Policymakers from the Federal Reserve and other central banks are now convened in Jackson Hole, where Jerome Powell’s keynote address is the focal point for investors.
His message last year was short and direct: The Fed’s overarching goal was to bring inflation back to its 2 percent target. This year’s message will likely be more nuanced: At the July FOMC press conference, Powell acknowledged there has been a softening in the labor market and an easing in inflation, but he indicated the Fed is unsure whether wage pressures will keep it elevated.
The Jackson Hole Symposium’s 2023 theme of “Structural Shifts in the Global Economy” is highly relevant considering the Great Recession and the COVID-19 pandemic were global phenomena. In both instances the Federal Reserve pursued similar policies, lowering interest rates to zero and quadrupling the size of its balance sheet. Yet the outcomes were very different: Inflation stayed surprisingly low during the earlier period, but it then spiked to a four-decade high in 2021-2022 before receding this year.
The Federal Reserve’s forecasts — which were close to consensus views — failed to anticipate the sustained low inflation in the first instance and the inflation surge in the second. One reason that inflation has proved so hard to forecast is the economics profession lacks a clear articulation of what causes inflation and what drives inflation expectations.
The Federal Reserve’s econometric model utilizes cost-push factors such as oil prices, import prices and supply-chain disruptions to calculate headline inflation, while a Phillips curve framework — in which inflation is inversely correlated with the unemployment rate — estimates the core rate.
When it became clear that the Fed significantly underestimated 2021’s inflation spike, economists who view inflation from a different lens were quick to point out the shortcomings of its approach. Monetarists contended that it ignored a surge in money supply during that spell, whereas problems in the financial system during the Great Recession limited the increase in money supply. More recently, John Cochrane of the Hoover Institution posited a fiscal theory of inflation that focused on the $5 trillion in government transfer payments that were financed by new Treasury debt as the basis for the inflation surge.
However, a key feature of the Fed’s approach has received less attention: Namely, it does not consider how the dynamic between wages and prices has changed since the 1990s when global markets for goods, services and capital expanded in unprecedented fashion.
The treatment of inflation as predominantly a domestic problem may have made sense following the breakdown of the Bretton Woods system in the 1970s and early 1980s. There was a wide dispersion of inflation rates and interest rates among the Group of Seven (G-7) nations, and key exchange rates varied widely. Subsequently, the principal economic policy development of the 1980s was the increasingly credible commitment of major central banks to anti-inflationary policies, resulting in a steady international convergence of national inflation rates and interest rates. This commitment was reinforced by another major international development in the 1990s — the collapse of the Soviet bloc and the entry of China and India into international markets for goods and services.
Even now, many observers do not fully appreciate how the process of price formation changed. During the high inflation era, U.S. businesses were content to pass along cost increases to their customers. Subsequently, as they faced increased competition from abroad in the first half of the 1980s — when the U.S. dollar was super-strong — U.S. businesses realized they had to streamline costs to survive. One result was the rapid growth of labor-intensive manufacturing outside the United States.
Technological progress — especially in information collection, storage and analysis — also became highly relevant by the mid-1990s. The result was another source of cost reduction and an increased ability to manage operations, increasingly on a global scale. At the same time, price comparisons became much easier for consumers of all sorts.
This combination of powerful new forces reversed pricing dynamics. Instead of costs driving prices, as was the case in more protected markets, the opposite paradigm became more common: Firms in many key industries increasingly became price takers and were forced to manage costs much more actively.
The impact has been evident in several ways. First, as economist James E. Glassman points out, U.S. businesses have been able to establish and sustain profit margins of about 10 percent of national income, up from 6 percent in the second half of the 20th century. This has occurred despite rising interest and wage costs. Second, the share of labor income has stayed under 60 percent of national income, well below the average of 64 percent in the second half of the 20th century, even though unemployment is hovering near a post-war low.
These developments carry important implications for the Federal Reserve. The principal reason it is leaving the door open for further tightening is that officials expect that wage pressures will keep inflation above its 2 percent target for some time. However, recent developments suggest that U.S. wages tend to follow inflation rather than lead it, and sluggish growth abroad points to a weakening of price pressures globally. Consequently, as long as U.S. businesses’ ability to pass on cost increases is constrained, the risk of U.S. inflation failing to recede further is lessened.
Finally, even in the context of increasing trade restrictions and the threat of future market fragmentation, Fed officials are well-advised to be alert to international economic and policy developments. In particular, they should consider the possibility that monetary and fiscal policies in Europe are becoming too restrictive, while China’s economy confronts problems that point to reduced inflation and even risk of deflation.
As for the economics profession, future research should reexamine the process of price formation in a still-highly integrated global economy.
John Lipsky is a senior fellow at the Foreign Policy Institute of Johns Hopkins University’s School of Advanced International Studies. Nicholas Sargen is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business.