. . . get a stupid answer.
A recent article on inflation beautifully illustrates the truth of this old maxim. Before getting to the article, let’s review another maxim, this one not at all old:
Never reason from a price change.
Thus, for instance, it would make no sense to ask people about the “welfare costs of inflation”, without first specifying whether the inflation was caused by less supply or more demand. But that doesn’t stop pollsters from asking. Here’s The Economist (from an article entitled “Is Inflation Morally Wrong?”):
Americans who responded to Ms Stantcheva’s surveys were angry for a number of reasons. Most believed that inflation inevitably meant a reduction in real incomes. They said that rising prices made life more unaffordable and prompted them to worry they would not be able to afford the basics. Respondents did not see a trade-off between inflation and unemployment—referred to as the “Phillips curve” by economists—but thought that the two would rise in parallel. Some 70% did not view inflation as a sign of a booming economy, but as an indication of one in a “poor state”.
Notice that all of the public’s beliefs are true if the inflation is generated by an adverse supply shock, and false if generated by a positive demand shock. Now contrast these views with the views of economists:
Why, then, are some economists more relaxed about rising prices? Inflation does present difficulties: it can undermine central-bank credibility and causes arbitrary redistribution from creditors to debtors. The constant updating of prices also carries costs for companies. Yet if all prices are adjusting at the same rate, the change is not as consequential as many workers believe. It no more means that workers are getting poorer than measuring someone’s height in feet rather than centimetres would mean that they are getting shorter. What is more, inflation is often the consequence of a hot labour market
Notice that the perspective of economists is mostly accurate if the inflation is generated by positive demand shocks, but quite misleading if generated by adverse supply shocks.
It’s not so much that the public and economists disagree about inflation; rather they are discussing entirely different concepts. It would be like conflating a decline in coffee prices caused by a caffeine cancer scare, with a decline in prices caused by a bumper crop of coffee beans. The effect on consumer welfare will not be the same!
Consider the following two views, both widely held by many people:
1. The public hates high inflation.
2. We need an independent central bank because politicians are tempted to enact expansionary monetary policies to become more popular.
Do you see the conflict here? The puzzle can be resolved, or at least reduced greatly, if we distinguish between supply and demand side inflation. Clearly the public hates supply side inflation, as it is associated with falling living standards. There are cases where demand side inflation is also somewhat unpopular (like right now), but this case is far more ambiguous. Here are some counterexamples:
1. Between 1929 and 1933, a contractionary monetary policy reduced the cost of living by roughly 25%. And yet President Hoover was highly unpopular.
2. Between the spring of 1933 and the spring of 1934, FDR’s expansionary monetary policy raised the cost of living by about 10% (which is even more than the peak 2022 inflation.) FDR was extremely popular.
3. Between 2008 and 2009, a tight money policy drove inflation sharply lower, to roughly zero. People saw the economy as doing poorly.
All three of these anomalous cases of public opinion moving in the “wrong way” in response to shifts in inflation share one thing in common. In each case, the inflation change was generated by demand side shocks. These reflect the views of economists, as discussed in The Economist article. I’m not suggesting that demand side inflation is always popular (it isn’t), rather that the welfare effects of supply and demand side inflation are vastly different, and the public has at least some ability to sense this difference. For instance, supply side inflation reduces real income, whereas demand side inflation temporarily raises real income (i.e. real GDP.)
Many people at the Fed think NGDP targeting is a bad idea. One argument you often hear is that the public understands inflation targeting, but doesn’t understand NGDP targeting. Nothing could be further from the truth. NGDP targeting is far easier to explain to the public.
Any Fed official suffering from the delusion that the public “understands” the Fed’s inflation targeting policy should go to a town meeting, and explain that when inflation falls to 1%, the Fed works hard to raise inflation back up to 2% (or even 3%, as with FAIT). Check out the incredulous looks on their faces. Yes, some of the public has vaguely heard about the Fed’s 2% target, but they assumed that meant the Fed was trying to make sure inflation did not exceed that level. Not one in a hundred understands the true nature of inflation targeting, which is a policy that assumes 2% inflation is actually a good thing, and that when inflation falls below that the level it is necessary to make the cost of living go up even faster.
