Joseph Gagnon on the Trinity of COVID-Era Inflation and the Upcoming Fed Framework Review

Joseph Gagnon is a senior fellow at the Peterson Institute for International Economics, a former senior Fed staffer, and a returning guest to the podcast. Joe rejoins David on Macro Musings to talk about the unholy trinity behind the COVID inflation surge and what history can teach us about the unusual inflation experience of that period. David and Joe also discuss the inflationary lessons from the Korean War, the Fed’s upcoming framework review, and much more.

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Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Joe, welcome back to the program.

Joseph Gagnon: David, it's good to be here.

Beckworth: It's great to have you on. Before we get to this unholy trinity, which sounds very scary— and those are my words, not yours— behind the inflation surge, I want to sit back and maybe take stock of what we've been through the past four years. We had a deep recession, the COVID recession, and then we had this inflation surge, and man, it seems like we're on the other side of that now. Just this past week, we had a really good PCE inflation report. It's almost like mission accomplished. So, let me begin with that. Is it mission accomplished, or was it too soon to declare it?

Gagnon: I don't know if you can ever fully declare it, because there could always be a surprise around the corner. But gee, it seems to me that the Fed has got to be happy with where things are. It's turned out about as well as could have been expected. A couple of years ago, I thought a recession was not inevitable but likely, more likely than not, and we've definitely avoided that.

Beckworth: Yes. I recently put a picture on Twitter of Jay Powell doing a celebratory dance. My producer made it for me in ChatGPT. It was a lot of fun, but I want to be careful that that dance is not premature. So, you recall George W. Bush, on that aircraft carrier, [with] a big banner [saying], "Mission accomplished," and we were there a few more decades after that grand delivery. Yes, so, I want to be cautious, but I also want to recognize what has happened. It's definitely a far better outcome than many anticipated. And so, I want to use that to segue into maybe a brief few moments here on this journey. So, as we talked about before [during] your previous visits, many people did not expect the inflation surge. And I know you are still flabbergasted by that because of the size of the fiscal stimulus. Let's come back to that, but let's talk about, again, this disinflation side. In your view, did many people get it right? Were people as off on the disinflation side as they were on the inflation surge side?

Predicting the Post-Pandemic Inflation Surge

Gagnon: Not as much.

Beckworth: Okay.

Gagnon: So, I think that, on the inflation surge side, almost nobody saw it. But on the inflation-disinflation side, I would say that the profession was very mixed. Some people thought that we would need a big recession to get rid of inflation, and some people thought, no, it's going to go away on its own. I was in the latter camp, and that camp has proved to be right. Now, you, earlier, talked about team transitory and what was the other? Team permanent?

Beckworth: Team permanent, yes.

Gagnon: Team permanent, team transitory. In hindsight, I would judge it as team transitory, except it was a longer transitory than they had expected. So, it's somewhere in between the two.

Beckworth: Okay, but you were surprised on that front end there, on the inflation surge, how many people missed it, and I've confessed many times on this program that I was one who missed it, but you did not. You and some of your colleagues at Peterson, Olivier Blanchard, maybe Larry Summers, a few of you got it right. What's your story for why you got it right and the rest of us got it wrong?

Gagnon: Well, a part of that veers into the unholy trinity. Nobody got it fully right. Nobody. And that's because there were three pieces of this inflation that uniquely merged, and one of which no one could have foreseen unless your name is Vladimir Putin. One of which you could argue should have been seeable, but no one saw it, and that had to do with the unique disruptions of COVID. And one of which I saw, and a few others saw, which was the fiscal expansion and aggregate demand surge, and that is what I have trouble getting my head around. 

Gagnon: I saw one of the three pieces, a few others saw one of the three pieces, but most people saw none of the three pieces. That strikes me as odd, given that textbook macro would have said that when you have a fiscal stimulus on the order of World War II, biggest in peacetime history, and you don't think that that's going to cause at least a little inflation— And I thought it would cause a big boom and unemployment would get down to a two-point-something level and inflation would get up to around four. So, I thought, in the end, okay, fine, that isn't optimal, but it's okay. What I didn't see was the other two pieces, and no one did.

Beckworth: Yes, and no one could have, right?

Gagnon: Yes.

Beckworth: Those were unexpected, but I like your point, though. Even if that scenario had played out as you foresaw it, that still was a better scenario than going through, say, a depression. I mean, what is a true counterfactual here, I guess, is the question, had we not responded as aggressively as we had? And I do think that, in the future, we could respond more precisely, thread that needle. I think it's possible. But what you're saying is that, looking back, when we added that extra $2 trillion, that big second package, the economy was already closing. I believe that the CBO put it somewhere near $600 billion, and we're adding quite a bit more.

Beckworth: I think Larry Summers had the great analogy that you're filling a bathtub up with water, and you're adding so much water that, at some point, it's going to overflow. Something is going to have to deal with this. So, yes, we got it wrong, and I think that if I have to look back at myself, maybe I was still thinking in a zero lower bound framework. I also relied on break-evens, the Treasury market, and you warned me, I believe on this very program, “David, don't trust the bond market," or, "Be very judicious with its use." Maybe that was how you would frame it.

Gagnon: Yes. I think that's right. I did write some blog posts back then about how the bond market is not a good long-run predictor, but it does react quickly. Whenever something new comes along, it can't foresee it, but it does react quickly when it does see it.

Beckworth: So, how do you feel about the bond market now that we're on the other side of this? So, if I look at inflation expectations— these shorter-term ones didn't get it until it was already happening. But medium to longer-term ones, they remained anchored fairly well. So, do you think that, at least, the long end of the expectations were verified or indicated?

Assessing the State of the Bond Market and Inflation Expectations After the Inflation Surge

Gagnon: Yes. So, my reading of this [is that] people talk about expectations, and there are all of these fancy models where expectations can do everything or anything— you can do amazing things. I don't know. I think of expectations as being people's lived experiences and what's in the back of their head or what's normal, and that moves slowly because, really, people often tend to think that maybe something will be different in the next year or two, COVID, whatever, but we'll eventually go back to normal.

