For release on delivery
10:15 a.m. EST
February 24, 2023
Discussion of the Paper "Managing Disinflations"
by Stephen G. Cecchetti, Michael E. Feroli, Peter Hooper,
Frederic S. Mishkin, and Kermit L. Schoenholtz
Remarks by
Philip N. Jefferson
Member
Board of Governors of the Federal Reserve System
at the
U.S. Monetary Policy Forum
New York, New York
February 24, 2023
Thank you very much for inviting me to discuss this paper. It is a timely review
for central bankers charged with lowering inflation to targets or, in the terminology of the
authors, managing disinflation. I really enjoyed reading it. Before I begin, let me remind
you that the views I will express today are my own and not necessarily those of the
Federal Open Market Committee (FOMC) or the Federal Reserve System.
My discussion time is limited. Therefore, I'll be selective. I will begin by briefly
describing what the paper is about. Then, I will summarize the authors' takeaways from
their analysis. Next, I will share my takeaways. Finally, I will offer some concluding
remarks.
So what is this paper about? Conceptually, the paper can be divided into three
parts. In the first part, the authors review historical disinflationary episodes in the United
States and other countries to see what lessons we might learn from past experience.
In the second part, the authors present a simple, tractable model that relates
interest rates, inflation, inflation expectations, and slack in the labor market. They use
the model to make predictions about future inflation.
In the third part, the authors provide advice to monetary policymakers on how to
address the current situation; that is, how to manage disinflation.
With that, let me cut to consideration of the authors' takeaways.
The authors' first takeaway, based on past disinflation episodes in the United
States and abroad, is that policymakers should expect that disinflation will be costly in
terms of foregone output or employment. They find that all 16 of the large policy-
induced disinflations in the four advanced economies they study were associated with a
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recession.1 As the paper makes clear, however, a good measure of judgment comes into
the exercise of identifying and quantifying disinflationary episodes. History is replete
with confounding factors that make parsing difficult. These factors include supply
shocks, labor market structure, economic conditions at the start of the disinflationary
episode, how "well anchored" are inflation expectations, and the speed at which a
disinflation is carried out. Even so, the authors are thorough in what they do. And while
one may quibble with bits and pieces, their argument that policymakers should accept
that disinflation is likely to be costly is well reasoned.
The authors' second takeaway from history is that state dependencies or
nonlinearities are also in play. The state dependency they note is that a higher initial
inflation rate is associated with a lower sacrifice ratio. To explain this finding, they
advance an argument based on policy credibility. Specifically, they argue that a high
initial inflation rate enhances the plausibility of central banks' willingness to incur the
cost of reducing inflation. That strikes me as plausible on its face, but there are other
stories that may also apply. In the interest of brevity, let me point out just one. Central
bankers are constantly warning of combatting inflationary shocks before those forces
become embedded in inflation expectations.2 The Volcker disinflation of 1981-82
1
They draw this conclusion by replicating some of the methodology from the literature on sacrifice ratios.
See, for example, Ball (1994) and Tetlow (2022) and references therein.
2
For example, Chair Powell, in testimony before the U.S. Senate, said, "We will use our tools to support
the economy and a strong labor market and to prevent higher inflation from becoming entrenched" (Powell,
2022a). This reasoning has a lengthy history, as evidenced by remarks in 2008 by then Vice Chair of the
Board of Governors of the Federal Reserve System Donald Kohn: "As demonstrated by historical
experiences around the world and in the United States during the 1970s and 1980s, efforts to bring inflation
and inflation expectations back to desirable levels after they have risen appreciably involve costly and
undesirable changes in resource utilization" (Kohn, 2008). And the sentiment is shared internationally, as
remarks by Bank of Canada Governor Tiff Macklem attest: "If we don't do enough [policy tightening],
Canadians will continue to endure the hardship of high inflation. And they will come to expect persistently
high inflation, which will require much higher interest rates and, potentially, a severe recession to control
inflation. Nobody wants that" (Macklem, 2022).
