My policy memo written for my American Economics Class with Larry Summers

 

TO: The Federal Open Market Committee 

FROM: Grace Cen, Harvard University

DATE: October 19, 2021

SUBJECT: 4% Forecasted Inflation and Subsequent Contractionary Monetary Policy 

 

Post COVID-19 is characterized by historically unprecedented inflation. Current inflation at 4%, is much higher than both the Fed’s inflation target of 2% and even the 3% rate that I advocate for, and will likely stay this way. In my subsequent analysis, I recommend that the Fed set a near term federal funds rate target of 2% that will gradually increase over time to achieve a long term federal funds rate of 4%. I also advise that, going forward, the Fed should get rid of the dual mandate and instead focus primarily on stabilizing inflation. 

 

Current Inflation has plateaued at 4%:

1. Pre pandemic, year over year percent change in CPI hovered around 2-2.5%. During the pandemic, in May of 2020, it dipped to 0.1%. By June 2021, it had skyrocketed to 5.4%, with no indication of it falling (Figure1).

• CPI excluding food and energy, the more volatile consumption categories, plateaued around 4% in August. 

• The rise in prices are due to the increase in aggregate demand from stimulus checks, as well as supply shocks/ decrease in supply from supply chain disruptions and government mandated shutdowns. Consumers are unable to spend their higher disposable incomes and instead turn to saving (Personal saving rates in April 2020 shot up to 33.8% month over month from 7.3% in December 2019), partially offsetting aggregate demand increases. 

• There is still much uncertainty over current inflation as we keep watch on the pandemic, supply chain, and savings. Thus, I suggest a more conservative, gradual approach for the setting of the target federal funds rate.

 

Figure1

 

​

​

​

​

​

​

​

​

​

​

​

​

​

​

​

​

  2. I moreso trust the Core PCE index (PCE excluding food and energy), widely regarded as a more reliable indicator than the CPI or PCE. Here’s why:

• CPI is too volatile on a month to month basis; in the 10 year graph below (Figure2), CPI changes by an average of 0.5% from December to January of each year. On net, CPI usually changes around 2% over 12 months so the 0.5% is pretty big. Therefore, we want to use core inflation measurements, like core PCE, which has the same long term average rate but is less volatile, because it weighs a survey of what businesses are selling and excludes the most volatile categories of goods (food and energy), whereas CPI only weighs what consumers surveyed that they purchase.

 

Figure2

​

​

​

​

​

​

​

​

​

​

​

​

​

​

​​

​

​

• PCE also incorporates the rural household consumption that CPI does not, important because rural populations feel the effects of inflation more than urban populations. CPI also does not include healthcare expenditures that PCE does when it is often an indirect, employer provided cost.

• Core PCE Trends (Figure3 blue line) actually tells us the same story as CPI, reaffirming our belief that current core inflation has plateaued at ~4%. Here, it does so in June.

  • Figure 3

 

 

 

 

 

 

 

 

 

 

 

 

​

​

This plateau will likely remain constant in the near term: Inflation staying sticky at 4% because:

• Looking to history: The last time we saw volatility as high as that of the post-pandemic was after the 2008 recession, which after a few months also reached a volatility plateau; this plateau stuck around until 2020 (Figure4). We have already reached a similar volatility plateau in June 2021, although now at a higher inflation of 4%. On the basis of what happened in both 2008 and 2001, we should expect continued high inflation at around 4% for the next 12-24 months because without increased volatility, inflation will not be able to reach a lower average rate. 

 

Figure4

​

​

​

​

​

​

​

​

​

​

​

​

​

​

​

​

• Sustained supply chain bottlenecks: experts say the supply chain problem will get worse as the US battles a shortage of truckers and raw materials. They say bottlenecks in every part of the interconnected supply chain will take long to fix. This means personal savings may continue to be pent up in the near term.

