Hi Marco: thanks for sharing your thoughts. It is indeed a very good overview of the key issues from a monetary policy perspective. I do see the debate centered around the destination of the policy rate in a scenario in which the economy is in some sort of ideal equilibrium (the most recent label is "equipoise"). You pointed out at the importance of fiscal policy and it is a bit surprising how that is out from the main monetary policy debate in terms of assessing for example its effectiveness. My view is that we are in a different regime, a regime of fiscal primacy. Finally I am a bit skeptical about the IMF paper's analysis. There is a good thread by V. Constancio on X (https://x.com/VMRConstancio/status/1808436550834798746) that provides some concerns on the analysis. Here is also one of the author's reply as well (https://x.com/gprimice/status/1811461250141827173).
Hi Gianluca, thanks, and thanks for the links to the debate on the IMF paper. I find Constancio’s criticism rather weak. He notes that the shocks made input costs and prices go up in sectors where there was no recession – but that is fully consistent with the authors’ argument that expansionary fiscal and monetary policy cushioned the negative impact on growth allowing the price shock to feed into higher inflation. In any case, for the US at least I think there is broad agreement that loose policies contributed to inflation.
I am as surprised as you by the silence on fiscal policy.
Question for you: when you say fiscal primacy, is it the same as fiscal dominance, so in essence the stance of fiscal policy becoming a constraint that conditions what monetary policy can do?
Regarding the paper, one indirect indication of weakness in the identification strategy is the stronger role that demand plays in accounting for inflation in Europe compared to the US (at least based on the version presented in Sintra).
When I mention "fiscal primacy," I am referring to a scenario where the business cycle is primarily influenced by fiscal policy. In the US, I believe a combination of a weak monetary policy transmission mechanism and substantial deficits make fiscal policy more significant in understanding the business cycle. This is the sense in which I refer to fiscal primacy. I plan to explore this further, as I believe understanding the interaction between fiscal and monetary policies is becoming increasingly important. I would be learn more about your thinking on this.
Marco, this is an awesome read, thank you. I should have paid more attention in Econ class clearly! A couple of very basic questions:
1. Why do we celebrate 2 - 2.5% inflation so much? Isn't price the area under the inflation curve? So if something cost $1 3 years ago and we had 5 - 8% inflation for 3 years, it now costs $1.20 ish. Why would we not want "negative inflation" for a couple of years?
2. Cold hearted question about immigration: Let's say we deport x million undocumented immigrants. I would imagine there would be a hit on consumption (deflationary?) and a corresponding lowering of competition in the labor market (inflationary?) Do these balance out? Is one force stronger than the other?
• You are absolutely correct, because what matters is purchasing power, how much goods and services people can buy with their income. Wages have risen, but not as much as prices, so most Americans are poorer today than before this inflation surge. From this perspective, a period of negative inflation, aka deflation would help. But most economists and policymakers are scared of deflation, on the assumption that monetary policy can more easily cure inflation than deflation. And to be fair, if deflation is brought about through a recession, it would likely reduce purchasing power rather than lift it.
• Deflation-phobia has dominated the period after the global financial crisis (post-2008). Personally, I think this phobia is not justified. Japan is the only country to have suffered prolonged deflation, and it was very mild. And Quantitative Easing can very effectively combat deflation (we can talk more about this if you want).
• As a relevant aside: the Fed’s objective is price stability. Prices growing at 2% per year are not stable (when we say we need to stabilize the earth’s temperature we don’t mean keep it growing at x%...). Price stability has been operationally defined at 2% for reasons that in my view are now irrelevant. It’s a longer conversation, but to your point it means there is little to celebrate in inflation above 2%.
• Immigration: a tough one. Straight answer is I really don’t know. My sense is the direct impact on prices through demand would be very small: we’re talking of a relatively small number of people (relative to the US population) with very low disposable income. On wages, economic studies have tended to find that higher immigration does not reduce wages across the economy but might depress wages for some lower-skills jobs. I think the aggregate net effect would be small, but I need to take a closer look at the issue before I say more.
Hope this makes some sense, happy to discuss further. -- Marco
Very interesting read. Thank you for sharing, Marco. I'm curious about your mention of "recklessly loose fiscal policy" in the last paragraph. I agree with your point. While we can all agree that no fiscal system is perfect, and despite being flawed and loose, the American economy continues to outperform others globally. In your opinion, what would be a good, tight fiscal policy that could improve or has improved upon this one?
I know I may have a reputation for being sarcastic (especially in energy discussions), but this is a genuine question from someone curious about a field outside his own.