Gagnon: It takes a lot to shake that loose, and we have seen it shaken loose in the past in other countries in history, in the US, but it takes a lot, and it takes time. In fact, it was more stable than I would have even predicted. I expected that it would be fairly stable, but it was even more stable. Especially when you look at the long run, say 5 or 10-year-ahead inflation forecasts. Take out that little bit that's in the near term, do a five-year, five-year forward, which is hard to do, but that thing was absolutely a rock. It didn't move a tenth.

Beckworth: It's amazing.

Gagnon: It's amazing. And more, it's almost too good to be true, but the Fed cemented that by talking correctly about what it was doing and what its aims were. And even if most people aren't paying attention to the Fed, some people are, and most people are reading what other people are writing who are paying attention to it, journalists. So, it filters through into the consciousness when you're wondering what the hell is going on and inflation is high, but you're reading the paper, the Fed is fighting it and its goal— And you hear other people say that that's only temporary, and it sinks in. And in the '60s and '70s, people weren't writing that. The Fed wasn't saying that and people weren't reading that inflation was ever going to go back, and they began to think, "Oh, this is the new normal."

Beckworth: Yes, that's a great illustration of how the Fed communicates. I've had people ask me, "Well, I don't wake up in the morning and ask, what's the 2% inflation target doing today? Where are we relative to it?" Or some people have said, "I won't wake up in the morning and look at the latest nominal GDP numbers, David." But you don't have to, right? That's the point, that the public doesn't have to. They just have to see its effect, its impact on the broader economy— job openings, things are going well, prices aren't rising too fast. So, they get to feel the vibes, the whole vibe economy discussion.

Gagnon: It filters through the few people who do follow the Fed. To me, a lot of it is— no, it's not entirely that. A lot of it is that people are just slow to react. But I think, if that was all there was, if people were just slow to react, then there would have been a small increase in that long-run expectation. Some people would have started to worry about it. I can't think of any other explanation for why that was so stable, that the long-run expectations were so stable, except that the Fed's message and actions filtered through so many different ways, so many different observers— journalists, economists, union leaders, business people, and business C-suites, politicians in Congress, all looking at what the Fed is doing and talking about it, and ordinary people getting that message in many different ways that this is not where the Fed is heading. And that was such a uniform message that if you read the papers day after day, you saw it hammered home over and over again. This is not what the Fed is aiming for. The Fed is going to reverse this. The argument was not whether the Fed was going to get there or not. The argument was how costly it would be. It was never about what the Fed would—

Beckworth: That's a good point. At the same time, people have been very vocal about the higher prices, price level. So, it’s an interesting bit of tension there. On one hand, I think you're right. Everyone agreed that we were going to return to 2%. It was communicated and percolated through the public media. At the same time, people are very unhappy that the price level was permanently higher. We've discussed this on the show. There's many reasons or stories we could tell. But let's go back to the credibility point. Don't you think the past work of the Fed also probably played into that? When the Fed said, "Hey, we're going to go back to 2%," it was taken seriously because they'd shown that they were committed to it in the past, right?

Gagnon: Yes, they'd shown that they're committed to it for over 20 years now, going on 30 years. So, that's one thing. But if you had looked back in times in history, there were also times when they had delivered very low inflation for a long time, and then they let go. So, that was part of it, and that's why any move would be slow. On top of that, I do think that communication and actions— I mean, the Fed started acting. It waited probably a few months too long, in my view, but when it acted, it acted very forcefully.

Beckworth: Very aggressively. It surprised everyone. It surprised, for example, the banking sector, which wasn't hedged well enough against interest rate risk. But even the Fed was surprised. The Fed is losing money too, for that matter, on its balance sheet. So, everyone was shocked by how aggressively the Fed had to react, but it did react, which I think is an important signal, as you say. So, one last thing on these few moments that we’re taking stock of this experience— So, I have a colleague now, at Mercatus, Eric Leeper. He's an affiliated scholar. He's real big, as you know, on fiscal theory of the price level. We've talked to John Cochrane and others. And I think that we would all agree that fiscal policy was very stimulative, very supportive, in '21. I think that 2020 was probably just keeping us above water. They would argue that the outlook for fiscal deficits, if anything, has worsened. The primary deficits, going forward, have increased, and I'm wondering what your thoughts are on that, because despite that, we are seeing inflation come down. It seems like we have still defied the laws of the fiscal theory of the price level.

Gagnon: I would agree. I think that, on the way up, it was hard to tell whether this was ordinary Keynesian stimulus or fiscal theory of the price level at work. But I think, on the way down, it has become clear because, if anything, the long-term fiscal outlook has gotten worse than you would have expected, and yet inflation has come down. That is consistent with the Keynesian story, which was that, as some of the stimulus receded and the Fed tightened, that was all you needed. But [with] the fiscal theory of the price level, people would have said, "Ah, no, the long-run fiscal situation is worse, so why is inflation coming down?" I'd like to hear how they explain it.

Beckworth: I want to be fair to my colleague and other guests on this show.

Gagnon: I love Eric. We started at the Fed the same year. We worked together in the same section.

Beckworth: And I think what Eric has said, in several pieces— there was a helicopter drop, which, I think I agree with that. And the fiscal theory would say that there would be a temporary increase in inflation. The price level would be permanently higher. So, it can tell a story for what happened. I think multiple theories can tell a story. What I think it struggles with is, going forward, why do we see inflation dropping down? That's the tough part. Alright, one last thing, Joe, on our discussion here about this journey, this past four years— and we discussed this last time, I believe, that we were together— and that is the fate of R-star, or as some like to call it, the R-star wars. Do we have any better sense of where the equilibrium or natural real interstate is headed? Is it permanently higher, do you think, or is it going to return to the pre-2020 lows?

