Gauti Eggertsson on the Post-Pandemic Inflation Surge and its Implications for Monetary Policy

Heading into the next framework review, there are numerous policy changes that the Fed could consider to help avoid inflationary crises in the future.

Gauti Eggertsson is a professor of economics at Brown University and is the author of several recent papers on the causes of the 2021-22 inflation surge and the lessons to be drawn from it for monetary policy going forward. Gauti is also a returning guest to Macro Musings, and he rejoins the show to talk about these papers and their findings. Specifically, David and Gauti discuss the role of the Fed’s FAIT framework in the post-pandemic inflation surge, the return of the non-linear Phillips curve, the merits of nominal GDP targeting and average nominal output targeting, Gauti’s policy suggestions for the Fed, and a lot more.

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:  Gauti, welcome back to the show.

Gauti Eggertsson: Thanks a lot for having me here.

Beckworth: It's great to have you on. You were last on in early 2017. It seems like a lifetime ago. Back then, of course, we were discussing liquidity traps, lower bounds on interest rate policies. Very different world today, and a very different topic today, we'll be getting into, with your papers.

Eggertsson: We were concerned with exactly the opposite issue, the fact that inflation was persistently below target, though, that's not a problem we have today. So, yes, I guess the conversation has changed quite a bit in the time that has passed.

Beckworth: It has, but it speaks to your ability and agility as a researcher and macroeconomist to tackle the problem at hand and draw lessons from that. You have two papers we're going to get into today, and I'll mention them up front and we'll get started. The first one is your 2023 Brookings paper with Don Kohn. That one's titled, *The Inflation Surge of the 2020s: The Role of Monetary Policy.* Your second paper is a more recent one with Pierpaolo Benigno that is titled, *It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve.*

Beckworth: You recently presented that at the AEA meetings just a few weeks ago down in warm San Antonio. I know parts of the country here have been very cold. You had to come back from San Antonio to these blizzard conditions. But, both very fascinating, and both very related papers. In fact, in your Brookings paper, you actually mentioned the whole non-linear point and you have a whole paper that expounds upon it.

Beckworth: So, I'm excited to have you on. Of course, you're part of a tradition that we'll talk about in a few minutes as well called the Princeton Macroeconomics Tradition or the Princeton School of Macro. My colleague Scott Sumner has written about that, and we'll talk about it in a few minutes. But just to set the stage or the context for our conversation, and I know most listeners know this, but just to make sure we're thorough, just to recap what happened in the spring of 2021, we see inflation begin to take off, everyone's surprised.

Beckworth: Forecasters are surprised. The Fed's surprised. All of us are surprised. It peaks in the summer of 2022. The CPI gets up to 9%. The core was a little bit less. But to keep it simple, we'll focus just on the CPI, and it got to 9%. It's now down close to 3%, so about a 6% drop since then. But everyone was surprised by it. The Fed was surprised by it. You note it in your paper, if you look at the Fed's Summary of Economic Projections, they completely missed it too.

Beckworth: It's interesting to look at those projections. As late as the March 2022 SEP, I was just checking before the show, they had their interest rate still [at] 2%, barely 3% over the next few years. Of course, we saw that that did not happen. Not only were there, of course, their inflation forecasts up, but their interest rate forecasts were off, and we saw some of the consequences of that, the interest rate risk that some of the banks bore and some of the banking turmoil in 2023. But that's the context. Let's jump into your paper, this first paper with Don Kohn, *The Inflation Surge of the 2020s: The Role of Monetary Policy,” and the whole paper focuses on the Fed's new framework introduced in 2020. What is FAIT? What is this new framework?

The Basics and Background of Flexible Average Inflation Targeting

Eggertsson: The framework was really developed in response to, really, the topic we were discussing here in 2017, that interest rates had been low for a long time. The Fed was sort of foreseeing a situation like Japan had been experiencing since the late 1990s, persistently low interest rates and output below where they would like to see, slow job growth, and so on. The framework was sort of designed to address that. In particular, they were trying to address what became known as, I think, [what] people within the Fed considered, looking back, a mistake, which was that they started to raise rates in 2015 on the following basis. In 2015, inflation had not reached the inflation target. But their estimate of the maximum employment was the employment consistent with about 4.9% unemployment.

Eggertsson: So what they then saw, as they started raising rates, is that inflation did not reach [the] target, and unemployment just kept falling down. In retrospect, they started to feel, because inflation was not reaching target, maybe this was totally unnecessary. So, I think people tend to forget, but right before COVID, the Fed was actually cutting rates. The reason was simply that they felt that, maybe, starting to increase rates in 2015 before inflation reached target, was a mistake.

Eggertsson: So, the way in which the new framework was formulated, this is, in a way, really to address that issue, so that when the economy would start heating up, then they would really wait for inflation to reach its target, because it would be very difficult to estimate what exactly is the maximum sustainable employment. That's the key philosophy behind it. Then, it expresses itself in a couple of ways. One is that they introduced an asymmetric weight on employment. In other words, they're happy with employment going above what they estimate as maximum sustainable employment. They're just very unhappy with it going below it. That's what the framework states. Number two was that they introduced this average inflation target, so if you would undershoot inflation for some time, you would want to make up for it in the future, but they were not quite specific [about] what the framework was for that. Both of these policies were really focusing on this low inflation environment and how to deal with that.

Beckworth: And I think the timing of the review process that led to this decision in 2020 starts in 2019 before the pandemic, right? 

Eggertsson: I think it may even be before 2019. There was a long period where they were reviewing the framework. And I think they really had in mind what they considered the mistake of 2015, raising rates before the inflation rate reaches target, based upon very inaccurate estimates of maximum employment, thinking that unemployment below 4.9% would be inflationary, which turned out not to be the case.