Thanks Fabio (I breathe in relief at having been spared your cutting sarcasm for once -- though you know I enjoy that too.) Yes, the US economy continues to outperform all others; i would say this is 80% thanks to the fact that the US economy is less regulated, less taxed, more flexible and competitive, and partly because of the above, a lot more innovative; and 20% thanks to good government policies. Policies have been getting worse -- hence my accusations -- which I fear will undermine our performance, if the trend continues. What would be a better fiscal policy? I would suggest:
1. when the economy is growing, a fiscal deficit of about 1-2% of GDP; when a recession hits, let it get larger to help people and the economy at large.
2. avoid general subsidies that foster corruption and undermine work incentives. Think of how much money has been stolen from the pandemic subsidies. Government help should go to those who need it.
3. Invest, and invest well. Government spending should focus on infrastructure (yes, also for green energy...), education, basic research, all things that can improve the country's productivity.
4. reform social security and public health care. They are bankrupt. Social security needs some combination of benefits reductions and higher contributions. Everybody knows they are unsustainable, so might as well fix them.
5. set taxes as low as possible compatible with financing these necessary and productive expenditures. Keep the tax system progressive (if you make more money you pay higher rates) but make it a lot simpler, eliminating the majority of exemptions and special rules. These are almost always just made to benefit some special interest group, and create all sort of distortions. The more complex the tax system, the more decisions by individuals and companies will be aimed at exploiting the rules rather than being guided by what makes economic sense.
6. To keep the deficit low except in recession is just common sense -- on average you can't spend much more than you produce. Whether to set the balance at high taxes and spending, or lower taxes and spending, is ultimately a social decision. In my view, the experience shows that a smaller government with fewer regulations leaves more space for innovation, which creates growth -- the US is the ultimate example.
hope this makes some sense, and as always happy to discuss!
Well argued. The neutral rate has to be conditional on forecasts of the future, especially fiscal policy. It’s interesting that within the FOMC there seems to be such a diversity of views on future US fiscal policy (presumably reflected in the diversity of neutral rate estimates). At the same time, there was one dissenter on the 50 basis points, which is quite unusual for the FOMC.
Very true, though I don't think the diversity of views among the FOMC on future interest rates is just due to different expectations on fiscal policy. So the question is, do their views differ so much because there is very high uncertainty on the economy, or because there is very high uncertainty on what model of the economy one should have in mind? I feel it's more the latter, but as you say, the degree of disagreement within the Fed, at a time when things are going well (they are pretty much on target on their dual mandate, they are not contending with a serious immediate crisis) is very interesting.
Hi Marco: thanks for sharing your thoughts. It is indeed a very good overview of the key issues from a monetary policy perspective. I do see the debate centered around the destination of the policy rate in a scenario in which the economy is in some sort of ideal equilibrium (the most recent label is "equipoise"). You pointed out at the importance of fiscal policy and it is a bit surprising how that is out from the main monetary policy debate in terms of assessing for example its effectiveness. My view is that we are in a different regime, a regime of fiscal primacy. Finally I am a bit skeptical about the IMF paper's analysis. There is a good thread by V. Constancio on X (https://x.com/VMRConstancio/status/1808436550834798746) that provides some concerns on the analysis. Here is also one of the author's reply as well (https://x.com/gprimice/status/1811461250141827173).
Hi Gianluca, thanks, and thanks for the links to the debate on the IMF paper. I find Constancio’s criticism rather weak. He notes that the shocks made input costs and prices go up in sectors where there was no recession – but that is fully consistent with the authors’ argument that expansionary fiscal and monetary policy cushioned the negative impact on growth allowing the price shock to feed into higher inflation. In any case, for the US at least I think there is broad agreement that loose policies contributed to inflation.
I am as surprised as you by the silence on fiscal policy.
Question for you: when you say fiscal primacy, is it the same as fiscal dominance, so in essence the stance of fiscal policy becoming a constraint that conditions what monetary policy can do?
Hi Marco, Thank you for your reply!
Regarding the paper, one indirect indication of weakness in the identification strategy is the stronger role that demand plays in accounting for inflation in Europe compared to the US (at least based on the version presented in Sintra).
When I mention "fiscal primacy," I am referring to a scenario where the business cycle is primarily influenced by fiscal policy. In the US, I believe a combination of a weak monetary policy transmission mechanism and substantial deficits make fiscal policy more significant in understanding the business cycle. This is the sense in which I refer to fiscal primacy. I plan to explore this further, as I believe understanding the interaction between fiscal and monetary policies is becoming increasingly important. I would be learn more about your thinking on this.
Marco, this is an awesome read, thank you. I should have paid more attention in Econ class clearly! A couple of very basic questions:
1. Why do we celebrate 2 - 2.5% inflation so much? Isn't price the area under the inflation curve? So if something cost $1 3 years ago and we had 5 - 8% inflation for 3 years, it now costs $1.20 ish. Why would we not want "negative inflation" for a couple of years?