Gagnon: I think that, in Europe and Japan, it's heading back to pre-2020 lows, or very close to [it]. I think that in the US, because of our runaway fiscal situation, it's not going all the way back. I think that the Fed has started to raise its estimate of R-star, but I think it has a little bit further to go. I think, currently, they're at 2.9, nominal R-star [is] 2.9, so real a R-star of just under 1. I think that maybe that's the low end of my estimate, I think maybe even a little bit more. I think that they might end up— the neutral rate would be between 3 and 3.5 nominal, so 1 and 1.5 real. I think that the US is unique because we have better demographics than Europe and Japan, and we also have a worse fiscal outlook than Europe and Japan. So, that's holding up R-star.

Beckworth: Okay. Well, we'll revisit this in a few years again, Joe, when you come back on for your next episode. Alright, let's move on to the unholy trinity behind the COVID inflation. Let me be very clear, listeners, that those are my words, not Joe's. I'm not talking about the unholy trinity found in the Book of Revelation in the Bible. There is one there, for those who are interested. Here, we're talking about the trinity that's outlined in Joe's new paper titled, *The Trinity of COVID-Era Inflation in G7 Economies.* So, I like this idea of the trinity, and you get into three things. You already touched on them earlier, but before we get to those three things that cause this global phenomenon of inflation in G7 economies, maybe walk us through some of the other research that's been done on this topic that you're building upon and adding to. And there's been several papers that have been trying to explain this. Probably the most famous is your colleague, Olivier Blanchard, with Ben Bernanke. They had a paper in 2023 that looked at the US. Then, they orchestrated a cross-country study with central banks. Maybe walk us through that paper as a way to get into your paper. What are some of the key findings from these studies?

What Caused the U.S. Pandemic-Era Inflation: Breaking Down the Literature

Gagnon: Sure, and these studies— first of all, our results are very consistent with the Bernanke and Blanchard results, as well as the other people who followed in Bernanke and Blanchard's way. We do it a little differently, but what Bernanke and Blanchard did was to try to split up inflation into a labor cost element, and then a non-labor cost element, and an expectations element. What they found, consistent with what we were saying earlier, is that the expectations elements were pretty minor. Short-run expectations, basically, are responding to current inflation and not adding much on their own, and long-run expectations were fairly stable. So, they allowed for that, but it was minor.

Gagnon: Then, what they found is that there was a big shock to the markup of prices over wages. A lot of that was energy, and food and energy related to the Ukraine war, but some of it was also some of the supply chain issues, and so, they looked at that. Then, they said that that shock is receding, but what's lingering was that labor markets have been pretty tight in the US, and they found that in many other— not every, but in many other advanced economies, that's also true, and that has been holding up inflation after the other things are receding. And they were mostly worried about that and whether that would unwind. That's where they left off. All of those results, I think, are very consistent with what Asher and I found.

Beckworth: One of the things in these papers, and you yourself have written about this, is this notion of a non-linear Phillips curve [that] seems to be really popular these past few years in trying to tell these stories.

Gagnon: Yes, it has, and there's been some papers that have pointed that out. Even the Bernanke and Blanchard approach uses a different measure of the unemployment gap, which is the ratio of vacancies to unemployment, so putting unemployment in the denominator. That creates a non-linearity there. So, there's already a non-linearity in their model, which makes the Phillips curve a bit more curved, the way I found it— not as much as I did, but still somewhat. So, it moves in that direction. Other people have also noticed that COVID presents a real problem for those of us who do Phillips curves because, normally, what you have to do is you want the unemployment rate minus the natural rate.

Gagnon: And this is why people who don't like Phillips curves don't like Phillips curves because they say, "The natural rate— how do we know what it is, and [how] it might move?" But I think that a sensible estimate of the natural rate before COVID moved very slowly and in response to institutional and demographic features. And in the US, where institutions are constant, it's very well modeled by the age of the labor force. As the working force ages, the natural rate falls, but it's a very slow process and very stable. And so, Phillips curves work quite well in the US with just that measure of the natural rate.

Gagnon: COVID is the first time in post-war history that the natural rate jumped for reasons unrelated to demographics. Basically, people were afraid to go to work. They couldn't go to work. Schools were closed. They had to stay home with their kids out of school, or [with] sick family members, or they themselves were sick. For all of these reasons, people were not working and being counted as unemployed, which meant that the rate that we could sustain had jumped way up, and it was a very unusual thing. How do you estimate that? There was no good way to estimate that.

Gagnon: What people found was that this ratio of vacancies to unemployment, I think, goes partway, not fully, but partway towards correcting that, because when unemployment went up, vacancies also went up, and so the ratio didn't move as much. And so, it might be a better measure of the excess demand in the labor market. So, that pushed us some way towards dealing with that problem, and I used it, too, in our work. So, anyway, Blanchard and Bernanke were among others— but others, too. Another paper by Larry Ball and Daniel Leigh, and I think maybe that they had some co-authors at the IMF, also used this ratio of vacancy and unemployment and found that it worked better than the simple unemployment rate.

Gagnon: So, that's been a new development since COVID. But my interpretation is that it was needed mainly because of the unique features of the natural rate in COVID, and that was most important in the US. You don't see that as much in Europe and other countries. It was more important in the US. I'm not quite sure why. Schools may have been closed longer in the US, and to get benefits in the US, you had to be unemployed. Whereas in Europe, it was funneled through your company, so you remained technically an employee even if you weren't going to work. Whereas in the US, you had to actually, literally, be registered as unemployed. So, that changed what unemployment was under COVID. So, in terms of translating the data into a Phillips curve, it was the worst in the US.

