Inflation Surges andMonetary Policy
Keynote Speech by Carl E. Walsh
Similarities between the 1960s and 1970s raise concerns that central banks are repeating mistakes that led to the Great Inflation. Two
explanations for this earlier period of inflation, that it was due toshocks and special factors or that it was the result of political pressures on monetary policy, seem particularly relevant today. Major
central banks such as the Federal Reserve and the ECB have beenslow to react to the surge in inflation due to COVID-19 and the war
in Ukraine. I investigate the consequences of policy delay and theimpact of a more aggressive reaction, conditional on policy being
delayed. In assessing the persistence of inflation shocks and in dealing with uncertainty about inflation dynamics, policymakers seem tobe ignoring lessons from the literature on monetary policy in the faceof model uncertainty.
Keywords: Inflation; Monetary policy; COVID-19
JEL Classification: E31, E52, E58

Distinguished Professor of Economics Emeritus, Department of Economics, University ofCalifornia, Santa Cruz, and Honorary Adviser to the Institute for Monetary and Economic
Studies (E-mail: walshc@ucsc.edu).

..............................................................................................................

This paper was prepared as a keynote address for the 2022 BOJ-IMES Conference on New
Dimensions and Frontiers in Central Banking, May 25–27, 2022. The views expressed inthis paper are those of the author and do not necessarily reflect the oﬃcial views of the
Bank of Japan. I thank Mai Hakamada, Andy Levin, and Shunichi Yoneyama for helpful
discussions.

MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION

39

I. Introduction
At last year’s conference of the Bank of Japan’s Institute for Monetary and Economic
Studies, inflation scarcely gained a mention; today, it is the critical issue facing many
central banks. From a longer-term perspective, of course, inflation is not a new issue.
But for more than a decade, and even longer in Japan, central banks have been wrestlingwith how to deal with inflation that is too low. Suddenly, concerns about the limits tomonetary policy due to the eﬀective lower bound (ELB) on nominal rates and the needfor makeup strategies to deal with extended periods of below-target inflation seemmuch less relevant. The primary challenge has shifted to one of containing a surge ininflation.
The disruptions associated with COVID-19 produced a sharp recession; GDPgrowth rates for the U.S., Japan, UK and the Euro Area all turned sharply negative
during the first quarter of 2020. Both monetary and fiscal policies were employed
to address the adverse economic impact of COVID-19. These policies stimulated
economic demand, but they did so at a time when the shift in demand from services togoods, combined with supply chain disruptions and the withdrawal of workers fromthe labor force, reduced aggregate supply, leading to a surge in inflation. This has
been further exacerbated by energy price increases this year associated with Russia’s
invasion of Ukraine, and forecasts for global economic growth have been downgraded.
Figure 1 CPI Inflation (% yoy): the U.S. (diamonds), Japan (circles), Euro Area(stars), UK (squares)

Note: Top panel: all items. Bottom panel: less food and energy.
Source: Federal Reserve Bank of St. Louis.

40 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy

Figure 1 shows inflation in the U.S., Japan, UK, and Euro Area from January 2019
to March 2022, as measured by the all-items CPI in the top panel and core CPI in thebottom panel.1 CPI inflation fell essentially to zero in all four economies in the first halfof 2020 as a result of COVID-19. As demand rebounded and supply constraints anddisruptions created an imbalance between demand and supply, inflation rose, exceeding
2 percent in the U.S. by early 2021 and in the UK and Euro Area by the middle of 2021.
Not surprisingly, price increases showed up particularly in flexible commodity prices,and, except for Japan, headline inflation has returned to levels not seen in the majorindustrialized economies since the Great Inflation period.
Only in Japan has inflation been below the BOJ’s 2 percent target, and core inflation(bottom panel) has, until March 2022, been negative. Both measures have been aﬀectedby temporary factors such as the decline in mobile phone charges. The BOJ’s April
Outlook for Economic Activity and Prices (Bank of Japan [2022]) reports estimates ofinflation adjusted for these factors and on an adjusted basis, CPI inflation reached 2.1
percent for the first quarter of 2022, while core CPI inflation was 0.7 percent. Thus, theJapanese economy, unlike the other three economies, has not yet experienced sustained
rates of inflation in excess of the BOJ’s target.
Inflation is now the pressing issue for policymakers in the U.S., UK, and Euro Area.
However, the central banks of all three economies were slow to react to rising inflation.
The Bank of England began raising its policy rate in November 2021, but the Fed only
did so in March 2022, and the ECB had still not changed its policy rate as of late May.
Of course, what matters is not the policy rate but real interest rates. The solidline in the top panel of Figure 2 is the U.S. 1-year nominal Treasury rate minus thecorresponding 1-year expected inflation rate; the dashed line is the 2-year nominal rateminus the 2-year expected inflation rate. Expectations are from the Cleveland Federal
Reserve Bank and are based on financial market date.2 All measures suggest that in
2021 real interest rates reached their lowest levels in the past 20 years. All series began
to rise in late 2021 in anticipation of eventual Fed tightening. However, they remain
extremely low. The bottom panel shows two measures of the 1-year real rate measured
as the 1-year Treasury rate minus measures of inflation expectations that are basedon household survey data, the Michigan survey and the NY Fed household survey.
Household surveys tend to show higher expected inflation than measures obtained fromfinancial market participants. However, as Figure 3 shows, household have been much
more accurate in predicting the path of core inflation than have expectations derived
from financial markets.
Central banks learned during the global financial crisis that balance sheet policies
could substitute for interest rate cuts at the ELB. As discussed by Orphanides (2021) at................................
1. Data from OECD Main Economic Indicators, retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/. All items Consumer Price Index for the U.S., Japan, UK, and Euro Area: USACPIALLMINMEI, JPNCPIALLMINMEI, GBRCPIALLMINMEI, CP0000EZ19M086NEST. Core CPI for
the U.S., Japan, UK, and Euro Area: USACPICORMINMEI, JPNCPICORMINMEI, CPHPLA01EZM661N,
GBRCPICORMINMEI.
2. Data in the top panel are from the St. Louis FRB FRED and show DSG1-EXPINF1YR and DSG2EXPINF2YR. The bottom panel shows DSG1-MICH and DSG1 minus the 1-year expected inflation ratefrom the FRBNY household survey. MICH is from the Univ. of Michigan, Survey of Consumer Finances:data from the FRBNY is from their Survey of Consumer Expectations, available at https://www.newyorkfed.
org/microeconomics/sce#/.

