After an outstanding job when Covid-19 hit in early 2020, with the Fed engineering the fastest recovery on record, in the third quarter of 2021 the Fed erred, allowing monetary policy to become overly expansionary.
With hindsight we see that was due to a misunderstanding of the severity and persistence of the shocks that were spun by the health crisis. Initially, the monetary shock from a deep and abrupt fall in velocity (a strong and abrupt increase in the demand for money), dominated the supply shock from lockdowns, supply chain disruptions, oil and food and later, war.
As I´ll show later in pictures, by March 2021, nominal aggregate spending (NGDP) had gone back to it´s pre Covid trend path. At that point, inflation rises because the supply constraint becomes binding. For the next four months, the Fed keeps NGDP evolving “on trend”, so inflation does not rise further.
It is important to point out that, even if the supply constraints were in fact temporary (a temporary upward shift in the short-run aggregate supply curve), the Fed should have kept NGDP on trend. The Fed´s focus, however, was on real activity, and with unemployment still around 5.5% the Fed expanded monetary policy, therefore increasing NGDP.
This was a monetary shock, with both inflation and real output increasing. After October 2021, the Fed “relented”, with trend NGDP easing off. RGDP also came down (motivating the recent “debate” about the economy having entered recession). The inflation trend first eased-off and then reversed. I say the “eagle has landed” because real output came down to its lower trend path (lower “potential”) and has so far remained very close to it).
The analytical “puzzle” is “solved” if we see the supply shock not as a temporary upward shift in the short-run aggregate supply curve, but a longer lasting leftward shift in the long-run aggregate supply curve (a fall in “potential” output).
The charts below illustrate the above discussion.
Note that while “potential” RGDP has dropped, its growth rate has remained the same as the pre pandemic rate (~2%) since the two trend lines have the same slope.
From the discussion above, and the pictures that result, it appears things are moving in the right direction: inflation falling, unemployment remaining low (the latest uptick in the unemployment rate comes from an increase in the labor force participation, a good sign!) and real output “smack” on “potential”.
It is thus unfortunate to see that Powell and the Fed don´t see things that way. This is reflected in Powell´s “pain speech” in Jackson Hole:
Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.
If he acts on his “beliefs”, there will certainly be a lot of pain!
You have a talented gift for macro.