Beckworth: Yes, a lot of things broke down during the pandemic. I recall that the Laubach-Williams natural rate measure of the interest rate— that it actually was not published, that the New York Fed quit publishing it for a while because it just blew up given what had happened with the Phillips curve. We had Gauti Eggertsson on [the podcast]. He also did this non-linear exercise. So, it’s really strange, but let me maybe step back and try to give my intuitive take on why this non-linearity is important. Essentially, we find ourselves on a part of this Phillips curve [where] we typically aren't there.

Beckworth: It's an extreme place, and it's very non-linear. It's not like it's a sudden spike that changes the direction. And the way, maybe, that I would think about it, as we talked about before— the Phillips curve can be thought of, in an undergraduate textbook, [as] like a short-run aggregate supply curve, and we just happened to have a shock that shifted it back. At the same time, aggregate demand shifted out, and it just placed us way up on the curve part of that short-run aggregate supply curve, and it's something that typically doesn't happen. You don't have these big discontinuous jumps. Is that a reasonable interpretation of this?

Gagnon: I think it's a reasonable interpretation. I think that getting an econometric estimate of that is almost impossible because it's so rare that we're there. What I find— If you think of the curve, the curve, I think, is really a hyperbola. For those of us who don't know or remember what a hyperbola is, it's a line— If you think of the vertical and the horizontal axis, it's a line that approaches the vertical axis. As it gets closer to the vertical axis, it gets ever steeper and steeper, and it almost becomes vertical. But then, as it approaches the horizontal axis, it gets flatter and flatter, ever flatter, almost horizontal. So, it goes from vertical to horizontal. 

Gagnon: We were on the horizontal part, with excess unemployment, for a very long time. You really want to be on that middle part, which has a nice downward slope but is not vertical or horizontal. That's where you want to be. But it's arguable that the COVID boom pushed us onto the steepest vertical part, which is impossible to measure. I've measured the horizontal and a bit of the middle part, but we almost never are on the vertical part. So, that's hard to get an estimate [of], but I think that's reasonable. You don't want to be on either of the extremes. You really want to be in the middle.

Beckworth: In terms of policymaking, right?

Gagnon: Yes.

Beckworth: It gives you more flexibility. Okay, well, let's go into your paper. We've discussed some of the previous research, some of the findings, this non-linear Phillips curve interest in it. The paper, again, is titled, *The Trinity of COVID-Era Inflation in G7 Economies,* and you have this, what I'll call, unholy trinity of factors that led to the outcome that we experienced in terms of the inflation surge, so walk us through it.

*The Trinity of COVID-Era Inflation in G7 Economies*

Gagnon: Sure. So, the thing that we do that's different from the Bernanke-Blanchard approach is that we use PCE inflation, which is what the Fed targets. Then, that can be split up into three components. It can be split up into durable goods, non-durable goods, and services. And so, rather than worry about expectations or labor market wages and all of the stuff that they worry about, we don't do that. We just look at those three components of inflation, and what we assert and find in the data is that each of those components is associated with one of these trinity of shocks.

Gagnon: In particular, the non-durable goods are really associated with the Ukraine war and the commodity shock that we saw. The durable goods are very much associated with the pandemic disruptions and the fact that people switched all of their spending to exercise bikes, and cars, and appliances, and such— that shift into durable goods, which clogged up ports and caused factory backlogs and everything. Then, the third thing, the tight labor markets that Bernanke and Blanchard worry about, shows up in services. And so, each element has its own dynamics and its own shocks. Then, we separate them that way. 

Gagnon: That's the additive value of our paper. Then, we look at the US and other G7 countries, and we find that every country has each of those elements but in differing amounts. In Europe, the commodity price is far bigger than in the US. In the US, the durable goods and the services is bigger. So, we have a commodity shock, too, and it's big, but relative to Europe, we have less of a commodity element, our natural gas market is somewhat cut off from the rest of the world. It's increasingly linked now, but at the time, it was very much, so we had low natural gas prices while they had high natural gas prices. Plus, they had disruptions in supply from Russia, which we didn't have.

Gagnon: So, they had to scramble through very high adjustment costs to get energy elsewhere, which we didn't have. Also, the food hit them worse. The food shocks hit them worse, partly because food is a bigger share of their price basket, and also because they're closer to Russia and Ukraine, and they rely more on those countries. So, for all of these reasons, Europe was hit much more by the non-durable goods, commodity price shock. The US was hit relatively more by the durable goods and the services, and we had a tighter labor market, but they had a tight labor market, too. So, all three shocks were true, were evident in every country, every G7 country, but they varied in different amounts.

Beckworth: Yes, you note that the latter two shocks— the commodity price or non-durable goods shock, and then the tight labor market shock— that those can be captured easily in standard macro models, but the first one cannot. So, one way that I think about this, again, going back to simple supply and demand shocks— the tight labor market reflects positive demand shocks and fiscal policy. The commodity shock is some kind of supply shock. [It’s] easy to wrap our minds around that, but that first shock was like a preference shock, and that's harder to capture in the model. Is that right?

Gagnon: That is right, and that is hard to capture, hard to get data that work well [for]. Bernanke and Blanchard ended up settling on a Google search for the word shortage, and I think that Google allows you to look at the frequency of searches for certain words, and it starts back in 2004, and they assumed it was 0 before 2004, or whatever very low frequency it was around then. Then, in COVID, it spikes and soars. Then, they put that in the regression, that works. Now, the problem with that is— and this is a problem that we had, too— is that it's very hard. We would like a pure supply term, but the worry is that people might perceive a shortage, even when it's demand-driven rather than supply-driven.

Gagnon: And so, we did it a little different. We restricted it to a search for semiconductor shortages. We further limited it from what Blanchard and Bernanke did to try to focus on the semiconductor story, because that was an interesting, and turned out to be a big, part of the story, was that when the COVID recession hit, automakers around the world, not just in the US, but everywhere, canceled orders for semiconductors years ahead, two to three years ahead, because they thought that there was going to be a major recession, and they knew from the past that recessions mean that no one buys cars.

