could add another $450 billion or more, thereby raising total plan costs to over $1 trillion. These details require future study.

The Biden Student Loan Forgiveness Plan: Budgetary Costs and Distributional Impact

Introduction

President Biden has recently announced a fact sheet for a student loan relief proposal that includes:

Debt cancellation: Individuals earning less than $125,000 (or $250,000 for families) a year will be eligible for up to $10,000 in debt cancellation. Pell Grant recipients earning less than $125,000 (or $250,000 for families) a year are eligible for up to $20,000 in debt reduction.
Forbearance: Student loan forbearance extended through December 31, 2022.
New Income-Driven Repayment (IDR): This plan proposes:

Capping monthly payments to 5% (relative to the current rate of 10% or more) of the discretionary income for undergraduate loan borrowers;

Covering the borrower’s unpaid monthly interest so that debt balances will not grow even when monthly payments are zero;

Raising the amount excluded from the calculation of discretionary income from 150% to 225% of the poverty line; and,

Forgiving loan balances after 10 years of payments, instead of 20 years, for borrowers with original loan balances of $12,000 or less.

The estimation methods herein largely follow our previous brief on student loan debt forgiveness, along with some updates to accommodate the new details released by the Biden Administration. Our previous brief also provides additional background into existing income-based repayment programs.

Loan Forgiveness (“Debt Cancellation”)

Table 1 reports the 10-year budgetary cost estimates for the student loan forgiveness portion of the Biden proposal. The $468.6 billion cost in 2022 corresponds to loans only for students who have separated from eligible post-secondary education and no longer have their debt payments deferred. The $519.1 cost over the 10-year budget window includes students currently enrolled in college with loan deferral status as well as future students during the budget window. As discussed in our previous brief, our loan forgiveness calculations include cost savings to existing income-based repayment programs with partial take-up rates.

Table 2A reports the distributional impact of loan forgiveness in 2022 across all ages while Table 2B restricts the ages to 25 – 35, an age range that is arguably a bit more consistent with lifecycle effects. About 74 percent (Table 2A) to 76 percent (Table 2B) of forgiveness accrues to households making less than $82,400 (Table 2A) or $88,043 (Table 2B). Relative to our previous brief, the extra Pell grant trigger bonus of an additional $10,000 in forgiveness—for a total forgiveness of up to $20,000 for Pell grant recipients—skews the distribution more toward lower-income households.

Loan Forbearance

Table 1 reports that loan forbearance will cost an additional $16 billion. This amount is “stacked” after loan forgiveness. The presence of loan forgiveness reduces the additional cost associated with forbearance. Given its size, the distributional impact is not reported, but it is more evenly distributed throughout the income distribution relative to loan forgiveness.

Income Driven Repayment

Table 1 also reports that the new IDR plan will cost an additional $70.3 billion over the 10-year window when “stacked” after the loan forgiveness and forbearance.

This new program will likely target lower income households even more than loan forgiveness noted above. However, assigning the new IDR gains to specific income groups with reasonable accuracy requires the use of confidential data and an associated mandatory external review period. We will revisit this issue in coming weeks.

This calculation also assumes that take-up rates in the new IDR proposal are the same as in existing income repayment plans. As we document in our previous brief, a majority of qualified borrowers do not enroll in existing programs.

Future Analysis is Needed

The new features in the new IDR proposal, however, could sharply increase take-up rates. Even many borrowers who anticipate not being qualified in future years would typically be better off enrolling in the intermediate years in which they are qualified. There would also be financial incentives for future borrowers to shift education financing toward more borrowing to take advantage of the 5% repayment threshold. If the Department of Education simply auto-enrolled borrowers for which it had sufficient information (i.e., switched from “opt in” to “opt out”), the additional costs of the IDR program alone could reasonably exceed $450 billion.

The actual net distributional effects (the “incidence”) of the new IDR program will also depend on future program details yet to be released. Part of the benefit might be captured by colleges and universities in the form of higher net prices, either higher tuition prices or reduced needs-based tuition offsets.

We plan to examine these issues in future work, especially as new program details emerge.

“…The U.S. labor force has roughly 2.5 million fewer workers since the pandemic began, compared to what it would have if the pre-pandemic workforce participation had continued and after accounting for the aging of the population, according to Didem Tüzemen at the Kansas City Fed. Its growth had already slowed before Covid-19, reflecting an aging population, declining birthrates and less immigration. The slowdown in immigration left the U.S. with 1.8 million fewer immigrants of working age than if pre-2019 immigration trends had continued, according to Giovanni Peri at the University of California, Davis…”

Nick Timiraos, "Jerome Powell’s Dilemma: What if the Drivers of Inflation Are Here to Stay?"Wall Street Journal, August 24, 2022, https://www.wsj.com/articles/inflation-jackson-hole-fed-powell-11661288446

Jerome Powell’s Dilemma: What if the Drivers of Inflation Are Here to Stay?