Beckworth: Yes, and kudos to the Fed and Jay Powell, the chair, because it's refreshing to see them willing to change, to look at new things, to adopt policies that update what's happened. At the time, you mentioned the mistakes they recognized ex post, so Jay Powell, I remember him testifying before Congress saying, "Yes, we got it wrong. Our estimate of the natural rate of unemployment, we got it wrong. It's time to update that." He had some speeches about how difficult it is to navigate by the stars, the R-star, the U-star.

Beckworth: There was, I think, a sense of humility here. "We don't have it all figured out. We're trying to do the best we can." And in 2012, they first got their official inflation target, so It's not been that long [since] they updated it. So, kudos to them for doing this at the time, and that was the issue. And maybe, who knows what the future holds? Maybe we'll be back to a world like that at some point in the future, once we're completely past the residual effects of the pandemic.

Beckworth: Maybe not, maybe that's a question we'll come back to later. Where is R-star going to end up when this is all said and done? But, to the big changes you mentioned, so, they changed their approach to maximum employment. Before it was deviation, a symmetric approach to it, and you mentioned that was a shortfall. Then, they also added that language, has to be inclusive and broad-based employment. Then, finally, the makeup part for average inflation targeting, and I know this is where I got excited. I suspect you got excited when you first saw it.

Eggertsson: Yes, I got super excited about that. I suppose I didn't pay sufficient attention to this change in the language about just talking about shortfalls instead of the symmetric overshooting and undershooting on the employment aspect of the mandate, which I think, in retrospect, at least, may have played a bit of a role in the— let me preface this. In a way, the Fed has dealt well with the last few years, in the sense that we are in a pretty good place right now.

Eggertsson: Having said that, there was a big spike in inflation, and I suspect that some of that could have been avoided by acting a little bit earlier than what they did in real time. And I think, especially in the fall of '21, I think it was then becoming increasingly clear that these were not just temporary forces pushing up inflation. And I think that the framework, and particularly their forward guidance, played a role in that lag, really, from when it should have been clear that these were not just temporary forces and some firming was needed.

Beckworth: Yes. So, we have the change to maximum employment. It’s asymmetric, as you said, the makeup part, which is similar to a price level target, but not quite. We'll talk about the details of that in a minute, and then, how it was actually implemented in forward guidance. Those all played a role in contributing to this inflation surge. But let's come back to that in a minute. I want to go back to the intellectual history behind this, because this is, again, a pretty, I think, momentous occasion, because this is really the first attempt, I believe, by an advanced economy central bank towards something like a level target, or makeup policy of some kind. I know you're a big fan of it. I know I'm a big fan of it. This was like a step in that direction, right?

Eggertsson: Yes. But I wouldn't say, though, that it is the very first attempt, because let's not forget that during the Great Depression, Roosevelt did, in fact, say-

Beckworth: That's fair.

Eggertsson: -that prices had collapsed by about 30%, and when he took office, relative to, let's say, 1927 or so, and he said that the explicit goal was to reflate the price level back to pre-Depression levels, and the Swedes followed a similar strategy. But yes, you would really need to reach back to the Great Depression. And even there, FDR was pretty vague, and he wanted to keep his options open. So it was not very firm, but there was this idea, though, that he wanted to target a level.

Beckworth: Maybe I should restate my claim; modern central banks.

Eggertsson: Modern, yes, that's right.

Beckworth: Yes, and even Roosevelt had some luck, too. He went off gold and devalued gold, but it also helped that Hitler and Stalin were causing gold flows into the US, which also contributed to this massive price level increase. But great accomplishment, at least, I think, in terms of academic work leading to real-world policy change. And I'm bringing this up, Gauti, because you are part of what my colleague, Scott Sumner, calls the Princeton Macroeconomic Tradition. And it had a hand in, and I dare say the legacy of it is, FAIT, and whatever else comes after FAIT. We'll talk about the framework review coming up later this year. But Scott had this paper he wrote for us called, *The Princeton School and the Zero Lower Bound.* I'm going to read just the first two paragraphs from it.

Beckworth: He says, "During the late 1990s and the first decade of the 21st century, a small group of economists revived the debate over liquidity traps and developed a framework for monetary policy at the zero lower bound. Because the key members of the school of thought were all teaching or studying at Princeton University during the early 2000s, I'll call this group the Princeton School. Paul Krugman's 1998 Brookings paper provided the basic model that underlies much of the new view, but work by Ben Bernanke, Michael Woodford, Gauti Eggertsson, and Lars Svensson also played an important role in shaping the view of stabilization policy at the zero bound. By the late 2010s, their ideas had begun to influence policy at central banks, including the Federal Reserve. Indeed, research by Krugman and other Princeton University members provided the rationale for the Fed's new policy of flexible average inflation targeting, which is the most important shift in the Fed's policy regime in several decades." So, this all goes back to the work you were doing as a group there. Tell us about that experience, what it was like, and what motivated this group to do the work?

The Princeton School of Economics: Ideas, Experience, and Motivations

Eggertsson: These were all people-- I guess one person missing there was Chris Sims, [who] was a very important part of the intellectual climate there. So, these were all people that I got attracted to that were interested in monetary policy. And the big, interesting question at the time was, really, Japan, which had zero interest rates. So, that experience was animating, I think, all of the people involved there, in what Scott calls the Princeton School. So, yes, it was a remarkable period in the sense that, on my PhD committee, were Ben Bernanke, Chris Sims, Paul Krugman and Mike Woodford. Three out of the four already have a Nobel Prize, one was a Fed chairman. I remember asking Mike Woodford, he was my main advisor, "Okay, so, these two have a Nobel Prize, and this is a Fed chairman, what have you been up to, Mike?" But he was, in fact, the one I was the research assistant for while I was there, and worked very closely with. But these other people also had a very strong impact.

