Unpacking Inflation: What History Teaches Us About Today's Economy ft. Carola Binder

[00:00:00] Carola

… where we show that there’s this huge divergence between Republicans and Democrats inflation expectations, especially in the Biden presidency.

So normally, people who support the president have lower inflation expectations and people who are of the opposite party have higher inflation expectations. And that’s still true, but the gap just widened so much that, during ’21, 2022, when inflation was rising, Democrats expectations didn’t budge and the whole rise in expectations came from Republicans.

[00:00:40] Intro

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Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions. Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:36] Niels

For me the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely Kevin Coldiron, to host a series of in-depth conversations to help uncover and explain new ideas to make you a better investor.

In this series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it so that we can all successfully navigate the challenges within it. And with that, please welcome Kevin Coldiron.

[00:02:12] Kevin

Thanks, Niels, and welcome everyone. So, for the past several years, the discussion about inflation has been framed in terms of whether the high rates we’ve seen since COVID are transitory or are they permanent? That’s been the debate, but our guest today has a different perspective.

She says that inflation has really been part of the fabric of economic debate in the US right from its founding, and it’s so important, in fact, that it’s fundamentally entwined with the fate of democracy. And since we’re only a few weeks away from an ultra-tight and an ultra-contentious election, it seems like the perfect time to discuss her ideas.

Our guest is Carola Binder. She’s an associate professor of Civic Leadership and Economics at the University of Texas, Austin, and she’s the author of a new book called Shock Values: Prices and Inflation in American Democracy. Carola, thanks so much for joining us, and welcome to the show.

[00:03:12] Carola

Thanks. It’s exciting to be here, especially since I’m a Breckley alum. I did my PhD at Breckley.

[00:03:18] Kevin

So, yeah, you know, on that, you know, you say, actually, right at the beginning of the book, that our understanding of current inflation environment, the current inflation environment, requires more than just economic analysis. Our post-inflation is actually closely tied to our approach to democracy and that both things have changed over time.

I’m curious, you mentioned Berkeley, where you did your PhD, where I teach. Is that a notion that you were taught at Berkeley, or is that a conclusion that you’ve kind of come to gradually over time in your own work and your own thoughts?

[00:03:53] Carola

Yeah, that’s a great question. And that’s not something that I was taught at Berkeley. It’s not something that’s generally a major part of what you learn in an economics PhD program where the training tends to be more technical. It’s mostly something that I came to over time.

I will say that Berkeley is one of the few Economics PhD programs that has still an economic history requirement for its PhD students. So, I took a great economic history course there. I had Brad Delong and Barry Eichengreen.

So, I got some exposure to economic history that I probably wouldn’t have otherwise because I had been a math major and undergrad, and thought I would probably just study more micro theory in grad school. But I did really love my economic history course.

And also, Christina and David Romer teach a kind of history focused US macroeconomic course, which also was great. And both of those things got me interested in studying macro and macroeconomic history.

But I started off with most of my research focusing on more recent times, when we have more data available, because I’ve been studying inflation expectations. Most of the surveys that we use start in 1978. So, the empirical work that I could do was mostly on more recent decades.

But I was studying inflation expectations in part because central banks placed so much emphasis, lately, on trying to influence the public’s inflation expectations. And so, researching in that area kind of naturally drew me into more about the politics of central banks because central banks are out there. They’re unelected, but what they do really affects the public. And increasingly, they’re really trying to interact kind of directly with the public. And when they do so, it tends to be pretty politically contentious.

So, I got more and more interested in that politics side of central banks, and also the legal side because the Fed and other central banks have kind of pushed the boundaries of what is legal for them to do. And I felt like I needed kind of a better understanding of the constitutional issues and the legal issues. That really motivated me to write the book because I wanted to understand these issues more.

[00:06:25] Kevin

So, was it a project that was, hey, I want to learn about this stuf, and as you started learning about it, you’re like, this is going to make an interesting book?

[00:06:35] Carola

More or less, yeah. So, as inflation was starting to rise, there was actually a Washington Post piece that kind of kicked off the book. It was (I think I mentioned it in the book), the Washington Post asked a bunch of different experts, what should the White House do about inflation?