You might argue that NGDP suffers from the opposite asymmetry, that the public doesn’t understand why excessively high NGDP growth would be a bad thing. Actually, the asymmetry with NGDP is much less of a problem. It takes a PhD in economics to truly understand why higher inflation can reduce unemployment. (And sometimes even that isn’t enough—see reasoning from a price change.) On the other hand, if you tell average people that very rapid growth in the public’s incomes might lead to the problem of high inflation, they’ll sort of understand.
The Fed needs to tell the public that monetary policy is not about interest rates, it’s not about inflation, and it’s not about unemployment. Monetary policy is about keeping national income growing at 4%/year. Full stop.
READER COMMENTS
Richard W Fulmer
Jun 21 2024 at 3:06pm
This seems to me to be treating a possible result of inflation as a cause of inflation. How can there be a general rise in wages without an increase in the money supply? If there can’t, then the action leading to high inflation isn’t the very rapid growth in the public’s incomes, it’s the additional currency that was introduced into circulation.
Moreover, as new money flows into an economy, won’t higher wages lag price increases? Finally, isn’t the increase in employment caused by the introduction of new money only temporary? If nothing else, it will almost certainly disappear as soon as the central bank puts the brakes back on, as it inevitably will.
Scott Sumner
Jun 22 2024 at 11:34am
Yes, I agree with all that. I’m not saying NGDP growth causes the inflation, rather that a monetary policy that generates fast NGDP growth will generate inflation. That’s why a 4% target is good. I think the public can understand that concept.
Thomas L Hutcheson
Jun 22 2024 at 10:24pm
So “NGDP targeting” is a subterfuge for inflation targeting so the Fed does not have to say out loud that it sometimes needs to crank inflation up above “target?”
Scott Sumner
Jun 23 2024 at 11:07pm
No, it’s the best policy. Make-up inflation (or disinflation) is simply one implication. Under NGDPLT, inflation during the 2020s would have been far lower, close to 2%.
Thomas L Hutcheson
Jun 25 2024 at 11:56am
I’ve hear that said before, but have never seen a head to head analysis of why FNGDPLT (or ~F) is better than FAIT, so I remain in a superposition of belief. I had hoped to find that in “Alternative Approaches …” but did not.
BK
Jun 21 2024 at 6:15pm
I’m surprised this analysis (and the economists interviewed) missed out on the importance of the distributional impacts of inflation. It’s all well and good to say “demand side inflation should benefit consumer welfare” (albeit temporarily), but this ig orws the fact that prices *don’t* rise uniformly at exactly the time the new money is entering the system, different wage contracts, fixed price agreements, etc. will all need to work through in the short term, which means that some will be harmed by the increased money supply, while others will be helped by it. Possibly the most obvious example is the Cantillon effect that Milei spoke to in his campaigning, where the government gets the benefit of each inflationary dollar they spend, because they get to spend it before the rest of the economy has a chance to adjust to it.
I do find it interesting that Scott thinks that people wouldn’t understand the central bank pushing for higher inflation. I remember “inflation is too low!” being a very common point of discussion from 2016-2020, but maybe that’s reflective of my informational environment being outside the public norm. This was from mainstream outlets like the Financial Review, etc. so not too far from the general populace.
Don Geddis
Jun 21 2024 at 7:32pm
When inflation is stable, prices adjust to expectations, and there are no important distributional effects.
There are no important Cantillon effects either. You misunderstand how monetary policy works. You talk about “the government” getting “the benefit of each inflationary dollar they spend … before the rest of the economy.” But expansionary monetary policy does not work by increasing fiscal spending with new money. The central bank does not fund the fiscal budget. (The Fed expands the money supply via Open Market Operations, not via fiscal expenditures.) Pure monetary policy (in the ideal world) has no fiscal effects at all. So the government does not, in fact, get the benefit from inflation that you imagine.
Matthias
Jun 22 2024 at 6:06am
Yes, any Cantillon effect requires that people are idiots, especially for expected inflation.
The whole discussion reminds me of the theory of the business cycle often advanced by ‘Internet Austrians’, where low interest rates reliably lead to overinvestment and then a slump, but not entrepreneur ever seems to anticipate this allegedly very predictable cycle.
Richard W Fulmer
Jun 22 2024 at 7:12pm
Predicting the end of a boom is easy because they always end. But timing the end is more difficult. While many people correctly foresaw that the housing boom would eventually end, few were able to pinpoint the date. Some did, though, and they made a fortune by selling short.
