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Key Takeaways

• With inflation on the rise, the Fed is making some puzzling policy decisions.

• Real rates are projected to move into negative territory. That means American families will be less likely to save and more inclined to borrow.

• But further stimulus isn’t needed while the economy is running so hot.

• The big question over the next weeks will be whether the Fed will lose its reputation as an inflation fighter, especially if there are signs that inflation pressures may be more persistent.

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Hey, Mr. President
All your congressmen too
You got me frustrated
And I don't know what to do
I'm trying to make a living
I can't save a cent
It takes all of my money
Just to eat and pay my rent
I got the blues
Got those inflation blues¹

When legendary blues musician B.B. King recorded those lyrics in 1983, he was holding a mirror to the American economy. Unemployment had peaked at about 11 percent just a year earlier, and inflation had soared to more than 14 percent at the dawn of the decade. Now 40 years after its vinyl debut, King’s “Inflation Blues” is threatening an encore.

At the most recent meeting of the Federal Open Market Committee (FOMC) on March 16, the Federal Reserve Bank announced its decision to raise its target for the federal funds rate from essentially zero to 0.25 percent. The current inflation rate for personal consumption expenditures (PCE) is much higher than the federal funds rate. The latest numbers from February are 6.4 percent for PCE inflation and 5.4 percent core inflation (excluding food and energy). By keeping the fed funds rate so low relative to inflation, the Fed drove the real short rate — the difference between the fed funds rate and core inflation — to negative territory. The real rate measures the return on savings adjusted for inflation. When the real rate is negative, the incentive to save is extremely low while borrowing and — in turn — investment are encouraged.

How low the Fed believes the real rate to be over the next years can be read off Table 1, which contains the most important data from the Summary of Economic Projections (SEP) that the Fed also released on March 16. The SEP contains what FOMC meeting participants believe are the most likely outcomes for real gross domestic product (GDP) growth, the unemployment rate, and inflation for each year from 2022 to 2024 and over the longer run.

These projections imply that the Fed expects the real rate at the end of 2022 to be −2.2 percent, the projected difference between the fed funds rate, 1.9 percent, and core inflation, 4.1 percent. For the years 2023 and 2024, the Fed expects the real rate to be 0.2 percent and 0.5 percent, respectively. Over the longer run, the Fed estimates a 0.4 percent real short rate.

Table 1. SEP Median Forecasts

The long-run real rate is of central importance for many questions we have about the economy. For example, whether or not households are saving enough for retirement crucially depends on the real rate of return on their savings. Until a decade ago, the long-run real rate was around 2.25 percent. At that rate, household savings of $1,000 would double to $2,100 in real terms over a period of three decades. If, however, the long-run real rate is only 0.4 percent, as estimated by the Fed (see Table 1), $1,000 of savings will stay roughly unchanged in real terms after three decades. That is a big difference for households that are saving for retirement.

A Jan. 13, 2021, speech by Richard H. Clarida, who stepped down as the Fed’s vice chair earlier this year, explained that a long-term real rate of 0.5 percent is indeed what we now should expect in a normal environment with inflation at the 2 percent target and the economy growing at trend.^[2]

There are many reasons for this big decline in the neutral real rate, or r-star, over the last decade in many industrialized countries.^[3] These advanced economies have experienced a dramatic slowdown in trend real GDP growth. Lower growth rates are associated with a reduced need for savings to fund investment and thus a lower r-star. The slowdown in growth can be attributed to an aging workforce as well as lower productivity growth.

The Fed is slow to fight inflation pressures

Fed officials spent weeks giving several speeches preparing the public for a liftoff in interest rates after a long time keeping rates at zero. Financial markets expected the 0.25 percent increase in the fed funds rate and now expect further gradual increases over the next year.

But the Fed’s announcement is puzzling. Negative real rates stimulate the economy because borrowing is cheap, which encourages investment. In the current environment, the economy does not need any further stimulus. Quite to the contrary, the economy has been running hot with levels of inflation that were last seen during the Great Inflation of the 1970s.

The current sky-high inflation rate (from a U.S. perspective, other countries are more used to these kinds of inflation rates) is due to a combination of supply chain disruptions, pent-up household demand, wide-ranging government aid programs to support the economy during the pandemic as well as further large-scale asset purchases by the Fed. While economists disagree about the relative importance of each of these factors, it is good to keep in mind that inflation is currently also high in many other industrialized countries that did not adopt the same policies as the United States. Over the last month, Russia’s war against Ukraine has further increased energy prices and thereby added to inflation pressures worldwide.

