Yesterday, Janet Yellen surprised markets again, when after weeks of a hawkish setup, she suggested that the Fed is not only uncertain “about when – and how much – inflation will respond to tightening resource utilization”, warning that the federal funds rate may “not have to rise all that much further to get to a neutral policy stance.” The market was delighted by this dovish turn, and sent the DJIA to new all time highs, while global stocks hit fresh record highs.
Now it’s time for day two, with Yellen appearing before the Senate Banking Committee. While the prepared remarks will be identical, in her speech on Wednesday, Yellen said the U.S. economy should continue to expand over next few years and stressed a gradual approach to tightening as central bank monitors inflation. The attention will be on the Q&A.
And, to help the Senate along, here are 3 questions that the Senate should ask Yellen, courtesy of Rafiki Capital’s Steven Englander.
If GDP, unemployment, consumption etc were exactly the same but inflation was stable at 2%, would the US be better or worse off?
Ask 100 people and 95 would say we are better off at 2% inflation, but being able too expand further without hitting output constraints is better than finding that you have topped out on the growth side. Imagine if we had hit 2% inflation when the unemployment rate was 6%, would we or the Fed be high fiving because we hit our targets? Below target inflation is a problem for the Fed in missing its dual mandates but it means that the economy has more room to grow, more jobs to create, more homes to build etc. However, having more room to expand is unambiguously a good thing from the economic viewpoint –with the caveat that if we are using the wrong tools and we generate asset market instability, there is a case to the contrary. But that is different than saying the new millennium would be here if there was 2% inflation rather than 1.5%, but everything else was the same.
2) Are persistently low inflation countries – Germany, Japan, Switzerland, Denmark – worse off than higher inflation countries over the long run
Persistent low inflation in these countries does not look to be doing a lot of damage. Unemployment is low, none of them are anywhere close to recession, most have current account surpluses, GDP per capita is doing no worse than anywhere else. The zero bound is a problem if we fall into a deep recession, but there seemed to be some resilience in these economies to shocks as well. There is a strong case that the zero bound is an issue and that negative rates and QE do not work as well as advertised, but that suggests that low inflation countries must be ready to use fiscal policy near the zero bound when a demand shock hits (not clear you need it if there is a supply shock). The cult of 2% inflation has a lot of adherents, but it is unclear that the number is as canonical as made out to be, or the implications of missing it as bad.
3) Is low inflation that comes from supply shocks as big a threat as low inflation that comes from demand shocks?
You can undershoot inflation because supply-shocks are pushing inflation down and you can undershoot on inflation because demand is going down the tubes. Empirically there is a difference. Demand shocks that lead to recession tend to be acute. The run-up in unemployment, drop in GDP and downward pressure on prices are concentrated and intense. Supply-side shocks can also put downward pressure on inflation, but they don’t necessarily raise unemployment, they almost certainly increase GDP and the price move is much more gradual. The question is whether the economic consequences of such shocks are the same and whether the same macroeconomic response is appropriate.
As Englander says, “these are not meant to be ‘gotcha’ questions. Right now, it seems to be that technological progress is capital saving, and quite possibly is eroding the rents earned by some skilled labor. There also seem to be large economies of scale to growth driven by IT innovation. The implications of low inflation in a world where supply-side shocks dominated may be very different than the implications of low inflation in the world I grew up in – where low inflation meant big demand shocks or policy tightening had hit and policymakers had to figure out to what degree to offset or accommodate such shocks or restimulate.”
Finally, we wonder if there will be another bitcoin moment:
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