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resulted in a painful recession. But the reduction in inflation was large. Thus, measured
in terms of percentage points of inflation reduction, as is conventionally done, it was not
particularly costly.3 A plausible, if partial, explanation for this finding is that the Volcker
disinflation was carried out before the inflation associated with the second OPEC oil
price shock had become entrenched in inflation expectations and more generally at a time
when inflation expectations were fluid.4 This is relevant as my colleagues on the FOMC
and I strive to bring down actual inflation promptly in order to preserve the "well
anchored" longer-term inflation expectations we see in the data. It is also consistent with
the authors' argument that swift and relatively painless disinflations of the past were due
to early and sharp policy interest rate increases.
The authors' third takeaway from history is that easing monetary policy before the
disinflation is complete, or easing by too much, is costly.5 My reading of this claim is
that while central bankers might entertain hopes that they will directly see a dividend
from early, forceful policy actions, historical experience suggests that they should not
count on such a favorable outcome.
And, finally, they argue that policy needs to look ahead and act preemptively.
While the authors do not present evidence to support this claim, it is an argument with
which policymakers nearly always agree, in principle, but find difficult to execute, in
practice. As I'll discuss in a minute, choosing the appropriate stance of monetary policy,
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in real time, to influence expected future economic conditions is a difficult task in the
best of circumstances. It is all that much more difficult when the economy is
experiencing a once-in-a-century disturbance of worldwide significance.
As you have already heard, the authors outline a very simple model that relates
interest rates, slack in the economy, inflation, and inflation expectations. They use this
model to forecast inflation in the year 2021 and evaluate the model's predictive
performance, employing alternative measures of slack, linear and nonlinear relationships,
and different sample periods. Interestingly, the various measures of slack, and
specifications for slack, make little difference. The models do a little better when you
allow them to see data from the era of high and volatile inflation in the 1960s and '70s
instead of restricting consideration to the Great Moderation period, as empirical tests for
structural breaks would surely have suggested.6 Two key and related reasons for this
improvement are that inflation expectations in the 1960s and 1970s were more persistent
and that the slope of the empirical Phillips curve was steeper than during recent history.
The authors' policy takeaways fall into two classes. First, there are the
conclusions that pertain to the current situation. They suggest that the unusually large
and rapid tightening in policy in 2022 was good policy. In particular, the authors
contend, on page 19, that "the apparent anchoring of long-term [inflation] expectations
may reflect in part the FOMC's unanticipated shift toward aggressive rate hikes." In
addition, despite the rapid tightening to date, the authors contend that additional monetary
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policy tightening is likely to prove necessary to achieve 2 percent inflation by 2025 and is
likely to lead to a mild recession.
Second, there are the more general takeaways. The authors favor aggressive
monetary policy tightening-or preemption-over gradualism. And they argue that the
costs of increasing the target rate of inflation outweigh the benefits because the loss of
credibility from showing a lack of resolve to achieve 2 percent inflation will persist.
Now, let me share my takeaways. First, figure 4.1 in the paper demonstrates that,
standing at the end of 2020, it would have been difficult to forecast the increase in
inflation we observed in 2021 and 2022: The out-of-sample forecasts are far below the
actual. This result stands despite the authors having benefited from knowledge of how
economic forces played out that would not have been available in real time. Here, I
emphasize the unprecedented nature of the pandemic, with its wide-reaching economic
effects and comingling of economic and public health policies. It's just very difficult to
formulate forecasts and implement preemptive monetary policy in real time, especially
under such extraordinary circumstances.
A corollary, of sorts, of this observation is that the idiosyncratic nature of the
pandemic implies that economic models, while still useful in many respects, are going to
have limited applicability. Taken at face value, the model assumes, as all models do, that
the past tells policymakers what they need to know. But current inflation dynamics are
being driven by some pandemic-specific factors not seen in the historical data. It follows
that policymakers need to look at a broader range of factors to understand recent inflation
dynamics.