Eggertsson: The bottom line was that, if you're interested in monetary policy, the interesting question, really, I thought at the time, and I thought it was obvious, was Japan. And it was almost a little bit weird, because then, when I came out of grad school, this was at a time where grad students were not going all over conference. I really never left the sheltered environment of Princeton. When I went out to the wider world talking about the zero bound and liquidity traps and all of these things, people would look at me with wide eyes like I was crazy, when they realized that I was operating under assumptions that were not as widely accepted as they were at Princeton at the time.

Eggertsson: Just the idea that printing money and buying shares and bonds wouldn't do anything… Everybody agreed on that, but if you went outside of the halls of Princeton, people thought, "What? No, we all know that if you increase the money supply, then you're going to have inflation." Lo and behold, Japan, 10-fold… well, between then and 2006, maybe four-fold of the money supply. Now, I think it's 10-fold relative to what it was [in the] mid-'90s, and inflation hasn't done anything, if you measure money as the monetary base, but this was just not accepted at the time. That became a big surprise to me, but in retrospect, it was not surprising, because it was a very special place at that time. I don't think there's, unfortunately, as much left of the monetary tradition in Princeton now, it has moved on to other places.

Beckworth: I remember reading Michael Woodford's work on Japan, among others in that group, and making his very convincing case that really spoke out to me about Japan's-- The first trial of QE was Japan in 2001-2006, and he noted that the monetary base, it increased, but then it came back down to trend. It was as if it was expected. The body politic knew that this was nothing more than just a temporary operation. So, two things that I got out of this literature. One is the importance of an expected, permanent increase in government liabilities. Then later, it took some time for me to digest this, but to have a permanent increase in the monetary base implies something about future fiscal policy. It implies what you can do with taxes, and that ties into the fiscal theory of the price level, Chris Sims, and stuff.

Beckworth: So, quantities matter, yes, but it's tied into fiscal policy and expectations, and this is where forward guidance, all of that stuff comes into play, so very fascinating. Now, I want to segue from that into one of the Fed officials during the time of FAIT, and that's Rich Clarida, who was also highly influential in the New Keynesian literature, but he was there. He was the vice chair at the time, and he, I think, was the intellectual force behind the push for FAIT. He gave several speeches on this, and he gave a speech in late 2020. Then, I'm looking at one from January 2021, and I want to highlight something he says, so I can tie it back into what we've just discussed. He says here, "As I highlighted in his speech at the Brookings Institution in November 2020, I believe that a useful way to summarize the framework defined by these five features,” that's FAIT, “is temporary price level targeting that reversed to flexible inflation targeting once conditions for lift-off have been reached."

Beckworth: And he goes on to mention that Bernanke talked about it. He mentioned that you and Woodford have talked about something like this. Reifschneider and Williams talked about something like this. So, it's interesting to see Clarida call FAIT a version of the temporary price level target, which, again, is tied into this Princeton School. So, it's very clear that the mapping, I guess, from Princeton to FAIT seems pretty clear to me, at least.

Eggertsson: Yes, I think it was part of this discussion. And to be fair, there were also other people that were around the same time. Actually, John Williams, who is now the president of the New York Fed, he had done some important work with Reifschneider that was also along similar lines, Wolman in the Richmond Fed as well. So, I think that a lot of this was driven by this academic work done at Princeton and at the board. I mean, the board, and the Federal Reserve in general— the academia was slow outside of Princeton, but the Fed was already thinking about these issues as well around this time. I recall that just because that was-- when I was walking around coming out of school, I could see that people got it there, what I was talking about.

Beckworth: Interesting.

Eggertsson: While, in other places, you would be met with wide eyes.

Beckworth: Oh, very fascinating. Okay, let's go back to FAIT, then, and its role in the inflation surge, 2021 to 2022. We've already touched on the three big, I think, elements, or avenues, channels through which it could have contributed. One is the change in its approach to maximum employment. Two was the makeup part of the inflation target, the flexible average inflation target. And three, it's implementation/forward guidance. Let's start with the new approach to maximum employment. It had both shortfalls versus deviations. It's asymmetric, as you framed it. Also, it has new language, the inclusive and broad-based. How important do you think that change was to the Fed falling behind the curve when it did?

The Role of FAIT in the 2021-22 Inflation Surge

Eggertsson: I think that they were more willing to risk employment going above what they considered as maximum employment than risk it going below it. That's literally, in a way, what it says. So, I think that played some role there. It's unclear to me how much this more inclusive measure… if that had really had a big impact or not. Perhaps, but it's not as obvious to me. I think the biggest thing was that, what I think was a pretty important aspect was, as they announced the new framework in, I think, it's August 2020 or so, this is mid-COVID, of course. Chairman Powell, then, they do what they call the forceful implementation of the target with the forward guidance in 2008, where they essentially say that they're going to keep the interest rate at zero until inflation is above target and employment is above what they define as maximum sustainable employment.

Eggertsson: So, in a way, it was a perfect policy for 2015, because then you would've had to wait for inflation to go over the target before you started tightening. But, it turned out that, for 2021, it was not so great, because then it happened the other way around. Inflation shot over the target, and the labor market indicator they were looking at didn't look like they had reached pre-COVID targets. So, they were looking at prime age employment to population and just the unemployment rate. These hadn't really reached pre-COVID levels until they finally started raising rates in March 2022. So, inflation starts surging around May or in the summer, right?