41

Figure 2 Real Interest Rates

Note: Top panel: 1-year (solid) and 2-year (dash) uses inflation expectations from the FRB Cleveland
based on financial market data and surveys of Blue Chip and Professional Forecasts. Bottom
panel: 1-year based on household expectations (Univ. of Michigan, Survey of Consumer Finances (solid), and NY Fed Survey of Consumer Expectations (dash)).
Source: Federal Reserve Bank of New York; Federal Reserve Bank of St. Louis.

last year’s conference, this lesson was applied during 2020 when COVID-19 hit. Policy
tightening in the face of rising inflation could therefore have been implemented without
raising policy rates by shrinking the size of the balance sheet—quantitative tightening.
However, the Fed and the ECB continued to increase their balance sheets throughout
2021, with the Fed only slowing purchases in November. The ECB announced plans to
reduce its balance sheet in 2022Q3.
The current environment, with its high inflation and slowing growth—a return ofstagflation—brings many reminders of the 1960s and 1970s, and with them, concernthat we may be headed to a new era of high inflation. Figure 4 shows the U.S. inflation
and unemployment rates from 1960 until 1985. Inflation is measured by both the PCE
price index and core PCE (PCE less food and energy); the unemployment rate gap
is measured by civilian unemployment less the CBO’s estimate of the natural rate ofunemployment. The two large oil price shocks in the 1970s created surges in inflationthat are clearly visible in the figure. Even though core PCE excludes food and energy
prices, both inflation measures paint a very similar picture. The dashed line shows a

42 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy

Figure 3 The U.S. Core CPI Inflation (solid), Core PCE Inflation (dash), U. of Michigan
Expected Inflation (circles), and 1-year Expected Inflation from FRB Cleveland, FRED: EXPINF1YR (diamonds)

Source: Federal Reserve Bank of St. Louis.

linear trend estimated using PCE inflation between 1960 and 1981 as inflation drifted
upwards from around 2 percent to almost 10 percent.
The major policy mistake during this period was not the volatility of inflation
caused by oil shocks. It was allowing inflation to have a decades-long upward trend.
The challenge now is to prevent transitory surges in inflation from increasing trend inflation. Key lessons were learned from the Great Inflation experience. These include
the importance of an independent central bank, one with a clear commitment to low
inflation, combined with transparency about its inflation goals and a communications
strategy that explains policy in terms consistent with its goals—in other words, an independent and accountable central bank. And unlike the post-financial crisis decade ofzero nominal interest rates during which many central banks found themselves in an
unfamiliar environment (Japan being the exception here), central bankers should havebeen well-schooled in how to deal with a resurgence of inflation.
The surge in inflation and the slow response of central banks raises several questions. First, how costly is delay when fighting a surge in inflation? If policy is slow toreact, should it then compensate by reacting more aggressively? COVID-19 and Rus-

43

Figure 4 Year over Year Inflation as Measured by the PCE (solid) and Core PCE (black
dotted), together with the Unemployment Rate minus the CBO Measure of
the Natural Rate of Unemployment (circles)

Note: Gray dashed line is estimated trend of PCE inflation for 1960/Q1–1981/Q4. Shaded areas arerecessions based on NBER business cycle dates.
Source: Federal Reserve Bank of St. Louis.

sia’s invasion of Ukraine have faced central banks with a very uncertain environment;
what do we know about dealing with uncertainty and have central banks been behaving
in ways consistent with that knowledge? Finally, is a repeat of the high inflation 1960s
and 1970s a possibility?
To address these questions, the rest of the paper is organized as follows. The issueof whether the Fed is behind the curve is considered in section II. The consequences ofa delay in reacting to inflation surges are considered in section III. Section IV compares
the current situation to the 1960s and 1970s with a focus on whether the lessons learned
about policy in the face of uncertainty have been followed. Conclusions are in the final
section.

II. Falling behind the Curve
The inflationary impacts of COVID-19 shocks were initially expected to be temporary(e.g., lockdowns, disruptions to supply chains) or sources of relative prices shifts as op-

44 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy

Figure 5 FOMC Projections for 4-quarter PCE Inflation at Different Meeting Dates

Source: Federal Open Market Committee.

posed to causes of general inflation.3 Prevailing expectations were that inflation would
fall as the shocks passed. Statements by leading central bankers suggested that the temporary nature of the shocks implied that no significant change in monetary policy wasneeded. Most central bankers, economists, and commentators were, therefore, caught
by surprise as inflation continued to surge in 2022.
Figure 5 shows the median inflation projections of FOMC members from December 2020 until March of this year. In December 2020, inflation for 2021 as measured by
the PCE index was projected to be 1.8 percent (yoy)—it came in at 5.5 percent. Eachset of projections since December 2020 reflected an upward revision to the inflation
projection. Even as late as September 2021, however, the FOMC continued to projectthat inflation in 2022 would be close to its 2 percent target. Only in December was therise in inflation recognized to be persistent, yet even then, 2022 inflation was projected
to be just 2.6 percent. In March of this year, the projection for 2022 jumped from 2.6
percent to 4.3 percent. Already, this looks like it will be too low, with January throughMarch seeing PCE inflation averaging 6.9 percent at an annual rate.
By April, the consensus was that central banks had been too slow in tackling inflation. New opinion pieces were appearing almost daily lamenting the fact that central
banks were behind the curve. For example, in speaking with the Financial Times in................................
3. As economies reopened during 2020, there were concerns that supply-side impacts, such as those on labor
force participation, would have long-lasting eﬀects.

