For approximately 30 years, Federal Reserve policymakers and other central bankers enjoyed a world in which market interest rates were falling, inflation was low, globalization effectively expanded the supply of labor, and markets for goods and services were becoming more open and stable.
As a result of the COVID-19 pandemic, those trends are now being challenged, if not upended altogether, in an event that may leave policymakers in the dark regarding what to expect in the future.
The U.S. central bank is already adjusting to one unanticipated set of changes – the outbreak of inflation combined with a slowdown in the growth of the labor force. The change in economic dynamics may be just the beginning of a lengthy reckoning, challenging central bankers to keep up and gain a deeper understanding of areas previously outside their jurisdiction, such as the economics of industrial organization and supply chain management.
“Identification becomes something of an art form, Atlanta Fed President Raphael Bostic stated last Friday during a panel at the American Economic Association (AEA) annual meeting. Economists sometimes describe the sorts of changes underway as a new economic “regime,” but “identification becomes something of an art form.”
The first step is to identify the regime change … Next, you need to understand the transition dynamics… and have a clear vision and insight into all of these. Trying to develop a single or unitary view that represents consensus becomes extremely difficult.
According to Bostic, the U.S. labor market has already undergone a significant change for the better, leaving the economy with a labor shortage and a population that makes different choices about work, leisure, and retirement.
However, the structural rift may be much deeper.
As part of the AEA’s agenda in New Orleans, there were discussions about the global economy not only adjusting to the pandemic, but also to new geopolitical risks stemming from Russia’s invasion of Ukraine and China’s uncertain position after the pandemic.
Supply chains built around relatively frictionless global trade may be recast along more expensive lines by manufacturers reluctant to rely as heavily on China or seeking to become more resilient. A global glut of savings and anchored low-interest rates may result in higher debt levels and interest rates in financial markets; another factor contributing to higher prices may be climate change adaptation, whether it is reducing damage or switching to lower-carbon alternative energy sources.
During a panel session at the AEA meeting on Saturday, Kenneth Rogoff, former chief economist at the International Monetary Fund and Harvard University professor, declared that the global economy may be at a turning point. A market calibrated to … Chinese growth and low-interest rates may prove to be fragile.”
A NEW LINE OF RESEARCH
During the past year, major stock and bond indexes experienced unprecedented joint losses, a correlated downturn that challenged portfolio management fundamentals and should have prompted new research on preparing for future crises, Kristin Forbes, a Massachusetts Institute of Technology professor and former member of the Bank of England Monetary Policy Committee, said on the same panel as Rogoff.
In the same way that recessions are typically identified only after they have begun, other economic turning points may not be apparent at the time they occur.
While then-Fed chief Alan Greenspan insisted that a shift to higher productivity was underway in the 1990s, he argued, correctly, that inflation would remain lower than expected and that lower interest rates were needed as a consequence.
A former Federal Reserve Governor Randall Kroszner, however, expressed concern that the profession had missed how changes in the U.S. mortgage market had allowed broader risks to the financial system to accumulate and eventually cause it to collapse.
Kroszner, a professor of economics at the University of Chicago Booth School of Business, told Reuters that policy should be made in real-time. Having a sense of humility and understanding that the models you may use, and the data you rely on, may not be appropriate in the future, is extremely important.
Adaptation by institutions like the Federal Reserve may take some time even when it is evident that changes are underway.
As one example, it has long been suspected that the so-called neutral interest rate – the point at which economic activity is neither constrained nor stimulated – was falling, theoretically allowing the Fed’s policy interest rate to remain low as well.
It was only in 2020, after the recession of 2007-2009, that this accumulated evidence was incorporated into Fed policy under a new approach that was designed to prevent premature interest rate increases.
It happened just in time for another shift in another direction as the Fed now faces a world that, instead of chronic shortages of demand and low inflation, may be characterized by excessive supply and high prices.
For example, the Federal Reserve has begun to throw out new research lines and theoretical frameworks to describe inflation.
Last week, Minneapolis Fed President Neel Kashkari compared recent inflation with surge pricing models used by technology firms such as Uber Technologies (UBER.N). During a panel discussion last week at the American Economic Association, Fed Governor Lisa Cook laid out the preliminary details of an agenda aimed at overhauling how the Fed understands pricing dynamics and how they affect monetary policy.
She suggested using “real-time and other novel indicators” to improve inflation forecasting. There is no such thing as too much data or analysis when the economy is disrupted by a once-in-a-century event.”
There is a growing focus on the supply side of the economy, something that monetary policymakers normally consider a “given” since interest rates are primarily used to encourage or discourage aggregate demand.
A country’s ability to supply goods and services may be beyond policymakers’ immediate control, depending more on factors such as regulatory policy, immigration, or, more fundamentally, the quality of the education system.
The pandemic, however, has demonstrated that policymakers cannot ignore it.
On Monday, Bostic told reporters in Atlanta that supply shocks can persist for quite some time in a way that our conceptual frameworks did not incorporate. As a first step in addressing the emerging economy, “I believe we need to understand how goods are made and how our systems affect this process.”