Eric S Rosengren: A look inside a key economic debate - how should monetary policy
respond to price increases driven by supply shocks?
Remarks by Mr Eric S Rosengren, President and Chief Executive Officer of the Federal
Reserve Bank of Boston, to the Massachusetts Chapter of NAIOP, the Commercial Real
Estate Development Association, Boston, 4 May 2011.
* * *
Of course, the views I express today are my own, not necessarily those of my colleagues on the Board of
Governors or the Federal Open Market Committee (the FOMC).
I would like to thank David Begelfer and his colleagues at NAIOP Massachusetts for inviting
me to join you today to discuss the economy and monetary policy.
I am happy that financial markets and the economy have made significant progress since the
depths of the financial crisis, but I am far less happy that the recovery to date has been so
undesirably slow and anemic. In my reading of economic history this is, unfortunately, typical
of economic downturns that are accompanied by severe financial disruptions.
The debate I'd like to focus on today is the one over the likely impact of recent increases in
the prices of food and energy, and how monetary policy should respond. The Fed's policy
stance, as you know, is currently very accommodative - a stance that I believe is appropriate
given the tentative recovery and still-high unemployment. But with food and energy prices
rising, some observers think the Fed should shift its stance to less accommodation - slowing
economic growth now to ensure we don't have undesirably high inflation in the future - even
though current measures of core inflation (that is, inflation omitting volatile food and energy
prices) remain low by historical standards.
As the recovery continues - albeit slowly - several events have occurred that further
complicate the outlook for inflation and real economic activity. Political upheaval in the Middle
East has contributed to sharply higher oil prices. Severe weather has reduced harvests from
Russia to Australia, causing higher prices for many agricultural products. And Japan's tragic
earthquake and tsunami caused not only terrible loss of life, but also disruption to a supply
chain that is increasingly global.
So today I would like to discuss how monetary policy should react when the economy is
buffeted by a series of these so-called "supply shocks." I'd like to just highlight my major
points before getting into the data and analysis that underpin my perspective.
First, I want to explain that while I will be making distinctions in this talk between so-called
all
"core" and overall or total measures of inflation, we at the Federal Reserve look at prices,
including food and energy prices, when developing U.S. monetary policy. While we often use
core measures as a guide to where overall inflation is most likely to go, our goal is to stabilize
overall inflation.
Allow me to preview one of my conclusions. Because my analysis suggests that recent food
and oil price increases have their roots in concerns about wheat harvests in Russia and oil
production in Libya and the like, I do not believe that monetary policy is the appropriate tool
to respond to these disruptions. While many observers see food and energy prices rising and
assume the Fed should tighten policy - raise the cost of money and credit - to head off
inflation, I would suggest taking a step back and recognizing that tighter U.S. monetary policy
will do nothing to stabilize Libyan oil production, reduce uncertainty about political stability in
the rest of the Middle East, or increase the wheat harvest in Russia.
In fact, tightening monetary policy solely in response to contractionary supply shocks would
likely make the impact of the shocks worse for households and businesses. To see why this
is so, it is important to keep in mind how supply shocks affect the economy.1
First, supply shocks can lead to increases in food and energy prices that slow economic
growth. For example, because a person's need to drive may not be very flexible, spending on
gas consumes a bigger portion of their budget. So an oil shock tends to force consumers to
reduce their spending on other goods and services as they absorb higher oil costs.2
Second, while the prices of goods directly affected by the supply disruption increase, other
prices in the marketplace may be unaffected - at least initially. If the supply shock involves
food or energy, this dynamic causes measures of total inflation to rise, but does not have a
large impact on what economists call core inflation - which excludes the volatile food and
other
energy sectors. But in the longer-run, the impact of the supply shock on the prices of
goods will depend importantly on how inflation expectations respond to the shock. If people
expect that food and energy prices will stabilize - in other words, that the price shock will be
temporary - and do not believe that the central bank will allow any long-run effect on
inflation, then the disruption to total inflation will likely be temporary and the total inflation rate
will eventually converge with the lower core inflation rate. Since 1986, this has largely been
what happened when we experienced these types of supply shocks - as I'll illustrate in a
moment with some charts.
Alternatively, if expectations of inflation do rise in response to the supply shock, then
(nominal) wages and salaries across the economy will be pressured to increase over time to
keep pace. If that happens, the supply shock could affect prices throughout the economy -
not just those that that were part of the initial supply shock. In this case, the core rate of
inflation rises to converge with the higher measure of total inflation. This was the U.S.
experience in the 1970s, for reasons I'll discuss in a moment.