45April, Otmar Issing, former Chief Economist of the ECB, was quoted as saying “It is
obvious the ECB is late to react, while the Fed might be even more behind the curve.” 4
And the Economist magazine for the last week of April carried a cover headline of“The Fed that failed.”
A. Comparing to Simple Rules
One way to judge the Fed’s policy response and assess whether it is behind the curve
is to compare it to the recommendations of simple instrument rules.
To do this, I use two rules, both taken from the Fed’s July 2021 Monetary Policy
Report (see, for example, Federal Reserve Board of Governors [2021] p. 44)5 The firstrule is the basic Taylor rule expressed in terms of the unemployment rate relative to its
long-run value: 
TR: it = rtLR + πt + 0.5 πt − πLR + utLR − ut .
The second is the balanced-approach rule, a rule which doubles the weight on unemployment deviations:
BA: it = rtLR + πt + 0.5 πt − πLR + 2 utLR − ut .
I set the inflation target at 2 percent and for projections prior to March 2022, I
assume a value for the long-run real rate of 0.5 percent. The long-run real rate waslowered to 2.4 percent in the March 2022 projections. These values were consistent
with the FOMC member’s projections for the longer-run value of the federal funds
rate. The median projections of the FOMC’s members for inflation and unemployment
were used to see what the rules would imply for the funds rate.6
The December 2021 and March 2020 FOMC’s projections for the funds rate areshown by the solid line with crosses (Dec 2021) and the solid line with circles (March
2022) in Figure 6. These are the same in both the upper and lower panels. The FOMC
projections of inflation and unemployment are used to calculate the funds rate impliedby the Taylor rule (top panel) and the balanced-approach rule (bottom panel). The
implied funds rates for the rules are shown by dashed lines with crosses for the Dec.
2021 inflation and unemployment rate projections and with circles for the March 2022
projections.
Based on the December 2021 projections, both rules imply the funds rate should benear 4 percent in 2022 and 2023. In December 2021, the FOMC was projecting a funds
rate of just 0.9 percent for 2022 and 1.6 percent for 2023. At the March 2022 meeting,
the FOMC projections for 2022 would imply a funds rate under the Taylor rule ofalmost 7 percent in 2022, falling to 4 percent in 2023. The balanced-approach rule
paints a similar picture. In contrast, even as recently as March, the FOMC members
were projecting that the funds rate would end in 2022 at less than 2 percent.
................................
4. See Arnold (2022).
5. These rules were dropped from the February 2022 Monetary Policy Report.
6. Simply plugging in realized inflation and unemployment into these rules would suggest the federal funds rateshould have been near 8 percent by December 2021. Of course, if the FOMC had followed either of theserules, the paths of both inflation and unemployment would have been much diﬀerent.

46 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy

Figure 6 Policy Rate Implied by FOMC Projections of Inflation and Unemployment

Note: Crosses are policy rate projections from Dec. 2021, circles from March 2022.

Of course, one could reconcile the FOMC projections for the funds rate with therules based on their projections for inflation and unemployment if FOMC members
currently think the neutral real interest rate is much lower than the 50 basis point value
I employed, or if the relative measure of labor market conditions points to much greater
underutilization of the American work force than the unemployment rate and the CBO
estimate of the natural rate suggest. Perhaps, but the neutral rate would need be close
to −4 percent to reconcile the two, and the analysis of Domash and Summers (2022)
suggests that the U.S. labor markets are much tighter than traditional measures suchas the unemployment rate indicate and are more like what one might expect with a 2
percent unemployment rate.
A final way to reconcile the diﬀerence would be to interpret the gap as the FOMC’s
assessment of the impact of running down the Fed’s balance sheet—quantitative tightening. This would require imputing an extremely and implausibly large eﬀect to quantitative tightening.7................................
7. The gap between the Wu-Xia shadow rate and the fed funds rate is often interpreted as an estimate of the
impact of the balance sheet. This gap was close to 2 percent in 2021 and then fell to zero in March 2022 when
the funds rate was raised. See https://www.atlantafed.org/cqer/research/wu-xia-shadow-federal-funds-rate.
Because the Fed’s balance sheet had continued to increase, it is hard to attribute the slowing of the increase as
suﬃcient tightening to close the roughly 3 percentage point gap between the March 2022 FOMC projection
and the Taylor rule recommendation for 2022.

47

III. Is It Costly to Delay?
Based on these simple rules, rules often employed as reasonable benchmarks for monetary policy, together with the FOMC’s projections for inflation and unemployment, theFed is far behind the curve in dealing with the surge in inflation. However, this conclusion may be premature. After all, since December the Fed has been talking about rateincreases, and such forward guidance has the potential to be quite powerful. Perhaps
the belief that central banks will eventually respond to inflation is suﬃcient to ensure
the inflation surge is stabilized.
The Taylor Principle, imbedded in standard policy rules, requires that the policy
rate increase more than one-for-one with inflation, but it does not require the full increase to occur immediately. When private sector behavior is dependent on expectations of future developments, the literature on the power of forward guidance suggests,
perhaps implausibly, that the credible promise of a future rate increase can serve almost
as eﬀectively in stabilizing the economy and controlling inflation as an actual increase
today.
To examine this issue, I subject a basic new Keynesian model to a positive andpersistent inflation shock and examine the impulse responses when policy reacts witha delay. The core of the model is very standard, three equations in inflation, an output
gap, and the policy rate given by equations (1)–(3). Partial indexation to lagged inflation introduces endogenous persistence into the inflation equation (1), while habitsin consumption introduce endogenous persistence into the Euler equation (2). Policy
inertial results in the lagged interest rate entering (3), where π(4)t is 4-quarter inflationand k ≥ 0 reflects the delay in the policy response. The time period is taken to be aquarter.

1(βEt πt+1 + χπt−1 + κxt + vt ) ,πt =1 + χβ





1
1−η 
xt =
Et xt+1 + ηxt−1 −it − Et πt+1 − rt∗ ,
1+η
σ


it = ρi it−1 + (1 − ρi ) r∗ + φπ π(4)t−k − ut−k .

(1)
(2)
(3)

Parameter values in the structural equations are β = 0.995, σ = 1, and κ = 0.17,
which are taken from Galí (2015). For policy inertia I set ρi = 0.85, for the indexation
χ = 0.685, and for the habits parameter η = 0.852, based on the estimates of Dennis(2009). In the policy rule (3), φπ = 1.5, and I allow k = {0 1 2 3 4}. To represent a moreaggressive response, I double φπ from 1.5 to 3.0. I also reduce policy inertia to 0.5 asa second way of capturing a more aggressive response. Expectations are assumed to
be based on full information and are rational (FIRE) in the standard sense of model
consistent.
I add a fourth equation to link the output gap with unemployment—Okun’s Law:ut = −0.5xt .

(4)The coeﬃcient of −0.5 in (4) is consistent with a basic Taylor rule as given in the table

48 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policyof instrument rules in Monetary Policy Rules in which the coeﬃcient of 0.5 on the
output gap in the original Taylor (1993) rule is replaced by the unemployment rate gap
with a coeﬃcient of 1.
To allow for a temporary inflation shock without limiting it to an AR(1) process,I assume vt follows an ARIMA(1,3) process, given by (5), where ev,t is a white-noise
innovation to the inflation shock vt :vt = 0.5vt−1 + ev,t + 1.2ev,t−1 + 1.1ev,t−2 + 0.5ev,t−3 .