Gagnon: It turned out that this was a unique recession, in which the spending that was cut was not on cars. It was on other things like airfares and restaurants, and people didn't stop buying cars. In fact, they started buying more cars, and it took the automakers almost a whole year to really understand the depth of their mistake. They kept thinking that the slowdown was going to happen, and it didn't. Meanwhile, they're selling more cars than they're producing, and inventories are falling, falling, falling.

Gagnon: Finally, a whole year later, they tried to reinstate the semiconductor orders, but other durable goods producers had already put in their orders, because they were experiencing high demand for washing machines, and exercise bikes, and God knows what. So, there was just this massive explosion of demand for semiconductors at a time when the semiconductor producers themselves had cut back investment because all of these orders fell. So, the semiconductor people and the auto people were basically caught flat-footed.

Gagnon: They were expecting a fall in demand, and they got a rise in demand, and it took time to work their way out of that. That turned out to be surprisingly big, because this is not just in autos, but it was mainly in autos, and autos is an important category, and so that turned out to be the single biggest element. We also looked at something that other people have not looked at, the share of spending on durables versus services, that ratio, and [we] put that in the regression to see, if there's a big swing into durables, are you going to hit bottlenecks or non-linearities? And that is significant, but it's mostly significant in the US and a few other countries, but not every country, and it's most important in the US. And it turned out that this shift into durables was much bigger in the US than everywhere else, and I don't understand, fully, why. So, it explains a noticeable amount of inflation in the US, but very little in other countries.

Beckworth: That's interesting.

Gagnon: It's a bit of a puzzle, yes. But the semiconductor shortage term— that works, again, not everywhere, but in most places, and it's relatively more important.

Beckworth: So, is part of the story, for that unique finding about the US, that people moved from downtown cities to more rural settings or to the suburbs? Was that more of a phenomenon in the US, I wonder, than overseas? Maybe that's part of the story?

Gagnon: It may be, if you think about the more limited ability of that in Japan and Europe, but in Canada, maybe, you would have expected it.

Beckworth: Right. That's fair.

Gagnon: But I don't see it much in Canada, either.

Beckworth: That's interesting. Well, one last question on your paper, here, before we move to your other paper, and that is the question that always comes up in this discussion. What percent is due to poor policy versus shocks that we had no control over? So, it'd be that last shock, the last shock that measures or reflects the tight labor market. So, let's just say that we could have thread that needle more precisely. The Fed tightened sooner. Fiscal policy was just appropriate, just the right amount, no water overflowing the tub, so to speak. How much difference would that have made, do you think? In terms of the overall inflation, is there a percent that you would attribute to that?

Gagnon: That's a tricky question, and we don't address it head-on in the paper, because the worry is that you can't say all of the services inflation is due to this shock, because, to some extent, services inflation is responding to the inflation and the other things.

Beckworth: Yes, bleeding over.

Gagnon: There's a bleeding over of workers trying to catch up with lost real wages. So, I don't have a split, but my gut feeling is a small but noticeable amount. So, if inflation went from two to eight and is now back close to two, [then] that shock, on its own, just the strong demand fiscal stimulus thing, might have only gotten us to three or, at most, four. And I now think that four is pushing it. I think that it would have been something in the threes.

Beckworth: So, that's a victory for team transitory, then. [It’s] mostly a team transitory win, a little bit for team permanent, or as you said earlier, a mix, but with the mix leaning heavily towards team transitory.

Gagnon: I think that these results, and the Bernanke-Blanchard results, are more in the team transitory camp, but not 100%.

Beckworth: Okay. So, your other paper is related to this. Again, [it’s with] the same co-author, Asher Rose. And this is a forthcoming paper as well, but the paper is titled, *Why Did Inflation Rise and Fall So Rapidly? Lessons from the Korean War.* So, what does the Korean War tell us about this experience?

*Why Did Inflation Rise and Fall So Rapidly? Lessons from the Korean War*

Gagnon: Well, I like this paper. It's very short, by the way, readers, if you want a really short paper. I wish that it was available now, and I hope that it will be available soon, but I just don't know when it'll get through our publication process at Peterson. We have rigid quality control and a bit of a backup right now, but it will come out in the fall at some point. Actually, the first thing that I wrote about COVID inflation back in February 2021 was comparing what might happen in the future to the Korean War. And as it unfolded, that analogy really seemed to hold together and still seems to hold together.

Gagnon: And it's interesting to note that, in both inflations, if you look at it since World War II, there was inflation at the end of World War II when they released wage and price controls, and there was a burst of inflation. So, put that aside, because that was pent up from the war. But starting in 1949, when that was over, until the present day, we've had four inflation surges in the US that were noticeable. They were the Korean War, 1950-51, the first oil shock of '73-74, the second oil shock of '79-80, and then COVID. Those are the real big surges in inflation. If you look at our paper graphs, then you can see it. 

Gagnon: Interestingly, the COVID inflation looks very much more like the Korean War inflation than it does like the other two, in the sense that, in both cases, inflation came down rapidly and fully to where it was before it started. In the other two shocks, in the oil shocks, inflation rose and came down, but it didn't come down to where it started. It ratcheted up and ratcheted up, and this is because the Fed did not have a strict inflation target and did not have a goal of returning inflation all the way back. And this is fundamentally different from where we are now. So, in the '50s, the Fed did, and we went back all the way, and it was quick. The other thing is that if you look at unemployment during these inflation bursts, in the two '70s inflation shocks, unemployment rose as inflation came down. In the COVID and the Korean War, unemployment fell as inflation came down, which is pretty amazing.

Beckworth: That's great.

Gagnon: So, we argue, that it's all about monetary credibility, but an interesting substory in all of this is that if you look at the shift of spending onto durable goods, the share of consumption in durable goods, that surged the most in post-war history in, guess what? COVID and the Korean War. In the Korean War, the story is that people remembered wartime rationing, and when the war broke out, when the Korean War broke out, it was only five years later, after the end of World War II, and people remember the rationing. They rushed to the stores to buy anything that they could buy, and they bought non-durable goods, like toilet paper and food, but they mostly bought durable goods.