Eggertsson: So, that whole period, the summer and until March— and I think, especially in the fall of '21— I think that then it becomes clear that it is not temporary, because you're seeing inflation in core, the part of inflation that excludes the most volatile components of it, like food and energy. So, it was becoming clear then, but then, I think, and they said as much, that they felt themselves somewhat bound by this forward commitment that they're not going to raise rate until employment would recover to what they deemed as maximum employment. Then, there was no qualifier with what was going on with inflation. So, I think that was problematic.

Eggertsson: And there was a second thing that he didn't mention, but for reasons that to me— and we talk about this in the paper, Don Kohn and I— for reasons, to me, that seemed totally unnecessary, they could have had the emphasis that they were going to draw down their quantitative easing, or the tapering as they called it, with plenty of warning and wouldn't start lifting rates before that. It seems like no reason to be tying interest rate policy to that. I mean, the Bank of England started raising rates before, fully. So, that [also] put an artificial delay into play that may have played some role. 

Eggertsson: But I think, certainly, the framework, to the extent that it informed this forward guidance, I think, played a role. As far as the average inflation targeting is concerned, I don't think that played any role here, because they pretty quickly undid whatever shortfall in inflation we had seen in the past. I think of it more as a tool that may become very useful going forward, which I suspect we may need to use in the next recession when, if interest rates collapse again to zero— and I suspect that maybe next time we talk, that's going to be the problem we're going to be talking about.

Eggertsson: The markets seem to be fluctuating a bit on their view on that. There are wild fluctuations in the long run. In the beginning, it seemed like they were still of the secular stagnation view that low-interest rates were here to stay and this was just a temporary thing. Then, they seemed to move their views a little bit. Now, yes, I think that's the big question. When things normalize, are we back to very low rates, or is the new normal going to be something more like—?

Beckworth: Let's just say I got burned by the bond markets during this period, because I wrote an op-ed that I've mentioned on the podcast before. I was invited to write an op-ed in The New York Times about inflation, and the title they gave [it] was unfortunate, but it said, *Stop Worrying About Inflation.* So, this was in early 2021. Of course, inflation takes off. But, what I invoked with my co-author was, look at break-evens, look at the bond market. It's not worried at all.

Beckworth: And the flip side of that, we're coming down, rates have gone up a little bit. I believe the 10-year is just about 4%, but it was down to 3.8% or so, 3.7%, and nothing had changed fundamentally about the structure of the economy, at least in my view. There wasn't fiscal reform or anything happening in the future. And so, I take the bond market with a much bigger grain of salt now in terms of what it tells me. Although, with that said, they know a lot more than I do about– they're paid to know this stuff really well. But, I’m much more cautious in taking what they say in terms of what actually is going to happen in the future.

Eggertsson: It's funny you should mention that op-ed, because I had the same unfortunate experience, although I was a bit luckier than you… well, both lucky and unlucky. My timing was even worse than yours. I wrote the first, and probably the last, op-ed I will ever write. That was when it was starting to look like, in the end of September, that team temporary may have been right, because there was a small sort of downward-- just for a brief moment, brief enough for me to write an op-ed. But, the part in which I was lucky was that it was written in Japanese, so I don't think anybody read it. But, there, I took the view that this was a temporary phenomena, only to discover that I was wrong, and I needed to re-examine my framework, because I was also taking a lot of comfort from the fact that, like you, inflation expectations had not moved at all.

Eggertsson: And the person through which we have been thinking about inflation really going out of control was the '70s, when inflation expectations were going all over the place. That was simply just not happening then. Throughout this, the inflation expectation… and, I guess, you can say that's a testament of the Fed's credibility, how stable inflation expectations have actually been.

Beckworth: Absolutely. All of that hard-earned credibility paid off. And you had a chart in your paper that was really useful. This is in your second paper, the nonlinear paper. You go back to the '70s, and you show the inflation rates and you show inflation expectations. And it was really neat to see them on the same graph, because the inflation expectations, they go up practically almost… not quite, but almost one for one with the high inflation in the '70s, so much, much higher inflation expectations. You can see the unanchoring taking place, whereas, in the past few years, it went up a little bit, but nowhere near the magnitude of actual inflation, which is a stark difference.

Eggertsson: Right, and this even… the picture I show there shows just one year ahead. It's from a Livingston Survey, one year ahead inflation expectations, because that's the only inflation expectations measure we had that went back that far. It's even more striking if you look at longer-term inflation expectations. We have them just from the beginning of the Volcker era. And people around 1980, they were expecting inflation five years from now to be remaining around 10%. So it was not just the chart, it was really [that] inflation expectations became completely unanchored during that period in a way that we haven't seen since.

Beckworth: Okay, so we've talked about the new framework. We've talked about its implementation. The statement they had, I'll just read that for the sake of thoroughness, but from September 2020 to November 2021, the FOMC stated, for conditions of ending the makeup policy and starting to lift off work, "Labor market conditions have reached levels consistent with the committee's assessment of maximum employment, and inflation has risen to 2%, and is on track to moderately exceed 2% for some time."

Beckworth: So, you've kind of touched on that mix. It's the implementation of the framework, it's what is maximum employment, maybe not the FAIT part so much, the average inflation part as much, but let's move on to a few other pieces of the puzzle that may have played a role. I think this next one played a big role, and that's fiscal policy; the huge, I would say, helicopter drop that was done during this time. I know you believe it was consequential as well, but I'm curious, do you view it being consequential from a fiscal theory of the price level perspective, or more like a hydraulic Keynesian perspective?