(5)

The parameters in the shock process are ad hoc, but they imply a positive innovation
causes vt to rise over the first 3 quarters and then decay.
COVID-19 and the disruptions from the Russian invasion of Ukraine have, andwill continue to have, complex impacts on both aggregate demand and supply in the
global economy. To represent these as a shock to firms’ marginal costs is too simple,
but it captures the chief issue facing central banks—what to do in the face of a surge
in inflation that forces a trade-oﬀ between stabilizing inflation and stabilizing the real
economy. My view is that, in addition to direct eﬀects on marginal cost, other impactsof COVID-19 and the war in Ukraine have, on net, acted to reduce aggregate supply
relative to demand, reinforcing the need for interest rates to rise.8 Thus, any costs
associated with delaying in the face of an inflation shock would be even larger if theshock also, on net, increased aggregate excess demand.
A. Delay in a Basic Sticky Price NK ModelI start with the basic NK model without endogenous or policy inertia (χ = η = ρi = 0).
Figure 7 shows the results of a positive innovation to the inflation shock. The solidline with crosses is for the no delay (k = 0) policy, while the solid line with diamonds
denotes a four-quarter delay (k = 4) with φπ = 1.5. The solid and dashed lines withdiamonds diﬀer based on the value of φπ employed, with the solid line based on φπ =1.5 and the dashed line representing a stronger response to inflation (i.e., φπ = 3.0).
Comparing the solid lines with circles and diamonds reveals that the real interest
rate (upper right panel) initially falls and takes longer to turn positive when k = 4.
Delay results in a lower peak rise in unemployment (lower left panel), but unemployment also stays above its steady-state value longer and continues to fluctuate rather
than converge smoothly back to steady state as it does when policy is not delayed. Delay actually reduces the rise in inflation (lower right panel) and returns inflation to its
steady-state faster, though inflation does continue to cycle.
When policy reacts more strongly (i.e., φπ = 3.0), a standard trade-oﬀ arises—
responding more strongly succeeds in reducing the rise in inflation at the cost of ahigher peak rise in unemployment. An aggressive response after delaying does notcontribute to a soft landing. Note that an aggressive response when policy is delayed
generates long lasting fluctuations in the policy rate.
The intuition for why delay does not play a large role is based on the strong eﬀectof forward-guidance policies at the ELB in NK models. Credible policy actions that................................
8. Oil price shocks act like a negative demand shock, in particular for energy importers such as the Euro Area
and Japan.

49

Figure 7 Response to an Inflation Shock: Different Delays and Policy Responses toInflation without Endogenous Persistence

will occur in the future have large eﬀects on current output and inflation.
B. Endogenous Persistence
The previous figure was based on purely forward-looking model with no endogenous
persistence in either the inflation process (1) or the aggregate demand relationship (2)because χ = η = 0. There was also no inertia in the policy rule, ρi = 0. I now set
these parameters to their baseline values: χ = 0.685, η = 0.852, and ρi = 0.85. With
this calibration, results are shown in Figure 8. As in the previous figure, the solid linewith crosses is for the policy that reacts immediately to the shock (k = 0); the solidline with circles shows responses when policy delays four quarters before responding(k = 4). The response parameter in both cases is 1.5. The dashed lines are for k = 4
and a response coeﬃcient of 3.0.
The primary thing to note is that the behavior of unemployment and inflation is very
similar under all three policies. In terms of controlling inflation, delaying the monetary
policy response reduces the peak rise in inflation, while it increases the peak rise in
unemployment. Delay also postpones the recovery of unemployment. There is a tradeoﬀ between stabilizing inflation and stabilizing unemployment, but the diﬀerences are
relatively small.
What the delay does create is much larger future fluctuations in the policy rate, unemployment, and inflation. Responding more aggressively by doubling the coeﬃcienton the rule to 3.0 results in large swings in the policy rate, while the near-term eﬀect isto dampen the peak rise in inflation at the cost of a higher peak unemployment rate.

50 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy

Figure 8 Response to an Inflation Shock: Different Delays and Policy Responses toInflation with Endogenous Persistence

Responding more strongly to inflation is one definition of acting more aggressively.
Another interpretation of calls for a more aggressive response is to react with less inertia. The rules in Figure 8 all incorporate a high degree of inertia, reflected in thecoeﬃcient of 0.85 on the lagged policy rate; an aggressive response could mean reducing the inertia in the policy response. This is investigated in Figure 9. The blacklines in the figure are repeated from the previous figure. The solid gray line maintains
the baseline response coeﬃcient of 1.5 but reduces the parameter on the lagged policy
rate from 0.85 to 0.5. The gray dashed line corresponds to a policy with a response
coeﬃcient of 3.0 and inertia of 0.5.
There are two lessons. First, policies that dampen the peak rise in unemployment
lead to the highest increases in inflation. Thus, the standard trade-oﬀ in the face of
cost shocks applies. Second, combining aggressive moves when policy is behind thecurve leads to prolonged fluctuations, particularly in the policy rate. Policy ends up
oversteering, forced to swing the rudder from one direction to another, raising the issue
of instrument instability.9 In fact, the model becomes unstable if delay is too long (over7 quarters) and policy is too aggressive.
To summarize, if inflation expectations are firmly anchored, a credible policy ofdelaying before reacting to a persistent positive inflation shock has only modest eﬀects
on the behavior of inflation and unemployment due to the power of forward guidance;
credible promises of future action have large eﬀects today. Since the Fed is behind................................
9. The issue of instrument instability in the conduct of monetary policy was first investigated by Holbrook (1972)
and Lane (1984).

51

Figure 9 Response to an Inflation Shock: Different Delays, Inflation Responses, andPolicy Inertia in Model with Endogenous Persistence

the curve in reacting, it may be a relief to know that if the public always knew theywould eventually respond, the delay may not be very costly. But given that a reaction
was delayed, does it make sense to respond more aggressively? The impulse responses
suggested that responding more to inflation does help stabilize inflation somewhat, but
at the cost of more volatile unemployment. It also leads to a significant increase ininterest rate volatility.
If a more aggressive response is interpreted to mean a less inertial policy reaction, then the volatility of the policy interest rate increases significantly when ρi isreduced. Inflation is marginally less volatility, while unemployment becomes morevolatile. However, when economic behavior is characterized by both forward-looking
and inertial behavior, delay can result in instrument instability.10
C. Anchored Expectations
The results so far have been based on a model that assumes long-run inflation expectations are anchored, focusing only on the impact of policy delay on short-run dynamics.
A failure to respond to a persistent rise in inflation may cause long-term expectations
to become unanchored. If the private sector began to expect higher inflation, these expectations feed through into price and wage setting decisions, resulting in an upward
drift of inflation such as occurred during the 1970s. This, in turn, would also lead to................................