That said, booms typically end soon after the Fed “takes away the punchbowl.” Still, when the boom is in full swing, it’s hard to resist dipping into the punch. Moreover, young investors who had never been through a downturn (and there were plenty of those before 2007-2008) had yet to learn history’s lessons.
BK
Jun 22 2024 at 6:56am
“The government” was an basic gesture towards the example of the Cantillon effect, not necessarily how it is playing out in the current economic environment via the Fed. I’m talking about the distributional impacts of where the marginal dollar is expanding in the money supply. Those with access to draw on new credit benefit more than those who don’t. I don’t think it’s controversial to say that debtors benefit in an inflationary environment? (More precisely: in an environment where inflation is increasing beyond the expectations baked into the interest rate than when they drew on credit).
A different thought occured to me pondering this article later in the day, which is that the general populace doesn’t like inflation even if it is reflective of an environment with a lower unemployment rate. The harms are on the general populace, whereas the benefits are concentrated in the marginal workers who wouldn’t have been employed otherwise. What proportion of the populace would this actually represent? Maybe 1-2%? Not to mention the ability of that 1-2% to attribute their employment to the “excess heat” in the economy is going to be basically impossible. No suprise that “most people” are annoyed despite “better” conditions.
Scott Sumner
Jun 22 2024 at 11:37am
“I don’t think it’s controversial to say that debtors benefit in an inflationary environment?”
This is true. But the Cantillon effect discussion is often confusing. People speak of “who gets the money first”, as if that’s important. Well, when the Fed injects money into the economy, it is creditors that get the money first (i.e. bondholders), not debtors.
Don Geddis
Jun 22 2024 at 12:49pm
If you were to try to be more precise about Cantillon effects, you would likely find that you are unable to locate any actual evidence of them. That model of inflation is simply not how inflation actually works.
As for debtors benefiting from inflation, even you realize that you are blurring the lines between stable inflation, vs. unexpectedly increasing inflation. They are very, very different things. You should take more care to keep them separate, when you do economic analysis. Most of the complaints that people have about unexpectedly high inflation do not actually apply to stable expected inflation.
I agree with your intuition that most workers are not the marginal worker newly employed by lower unemployment. That said, there is more economic benefit than just the lone individual getting a job. They not only earn a living, but they (in general) produce more value to the economy than they cost, thus raising total productive output. And of course they in turn spend their income on other goods and services. Mortgages and debts get paid, bankruptcies avoided. (One might even speculate that avoiding unwanted idleness could lower crime rates.) An employed person has a positive impact on the economy (and on the other citizens) far in excess of their personal selfish benefit.
Scott Sumner
Jun 21 2024 at 10:22pm
“but maybe that’s reflective of my informational environment being outside the public norm. This was from mainstream outlets like the Financial Review, etc. so not too far from the general populace.”
You are way outside the public norm, more like the top 1% in terms of being well informed on monetary policy.
As far as Cantillon effects, I wouldn’t go quite as far as Don Geddis in the comment above, but the effects are very small.
Jeff
Jun 23 2024 at 11:14am
I don’t read Financial Review but I do recall the talk of inflation being too low. However, at the same time, it was also obvious that the discrepancy was trivial, on the order of tenths of a percent, and that there was also no apparent effect on the health of the labor market. One could just as easily have concluded that the 2% target was needlessly high. In addition, most of the justifications for wanting higher inflation (e.g. nominal wage rigidity) seemed (and still seems) to be largely academic and unconvincing, especially relative to the amount of actual wealth transfer these stories were carrying water for over those years in the form of asset inflation and lower tax receipts enabled by seignorage.
So, I think it was genuinely surprising to many people in 2020 that so many policymakers seemed to be grasping for any excuse to provide even more monetary expansion. The unemployment story was an obvious ill fit. Everyone knows that there are lots of waiters and bartenders, so if the government orders all bars and restaurants closed then many people will be ipso facto out of a job until the order is lifted. It doesn’t indicate any permanent increase in the demand for money. And if loose money was supposed to enable wealth redistribution it seems like a crazy way to accomplish that. Poor people were supposed to know that while the government was telling them to stay home and mask they were *really* supposed to be out shopping for real estate? Seems ridiculous.