Gagnon: They wanted toasters and TVs and automobiles, because they remembered that those were the things that were hardest to get in World War II. And so, there was a surge of durable goods inflation [during] the Korean War, just as there was a surge of durable goods inflation [during] COVID, and not in the other two inflation surges. And so, the Korean War surge was actually even shorter-lived than COVID, because the Korean War, interestingly, was financed entirely by taxes. It was probably the only war in US history that was financed entirely by taxes. Harry Truman was very amazingly honest and aggressive and pushed Congress to raise taxes, and they did.

Gagnon: And the deficit, actually, after initially building up a tiny bit in the first months, came down. It was actually lower by the end of the war than [when] it started. It was an amazing thing. And so, the Fed raised rates a little bit, but they didn't have to do much, because it was being entirely taxed away. And when they didn't impose rationing and they did raise taxes, consumer spending on durable goods collapsed within 6 to 12 months after it boomed. And so, the whole inflation surge just went away, melted away, [during] the Korean War. COVID didn't melt away that fast, but it was pretty fast. Instead of 6 to 12 months, it was more like 12 to 24 months, but we are there.

Beckworth: That is so interesting. So, I wonder, if you were to look back at the data— and I'm not sure that the data is available for the Korean War on this, but inflation expectations— one thing that Gauti Eggertsson noted in his study, and we talked about when he was on the podcast, is that if you look at inflation expectations in the 1970s compared to COVID, they really take off during the Great Inflation, as you mentioned, because expectations are becoming unanchored, [and] the Fed is not consistently targeting inflation. There's no credible nominal anchor in the 1970s. There was one during COVID.

Beckworth: And so, as we talked about earlier, you don't see long-term inflation expectations go up. You see short-term ones go up temporarily. But even short-term inflation expectations— they don't rise anywhere near where they did in the 1970s. So, I wonder, if we went back to the 1950s— and I'm not sure there's data available. Maybe the Livingston Survey goes back. They'd probably see something similar to that, because we see this other pattern with durable goods. So, that would be really fascinating to see. And do we have the vacancy to unemployment ratio for that period?

Gagnon: Yes. So, some researchers have extended vacancy rates back, and you can create a V over U ratio. And actually, we run a regression in this paper where we regress inflation on V over U. Initially, the components of PCE prices— we regress inflation on the V over U, and it works pretty well. And I didn't mention one of the most amazing things for statisticians, in our paper, is that we find that the parameters of the model didn't change under COVID, which, when you think about the amazing shock COVID was, one of only four inflation spikes in the post-war period, the parameters of the model don't change at all.

Beckworth: It's remarkable. Yes.

Gagnon: It's remarkable. You regress on the first period, and then you extend it. The parameters don't change. It's amazing.

Beckworth: So, there's so many similarities between the COVID inflation and the Korean War inflation. The parameters are stable. Probably, inflation expectations are very similar.

Gagnon: Oh, inflation expectations, you mentioned it. The Livingston survey started in the '70s. So, it doesn't go back to the '50s. But what does go back are bond yields. If you recall, this is right around the time that the Fed was allowed to stop targeting bond yields— the Fed Treasury Accord. And bond yields did not soar. Even when the Fed was given this freedom and they stopped targeting bond yields and the bond traders knew this and everything, they didn't move. Again, because people just really believed that the Fed wouldn't allow inflation, and they saw that the government was raising taxes, and they saw no need to raise bond yields.

Beckworth: Alright, so, inflation expectations, vacancy over unemployment, all of these things look very similar to the trajectory of inflation itself. So, [these are] two data points now that we can look at.

Gagnon: Oh, and big difference. There is one difference between the Korean War and COVID, and that was commodity prices. You didn't have an equivalent of the Ukraine War commodity price drop in the Korean War that didn't raise global commodity prices. So, that is another reason why the Korean War inflation came down much quicker than the COVID inflation, because the COVID inflation was perpetuated by this sort of--

Beckworth: But at least the part of the COVID inflation, the durable goods part— it maps on very closely. So, there are a few--

Gagnon: Except, again, it's also a bit more persistent, because, again, the tax rise and the lack of rationing really shut down that durable surge. So, it only lasted 6 to 12 months. Whereas in America, the durable surge lasted about 24 months. So, that durable surge was much longer under COVID.

Beckworth: Okay, so, these are both forthcoming papers, and we will let you know when they do come out, but we appreciate you talking about them. Let's transition from these papers into something that is about to unfold at the Federal Reserve, and that is the framework review. Every five years, the Fed meets. It met last in 2019, 2020. It's time again. There'll be a new cycle that's supposed to start sometime later this year, going into next year. So, let's talk about the lessons learned from the COVID inflation, if there are any that are relevant for the framework review. Let's start there. Do you see anything that we've learned and gleaned from how well FAIT held up under the COVID inflation that we should maybe think about when we start this review?

Inflation, FAIT, and the Upcoming Fed Framework Review

Gagnon: Well, I hear people say that the change to the FAIT framework was unfortunate, because it caused the Fed to not tighten early enough in this inflation. I could see the argument for that, because they set themselves some bars to hurdle that were pretty high before they would begin to tighten. But I fundamentally don't think that's the main problem. To me, the main problem was that they just didn't have the right forecasts. They didn't see the effects of the massive fiscal stimulus, which is the thing I told you that I can't get my head around. But they were in good company, because every single private sector forecaster that I'm aware of didn't see it coming. This massive failure to follow textbook macro is--

Beckworth: -Even the bond market didn't get it right.