10. When φπ = 3.0, the model becomes unstable when k > 7.

52 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy

Figure 10 Inflation Expectations

Note: Top panel—Michigan (solid), NY Fed median 1-year (dash) and 3-year (dot dash). Bottom
panel—Japan: Opinion Survey 1-year (solid) and 2-year (dash).
Source: Federal Reserve Bank of St. Louis; Bank of Japan.

an expansionary fall in real interest rates further contributing to a rise in inflation ifmonetary policy fails to react suﬃciently (i.e., if it violated the Taylor Principle).
Figure 10 shows several survey-based measures of household inflation expectationsin the U.S. (top panel) and Japan (bottom panel).11 All have shown increases in recent
months, though longer-term expectations have shown smaller increases. Expectations
based on financial market data, not shown, have remained much more anchored in
the U.S. and remain closer to the Fed’s 2 percent target. In Japan, firm inflation expectations are also much lower than those of households. However, for understanding
the possible implications for actual inflation, Coibion, Gorodnichenko, and Kamdar(2018), in their review of empirical evidence on the Phillips Curve, conclude that “. . .
household expectations appear to play a special role in making the Phillips curve stable and inflation predictable.” (p. 1475). As Figure 3 showed, household expectations
have tracked the actual path of inflation over the past year better than have expectations
from financial markets. Thus, the rise in household inflation expectations is particularly
worrisome.
................................
11. Inflation expectations for Japan are the average of bias-adjusted responses of inflation expectations in the
Bank of Japan’s Opinion Survey. Biases are adjusted using the method of Nishiguchi, Nakajima, and Imakubo(2014).

53

Figure 11 Response to an Inflation Shock with “Behavioral” Expectations of Future
Inflation Based on Bianchi, Fisher, and Melosi (2021)

The prior impulse response functions assumed rational expectations. At last year’s
conference, Evans (2021) discussed a form of behavioral expectations due to Bianchi,
Fisher, and Melosi (2021) which, in turn, built on the work of Bianchi and Melosi(2017). Applied to expected future inflation, the assumption was thatẼt πt+1 = 0.86πt−1 − 0.11ut ,(6)

where the operator Ẽt denotes the time t behavioral expectation of future inflation.
Replacing Et πt+1 with Ẽt πt+1 in the model given by (1)–(5) produces the results shownin Figure 11.12 The maximum delay shown is k = 3 as the model becomes unstable
for longer delays. Greater policy inertia also generates instability, so results are only
shown for ρi = {0 0.5}. Comparing results with Figure 9 illustrates how expectations
matter. With inflation expectations given by (6), the consequences of delay are larger,
generating large fluctuations in both unemployment and inflation. Delaying too long inreacting to a surge in inflation can generate explosive fluctuations in inflation.
Anchored expectations are not something central banks can take for granted. Nor isit safe to assume that temporary shocks have temporary eﬀects on inflation if monetary
policy fails to react. Modern inflation theory tells us that in the absence of a policy................................
12. For this simple exercise, I continue to assume expectations of future output in (2) are rational on the grounds
that the Euler equation relates to household’s expectations of their own future income, for which they may
have more accurate information than they do about future aggregate inflation.

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Inflation Surges and Monetary Policy

response, a return to target inflation after temporary shocks have passed is only one
possible equilibrium; others are also possible in which inflation remains high wellafter the shock has fully dissipated. And outside of the world of full information andrational expectations, we lack any empirically grounded theory of expectations that
ensures inflation expectations will be consistent with the central bank’s policy.13
What does anchor inflation expectations? They are anchored by faith in the central
bank’s commitment to a clear and transparent inflation target, and that faith is validated
when policy actions are consistent with achieving the target. Talk may be crucial when
inflation is below target and the ELB is a constraint, but when inflation is above target,
action is needed to validate the public’s faith that inflation will be controlled.
Importantly, one cannot divorce the future path of inflation expectations from anassumption about monetary policy. Whether inflation is anchored or not comes down
to the credibility of the central bank. Thus, as Reis (2021) puts it (p. 40): “One lesson
from the 1967–73 experience is that policymakers should keep a close eye on measuresof the expected inflation anchor, and not give in to the temptation to dismiss them as
temporary noise or as vague psychological factors. A more general lesson . . . is thatpolicy can play a role in where the anchor ends up.”That is why statements by central bankers over the past year that gave the impression inflation would fall once shocks had passed, without making any explicit link tothe monetary policy actions needed to ensure the rise in inflation is temporary, were
troubling.
The 1970s illustrated the dangers of treating inflation as if it were somehow exogenous to monetary policy. A somewhat surreal exchange from the transcript of the
FOMC meeting on September 9, 1978 is quite revealing. Lawrence K. Roos, Presidentof the St. Louis Federal Reserve Bank, expressed exasperation as inflation rose towards
8 percent, saying“I’m really not trying to be critical, but is our monetary policy responsibility
such that we should maybe discuss whether we’re satisfied to see the economy
drift into an 8 percent inflation rate? And if not, are there things that we can do
to aﬀect this? . . . Are we in any way the masters of what happens, or are we
merely observers on the sidelines? I’m lost.”
Fed Chair G. William Miller then drew upon the U.S. Constitution’s 5th Amendment protection against self-incrimination in responding “I take the fifth.”
I am confident that no central banker today would fail to connect inflation developments with monetary policy. Still, some discussions have come close to implicitly
downplaying the role of policy in anchoring expectations.14................................
13. As Carvalho et al. (forthcoming) put it, theories “provide little guidance on how market participants form
these expectations, or how policy ensures expectations to be consistent with central bank objectives. Indeed,most models simply assume long-term expectations are consistent with the policy strategy of the central
bank.”
14. For example, at last year’s conference, Federal Reserve Bank of Chicago President Charles Evans devoted
his panel remarks to inflation (the only presentation last year to focus on inflation). Yet monetary policy wasnever mentioned in his discussion of inflation expectations.