Scott Sumner
Jun 23 2024 at 1:37pm
Two points:
We should not discuss monetary policy in terms of inflation. But if people insist on doing so, then yes, the economy needed more inflation in the early and mid-2010s, and again in 2020.
The real issue is NGDP, not inflation. Talking about inflation is just reasoning from a price change.
Andrew_FL
Jun 22 2024 at 11:46am
Actually people are correct that inflation reduces their real income in the demand side inflation case because in the real world nobody renegotiates their wage rate with their employer every month
Scott Sumner
Jun 22 2024 at 12:35pm
Real hourly wages grew a lot during the deflationary period between 1929 and 1931. Do you think people felt better off? (Average real incomes fell sharply during this period.) Don’t conflate wages and income, they are radically different concepts.
Andrew_FL
Jun 22 2024 at 2:26pm
Your error is mistaking aggregates for individuals. The path of individuals real income can diverge drastically from average real incomes. The job losers in the depression saw their wage income drop to zero. People who kept their jobs saw large increases in their real wage income. Anyone who both kept their job and earned overwhelmingly wage income absolutely saw their real income increase during the depression. People who earned other forms of income as a significant part of their total income also saw their total real income fall. “Obviously no one’s real income increased during the depression” is wrong.
Scott Sumner
Jun 23 2024 at 11:10pm
“Obviously no one’s real income increased during the depression” is wrong.”
And obviously no one suggested any such thing.
“Your error is mistaking aggregates for individuals.”
No, I did not make that error, obviously. I spoke of averages.
Richard W Fulmer
Jun 22 2024 at 7:21pm
The following is my attempt to translate your statement into the vernacular:
Andrew_FL
Jun 23 2024 at 2:16pm
People lost business income as well.
In aggregate terms BEA divides personal income into compensation (wages and salaries + supplements), proprietor’s income, rental income, interest income, dividend income, and transfer payments. We can reasonably infer that most people saw all other forms of income except transfers decrease 1929-1933. But compensation was 60% of total personal income in 1929, so even on average it is the largest component of income, and you can be sure that for many people it was much more than 60% of their income.
steve
Jun 22 2024 at 12:14pm
I think people will still have some trouble accepting NGDP. They already dont seem to be able to grasp the idea that it’s not just prices increasing but also whether or not incomes are rising. What they really want is magic. Incomes should increase all the time but prices never change. People dont have an understanding on these issues based upon reading economists or listening to them. They have developed their opinions by listening to their political leaders and the thought leaders of their preferred tribe who almost never achieve their positions based upon an understanding of economics and a willingness to tell people the truth.
Steve
Scott Sumner
Jun 22 2024 at 12:38pm
“I think people will still have some trouble accepting NGDP.”
This really doesn’t matter, as almost no one pays any attention to monetary policy. When people ask me what I do, I say that I study monetary policy. Hardly anyone I speak to even knows what that means–even those with a college education. They ask questions like, “Do you mean government spending?”
marcus nunes
Jun 22 2024 at 4:08pm
Even a “big name” like Olivier Blanchard has no inkling that throughout his interview he is “reasoning from a price change”!
(100) It is important to understand the “nature of the beast” (substack.com)
Jim Glass
Jun 22 2024 at 6:53pm
Employee Compensation Index and Personal Consumption Expenditures Index, five years through Q1 2024, via FRED:
Employee compensation + 20.5%; Personal expenditures + 19.1%
Everybody intuits that each dollar of increased price they pay is a cost to them. Nobody intuits that it is a matching increase of income to someone else. And vice versa.
Jim Glass
Jun 22 2024 at 7:14pm
Yes. Perhaps to make the differences between the two clearer in everybody’s mind the econ profession should come up with a simple, catchy slogan or mantra. Your “Never reason from a price change” is a fine example and catching on. Something like that. Maybe even adopt a clear *definition* of “inflation” to distinguish it from mere “price changes”. If there are two entirely different concepts there should be two names. Else, how is one name for two different concepts not going to confuse the public, plus economists and even the Fed itself?
“Inflation is a fall in price — of money against everything. Real price increases are in items against each other. Completely different!”. That’s not catchy at all, and doesn’t express the real effects — but the Fed ought to be able to hire a PR team to come up with something. Maybe a limerick?