Central bankers worry that the recent surge in inflation may represent not a temporary phenomenon but a transition to a new, lasting reality.

To counter the impact of a decline in global commerce and persistent shortages of labor, commodities and energy, central bankers might lift interest rates higher and for longer than in recent decades—which could result in weaker economic growth, higher unemployment and more frequent recessions.

The Federal Reserve’s current round of interest-rate increases, which economists say have pushed the U.S. to the brink of a recession, could be a taste of this new environment.

“The global economy is undergoing a series of major transitions,” said Mark Carney, former Bank of Canada and Bank of England governor, in a speech at an economics conference in March. “The long era of low inflation, suppressed volatility and easy financial conditions is ending.”

The challenges for policy makers will take center stage from Thursday to Saturday when they gather for the Kansas City Fed’s annual retreat in Jackson Hole, Wyo., being held in person for the first time since 2019.

The Fed could still succeed at curbing inflation by raising interest rates. Postpandemic headwinds might abate or fail to materialize if protectionism and geopolitical risks recede, labor productivity improves, a slowdown in China’s economy reduces demand for global commodities, or new technologies reduce the costs of developing new energy sources.

“Since the pandemic, we’ve been living in a world where the economy is being driven by very different forces,” Fed Chairman Jerome Powell said on a June panel discussion in Portugal. “What we don’t know is whether we will be going back to something that looks more like, or a little bit like, what we had before.”

European Central Bank President Christine Lagarde on the panel offered a more pessimistic appraisal: “I don’t think that we are going to go back to that environment of low inflation.”

The new environment reflects the stalling or potential reversal of three forces that pushed inflation down in recent decades by limiting workers’ ability to win higher wages and companies’ ability to raise prices.

• Force 1: Globalization. Increased flows of trade, money, people and ideas flourished with the Cold War’s end and China’s entry into the international trading system in the 1990s. Multinational companies using new technologies constructed global supply chains focused on driving down costs by finding the cheapest place and workers to produce products. Worldwide competition drove prices lower for many goods.

This helped keep U.S. inflation stable. Over the 20 years that ended in 2019, U.S. goods prices rose an average of 0.4% a year, while services prices grew 2.6% annually, leaving “core inflation”—which excludes volatile food and energy prices—around 1.7%.

“If you had all of your supply chain in just one country, you have to question why take that risk in a world where pandemics could hit or country relations could deteriorate or wars could happen between countries,” said Richmond Fed President Tom Barkin, a former McKinsey & Co. executive. It is difficult to predict just how durable such changes will be, he added.

• Force 2: Labor markets. In an August 2020 book, “The Great Demographic Reversal,” former British central banker Charles Goodhart and economist Manoj Pradhan argued that the low inflation since the 1990s had less to do with central-bank policies and more with the addition of hundreds of millions of low-wage Asian and Eastern European workers, which held down labor costs and prices of manufactured goods exported to richer countries.

Mr. Goodhart wrote that global labor glut was giving way to an era of worker shortages, and hence higher inflation.

Meanwhile, the U.S. labor force has roughly 2.5 million fewer workers since the pandemic began, compared with what it would have if the prepandemic trend in workforce participation had continued and after accounting for the aging of the population, according to an analysis by Didem Tüzemen, an economist at the Kansas City Fed. Its growth had already slowed before Covid-19, reflecting an aging population, declining birthrates and less immigration. The slower growth rate of the U.S. workforce could force wages higher, feeding inflation.

Wages rose about 3% annually before the pandemic. Average hourly earnings grew 5.2% in the year ended in July.

Mr. Powell in a May interview pointed to the potential for reduced immigration to create a “persistent imbalance between supply and demand in the labor market.” He added: “If you have a slower growing labor market, you’re going to have a smaller economy.”

• Force 3: Energy, commodity prices. Energy and commodity firms haven’t heavily invested in new production over the past decade, creating risks of more persistent shortages when global demand is growing. When the Fed broke the back of high inflation in the early 1980s, then-Chairman Paul Volcker enjoyed some helpful tailwinds in the form of decadelong investments in oil.

Before the emergence of these three factors, the Fed could raise rates at a leisurely pace and could pursue policies that simultaneously kept unemployment and inflation low, something economists later dubbed the “divine coincidence.”

That was possible when the main threats to the economy were “demand shocks”—pullbacks in hiring, consumer spending and business investment—which slow both inflation and growth, as in the recessions of 2001 and 2007-09.