2. Cold hearted question about immigration: Let's say we deport x million undocumented immigrants. I would imagine there would be a hit on consumption (deflationary?) and a corresponding lowering of competition in the labor market (inflationary?) Do these balance out? Is one force stronger than the other?
Pardon the naivete in advance!
Sanjeev
Thanks Sanjeev, and excellent questions.
• You are absolutely correct, because what matters is purchasing power, how much goods and services people can buy with their income. Wages have risen, but not as much as prices, so most Americans are poorer today than before this inflation surge. From this perspective, a period of negative inflation, aka deflation would help. But most economists and policymakers are scared of deflation, on the assumption that monetary policy can more easily cure inflation than deflation. And to be fair, if deflation is brought about through a recession, it would likely reduce purchasing power rather than lift it.
• Deflation-phobia has dominated the period after the global financial crisis (post-2008). Personally, I think this phobia is not justified. Japan is the only country to have suffered prolonged deflation, and it was very mild. And Quantitative Easing can very effectively combat deflation (we can talk more about this if you want).
• As a relevant aside: the Fed’s objective is price stability. Prices growing at 2% per year are not stable (when we say we need to stabilize the earth’s temperature we don’t mean keep it growing at x%...). Price stability has been operationally defined at 2% for reasons that in my view are now irrelevant. It’s a longer conversation, but to your point it means there is little to celebrate in inflation above 2%.
• Immigration: a tough one. Straight answer is I really don’t know. My sense is the direct impact on prices through demand would be very small: we’re talking of a relatively small number of people (relative to the US population) with very low disposable income. On wages, economic studies have tended to find that higher immigration does not reduce wages across the economy but might depress wages for some lower-skills jobs. I think the aggregate net effect would be small, but I need to take a closer look at the issue before I say more.
Hope this makes some sense, happy to discuss further. -- Marco
Very interesting read. Thank you for sharing, Marco. I'm curious about your mention of "recklessly loose fiscal policy" in the last paragraph. I agree with your point. While we can all agree that no fiscal system is perfect, and despite being flawed and loose, the American economy continues to outperform others globally. In your opinion, what would be a good, tight fiscal policy that could improve or has improved upon this one?
I know I may have a reputation for being sarcastic (especially in energy discussions), but this is a genuine question from someone curious about a field outside his own.
Thanks Fabio (I breathe in relief at having been spared your cutting sarcasm for once -- though you know I enjoy that too.) Yes, the US economy continues to outperform all others; i would say this is 80% thanks to the fact that the US economy is less regulated, less taxed, more flexible and competitive, and partly because of the above, a lot more innovative; and 20% thanks to good government policies. Policies have been getting worse -- hence my accusations -- which I fear will undermine our performance, if the trend continues. What would be a better fiscal policy? I would suggest:
1. when the economy is growing, a fiscal deficit of about 1-2% of GDP; when a recession hits, let it get larger to help people and the economy at large.
2. avoid general subsidies that foster corruption and undermine work incentives. Think of how much money has been stolen from the pandemic subsidies. Government help should go to those who need it.
3. Invest, and invest well. Government spending should focus on infrastructure (yes, also for green energy...), education, basic research, all things that can improve the country's productivity.
4. reform social security and public health care. They are bankrupt. Social security needs some combination of benefits reductions and higher contributions. Everybody knows they are unsustainable, so might as well fix them.
5. set taxes as low as possible compatible with financing these necessary and productive expenditures. Keep the tax system progressive (if you make more money you pay higher rates) but make it a lot simpler, eliminating the majority of exemptions and special rules. These are almost always just made to benefit some special interest group, and create all sort of distortions. The more complex the tax system, the more decisions by individuals and companies will be aimed at exploiting the rules rather than being guided by what makes economic sense.
6. To keep the deficit low except in recession is just common sense -- on average you can't spend much more than you produce. Whether to set the balance at high taxes and spending, or lower taxes and spending, is ultimately a social decision. In my view, the experience shows that a smaller government with fewer regulations leaves more space for innovation, which creates growth -- the US is the ultimate example.
hope this makes some sense, and as always happy to discuss!
Well argued. The neutral rate has to be conditional on forecasts of the future, especially fiscal policy. It’s interesting that within the FOMC there seems to be such a diversity of views on future US fiscal policy (presumably reflected in the diversity of neutral rate estimates). At the same time, there was one dissenter on the 50 basis points, which is quite unusual for the FOMC.
Very true, though I don't think the diversity of views among the FOMC on future interest rates is just due to different expectations on fiscal policy. So the question is, do their views differ so much because there is very high uncertainty on the economy, or because there is very high uncertainty on what model of the economy one should have in mind? I feel it's more the latter, but as you say, the degree of disagreement within the Fed, at a time when things are going well (they are pretty much on target on their dual mandate, they are not contending with a serious immediate crisis) is very interesting.