If it’s catchy enough the Fed could even sing it *to itself* to avoid repeating performances like in 2008: A recession started in December 2007, under the weight of the price of oil more than doubling in the 12 months to mid-year to $233/barrel (today’s money). Nevertheless, the Fed cited inflation risk resulting from the rising price of energy in deciding to hold interest rates unchanged in June, August and September — as the economy plunged into deflation, and we know the rest.
Perhaps if the Fed had had a mantra to recite to itself, it would have remembered that a hugely rising price of energy price like that is deflationary — and some of the public would have understood as well.
spencer
Jun 23 2024 at 11:08am
You don’t know what monetary policy is. Banks don’t lend deposits. Deposits are the result of lending. So, all monetary savings are lost to both consumption and investment. Case closed.
spencer
Jun 23 2024 at 11:10am
Inflation is the Ill-defined economic bogeyman. There is no such thing as the “wage-price spiral”; the “price-wage spiral”; or the “cost-push spiral”; in the sense that increases in wages, prices, or costs are causes of inflation.
Unless effective demands (money times transactions’ velocity) are adequate to prevent a cutback in sales, or a diversion of purchasing power to the price raisers, any administered increase in prices will result in less sales, smaller outputs, less employment, lower payrolls and less demand for products—in other words, depression and deflation in due course.
spencer
Jun 23 2024 at 11:11am
Asset valuation prices are driven from the appraisal of loan collateral, in this case Reserve Bank credit, which depends upon Gresham’s law: “a statement of the least cost “principle of substitution” as applied to money: that a commodity (or service) will be devoted to those uses which are the most profitable (most widely viewed as promising), that a statement of the principle of substitution: “the bad money drives out good”.
spencer
Jun 23 2024 at 12:57pm
Monetary policy objectives should be formulated in terms of desired rates-of-change, RoC’s, in monetary flows, M*Vt [volume X’s velocity], relative to RoC’s in R-gDp.
-Michel de Nostradame
Thomas L Hutcheson
Jun 25 2024 at 12:04pm
I disagree. Policy should target outcome variables of interest to “outsiders,” inflation/PL or NGDP/NGDP dot.
Travis Allison
Jun 23 2024 at 1:28pm
Scott, would you say that demand side inflation is necessary to reduce real hourly wages for people who lose their jobs so that those who are unemployed can get hired again more easily? If that’s the case, then people who have jobs (and so long as their hours aren’t cut due to economic stress) will dislike demand side inflation because they will need to ask for a higher wage to keep up with rising prices. Their wages are lagging inflation. Since the number of people with jobs is usually much greater than the number of people without jobs, demand side inflation should be in general unpopular. Add the fact that some of the people with jobs won’t realize that they have a job because of the demand side inflation. All that anyone sees is a decline in individual income due to demand side inflation.
The GD was different because of the high rate of unemployment and perhaps hours worked were also cut. So in the GD a large percentage of people could benefit from demand side inflation. In the pandemic recession, a large percentage of people still felt so comfortable that they went on a massive capital expenditure spree (home buying and upgrades). So for those people, both the supply side inflation and the demand side inflation were very unpopular.
Scott Sumner
Jun 23 2024 at 1:44pm
You forget that many people with jobs also own stock. During 2008-09, only a small percentage of Americans lost their jobs. Inflation fell to zero. And yet polls show people were upset about the economy, partly because their income from capital fell sharply.
In any case, it’s just dumb to talk about the public’s views on inflation. The public doesn’t have coherent views on inflation. What the public wants is a healthy economy—which you get by targeting NGDP growth at 4%. Then just forget about inflation—it doesn’t matter once NGDP growth stabilizes along a 4% trend line.
Travis Allison
Jun 25 2024 at 1:15pm
I 100% agree with your last point.
Would you agree with the first sentence of my question: “demand side inflation is necessary to reduce real hourly wages for people who lose their jobs so that those who are unemployed can get hired again more easily”?
Thomas L Hutcheson
Jun 25 2024 at 12:01pm
“which means that some will be harmed by the increased money supply, while others will be helped by it.”
Correct. Bank if the central bank increases inflation only by enough to facilitate adjustment in relative prices (given that some prices like real estate leases and wages are downwardly sticky), more will be helped than harmed.
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