The Role of Fiscal Policy

Eggertsson: Yes, I'm not sure that I would want to call it hydraulic, but I think that would be closer to where I'm getting it. If you just look at measured disposable spending over history going [back], and I've done that. The spike that happens there in March 2021 is really unprecedented in the data. This spike is so sharp and visible that it seems almost inconceivable to me that it did not… and then inflation started picking up right away right around that time.

Eggertsson: And yes, it seems extremely plausible to me that that generated quite a bit of spending and increased demand significantly in those initial phases of the inflation surge. I do think that played a role. I guess I'm less sympathetic to the notion stemming from the fiscal theory of the price level, because, essentially, the way I like to think about that is, if there is high outstanding government debt, the Fed is going to become more concerned with keeping interest rates low to inflate away some of that debt.

Eggertsson: And, at least in this, I think that has been important in the US economic history, especially during wartime, but I'm not sure that it played a major role in the Fed decision at that time, the fact that the deficit was going up, which is essentially how I think about the role of fiscal theory, that is filtering into the policy decision of the Fed. But, clearly, it did during World War II because literally there was a panic on Treasuries.

Beckworth: So, let me take this from the fiscal theory of the price level, my takeaway, and I know I'm not going to do it justice, and Eric Leeper, by the way, is now a visiting colleague at the Mercatus Center. If he's listening, I apologize in advance. But I think of it more as— going back to what we talked about earlier— if there's a permanent increase in government liabilities that's not going to be matched by taxes or drawn down in the future, it's completely unbacked.

Beckworth: The COVID spending, there were no claims made that the government, in the future, would raise taxes or run primary surpluses. To me, it was like a permanent increase in the quantity of government liabilities, a one-time pop, so you'd expect a price level to go up, you'd expect some inflation to go up and then maybe eventually come down. That, to me, ties into the arguments that you've made in the past, that you need a permanent increase. Now, I know it was more monetary base, but it has to be tied to the stance of fiscal policy.

Eggertsson: The work that I had done in the past that was related to how you could generate inflation, was really how you could use monetary and fiscal policy jointly to increase inflation. The idea there was partially born out of study in the Great Depression that when FDR was trying to inflate the price level, and they had some credibility problems, he would just say, in one of his fireside chats, "Look, we will do this one way or another, and we are going to just increase credit or government debt until we achieve this target." But there, I think it tied very much to fiscal and monetary policy jointly trying to increase the price level.

Eggertsson: But I don't think that was really what was happening here. I don't think the Fed was interpreting this stimulus as a license to, or a mandate to, keep interest rates low in order to keep the debt burden lower. I think it was more just the fact that that increased demand to a degree that people were not quite expecting. Additionally, and maybe more importantly, and this was one of the rationales for the framework and why it was asymmetric, was that people thought that the cost of employment going above its maximum… the risk of inflation was very low.

Eggertsson: That was literally what the policymakers were saying. Don and I have some quotes in our paper where the paper says that, given that the inflation is going to respond so little based on our estimate for employment going a bit above maximum employment, we should not be that concerned with it given how the cost of going under it is, which leads us to the next thing. Then, okay, what was the trigger of the inflation?

Eggertsson: There, my take is really coming to the papers you were talking about, which is-- I could summarize as follows: The last big inflation we experienced was in the 1970s, where inflation— and I think everybody agreed that expectations played a key role in it— Everybody started expecting future inflation, and that becomes self-reinforcing in a way. But, the labor market was very slack. So, I think, in a way, it created a blind spot. So when we were looking at inflation in 2021, and seeing it going up, we saw that inflation expectations were not moving and said, "Oh no, this doesn't look like in the 70s. Maybe we should have looked at the other episodes where we have inflation surges,” which are essentially four other ones: World War I, World War II, the Korean War, and Vietnam War.

Eggertsson: What do these things have in common? One thing they have in common, and this is what we documented in this paper, is that you have a high degree of labor market tightness, which we measure as the number of firms looking to fill jobs divided by number of workers looking to find jobs. If that goes above one, well, then you have more firms looking to hire than people looking to find a job. That's [what] we define as a tight labor market.

Eggertsson: Apart from the 70s, in all of those other cases of inflation surges, we have had that labor tightness, meaning that the labor market, by this measure during this episode, is the tightest it has been since World War II. This is a different measure than what the Fed was looking at. They were looking just at unemployment or labor force participation relative to the population, which had not reached pre-COVID levels. The issue was that there was still some unemployment, but people were pretty picky about the jobs they were taking. The vacancies may have been in other sectors, because there was an uneven recovery. People were demanding more goods relative to services, and so on.

Beckworth: So, this second paper that we're now jumping into, just to repeat the name of it, it's called, *It's Baaack: The Surge in Inflation in the 2020s and the Return of the Non-Linear Phillips Curve.* Now, Gauti, I know this is the longer paper. You also did another paper for the AEAs, and based on what I saw from the online video, you actually document cross country evidence in that one. Is that correct?

2020s Inflation and the Return of the Non-Linear Phillips Curve

Eggertsson: Yes. We did a simplified version of this which is called… The title of the paper is now, *The Slanted L Phillips Curve.* There, we just looked at unemployment, and related it to inflation, and we get a curve that looks like an L except the [inaudible] X slightly slopes downwards, that gives you a normal tradeoff between inflation and output, but once you hit maximum production capacity, if you have hired everybody, well, then if you increase demand, there's only what firms are going to be able to satisfy, because they are out of people to hire, and the only way is up for inflation.