We at the Fed need to very closely monitor the data to make sure that inflation remains
contained. And we will. But as I believe I will demonstrate this morning, the most likely result
is that these supply shocks cause slower growth in the near term while having only a modest
effect on longer-term inflation rates - which has been the U.S. experience since 1986.
Unemployment remains quite elevated, at 8.8 percent, and I anticipate a slower return to full
employment than we would have experienced absent these supply shocks. With the core
inflation rate over the prior year at a little above 1 percent, I anticipate only a gradual return
of core and total inflation rates to something like our consensus "stable" rate of about
2 percent, over the medium term.
If the economic data continue to support this outlook then the current, accommodative stance
of monetary policy is appropriate, and can remain in place and continue to support economic
growth - so that we continue to make progress toward our goals of returning to full
employment and a sustainable long-run inflation rate - the two elements of the Federal
Reserve's dual mandate from Congress.
The impact of recent supply shocks
Now that you know my basic take on this key - and current - economic debate, allow me to
flesh out my perspective with the supporting data and analysis. The full impact of the recent
shocks to supply that I mentioned at the outset will likely emerge over time. But clearly there
have been significant increases in a variety of food and energy prices. As Figure 1
illustrates, the recent turmoil in the Middle East has contributed to a significant increase in oil
prices, which have risen to over $100 a barrel. This is well above the average of nearly $80 a
barrel experienced over 2010, but at the same time still well below the peak of $146 a barrel
that occurred in mid July, 2008.
The recent volatility in oil prices, as the chart shows, is quite striking. Sharp increases have
been followed by sharp decreases. This is one reason we may not want to overreact to price
changes - they could be transitory.
Figure 2 shows the movements in oil prices - their percent change from a year earlier, in the
top line - relative to the change in compensation (the lower line), since 2000. Oil prices have
risen recently, but based on the history captured in this chart, one would not expect much of
a response in wages and salaries. This, of course, is one reason why consumers feel worse
off after an oil supply shock. Prices at gas stations in Massachusetts are now around $4.00 a
gallon, yet most people's need to drive cars has not changed much if at all. So income
available for buying other goods and services has been squeezed by the increase in oil
prices.3
Some softness in measures of consumer confidence suggests that consumers tend to be
less confident about the future when oil prices rise. If consumers pull back spending as a
result of a supply shock, it has the potential to be a drag on the economy. The Boston Fed's
statistical modeling suggests that a $20 increase in the price of a barrel of oil will shave
roughly four-tenths of a percentage point off the rate of economic growth over two years, and
cause the unemployment rate to be roughly two-tenths of a percentage point higher than it
would be absent the oil shock. While this is certainly not enough to completely stop the
recovery, it does imply a slowing down of its pace.
Oil is not the only commodity to experience price increases of late. A variety of agricultural
prices have also increased. For example, Figure 3 shows the movement of wheat prices
over the last decade. Droughts in Russia, flooding in Australia, and increased demand in
emerging markets have all placed upward pressure on wheat prices.
As with oil prices, higher food prices appear to be responding to supply and demand features
of this market - and these types of price changes cannot be offset by monetary policy. It
goes without saying that monetary policy cannot alter the supply of oil from volatile parts of
the world, nor weather conditions in countries that are major exporters of agricultural
products. Monetary policy can have a role in insuring that relative price changes do not alter
inflation expectations. Rising inflation expectations could make it difficult to achieve a
moderate and acceptable inflation rate over the medium term.
Historical experience with supply shocks
Supply shocks are not unique to this period. However, the evidence shows that the economic
impact of supply shocks on inflation has changed over time - actually quite dramatically.
Figure 4 shows the inflation rate (total inflation and core, which again excludes food and
energy) since 1970. What is striking is the way the behavior of the two series differed in the
1970 to 1985 period versus the period from 1986 to the present. The interplay of core and
total inflation is very, very different in the more recent period than it was in the former.
I realize that delving into topics like total and core inflation can seem a bit abstract. So let me
bring in something a bit straightforward - energy prices and inflation. Figure 5 shows the
profound effect that energy prices had in the 1970s on core inflation. In the 1970s the lines
move up and down together as core inflation increased with energy prices. That is why my
earlier chart shows core and total inflation moving so closely in that era. But since 1986,
dramatic movements in energy prices have not affected core prices.
My next two figures look at each period separately. Figure 6 shows that for much of that
earlier period, inflation rates were much higher than they are currently. From 1970 to 1985,
inflation was quite volatile - with total inflation (measured by the all-items Consumer Price
Index or CPI) peaking at almost 15 percent, in 1980. The key observation is that during this
period, increases in core inflation tended to follow increases in total inflation (which includes
food and energy). The oil and food price increases "pulled" core inflation.