55IV. The Return of the 1970s
Is it possible that this year’s surge in inflation will lead to a prolonged period of highinflation? In considering this possible, it is useful to review the four primary but notnecessarily mutually exclusive explanations for the Great Inflation: 1) shocks and special factors (Blinder and Rudd [2013]); 2) the belief in a static Phillips curve trade-oﬀ(Romer and Romer [2002]); 3) imperfect information leading to an overestimate of potential output (Orphanides [2003], Primiceri [2006]); and 4) an inherent bias towards
inflation due to political pressures and an inability of central banks to credibly commit
to low inflation (Kydland and Prescott [1977], Barro and Gordon [1983]).
There are aspects of each of these four explanations that seem very relevant today.
I want to focus, however, on the first and the last ones on this list.
A. Shocks and Special Factors
Blinder and Rudd (2013) have argued that sharp increases in inflation during the 1970s
were due to supply shocks and special factors that included oil embargoes, crop failures, corn blight, and the disappearance of Peruvian anchovies. Inflation fell sharply
once these factors passed.
This explanation seems very consistent with the thinking of the Fed and the ECB
last year. Policymakers frequently mentioned special factors—beginning with statements that the rise in inflation would subside once the base eﬀects of the prices decline of 2020 dropped out of the year-over-year calculations—to explain why inflation
would be temporary. Bad shocks happen—structural shifts, labor force participation,
work-from-home, supply chain disruptions, semi-conductor shortages, and shifts awayfrom reliance on far-flung supply chain networks during 2021, compounded by oil
price spikes and disruptions caused by Russia’s invasion of Ukraine in 2022. Because
each of these could be viewed as temporary, the argument was that inflation would fall
once the shocks passed and there was little need for policy to respond.
In discussing the sources of the inflation of the 1970s, Reis (2021) argued that an
important factor explaining why oil shocks had a lasting eﬀect on inflation was that
“internal forecasts (by the Fed) that all shocks had temporary eﬀects led to a belief that
inflation expectations remained anchored.” The Fed underestimated the persistence of“temporary” shocks in the 1970s, and, unfortunately, this also seems to be the casenow. As Figure 5 shows, the FOMC in December 2021 was projecting that inflation
would decelerate from 5.3 percent in 2021 to 2.3 percent in 2022. Given that realized
PCE inflation for the first three months of 2022 averaged 6.29 percent, inflation would
need to sharply decline over the remaining months to an average of 3.64 percent toachieve the FOMC’s projection of 4.3 percent inflation for 2022.15
1. Uncertainty about exogenous shocks
The persistence of exogenous shocks such as COVID-19 and the war in Ukraine isclearly important for forecasting the path of inflation and calibrating the appropriatemonetary policy response. However, policymakers face a great deal of uncertainty................................

15. PCE inflation has averaged (1/3)*(6.01+6.27+6.59) = 6.29 percent during January–March 2022. To hit theyoy projection for 2022 of 4.3 percent, PCE inflation would need to average (4/3)*(4.3 − (1/4)*6.29) = 3.64
percent for April through December.

56 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy

when it comes to assessing whether any shock will be temporary or persistent. Fortunately, work carried out in the early 2000s investigated the issue of monetary policy
under uncertainty.16 In particular, this research oﬀers guidance on setting policy when
the persistence of exogenous shocks is uncertain, guidance that policymakers today
seem to be ignoring.
Before getting to those insights, however, it is worth pointing out that simple rules
such as the Taylor rule (or any of the others in the Fed’s Monetary Policy Report) do notdepend at all on knowing how persistent a shock is. Each rule implies the central bankshould react the same way to actual inflation and unemployment, regardless of whether
the shock itself is purely transitory or very persistent. Yet it is generally accepted that
the Taylor rule delivers reasonable guidance for monetary policy except, of course at
the eﬀective lower bond for the nominal interest rate.17 The Taylor rule is not optimal,
but it is robust.
One can consider deviating from the original coeﬃcients in the Taylor rule andoptimize these based on a chosen objective function. It turns out that if one optimallysets the response coeﬃcients to stabilize a quadratic function of inflation and unemployment, one does better by overestimating the persistence of inflation shocks when
deriving the optimal coeﬃcients.18 This is due to the fact that the costs of inflation andreal fluctuations become larger the more persistent the shock is.
A key insight, therefore, is that policymakers should overestimate the persistenceof inflation shocks, just the opposite of what they were doing in 2021. Rather than treat
an inflation shock as temporary, it would have been better if policymakers had acted asif the shock was likely to be persistent.
Further insight into policy and model uncertainty comes from work by Hansen andSargent (2003) on robust control in which policymakers act as if there is an evil agent
that is trying to make their policy look as bad as possible. Optimal policy then protects
the economy from the worst the evil agent can deliver. As a practical application of thisapproach, I showed in Walsh (2004) that the robust control approach implies monetary
policymakers should act as if the evil agent will hit the economy with an adverse inflation shock just when the economy is facing an expected slowdown and inflation isabove target. Of course, in the robust control framework, the evil agent doesn’t reallyexist, but this scenario does fit the case of the war in Ukraine which occurred whenpolicymakers were already worried about a growth slowdown and an inflation surge.
Acting as if there is an evil agent helps ensure that policy is prepared for the worstcase scenario. More generally, a policymaker seeking robustness should systematicallyoverestimate the persistence of any inflation shock. During the past year, central bankpolicymakers seem to have done just the opposite.
2. Model uncertainty
Uncertainty about the persistence of shocks is not the only source of uncertainty facedby policymakers. I mentioned earlier that the results on policy delay were obtained
from just a single model. It would be useful to do a full analysis of the robustness of................................
16. I discuss some of this research in Walsh (2003).
17. Giannoni and Woodford (2003a, 2003b) showed how, if the central bank cares about interest rate volatility,
optimal interest rate rules do not depend on the persistence of shocks (ignoring the ELB).
18. See Walsh (2003).

57

Figure 12 Response to an Inflation Shock in the Rudebusch-Svensson Model:
Delays Greater than Two Quarters Lead to Instability

the results to gain more insight into the consequences of delay when policymakers face
uncertainty about the true (best?) model of the economy, but a useful starting point forsuch an analysis is provided by the work of Levin and Williams (2003). They showedthat one can protect against model uncertainty by basing policy on a more backwardlooking model than the policymaker truly believes characterizes the economy.19 Thus,
a desire for robustness in the face of model uncertainty suggests policymakers should
overestimate the degree of endogenous persistence in the economy.
The model Levin and Williams used to illustrate this point was a completely
backward-looking model estimated using U.S. data by Rudebusch and Svensson(1999). What does such a model imply about policy delays and aggressive responses?
The answer is shown in Figure 12.
Impulse responses are shown for delays of zero and 3; the model becomes unstable
when the policy delay is any longer and policy is too aggressive (i.e., when φπ = 3.0).
Nor can the model be solved when the inertia in the policy rule is as high as the baseline value of 0.85. Large and potentially explosive fluctuations arise when policy isdelayed, particularly when attempts to compensate for delay are made by responding more strongly to inflation. Because the Rudebusch-Svensson model is backward................................
19. Levin and Williams compared how policy rules optimized for one model performed in an alternative model.
They found that rules optimized for a forward-looking model performed poorly in the backward-looking
model due to Rudebusch and Svensson (1999), while the rule optimized for the Rudebusch-Svensson model
also delivered reasonable results in the forward-looking model.