Eggertsson: So, we are arguing that that point was being hit, not just in the US, but also in Austria, Canada, Germany, France, UK, Italy, and Japan. So, this is, relatively, sort of loose empirical evidence that we show there, and in the longer paper… so, the slanted L as an example of very… because I forgot to mention that about these inflation surges. A key part of the argument we are making in both papers is not just that the labor market was tight, because the Fed was saying, during the new framework, even if employment goes a bit above maximum employment, our estimates suggest that that's going to have a very small impact on inflation, and that was the presumption I was also operating under, but I think what I failed, and many other failed to recognize, was that since the 70s, we never really had been running a very hot labor market by this metric. What we call V over U, vacancy over unemployment, was below one [during] that whole period.

Eggertsson: It was only during post-COVID that we really see it jumping up to becoming very tight, and in the paper, we show that then you should expect that inflation starts increasing a lot more for any extra stimulus. The reason is just this intuitive notion that the slanted L, once you have hired everybody and there's increased demand of a firm's product, well, what are they going to do? They're not able to produce more, because they’re out of people to hire, and then they're going to raise their prices, or, also, they could ration. We actually did see some of that during COVID. Companies started closing on certain days, or because they were reluctant to raise prices too much.

Beckworth: So, the non-linearity, intuitively, makes a lot of sense. The real world is non-linear, so you'd expect this with the Phillips curve as well, and you provide this evidence. And, just to be clear, you're arguing that this non-linearity kicked in, which is unusual, because in the past few decades we didn't see that non-linearity kick in. It kicked in because it was so unusual during the pandemic.

Eggertsson: It kicked in because the labor market became unusually tight for a couple of reasons. A, it was because of the big increase in demand due to the Biden stimulus, partially, and also due to the fact that there were some sectoral reallocations as the growth in the service sector was slower than in the goods sector. So, that meant that if you would call the employment consistent with-- The natural rate of unemployment was slightly higher, so it was sort of those two things.

Beckworth: So, the threshold effect can be dynamic. It doesn't have to be at the same place all the time, depending on-- 

Eggertsson: No. I was saying this, number one, just because it's intuitive, more firms looking for workers, and workers looking for jobs. That was the founding father of labor economics, Barrett, he used that, but in our paper, it's actually a time-varying thing that depends on a lot of factors. But it seems like, in the data, actually, one works remarkably well. If you just look at the evolution of this metric and you have inflation and then you see that whenever this thing is above one, well, it seems that we have inflation; that being the late 60s, the Korean War, World War II, and World War I.

Beckworth: Yes, figure six in your paper was very convincing on that front. Now, going back to the Phillips curve version, where there's non-linearities in it, what does this mean? Or how does this help us understand the inflation surge? Because you explained that it actually adds weight, or you get more bang for your buck with supply shocks and demand shocks, if you get this non-linear Phillips curve.

Eggertsson: It's pretty intuitive, right? If you also see the price of all of your other… I mean, labor is only one input in production, but if you see an increase in price of some of your other inputs as well, and you cannot hire people to substitute for it, then changes in the prices of these other inputs are going to have an even bigger impact than usual. That's a key finding there, which is both theoretical and empirical, but, I think, empirically, is even more interesting, is that the supply shocks— and there's a lot of people that argue that supply shocks are playing all of the role in explaining the inflation that we have seen, and our conclusion is, yes, they played a major role, but you really need to interact it with this labor tightness.

Eggertsson: One way of seeing that, or making that case that, in any event, is compelling to me, is that we show how people constructed measures of these supply shocks prior to the pandemic. There's a cottage industry of creating, now ex post, all sorts of supply measures that suspiciously correlate with the inflation surge. But if you look at how people actually construct it prior to this particular event, what you will see is that the supply shocks, in historical context, were not that big.

Eggertsson: They're trivial compared to the oil shocks in the 70s, in orders of magnitude. It’s pointless, the point that talks about Figure 17 in our paper, since our audience won't be able to see them. But, if they feel so compelled, they can look up my, *It's Baaack,* paper and that's just the time series for the supply shocks, and if you use the method people have been using prior to the pandemic, then there's not a lot going on there. No, there is something going on there, don't get me wrong, but you need to interact it with this labor market tightness, and then we find that it actually supercharges them; that If the price of all of these inputs, let's say oil, and you cannot use labor in any way to substitute, then it makes it all the more powerful.

Beckworth: And you have a great decomposition in your paper. Earlier, I mentioned that figure six is actually for this decomposition. The earlier figure should have been figure four, I think I meant, [for] the convincing case for the non-linearity. But figure six, I believe, is where you have this decomposition based on this identification. And it was really interesting, because you show that if you have this interaction term, then the tight labor markets, interacting with this non-linearity, you really do explain a lot of the inflation. Supply shocks also matter, but you see a much bigger importance for tightness of labor markets or demand if this non-linearity kicks in. If it's not there, it's much smaller.

Eggertsson: If it's not there, then you wind up with the conclusion that I think both you and I were reaching when we [wrote] our very untimely op-eds that…. Because expectations weren't moving and available estimates of how much inflation would respond to changes in output or employment, you wouldn't see a whole lot of action. And this graph actually doesn't have the last two quarters, unfortunately, because we haven't had time to update it yet.

Eggertsson: My suspicion is that it's already showing up there, that most of the downtick in inflation is due to the supply shock easing. That's good news and bad news. It's good news because inflation is getting close to target. It's bad news because the labor market is still pretty tight. So then, the analysis suggests that we are still pretty vulnerable to negative supply shocks or inflationary supply shocks.