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Let me illustrate this point by considering three large categories that make up core
personal consumption expenditures inflation. These are core goods inflation, housing
services inflation, and inflation in core services excluding housing. It's useful to look at
these three categories separately because the driving forces behind each differ. Some of
these forces are pandemic specific, and understanding the different causes should help us
predict what will happen to inflation going forward.
Focusing on the price of core goods, the black line in the chart, you can see how
goods prices started climbing in the second half of 2020 and rose sharply in 2021 as the
pandemic-driven disruptions to social interactions induced a rapid shift in demand from
services to goods, exacerbating snags in global supply chains. By the end of 2021, once
vaccines were developed and deployed and people slowly emerged from isolation, the
shift in demand back to services began, and supply chain bottlenecks started to ease.
Thus, inflation in this category came down substantially over the course of 2022. The
strengthening of the overall economy may have played a role in core goods price
inflation, but it was likely secondary to the roles played by goods-specific demand and by
the production and distribution network for goods over this period. In contrast, housing
services inflation, the blue line in the chart, picked up appreciably in 2022 after having
softened early in the pandemic. Inflation in this sector is also driven by certain
pandemic-specific factors. In particular, the surge in work from home led to an abrupt
increase in the demand for bigger homes located in smaller metro areas or further from
city centers. House prices and rents increased significantly. We have not seen a decline
in housing services inflation yet, but recent data on new leases and lease renewals
indicate that we soon will. Lastly, we have inflation in other core services, the red line in
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the graph, a large category that covers activities as varied as travel and recreation, and
medical and legal services. Inflation for these services, most of which are labor
intensive, has remained stubbornly high. An important source of inflation pressures in
this category has likely been the shortage of workers, which has pushed up labor costs at
rates above those consistent with 2 percent inflation. The inflation outlook for this
nonhousing category of core services will likely depend in large part on whether labor
demand moves into better balance with labor supply and growth in nominal labor costs.
Recent data suggest that labor compensation has indeed started to decelerate somewhat
over the past year but is still running too high to be consistent with returning inflation to
2 percent in a timely and sustainable fashion. The point is that the inflationary forces
impinging on the U.S. economy at present represent a complex mixture of temporary and
more long-lasting elements that defy simple, parsimonious explanation.
The ongoing imbalance between the supply and demand for labor, combined with
the large share of labor costs in the services sector, suggests that high inflation may come
down only slowly. The paper notes the role of central bank credibility in managing
disinflations, but I do not attribute the persistence in inflation to a lack of Fed credibility.
Indeed, there is evidence in support of central bank credibility, including that long-term
inflation expectations are not far from the FOMC's 2 percent target.
Let me conclude with a summary of my takeaways.
History is useful, but it can only tell us so much, particularly in situations without
historical precedent.
The current situation is different from past episodes in at least four ways. First,
the pandemic created unprecedented disruptions to global supply chains. Second, the
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pandemic is having a long-lasting effect on labor force participation rates. Third, the
credibility of the central bank is higher now than it was in the 1960s and 1970s. Fourth
and most importantly, unlike in the late 1960s and 1970s, the Federal Reserve is
addressing the outbreak in inflation promptly and forcefully to maintain that credibility
and to preserve the "well anchored" property of long-term inflation expectations.
Finally, economic models are important tools but need to be used with careful
interpretation and judgment when history does not speak to the current situation. Sound
decisionmaking requires that their findings be complemented with additional analytical
tools, including careful scrutiny of real-time data.
Thank you!
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References
Ball, Laurence (1994). "What Determines the Sacrifice Ratio?" in N. Gregory Mankiw, ed.,
Monetary Policy. Chicago: University of Chicago Press, pp. 155-93.
Cecchetti, Stephen G., Michael E. Feroli, Peter Hooper, Frederic S. Mishkin, and Kermit L.
Schoenholtz (2023). "Managing Disinflations," paper presented at the U.S. Monetary
Policy Forum, New York, February 24.