Gagnon: Even the bond market didn't get it. Nobody got it. I have to say, I'm proud of Peterson because the people I know who were voices in the wilderness saying, “this is going to be inflationary,” were almost all at the Peterson Institute, including my boss, Adam Posen, our vice chairman, Larry Summers, my senior fellow colleague, Olivier Blanchard. So, why are we the only ones that believe? No one else believes in textbook macro anymore?

Beckworth: I guess Adam Posen has a great selling point when he hits the donors up for money. "Hey, we are the only organization, the only think tank that got it right."

Gagnon: We didn't even get it fully right, as I said earlier, but we got part of it right.

Beckworth: Yes.

Gagnon: Seeing what I saw, and given FAIT, I would support the FAIT framework. I think, given the size of the fiscal stimulus, to me, it would have justified saying, "Look, we're now so confident that we're not going to have an undershoot of inflation. We're going to have a bit of an overshoot, and we feel that quite confidently." That, starting in March 2021, I would have started tapering QE. And by June or September of 2021, I would have been raising rates, a full six to nine months ahead of what they actually did.

Beckworth: And you think they could have done that with FAIT, with the framework they have? They just got the forecast wrong.

Gagnon: Yes, because by June of 2021, inflation was already rising. I think it was above two by that point, and you had very strong reason to believe it was going to actually go further above two. And so, you've already had your overshoot, and it was just so big. I think it would have been fully justified within FAIT, given the size of this fiscal package, to say, “We're totally confident that we're going to get a decent overshoot of inflation.”

Beckworth: Okay, well, I've been looking at a lot of the conference proceedings and papers that have been written on the framework review. Let me list a few of the patterns that I see in these reviews. In fact, we have our own coming out, from the Mercatus Center. But something that comes up often in these discussions is the shortfalls from maximum employment. There's two asymmetries that were introduced into FAIT. One was makeup policy only from below 2%. The other was shortfalls from maximum employment, whereas before it was deviation.

Beckworth: It was symmetric around— above or below, and it seems to me that a lot of people put most of the blame, to the extent blame is needed, on the shortfalls from maximum employment. They would say that that's really the weakest link in FAIT, because what it effectively does is it forces the Fed to not look at the labor market as a sign for future inflation. You have to allow labor markets to run hot. You can't, for example, use the Phillips curve fully, because you're tying one hand behind your back because even though you might think the labor market might give you an indication of where inflation is going, you can't use it because you can only look at shortfalls. How would you respond to that concern?

Gagnon: Yes, I get that, and it logically holds together, but I think that the labor market under COVID was so unusual and it was so clear that there were reasons that people weren't working that just never happened before— the school closures and the fear of getting sick and such, and the shift across industries. You're a restaurant waiter— you're going to go suddenly work in an auto factory right away? It's just how quickly people could shift from vastly different jobs, let alone be willing to work. So many issues that it would have justified stepping back and saying, "Well, we just don't know what a shortfall is anymore."

Gagnon: So, again, yes, I could see where you could make that case if you're sticking to— you think it's a 4% NAIRU, and you're not at 4%. But there's so many reasons to think the 4% NAIRU was no longer operative under COVID. It was in the paper every day, things that you'd never seen before about people— again, school closures, fear of getting illness, shutdowns because of workplace infections. To hang on to a traditional 4% or 4.5% full employment target in the face of that is just nonsensical.

Beckworth: So then, this goes back to your original point, getting the forecast right, so, forecast where full employment is, where a hot labor market is. You're saying that even with that language in there, they still could do some preemptive tightening based on where they think labor markets are going, even if it says to respond only to shortfalls. And I think, probably, Joe, where you're going with this, and correct me if I'm wrong, is that you're thinking [about] more normal times— for example, the 20 years leading up to 2020, where some would argue that the Fed probably was a little too tight unintentionally because they got their estimate wrong of this, so, almost like a plucking model, Milton Friedman's plucking model. You want to be careful and prevent that type of world from happening.

Gagnon: Yes, absolutely. And by the way, maybe this is a good segue, as we're getting near the end of the hour. Instead of looking at unemployment, if I looked at nominal spending, that was starting to boom. And not only was it starting to, already, by late 2021, but in early 2021, you had every reason to expect that it would.

Beckworth: Yes, forecasts. You look at forecasts from consensus forecasts, probably by spring, definitely by summertime 2021. It should have been sending red alarms to you. So, we're sitting here, Joe, and we have these nominal GDP targeting mugs, and I just want to ask you, what are your reasons for supporting it? You just mentioned the COVID experience, but in general, why champion it? And I want to be very clear, I don't expect the Fed to go all in on nominal GDP targeting [during] this next framework review, although I would love it if they did. I do think that they could use it as a benchmark or as a framing discussion. So, this is what nominal GDP level targeting can do. Can we move FAIT closer to it? But why should they even consider it in the first place?

Why Should the Fed Consider Nominal GDP Targeting?

Gagnon: There's many reasons. The ones that I like are— simplicity is one number. We know that they have a dual framework. We know that they have a dual mandate, but nominal GDP includes both elements of the mandate. Now, it's true that it does it in a certain fixed way, which, you could make a case is not optimal, but I have never read anyone persuasively explain to me why it's not optimal. What is wrong with the implicit weighting that nominal GDP gives you between output and inflation?

Gagnon: Obviously, the mandate is about employment, but we know that that moves pretty much with output. So, it seems to me that in the absence of some strong reason for having a different weight than is implied by nominal GDP, why not just have the simplicity of it? I think that some nominal spending aggregate like nominal GDP is closest to, it seems to me, what monetary policy ultimately affects in the economy. It affects people's spending. It doesn't really tell you how that spending translates into inflation versus output.