Beckworth: Yes, I noticed that in your chart, that at the very end, that red bar is negative, which is a supply side shock, which means that this inflation is coming from supply side fixes. But, man, there's still a big chunk of that orange-yellow bar that's from the interaction, which could be something we need to think about, or watch closely. Let's move on from this to policy recommendations going forward. In your first paper, your Brookings paper with Don Kohn, you actually have some policy suggestions, and you draw lessons both from the Fed's framework, FAIT, and also lessons for forward guidance. So, maybe share those with us, and what the Fed could do with them in the next framework review coming up in a few months.

Policy Suggestions Moving Forward

Eggertsson: When we looked back, Don and I, I think we came to the conclusion that, perhaps, this asymmetric nature of the employment objective created more problems than it solved, so to speak, and that it would be wise to have a symmetric target. I guess the second was that there seems to be, to us at least, no reason to be making any statement or commitments about tying interest rate policy to quantitative easing measures, which are, really, I think of largely as focused on particular markets where you may have some difficulties there. There's no contradiction in still having some policy target against a specific market to promote market function and, at the same time, raising interest rates. Tying the two together seemed like they were just artificially tying their hands for no good reason. I guess a third thing was that we felt that this forward guidance in 2020… it seemed like an excellent solution to the wrong problem.

Eggertsson: I mean, it is an ingenious way of preventing a repeat of 2015, raising rates prematurely, but, if employment was recovering more quickly than inflation, but not very well designed if inflation was recovering more quickly than employment and output. So, I think being more robust, checking these— which is maybe not a deep insight, but it seemed like that particular forward guidance tied their hands too tightly, almost not robust to an alternative sequence of shocks like we saw, at least, ex post. Those would be broad-based policy lessons that I would take out of it. And I think that the average inflation target is a valuable tool, I don't think it played a role here, but I think it may be relevant in the future, and I would keep that there. But, maybe this asymmetry, I think, is a bit problematic.

Beckworth: Yes, so you and Don make this point that you want to have a framework that can handle all kinds of situations, not just the 2010 period. You want one that's robust, and I think that's where your symmetry point comes in. And so let me make a case here. I think you probably know where I'm going to go with this, but, let's circle back to what FAIT is a version of, at least according to Rich Clarida, and that's a temporary price level target proposed by Bernanke. And Bernanke, in 2017, had some blog posts where he wrote this up, and I just want to read an excerpt from his post. And the blog post’s name, it's a Brookings blog post, is, *Temporary Price Level Targeting: An Alternative Framework for Monetary Policy,* October 12th, 2017.

Beckworth: He goes through the challenges that we've been talking about for zero lower bound periods, and he goes on to make the case for a price level target. He goes, "For these reasons, adopting a price level target seems preferable to raising the inflation target. However, this strategy is not without drawbacks.” One is that it’s a big change, but there's a second one, which is what, I think, is the key basis for temporary price level targeting and for FAIT. “Another drawback is that the ‘bygones are not bygones’ aspect of this approach is a two-edged sword. Under price level targeting, the central bank cannot ‘look through’ supply shocks that temporarily drive up inflation, but must commit to tightening to reverse the effects of such shocks on the price level.”

Beckworth: “Given that such a process could be painful and have adverse effects on employment and output, the Fed's commitment to this policy might not be fully credible.” Then later he says that this temporary price level target handles that situation, because if inflation does go up because of a negative supply shock, you can still see through it, but you're only responding to inflation effectively from demand shocks. And to me, I completely agree with that. I think that makes sense. You don't want to further weaken or harm an economy that's been hit by a negative supply shock, like the pandemic. Inflation goes up, you don't want to tighten rates excessively. You want to, one, look through supply shocks, to the extent that inflation's well anchored, and two, respond only to inflation from demand shocks. Well, I think that there's an easy solution to this, at least in theory or principle, and that's nominal GDP targeting.

Beckworth: You're cutting to the chase, you're looking directly at aggregate demand or some version of it, and you're trying to stabilize that. If you do that, you are effectively looking through supply shock inflation, because you ignore inflation in the short run. Now, as your co-author and friend Michael Woodford notes, a nominal GDP target can ultimately lead to a medium-run inflation target, given some potential real GDP path, but what are your thoughts? Would that be a potential approach or way of handling the inflation surge we saw, or would it have not made much difference?

The Merits of Nominal GDP Targeting

Eggertsson: I guess the context of Ben's post, as I understand it, is mostly as a temporary fix once you are hitting the zero low bound, not so much designed to deal with these types of overshooting, except to say that it would be unwise to have it work in both directions, because that would've meant that, yes, the inflation surge that we saw, now we need to undo it with deflation, which seems like a reasonable approach. I guess your question is, would it be good to replace the price level target with, instead, a nominal GDP target? I think that has some advantages and some disadvantages. In our original paper, actually, that I wrote with Mike in 2003, that was our formula. It was not exactly a nominal GDP [target], but it was some sort of weight of the price level and output, which is a little bit in that spirit.

Eggertsson: I guess one aspect of it that I suspect would make the Fed quite reluctant [to go] down that route is just the communication element of it, that it might be more difficult to communicate to people, “Well, we are targeting nominal GDP, not something we have been talking about,” and everybody understands, which is the price level. Although, I'm not particularly sympathetic to those kind of objections, in the sense that I think that the people you're mostly communicating to are really the financial markets.

Eggertsson: Then, they translate whatever you're communicating into mortgage rates and things that people actually observe. I'm less certain that— and I think the financial markets are pretty sophisticated. I'm sympathetic to the view. I think that they would mostly achieve the same thing if done appropriately. The weakness of the way it is stipulated in the new framework is that there's no specific window for over what horizon they're targeting their average inflation target. I guess it just gives them, at the very least, a justification for them coming up with a more specifically targeted policy in the future. That's how I interpret it. This is just giving the justification for a policy that, in the future, could be developed, if the need arises. And then, yes, it could be that it would be wise to stipulate instead with a nominal GDP or price level [target].