Kohn, Donald (2008). "Lessons for Central Bankers from a Phillips Curve Framework," remarks
given at the Federal Reserve Bank of Boston's 53rd Annual Economic Conference,
Chatham, Mass., June 11,
https://www.federalreserve.gov/newsevents/speech/Kohn20080611a.htm.
Macklem, Tiff (2022). "Opening Statement before the Standing Senate Committee on Banking,
Trade and the Economy," Ottawa, Ontario, November 1,
https://www.bankofcanada.ca/2022/11/opening-statement-011122.
Powell, Jerome H. (2022a). "Nomination Hearing," testimony before the Committee on Banking,
Housing, and Urban Affairs, U.S Senate, Washington, January 11,
https://www.federalreserve.gov/newsevents/testimony/powell20220111a.htm.
--- (2022b). "Monetary Policy and Price Stability," speech delivered at "Reassessing
Constraints on the Economy and Policy," an economic policy symposium sponsored by
the Federal Reserve Bank of Kansas City, Jackson Hole, Wyo., August 26,
https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm.
Sims, Christopher, and Tao Zha (2006). "Were There Regime Switches in U.S. Monetary Policy?"
American Economic Review, vol. 96 (March), pp. 54-81.
Tetlow, Robert J. (2022). "How Large Is the Output Cost of Disinflation?" Finance and Economics
Discussion Series 2022-078. Washington: Board of Governors of the Federal Reserve
System, November, https://doi.org/10.17016/FEDS.2022.079.
Discussion of the Paper
"Managing Disinflations"
Philip N. Jefferson
Governor, Federal Reserve Board
U.S. Monetary Policy Forum, February 24, 2023
Disclaimer: The views I will express today are my own and not necessarily those of the
Federal Open Market Committee (FOMC) or the Federal Reserve System.
Roadmap for the discussion
• Very brief description of what the paper is
about
• Summary of authors' takeaways
•
My takeaways as a policymaker
• Concluding remarks
What the paper is about
• Some history
• Some modeling
• Some policy
Authors' takeaways from historical
evidence
• Policymakers should expect that disinflation will
be costly
• State-dependencies or nonlinearities are in play
•
Easing monetary policy before the disinflation is
complete, or easing by too much, is costly
• Monetary policy needs to be preemptive
Authors' takeaways from the model
• The various measures of slack, and specifications
for slack, make little difference
•
The models do a little better when you allow them
to see data from the era of high and volatile
inflation in the 1960s and '70s instead of restricting
consideration to the Great Moderation period as
empirical tests for structural breaks would surely
have suggested
Authors' takeaways for policy
• Advice for the current situation:
- The unusually large and rapid tightening in policy in 2022 was
good policy
- Even so, additional monetary policy tightening is likely to
prove necessary to achieve 2 percent inflation by 2025
- Achieving a 2 percent inflation target will probably entail at
least a mild recession
• More general advice:
- Preemption is good: "Aggressive" monetary tightening is better
than gradualism
- The costs of increasing the target rate of inflation outweigh the
benefits
• The authors' model shows that standing at the end of
2020, it would have been difficult to forecast the increase
in inflation we observed in 2021 and 2022
• The idiosyncratic nature of the
pandemic implies that economic
models, while still useful in many
respects, are going to have limited
applicability
• For example, current inflation
dynamics are affected by
pandemicspecific factors
• Illustration:
- core goods (the black line)
- housing services (the blue line)
- core services excluding housing
(the red line)
• Current core inflation is more
persistent than most observers
suggest, but this is not due to lack
of credibility in the central bank
• Evidence in support of central
bank credibility is that long-term
inflation expectations are not far
from the FOMC's 2 percent target
Conclusions
• History is useful, but it can only tell us so much,
particularly in situations without historical
precedent
•
The current situation is different from past episodes
in at least 4 ways
• Economic models are important tools, but sound
decision making requires that their findings be
complemented with additional analytical tools