• Good vaccine rollout: Biden administration plans to launch booster shots to all adults soon and has early successes with child vaccine rollout. The public health crisis seems to be controlled and will probably not reintroduce price volatility in the near term. 

 

The Fed Should Shift its Focus Primarily to Price Stability:

 

This sustained 4% inflation means that the Fed should tighten the money supply. Before discussing what the Federal Funds rate should be set to to restrict this money supply, let us first establish what the Fed’s primary objective with monetary policy should be: keeping inflation stable. 

 

The Fed’s current dual mandate, specifically the Fed being responsible for also maintaining full employment, is outdated: 

1. Monetary policy cannot alleviate long term changes in skills needed. The pandemic has accelerated the shift to improved technology and automation. 

   • Post pandemic, there is still a large job recovery gap between jobs offered and jobs filled, especially in the service sector (1.383 million job recovery gap in October 2021), where many workers have indicated that they do not plan to return to low skill service jobs due to pre covid industry concerns: unpredictable tips, long hours, volatile scheduling, compounded by concerns of viral exposure and the trauma of furlough. 

   • Faced with worker shortages, many employers have adopted automated systems that increase productivity. 

   • This has led to a shift in demand for a different set of skills sooner rather than later, which easy monetary policy (quantitative easing, LSAP) cannot resolve. Instead, fiscal policy such as retraining and placement programs must be imposed.

 

   2. The dual mandate actually disincentivizes the aforementioned fiscal policy changes because it tacks liability for unemployment on the central bank instead of the government. 

 

Thus, the Fed should adopt a single inflation mandate, a practice many advanced European countries have already adopted! For the US, this involves setting a target inflation rate that is as forward looking as a single mandate: at 3%. 

 

The Fed Should Target a 3% Inflation Rate:

 

1. Our current 2% inflation rate is too low to combat the risk of secular stagnation, a phenomenon when real interest rates are zero or negative. This causes excessive savings (that hampers demand) and low investment (that stunts growth). Secular stagnation is a legitimate concern illustrated by:

• Recent evidence suggesting that neutral real rates are around zero (0.6 in April 2021), attributed to slower productivity and our demographic shift (baby boomers increasing savings as they approach retirement). 

• Heightened personal savings due to stimulus checks.

 

1. A 3% inflation target will also be more relevant after the pandemic, important because when we set an inflation target, we should be considering a long time horizon. 

• It is likely that aggregate demand will drop even further once the stimulus checks inevitably stop being provided. 

• Higher inflation is the solution here, encouraging investment by lowering real capital costs.

 

Using the Taylor Rule, the Fed Should Target a near term Federal Funds Rate of 2% that gradually increases to 4%: 

​

1. We assume that the Taylor rule is a descriptive, backward looking exercise, not to prescribe a federal funds rate, but to inform us of a reasonable upper bound of 4% for our federal funds rate. We also assume more emphasis on the inflation mandate than the unemployment mandate, steering us to the coefficients 0.7 and 0.3 respectively. 

• According to the Taylor Rule, where GDP potential is $19,697.336 B and real GDP is $19,368.31 B (Q2 2021), current inflation is 4%, the inflation target is 3%, and the neutral rate is 0.6, we receive a federal funds rate upper bound of 4.258877411645%.

• We settle on a slightly lower long term federal funds rate of 4% as we are likely underestimating the natural rate of employment due to automation (market requires new skills). Underestimating NAIRU would lead us to a higher upper bound than that of reality. 

 

    2. Beginning with a lower short term federal funds rate of 2% and then gradually increasing the short term rates to     achieve a long term rate of 4% would be more appropriate. 

• This allows us to hedge inflation uncertainty, preventing us from being too contractionary in the slim chance that the pandemic returns. If the current public health crisis worsens, we might see more volatility, inducing downward pressure on prices, and reducing our current inflation projection. 

• This also prevents us from making disastrously large shifts in interest rates, which may discourage too much investment.