58 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy

looking, the delay in reacting combined with a gradual policy response (k = 3 andρi = 0.5) leads to a fall in the real interest rate and unemployment actually declines,
exacerbating the rise in inflation.
I take the Levin and Williams result as a cautionary tale—give potential policies
a test in models with significant endogenous inertia and make sure that delay and aggression are not going to generate instability.
I have touched on uncertainty about the persistence of inflation shocks and thedegree of backward-looking aspects in the model. There is also a great deal of uncertainty about the appropriate structural model of inflation.20 Prior to the recent inflation
surge, there were arguments that the Phillips curve was very flat and that policymakers could push unemployment lower without needing to worry about any eﬀect on
inflation. In testimony before the U.S. House Committee on Financial Services in July
2019, Federal Reserve Chairman Powell had this exchange with Representative Ms.
Ocasio-Cortez (D-NY): Ocasio-Cortez “And I have been seeing lately that economists
are increasingly worried that the idea of a Phillips curve that links unemployment andinflation is no longer describing what is happening in today’s economy. Have you been
considering on that? What are your thoughts on that?” Chair Powell: “Yes. Very muchso. We spend a great deal of time on that. The connection between slack in the economy or the level of unemployment and inflation was very strong if you go back 50
years. And it has gotten weaker and weaker and weaker to the point where it is a faintheartbeat that you can hear now. It is still there. You can see it at the State level data
and things like that.”21
Uncertainty about the slope of the Phillips curve is a form of parameter uncertainty,
and the classic conclusion of Brainard (1967) was to exercise caution in the face of parameter uncertainty. As is well-known, Brainard’s result is model specific and does
not generalize. Ferrero, Pietrunti, and Tiseno (2019) reexamine monetary policy under
uncertainty in a NK model and find that uncertainty about the slope of the new Keynesian Phillips curve calls for a more aggressive response if the cost shock is suﬃciently
persistent. This result implies that when policymakers underestimate the degree of persistence, as occurred in 2021, they will react too cautiously to exogenous shocks to
inflation.
Uncertainty about the endogenous inertia that characterizes inflation dynamics is
also important. Söderström (2002) showed that this type of uncertainty calls for a moreaggressive policy response, a sharp contrast to Brainard’s conclusion that caution iscalled for in the face of uncertainty. A useful analogy is to consider the best way torespond to wildfires. An initial fire may burn itself out if fuel is scarce and weather
conditions are calm. But weather conditions might change and if winds pick up, thefire may rapidly spread. If it continues to spread, reaching areas with more plentiful
fuel, a fire can begin creating its own weather, further intensifying the fire. The best
strategy is to attempt aggressively to control even small fires to prevent them fromspreading. Similarly, a rise in inflation may trigger rising inflation expectations that,
if left unaddressed, lead to increases in wages and result in a wage-price spiral. A
cautious approach—waiting to see if inflation persists—can put policymakers into the................................
20. For example, see Rudd (2021) for a very critical assessment of the new Keynesian Phillips curve.
21. Powell (2019). For evidence on the Phillips curve in state level data, see Hooper, Mishkin, and Sufi (2019).

59

position the Fed finds itself today.
The literature on policy in the face of uncertainty assumed policy reacted immediately to shocks to inflation. Unfortunately, the results of section III suggested that an
aggressive response can generate instrument instability if the response is delayed toolong.
3. Lessons on uncertainty
I conclude that the literature on model uncertainty oﬀers the following lessons: 1) basepolicy on the assumption that temporary shocks are likely to turn out to be persistent;
2) policymakers should act as if they expect new inflation shocks just when they are
already facing the need to slow the economy down to deal with a surge in inflation; and
3) use models that overestimate endogenous persistence in designing policy.
In the current environment, all three of these lessons seem to have been ignored.
Of course, aggressively countering slight flare-ups of inflation need not require muchactual policy action. If the public is firmly convinced that the central bank will quickly
respond to inflation, expectations will remain anchored and will help stabilize actual
inflation.
B. Political Bias
A second explanation for the 1960s and 70s inflation that also seems particularly relevant now, at least in the U.S., points to an inflationary biases due to political pressureson central banks, combined with discretionary policymaking. An inability to crediblycommit to low inflation in an environment of systematic political pressures to exploit
the short-run trade-oﬀ between inflation and unemployment in the 1960s and 1970s led
the public to expect higher inflation. The best the central bank could do was deliver it.
As applied to the 1960s and 70s, the outline of the story is as follows. In 1962,
the first Economic Report of the Kennedy Administration set an interim goal of 4 percent for unemployment, a value well below current estimates of the natural rate ofunemployment for that period.22 Political pressures to achieve an unsustainably low
unemployment, combined with a static view of the trade-oﬀs oﬀered by the Phillips
curve, helped explain the rising inflation trend in the U.S. during the 60s and 70s.23
Today, there is vocal political support in the U.S. for ensuring an “inclusive” economic recovery and the lifting of interest rates by the Fed in December 2015 when theunemployment rate was 5 percent (and the natural rate was estimated to be 4.7 percent)is viewed as a mistake. In response, the FOMC’s “Statement on Longer-Run Goals
and Monetary Policy Strategy” was revised in August 2020 to define the employment
goal as “a broad-based and inclusive goal that is not directly measurable and changes
over time owing largely to nonmonetary factors. . . (Federal Open Market Committee................................
22. In the first quarter of 1961, the unemployment was 6.8 percent while the (current) CBO estimate of the noncyclical rate of unemployment in 1961Q1 is 5.9 percent. Of course, the concept of the natural rate only cameto prominence later due to Friedman (1968). Another similarity with the 1960s is that both then and now
fiscal policy was expansionary.
23. This story incorporates elements of three of the four standard explanations: the wrong theory (a static Phillips
curve), imperfect information (an underestimate of the natural rate of unemployment); and political pressures
together with the inability to commit. Another similarity between the 1960s and recent years is the Fed’s
apparent faith in fine-tuning as reflected in its belief that it can engineer a soft landing, reducing inflation
without causing unemployment to rise.