Beckworth: Well, I bring up nominal GDP because I believe it would address the symmetry thing. Whether you go above or below, you're treating it symmetrically. And I want to use that to go to a proposal you have, which is even more radical than my proposal. I'll come to it in a minute, but on the communication point, I agree, you communicate to markets. But I do think that, at some level, you can communicate this to the average household.

Beckworth: You could say, “look, we're targeting the average nominal income,” or if you're talking to a trade group, “we're targeting average sales across the economy.” So, there are ways. I agree [that] nominal GDP is something very foreign, and it would be a terrible marketing campaign, but I think that there may be ways to do that. And you wouldn't have to necessarily do just nominal GDP. You could do, like Skanda Amarnath with Employ America, they favor gross labor income, which would be a version of this, which would also work.

Beckworth: But I want to go to a proposal that you have that's very fascinating. I had to wrap my mind around it a few times to fully grasp it. In fact, I had an interaction with you on Twitter. You had to make it clear to me. But you had a proposal in 2020, I believe. You had a VoxEU column where you actually were talking about the Fed's new framework. The title of the essay was, *The Fed's New Policy Framework: A Major Improvement, but More Can Be Done.*

Beckworth: And that was drawn from an NBER working paper, I think, [during] the same year titled, *A Toolkit for Solving Models with a Lower Bound on Interest Rates of Stochastic Duration.* Now, you talked about a number of approaches, but one thing you bring up in there… I want to bring this up to give you a chance to air this out and share it with the world. You propose that the US Federal Reserve [should] target average nominal output.

Beckworth: So, I’m going to read here from your article, "Suppose the Federal Reserve were to target average nominal output relative to its trend over time. In this case, if nominal GDP is below trend, the Federal Reserve commits to overshooting in the future so that, on average, the nominal GDP target is met. If an economic contraction occurs with no drop in inflation, this policy regime prescribes a substantial monetary stimulus at the zero lower bound due to the fall in real output.”

Beckworth: “This makes the strategy more robust than policy frameworks, such as average inflation targeting, that rely on a fall in inflation. In Eggertsson et al. (2020) we call this a ‘history-dependent nominal GDP target.’” Now, I know, again, the context for this was the zero lower bound, those issues. But, again, I think that something like this would be robust at any period, right? High inflation, low inflation, but talk some more about this proposal, because it's actually different than a pure nominal GDP level target, right? It's kind of like the next step up.

Targeting Average Nominal Output

Eggertsson: Yes. So, now, I need to remind myself of the exact nature of our target. It just turns out that, when we were evaluating a variety of policy rules, this one was one that seemed to just work pretty well. So, that's where the analysis led us. And I guess the key property was that, yes, if you undershot your target, you had to make up for it. If you have been bad and missed your target on one side, you need to make up for it by, you know…

Beckworth: If you undershot your level target, which is distinct from like— because with the level target you would say, if you undershot your, say, inflation rate, you'd have a higher inflation rate to get to the price level target path. But what you're saying is, if you undershoot your level, you have got to be above your level. It's like the integral of a nominal GDP-level target of sorts.

Eggertsson: Right, so, it just turned out that this was a—and I think, here, I guess, one thing we didn't develop in detail would be a good way of communicating this. I guess you could say that if you're targeting nominal GDP and you're below it, you accumulate debt, and then you have to pay off that debt. Similarly, if you go above… I like using the word debt because people associate debt with being bad. But then you accumulate assets, you have to spend those assets, I guess. But you're going to keep track of the misses over time. That was the nature of this policy. And it seemed to do remarkably well. Now, what we didn't do there, and there was little excuse for it, except for at the time we were writing it, was to explore the robustness to supply shocks. But I agree with you, that I suspect that this would do quite well there. And I base that not just on complete guesswork, because this was, in a way, our attempt to put, in somewhat simpler terms, a similar proposal that Mike Woodford and I had in 2003, where we did allow for all sorts of shocks, and it seemed to work pretty well. And I think that that also informed Mike Woodford's proposal you referred to, I think, that was in 2012.

Beckworth: Yes, and that's a good point to bring out. I believe that you and Michael Woodford… what you favored was an output gap adjusted price level target or something, which is great in theory, but I think what you argued in practice is, just target the nominal GDP level path. That gets you pretty close, because we don't know in real time what that output gap adjusted price level is.

Eggertsson: But, in retrospect, I think, though, that the key element of the proposal we had in 2003, that I think played some role then and in policy, was that we stipulated the policy that… you didn't want to say, like Bank of Canada did immediately after a financial crisis, saying that they're going to keep rates low until some calendar date. Instead, the policy we advocated was that, no, you should instead just stipulate, “here are the conditions under which we're going to start raising rates.”

Eggertsson: In our example, it involved the price level and real output, but, it could be just in terms of inflation and unemployment, which is, in fact, what the Fed then did in 2012, when they tied their forward guidance to conditions. Because the advantage of that is that, then, when you have a… if you say, “I'm going to keep rates low until some date,” and you have a shock, well, you should change the date, right? Then, you'll constantly change the date, but, here, that happens automatically. You've just said, “oh, here are the conditions under which I'm going to raise rates.” So, then, if there are shocks, the market compute, themselves, what that implies about additional accommodation.

Beckworth: Great points. Okay, with that, our time is up. Our guest today has been Gauti Eggertsson. Gauti, thank you so much for coming on the program.

Eggertsson: Thank you. My pleasure.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.