In contrast, Figure 7 shows the total and core inflation rates since 1986. During this period,
inflation has been lower and less volatile. And unlike in the earlier period, core inflation does
not follow or gravitate to the level of total inflation. Total inflation jumps up and down as food
and energy prices live up to their reputation for volatility. The spikes are tough on
households, to be sure. But importantly, total inflation eventually gravitates to the core
measure that excludes food and energy. Core inflation stays "moored."
Figure 8 represents another way to use the available data to explore this relationship. It too
shows that the increases in total inflation in recent years have generally been temporary. For
each quarter from 1998 to 2010, the figure plots the difference between total inflation and
core inflation at the time, and the total inflation rate two years later. What it shows is that
when there is a supply shock such that total inflation (including food and energy) exceeds
core inflation, two years later total inflation tends to be lower - when supply shocks such as
oil prices drive up total inflation relative to core, the total tends to come back down toward the
core inflation rate.
Figure 9 performs similar analysis but focuses on the future core inflation rate, instead of the
total. It shows no strong relationship. When total and core inflation diverge, core inflation
tends to stay put. In other words, in recent years, when something like an oil shock causes
total inflation to diverge from core, there was no consistent implication for the future core
inflation rate. The shock to total inflation did not become embedded in core inflation.
Why is all this important? If supply shocks tend to have a transitory impact on headline
inflation, and do not pass through to any meaningful extent into core inflation, then monetary
policy need not respond to the price increases caused by the supply shock. Currently, we
have experienced sharply higher food and energy prices. If the relationship we document
over the last 13 years continues, we should expect the impact on inflation to be transitory -
and that total inflation will converge back to core inflation, which remains well below
2 percent.
To digress, it is likely the case that supply shocks have become transitory because of the
way in which monetary policy has tended to respond. So, as long as monetary policy
behaves about as it has in recent years, then there is no reason to expect supply shocks to
have lasting effects.
So is Fed policy behaving as it has since the mid 1980s? Interestingly, although Fed policy is
perceived as exceptionally accommodative, because of hitting the zero lower bound the
federal funds rate is actually higher - has come down less - than would be expected if the
Fed behaved as it has over the last 25 years. The current level of the funds rate suggest that
we have been less accommodative in recent years given that interest-rate reductions (policy
easing) ran into at the zero lower bound.4
Why the different reaction to supply shocks over time?
But how confident should we be that the relationship we have experienced over the past
25 years - little response in medium term inflation rates to supply shocks - will continue?
The answer is rooted in why we are seeing different reactions to supply shocks - in other
words a different interplay of total and core inflation - now versus in the past.
There are a variety of reasons why medium-term inflation has not been significantly
influenced by short-run supply shocks in recent years. In my view the reasons include the
increased role of services in the economy, the importance of labor costs in such an
economy, the reduced share of oil consumption relative to GDP, and as I mentioned earlier
the improved conduct of monetary policy versus the 1960s and 1970s.5
Figure 10 shows that the service sector has grown from a little over 60 percent of private
sector employment in 1970 to a little over 80 percent in 2010. As the economy has come to
emphasize services versus manufacturing, it may be that commodities (and thus their prices)
have become somewhat less important to the production of goods and services. And goods
prices are more volatile than services prices, and more likely to be priced like commodities.
shows the per capita consumption of oil declining in the United States.
Figure 11
Conservation measures by consumers and businesses have made the economy less
dependent on oil than in the 1970s. While oil remains a very important commodity, the trend
towards reducing dependence on oil provides greater insulation from oil-induced supply
shocks.
Figure 12 shows the U.S. share of world oil consumption (in blue) ticking down, but also
clearly shows (in red) the steady climb in the share consumed by three of the so-called
emerging-market economies - China, India, and Brazil. Figure 13 shows the growth in oil
consumption in those three countries, in the upper three lines. Both charts depict quite
strikingly the heightened demand for oil emanating from emerging markets.
Returning to the U.S. and inflation concerns, Figure 14 shows that the growth rate of
employee compensation has generally been declining over the past two decades. With
compensation slowing and productivity increasing, many firms have been profitable and able
to withstand increases in commodity prices without passing such costs on to final prices. This
fits with the observation that higher food and energy prices have not tended to have much of
an impact on prices in situations where food and energy are not direct costs of doing
business.