The Fed cut rates to near zero in 2008 to stimulate economic activity, held them there until 2015, then raised them at a glacial pace by historical standards. The unemployment rate fell below 4% in 2018, and inflation stayed at or just below the central bank’s 2% target. After raising the fed-funds rate to around 2.4% at the end of 2018, Mr. Powell cut rates slightly following a growth scare in 2019.

Those experiences heavily shaped the Fed’s initial response to the pandemic in 2020. Fearing another decade of sluggish growth and too-low inflation, it cut rates to near zero and promised to keep providing stimulus even after the White House and Congress aggressively boosted federal spending.

‘Supply shocks’

Rather than reducing economic demand, the forces that emerged during the pandemic were what economists call “supply shocks”—events that curtail the economy’s ability to provide goods and services, which in turn hurt growth and spurred inflation. Covid-19 lockdowns and stronger demand for goods disrupted supply chains, as did Russia’s Ukraine invasion and the West’s financial counterassault. Labor shortages emerged across the U.S.

With supply shocks, the Fed faces a harder trade-off between growth and inflation, because attacking inflation invariably means damping growth and employment. In such an environment, “there is no divine coincidence anymore,” said Jean Boivin, a former Bank of Canada official who heads the BlackRock Investment Institute.

The Fed and most other central banks initially misread the economy because, in early 2021, price increases could be traced clearly to the effects of the pandemic, affecting a small number of goods, such as used cars. By the end of the year, however, higher inflation had become increasingly broad-based.

One measure produced by the Dallas Fed, called a “trimmed mean” annual inflation rate, which excludes the most volatile categories to capture an underlying trend, rose from 2% last August to 3.5% in January and 4.3% in June.

“This is looking like the 1990s turned on its head,” said Stephen Cecchetti, a Brandeis University economics professor. “Every forecaster back then underestimated growth and overestimated inflation systemically for almost the whole decade. Now, it looks like we’re in for the reverse of this, which will be very, very unpleasant because it means we’re suddenly going to hit trade-offs.”

The low-inflation environment of the past 30 years caused consumers and businesses to not think much about price increases. Fed officials now worry that even if prices rise temporarily, consumers and businesses could come to expect higher inflation to persist. That could help fuel higher inflation as workers demand higher pay that employers would pass onto consumers through higher prices.

“The risk is that because of a multiplicity of shocks, you start to transition to a higher-inflation regime,’’ Mr. Powell said on the June panel. “Our job is literally to prevent that from happening. And we will prevent that from happening.”

Last year, Mr. Powell suggested he was skeptical of the idea that the forces underpinning globalization would shift overnight, as Mr. Goodhart suggested. But he has given more attention to the idea in the aftermath of the Ukraine war, which has highlighted the potential for significant economic and financial fallout from geopolitical conflicts.

By sending inflation, and especially energy prices, to such elevated levels, the war could serve as a trigger “to make people realize that inflation—and quite high inflation—is a real possibility,” said Mr. Goodhart. In turn, that could weaken the public’s confidence that “everything will go back to normal.”

“The argument of central banks, that they will get inflation back to target at 2% two years from now, is becoming increasingly implausible because they’ve said that all along and, of course, they haven’t achieved it,” he said.

Recession risk

The Fed’s aggressive interest-rate increases this year could be the first example of what happens with U.S. monetary policy in this new environment. Faster and bigger rate rises create greater risks of recession and could upend popular investment strategies by leading to more frequent losses for the two main components of traditional asset portfolios—stocks and long-term U.S. Treasury bonds.

Fed officials have raised the fed-funds rate by a cumulative 2.25 percentage points this year, the fastest pace since they began using the rate as their primary policy-setting tool in the early 1990s. The rate influences other borrowing costs throughout the economy.

The Fed began with a quarter-point increase in March, followed by a half-point rise in May and increases of 0.75 point each in June and in July. At their meeting last month, officials debated how and when to dial back the pace of those increases, according to minutes of the meeting released Aug. 17.

An important shift occurred between Fed officials’ May and June meetings, when Mr. Powell secured consensus that they would need to raise rates high enough to slow growth. Through the summer, Fed officials have been unusually united over their goal, but if the labor market cools and the economy slows, Mr. Powell could face a trickier task forging agreement.

Several former Fed officials who have worked closely with Mr. Powell say he is likely to err on the side of raising rates too much, rather than too little, because tolerating excessive inflation would represent a much greater institutional failure for the central bank. Mr. Powell has hammered home the primacy of lowering inflation to the Fed’s 2% target.

“We can’t fail on this,” Mr. Powell told lawmakers on June 23, describing the Fed’s commitment as “unconditional.”