Gagnon: That is determined by other things underlying that monetary policy can't really control. So, it's looking at those things separately [which] then raises the issue of, well, but you can't control them separately, so why not just aim at the one thing you can control, which is total aggregate spending? So, those are the reasons that I like nominal GDP. I wouldn't look at it only, I would look at other things, too, and I would try to forecast it, but it's simple. It's close to what monetary policy affects. I think it can be communicated well, too, and as you've said before, it seems to me that telling people that we want everyone's incomes, overall, to be growing at a constant steady rate, and every year— I might like a slightly higher target than maybe you. I like a 5% nominal GDP target, because I actually think that inflation can be too low and the economy works better with just a little bit more inflation, but not much.

Beckworth: Well, hey, I am all game for a 5% nominal GDP target, especially with the seeming increase in productivity growth, [with] real GDP, potential GDP, maybe [being] a little bit higher than we thought. And part of the appeal to me is that we don't know, and the simplicity— going back to what you mentioned— and the weighting issue. I've had that thrown in my face multiple times. “Well, often, monetary policy might change the weights.” The thing is, we don't know in real time. So, don't try to be God.

Gagnon: And no one's presented a convincing case [for] why a different weight would be important.

Beckworth: Yes. Well, I'll tell you the one that's, I think, the most convincing story. But again, these authors fall back to nominal GDP level targeting. So, Michael Woodford, Gauti Eggertsson— I've mentioned this many times in the program. They say that, usually, the optimal weights would end up being something that they would call an output gap adjusted price level target, which is a mouthful. But they say, "Look, we don't know that in real-time. We don't know precisely where that is.” But what we do know is that a nominal GDP level target is pretty darn close to that, and it's simple. So, just do that.

Beckworth: So, I think that simplicity— I do think [about] the communication issue. Like you said, what do people really care about? Their incomes, their nominal incomes, and put that on a stable path. Probably, the other critique that I get a lot is just the data issue. So, GDP is updated. There's revisions. My response always has been that we'll target the forecast like we talked about in 2021, [and it] gets you pretty close. I suspect that real-time data could be used and maybe more made available. What are your thoughts about that, the whole measurement issue surrounding nominal GDP, or some measure of nominal spending?

Responding to the Measurement Issue Surrounding Nominal GDP

Gagnon: That is a fair point, because I think that, looking at the labor market, looking at most inflation measures, especially CPI— [they] don't get revised much, unlike GDP, which gets revised more. But that may be the single most cogent argument against it, but even so, it may be an argument for an inclusive focus where maybe nominal GDP gets all or most of the weight, but not all of the weight, and you do look at labor market measures directly as well as price measures directly, I don't know.

Gagnon: Also, and one thing that I'm still struggling with, is how much of it should be a level nominal GDP target, which I think was your original view, but some of the stuff that you've done puts a little bit of bygones into that, and I don't think a very short-run nominal GDP growth target is the right thing either, but maybe something in-between, some growth with memory, but not complete memory, so that if there is a major revision to the level of nominal GDP for some statistical reason, we don't suddenly need to change everything to hit that. We kind of look through that to some extent. So, some way of looking through that revisions thing. Honestly, I don't know. I like nominal GDP targeting, David, and I think it's the right focus for monetary policy, but I actually haven't thought of a Taylor rule in terms of nominal GDP.

Beckworth: Well, I appreciate your humility, and I think that that's the key argument for nominal GDP targeting, is that we don't know a lot about the economy, and the best that we can do is try to aim for that thing, nominal demand or nominal incomes, that the Fed ultimately believes it affects over the long run. Of course, the fiscal theory of the price level folks would disagree with us here, but the Fed at least believes that it has control over the nominal size of the economy over the medium to long run, so why not focus on that? And to me, it's also the framing— just rethink things. Don't think about this so much in terms of month-to-month, transitory versus permanent. Think, where is the trajectory of the economy? So, going back to the COVID experience, nominal demand, the dollar size of the economy, fell through the floor in 2020. Something had to be done. So, that's the original CARES Act, the original fiscal support comes up.

Gagnon: Absolutely. The 2020 actions by the Fed and the fiscal policy were exactly right.

Beckworth: Yes, and they returned the dollar size of the economy to where it would have been. Now, we got a little bit above that. That's where the policy could have been done a little bit better, but the point being that if you'd framed it that way, maybe we wouldn't have had all of these conversations about, is it transitory or not? Is it permanent? Focus on that. And we talked about this before. I think that 2008 might have been a little bit different, too. The ECB tightened policy in 2008, 2011. Had it been looking at nominal GDP, it would have done things differently. The Fed was talking about rate hikes from the summer to the fall of 2008, because they saw commodity prices. But forecasts of nominal GDP were falling through the floor. So, I just think that it's a framing that's useful. It simplifies lives. I think it would actually, on some levels, make Jay Powell's life a lot easier.

Gagnon: Yes, that's an excellent point, which is that it really helps you when you're dealing with supply shocks. [There’s] the supply shock that we can't control, but we're keeping this part we can control, nominal spending, on an even keel, and let the chips fall within that. Yes, absolutely. So, that's good. Another thing that you've said in the past, which you didn't mention but I will mention, is, for financial stability, it really is helpful for households and businesses, when they're incurring debt, to know what their future income is going to be, which is really a nominal GDP thing, and it's in nominal terms, because almost all debts in America are in nominal terms. So, it sort of helps with financial stability because it gives people, as much as monetary policy can, some certainty about their future path of income.

Beckworth: Again, the COVID experience. We didn't have a big financial crisis in part because nominal incomes were stabilized by both fiscal and monetary policy. But I like what you said earlier, Joe. If nothing else, use it as a cross-check. You can still look at the labor market indicators, but also use it as a cross-check. And that would be a good first step for me— some small tweak to the framework this year, and then maybe in another five years we can do a little bit more. Again, if Fed officials are listening, all I'm asking is to use it as a benchmark. Maybe make a small step in that direction. You'd make me a very happy camper.

Gagnon: Right, okay.

Beckworth: Well, thank you, Joe. Our time is up today. Our guest has been Joe Gagnon. Thanks, Joe, for coming on the program.

Gagnon: Always a pleasure, David.