60 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy[2020]). Consequently, it would not be appropriate to specify a fixed goal for employment; rather the Committee’s policy decisions must be informed by assessments of theshortfalls of employment from its maximum level, recognizing that such assessments
are necessarily uncertain and subject to revision.”
Making policy decisions “informed” by employment shortfalls from a goal “that is
not directly measurable” has the potential to impart an asymmetric, inflationary bias
in policy (Blinder [1998], Ruge-Murcia [2003]). Thus, in 2021, even with the unemployment rate at record lows and other measures of labor utilization also high, the Fed
seemed reluctant to focus on dealing with rising inflation. In addition, the Fed’s 2019review of its policy framework and its adoption of asymmetric flexible average inflation
targeting meant it no longer even has a clearly defined inflation target.
The desire for central banks to do more—to not hold back a strong recovery—
clashes with the view expressed in 1955 by then Federal Reserve Chairman William
McChesney Martin who compared the job of the Federal Reserve to that of a “. . .
chaperone who has ordered the punch bowl removed just when the party was reallywarming up.”24
An inability to credibly commit to low inflation policies, combined with an incentive to seek short-term reductions in unemployment were central components ofmany theories of inflation developed in the 1980s. Works based on these theories wereparticularly influential in supporting the idea of independent central banks headed byinflation adverse central bankers—a Rogoﬀ (1985) conservative central banker—orconstrained by explicit inflation targets—Bernanke, Blinder, and McCallum (2005).
This idea was central to the consensus, as articulated by Bernanke, Blinder, and McCallum (2005) and Goodfriend (2007), that emerged from the inflation experiences of
the 1970s.
Support for this consensus seems to be eroding, suggesting a further risk to the
inflation outlook. Since 1976, a sample of members of the American Economic Association (AEA) has been surveyed periodically about their views on important macroeconomic and microeconomic questions. Recent results from this survey are reported inGeide-Stevenson and La Parra Perez (2021).25 For each of the economic propositions
on the survey, respondents were asked whether they agreed (A), agreed with provision(A+P), or disagreed (D).
The top panel of Figure 13 reports the results from the 2000, 2011, and 2021 surveys for two propositions: “The Federal Reserve should focus on a low rate of inflation
rather than other goals such as employment, economic growth, or asset bubbles” (toppanel), and “Management of business cycles should be left to Fed, not to fiscal policy”(bottom panel). For both propositions, there is a declining share of economists agreeingor agreeing with provisions, while the share disagreeing has grown.26 The first of these
propositions is central to the rationale for central banks to adopt inflation targeting. The
fraction of AEA members surveyed who disagreed with this proposition has risen from................................
24. Martin (1955), p. 12.
25. The 2021 survey was the first conducted online, and yielded 1436 responses once non-US residents andduplicate responses were eliminated. Details on the characteristics of the respondents are discussed in GeideStevenson and La Parra Perez (2021).
26. These two propositions were added to the survey in 2000.

61

Figure 13 Bars from Left to Right Show Proportion of Respondents in Each Survey
Year Who Disagreed (D, black), Agree (A, dark gray), or Agreed with Provision (A + P, light gray) with Each Proposition

Source: Geide-Stevenson and La Parra Perez (2021).

28.4 percent in 2000 to 61.6 percent in 2021. The fraction agreeing without provisions
has fallen over this period from 42 percent to 18 percent, while the share agreeing or
agreeing with provisions has fallen from 72 percent to 32 percent.
The changing views on the respective roles of the Fed and fiscal authorities inmanaging business cycles are not surprising, given the active use of fiscal policy inresponse to the global financial crisis in 2008–09 and during COVID-19 in 2020–21.
In 2000, 28.5 percent disagreed with the proposition that the Fed, not fiscal policies,
should manage business cycles; by 2021, this fraction had risen to 66.6 percent.

V. Summary and Conclusions
Central banks have fallen behind the curve in addressing the recent surge in inflation.
The implications of standard monetary policy models suggest, however, that the costsof delay are relatively small. An aggressive response combined with delay can, however, produce volatility in the return to steady state. The standard model, though, isbased on firmly anchored inflation expectations and a shared belief by all that mone-

62 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2022

Inflation Surges and Monetary Policy

tary policy will eventually respond strongly to inflation. If agents are backward-looking
or base actions on expectations that diﬀer from rational expectations, delay plus aggressive responses can lead to instability.
The Fed has underestimated the persistence of inflation shocks and inflation inertia. In doing so, it has forgotten the relevant theory for dealing with inflation surges ina world of model uncertainty. That theory suggests that policymakers should systematically overestimate the degree of persistence of inflation shocks, not underestimate
persistence in the hope shocks will quickly fade away.
The Fed may also have overestimated the maximum sustainable level of employment in a desire for a more inclusive recovery. It has established an asymmetric, unmeasurable objective that opens it to political pressures and imparts an inherent inflationary
bias to policy. Even among economists, there is declining support for monetary policy
to focus on maintaining low and stable inflation.
A policy framework that put increased emphasis on an unmeasurable goal that incorporates a bias towards expansion, combined with overconfidence in the public’s
belief inflation would remain anchored at 2 percent even as household inflation expectations moved above 4 percent over a year ago, are all uncomfortable reminders of theenvironment that led to the Great Inflation.
The pessimistic view, therefore, must be that all the pieces are in place for a repeatof the 1970s.
Let me conclude, though, by giving the optimistic view. Since December, the
FOMC has consistently signaled that interest rates will rise. The credibility of the
Fed’s 2 percent inflation target still seems suﬃcient to keep long-term inflation expectations anchored. While slow to address the rise in inflation, the power of forward
guidance, combined with near rational expectations and the basic forward-looking nature of households and firms may mean that the late start to addressing the surge ininflation will end up mattering little. Most importantly, there seems to be a recognition
that maintaining the inflation anchor requires action on the part of the central bank andthat the trend rate of inflation is ultimately determined by monetary policy.
Only time will tell whether the advanced economies now facing surging inflation
will see inflation quickly return to target. If not, a costly recession is likely to be necessary to re-establish a low-inflation environment. Ironically, the costs of such a recession
will fall disproportionately on those the Fed had hope would benefit from pursuing amore inclusive expansion.

63

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