In last year’s speech, Clarida explained the type of policy rule that he would consult for the liftoff in interest rates given the new policy framework adopted by the Fed.  A policy rule describes what the Fed should be doing and what kind of fed funds rate it should set given where the economy is.

That policy rule is a Taylor-type rule (named after my Stanford colleague John Taylor, probably the most famous monetary policy expert in the world). The rule sets the fed funds rate to a neutral rate of 2.5 (the 2 percent inflation target plus a 0.5 percent real rate) but raises the fed funds rate if inflation is higher than 2 percent. Clarida recommended a 1.5 response coefficient to inflation deviations from the 2 percent target. The policy rule looks like this:

Recommended fed funds rate = 2.5 percent + 1.5 × (inflation rate − 2 percent).

Since core inflation is currently 5.4 percent, the rule recommends a fed funds rate of 7.6 percent! It is obvious that we are far away from this goal even after the last FOMC meeting.

What should the Fed do? Clarida advocated that the Fed should not close the wide gap between its goal and the current fed funds rate in one giant step. Instead, he recommended that the Fed should take a much more gradual approach. How gradual? The answer is an inertial Taylor rule, which says that the Fed should place a large 80 percent weight on where the economy is right now (before the Fed decision, that was a zero fed funds rate) and a modest weight of 20 percent on where the Fed should be (the 7.6 percent recommended fed funds rate, given the current sky-high inflation rate).  

The inertial Taylor rule says that the fed funds rate should already be at 1.72 percent since the last FOMC meeting. Given the current inflation pressures, we should have thus seen a massive rate hike on March 16, 2022 — seven times as high as the actual 0.25 percent decision.

The rule also helps to think about the Fed’s plans going forward. The Fed’s own estimate of 4.1 percent core inflation for the end of 2022 from Table 1 implies a 5.65 percent interest rate target. Its 1.9 percent projection for the fed funds rate is much lower than that. These numbers reveal that the Fed thinks the economy will only be a third of the way toward its interest rate target by the end of the year. Moreover, the Fed expects inflation to drop by half over this year while projecting strong real growth: Projected real GDP growth over the next years is higher than the 1.8 percent long-run projection in Table 1.

These projections are highly optimistic. The Fed knows that the economy is like a car driving downhill at a speed far above the speed limit. It also anticipates forces down the road that will further push the car to higher speeds. Moreover, the Fed is aware that its own actions will also further accelerate the car, while policy rules for the conduct of monetary policy would have called on the Fed to step on the brakes. But Fed officials are convinced that the car’s high speed is only temporary — somehow the forces of nature will slow down the car and the car will roll to a stop right at the bottom of the hill.

To respond to strong real growth down the road, John Taylor’s original policy rule puts a positive coefficient on deviations of output from trend, a variable called the output gap:

Taylor’s recommended fed funds rate = Clarida’s recommended fed funds rate + 0.5 × output gap.

The Fed’s projections of real GDP growth in excess of 1.8 percent long-run growth in Table 1 can serve as a proxy for the output gap. Since projected growth is high, the Taylor rule prescribes a higher fed funds rate than Clarida. To summarize, all these policy rules suggest that the Fed is not stepping on the brakes enough.

The Great Inflation of the 1970s

The last time the Fed fell behind the curve was in the 1970s. Back then, Fed leaders Arthur F. Burns and then G. William Miller reacted slowly to the rise in inflation. Both chairmen thought it was important to promote economic growth even if it resulted in inflation. Moreover, they believed that inflation was caused by forces outside the Fed’s control, such as high energy prices. Therefore, they did not tighten enough — driving real rates to negative territory, just like today.

In joint research with Stanford PhD students Matteo Leombroni and Ciaran Rogers and my Stanford colleague Martin Schneider,^[4] we study the “Great Inflation” of the 1970s more closely. Figure 1 plots key household sector positions over the postwar period. The yellow shaded areas are three episodes for which we have more detailed household-level data on portfolios: the late 1960s, the 1ate 1970s, and the mid 1990s.

Figure 1 shows that during the 1970s, the yellow shaded area in the middle, household net worth as a fraction of GDP fell by 25 percent, before recovering again to its late 1960s value.

Our research attributes the drop in net worth to two key developments.