4
The Fed's Large-Scale Asset Purchases have partly, but not completely, substituted for the constraint
imposed by the zero lower bound on policy easing. With all the excess capacity - a reflection of our inability to
be as accommodative as we might have liked, given the zero bound - it seems unlikely that supply shocks will
turn into increased inflation expectations that will affect wages and non-oil, non-food prices.
5
Vice Chair Yellen notes that "a key lesson from the experience of the late 1960s and 1970s is that the stability
of longer-run inflation expectations cannot be taken for granted. At that time, the Federal Reserve's monetary
policy framework was opaque, its measures of resource utilization were flawed, and its policy actions
generally followed a stop-start pattern that undermined public confidence in the Federal Reserve's
commitment to keep inflation under control. Consequently, longer-term inflation expectations became
unmoored, and nominal wages and prices spiraled upward as workers sought compensation for past price
increases and as firms responded to accelerating labor costs with further increases in prices. That wage-price
spiral was eventually arrested by the Federal Reserve under Chairman Paul Volcker, but only at the cost of a
severe recession in the early 1980s. Since then the Federal Reserve has remained determined to avoid these
mistakes and to keep inflation low and stable."
[http://www.federalreserve.gov/newsevents/speech/yellen20110411a.htm]
shows two measures of inflation expectations, plotted alongside oil price
Figure 15
movements. The red line shows what professional forecasters expected inflation to average
over the next 10 years, at various points in time. Their expectations have declined somewhat
over the past 20 years, but what is striking is the relative stability of their inflation
expectations. In addition, there was no significant reaction to the oil price shock that we
experienced in 2008. The chart also shows a second measure of inflation expectations - the
University of Michigan Survey (the green line), which asks respondents about their
expectations for inflation over the next 5 to 10 years.6 Again these expectations are not very
responsive to movements in oil prices, and have remained quite stable over the past two
decades.
It is worth noting that countries can be affected quite differently by supply shocks. As
Figure 16 shows, the importance of food in the "basket" of goods purchased by consumers
can vary greatly by country. In less developed countries, food is a very significant component
of overall purchases by consumers. In a developed country such as the United States, food
is a much smaller share of overall purchases. Thus the impact of a food-supply shock on the
overall inflation rate and on other important economic variables such as wages and total
imports can vary widely by country. Given the different impacts of supply shocks, it is not
surprising that monetary policy is likely to react differently to a supply shock such as food,
depending on the unique characteristics of the particular country.
Figure 17 shows that in the United States, the importance of food as a component of
inflation measures has been declining over time. And, despite improvements in energy
conservation that have lowered the per capita consumption of oil, higher energy prices have
contributed to recent increases in the importance of energy in the consumer price index. The
fact that food and energy prices have been quite volatile recently, but remain a relatively
small part of the entire basket of goods, helps to explain why core inflation rates have not
been particularly responsive to food and energy shocks.
Concluding observations
In conclusion, I recognize that recent supply shocks have caused pressures on many
household budgets, and have led some analysts and observers to become concerned about
potential long-term inflationary impacts. However, I think the evidence shows that over the
past 25 years most supply shocks have been transitory - and have had no long-lasting
imprint on longer term inflation, or on inflation expectations.
Nonetheless, recent historical trends do not always continue, so it is important to monitor
inflation dynamics very closely to make sure that this pattern is continuing in the incoming
data. In particular, I will look intently at whether there is any evidence that the expectations of
underlying inflation have changed. To date, expectations seem quite stable and show no
evidence of diverging from the recent past. I am committed to responding decisively, and as
forcefully as necessary, to ensure that long-term inflation expectations remain stable and that
food and energy price increases are not passing through to other prices.7
Given the important role of labor costs in a developed, services-focused economy such as
the United States, it is important to closely monitor trends in labor markets. Currently, wages
and salaries are reflecting heightened unemployment, and show no evidence that potential
inflation concerns are placing upward pressure on wages and salaries.
Core inflation rates tend to be a reasonable predictor of inflation in the intermediate term.
Core inflation remains well below my long-run target for inflation. This gives us flexibility to
focus on accommodative monetary policy doing what it can to promote more rapid growth in
the economy. As Figure 18 illustrates, the percent of the adult population that is employed
now is quite low in relation to recent history, and has shown only a slight improvement over
the course of the recovery.
So with significant slack in labor markets, stable inflation expectations, and core inflation well
below our longer run target, there is currently no reason to slow the economy down with
tighter monetary policy. Until we make more progress on both elements of the Federal
Reserve's mandate - employment and inflation - the current, accommodative stance of
monetary policy is appropriate.
Thank you.
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