First, baby boomers entered into asset markets. The average asset market participant thus became younger. Second, inflation eroded the value of bond portfolios, which are nominal assets, and made households poorer. Being young and poor lowers the propensity to save and thus diminishes net worth. The other lines in the figure are the three main components of net worth: housing, equity, and net nominal assets (the difference between any holdings of bonds and household debt).

Figure 1. Household Net Worth in the United States as a fraction of GDP

Figure 2 shows portfolio weights in Panel (a), in particular a 20 percentage point shift away from equity and into real estate during the late 1970s. This portfolio adjustment was associated with large moves by asset prices in opposite directions. Panel (b) shows that — relative to their fundamentals — house prices rose while equity prices fell. For housing, the line in Panel (b) is the ratio of house prices to rents. For equity, the line is the ratio of equity values to dividends.

Figure 2. Financial Accounts of the United States and
own computations

Our research points to several reasons that high inflation made housing such an attractive asset during the 1970s. First, the U.S. tax code favors housing during high inflation: Mortgage interest deductibility is a bigger subsidy when mortgage rates are high. Moreover, capital gains on housing are largely tax-sheltered. Finally, dividends on owner-occupied housing — the implicit rental value of an owner-occupied house — are not taxed. All these features of the tax code matter more in times of high inflation because mortgage rates, capital gains on housing, and rents are higher.

A second reason behind the portfolio shift toward housing was strong disagreement about inflation among households. Based on data from the Michigan Survey of Consumers, we document that younger households had much higher inflation expectations than older households. While the median 5-year inflation forecast was 6.3 percent, households aged below 35 years were forecasting 10 percent inflation, while households aged 65 years and above were forecasting 5 percent inflation. Since most house purchases are made by younger households, the average home purchase in the 1970s involved a buyer who believed that real borrowing costs are low. Therefore, those buyers were willing to pay more for housing.

Additionally, an important contributing factor to the massive shift out of equity was high uncertainty during the 1970s. With high energy prices and the Fed not keeping inflation under control, there was much uncertainty about whether businesses would be viable. This uncertainty, together with a tax code that favors housing when inflation is high, can quantitatively account for the shift of household portfolios away from equity toward housing.

Back to the 1970s?

Are we in a time machine on our way back to the 1970s? A quick glance at rising ratios of house prices to rents seems to suggest that the answer to this question may be yes. However, uncertainty in the U.S. is relatively low at the moment. The public still trusts the Fed to rein in inflation. As a consequence, the ratio of equity values to dividends managed to stay high despite the currently high inflation. That is different from the 1970s.

The big question over the next weeks will be whether the Fed will lose its reputation as an inflation fighter, especially if there are signs that inflation pressures may be more persistent. Right now, short-run inflation expectations are elevated, but the public believes the Fed will take us back to 2 percent inflation over the longer run.

We can see this trust, for example, in break-even inflation, defined as the spread between the interest rate on Treasury bonds and the interest rate on TIPS (which are government bonds that are protected against inflation). Break-even inflation over the next five years is 3.41 percent and 2.83 percent over the next 10 years, quite low compared with the high inflation rate we are currently witnessing. If inflation expectations over the longer run increase, Treasury bond investors would demand to get paid a higher nominal interest rate by the U.S. government relative to the interest rate on TIPS as a compensation for the lower expected real value of the associated bond payments.

Fighting inflation is not a pleasant task. When former Fed Chair Paul Volcker raised interest rates to lower inflation, car dealers sent him coffins containing the keys of unsold cars and farmers protested in front of Federal Reserve Bank buildings.

Many Southern European countries before the introduction of the Euro did not have a top central banker with a reputation like Paul Volcker. As a consequence, inflation in these countries always fluctuated between very high and sky-high — an important argument for the creation of the Euro and for the location of the European Central Bank in Frankfurt, Germany. The more time passes and inflation stays as high as it is currently, the more Fed Chair Jerome Powell risks to lose his own reputation to be tough on inflation.

Once that reputation is gone, our time machine will complete its journey and arrive in the 1970s. And that will have us all singing the blues. Let’s hope for the best.

Monika Piazzesi is a �������Senior Fellow and the Joan Kenny Professor of Economics at Stanford. Her research focuses on the interactions between financial markets and the economy.

Footnotes

[1] B.B. King, “Inflation Blues,” Track 1 on Blues ‘N’ Jazz, MCA, 1983, vinyl.

[2]