One, I thought, interesting title, What Should the White House Do? It’s the Fed that we have kind of in charge of inflation. But these different experts were giving ideas about what to do about inflation, including one who wrote about price controls and called them the democratic solution to our country’s inflation problem. And I thought, well, why is that democratic? What does that mean?

And I was thinking about, well, okay, what central banks do also isn’t exactly democratic. We don’t vote on monetary policy. We don’t vote on our central bankers, but somehow, we have these institutions in place.

And I thought there would be kind of a book explaining the history of price stabilization in the US, and there wasn’t one. And I felt like, well, this is exactly what I want to know about, and I guess I am the person to write about it. So, then…

[00:07:53] Kevin

Cool. Well, okay, so you said price stabilization, price stability. So let me… There are different ways to talk about your book.

Its written chronologically, starting with the American Revolution going up through Covid. But there are also these themes that emerge from it. And so, I thought maybe we could talk about it thematically rather than chronologically.

Maybe the first theme is literally just, well, what does inflation historically mean? When someone in the late seventeen hundreds, or the middle eighteen hundreds, or even just before the Fed started in the early nineteen hundreds, debated and talked about prices, what were they talking about? It doesn’t feel to me like they were talking about inflation in the modern sense. They were more talking about price stability.

What’s the difference between price stability, historically speaking, and inflation as we think about it today?

[00:08:49] Carola

Yeah, they definitely weren’t, around the American revolution, thinking about inflation as we would today, because it wasn’t measured then as it is now. We didn’t have a Bureau of Labor Statistics collecting data on prices of different goods and services, and aggregating, and making a price index the way we do now.

But people could observe prices of individual goods and commodities, and they could see that the price of corn is rising, or the price of wheat is rising. They could observe trends in particular types of prices. And the prices that tended to be really important were prices of crops and farm goods, because many people in the country were farmers. And those prices were often set on global markets – depending on not only conditions in the US, but conditions in their trading partner’s economies. So, people didn’t really use the word inflation the way we would now.

A bigger concern often was devaluation. Is the dollar becoming more or less valuable? There was an understanding that if the money supply increased, then the value of individual dollars could fall.

It takes the ability to measure prices and to compute an inflation index, before you can really talk about inflation in the sense we have it today. But even the measurement of inflation has also been pretty driven by politics.

So, mostly in war times, in the civil war, there was this question about how much are prices rising because of all the money we’re printing? And this would become a political question in other wars, too.

If there’s any kind of controls on prices and controls on wages, if prices are still rising despite the controls, then people whose wages are controlled say, well, we need cost-of-living increases. Then there’s some argument about how much should that cost-of-living increase be? You need some measure of how much the cost of living is rising. And if it’s underestimated, that’s going to hurt labor relative to the employers.

[00:11:18] Kevin

I guess the theme that I took out of it is that we, now, our modern conception of inflation is how much price increase is good or bad? Is it 2%, 5%, etcetera? But in the past, you had long periods of deflation, periods of accelerating inflation. So, it was really about, how can we, I guess, eliminate that instability.

What I found fascinating in your book is that, I guess, the view of paper money, in terms of whether or not it would help price stability or hurt it, kind of changed over time. It seemed like, to me, maybe that’s not right.

You had some people, for instance, like Andrew Jackson, who, to non-American listeners, was this guy who was very much an individualist, promoting the interests of the west and farmers, very skeptical of government power. And his view was that centralizing power, it was unstable, we need gold.

But then later on in the eighteen hundreds, you have guys who are also representing the west and farmers, like William Jennings Bryant, who kind of had the opposite view, that, hey, actually gold is creating instability, and we need a more open monetary system to promote stability. So, I’m kind of curious, is my reading right? Has the view of paper money as a kind of, I don’t know, a mechanism of stability versus instability changed over time?

[00:12:52] Carola

Yeah. So that contrast between Jackson and Bryant was one I thought was really interesting and I wanted to highlight in the book. If you think about now, which political party tends to be more in favor of tighter money, more of a focus on following a really strict inflation target, or even promoting a return to the gold standard, that tends to be a more right-wing perspective.

You would never hear anyone on the left calling for a return to the gold standard, but you might hear that on the right, or you might at least hear the Fed needs to just focus more on controlling inflation. The interesting thing is that it was Andrew Jackson who was a really staunch supporter of hard money. And the Jacksonian Democrats, they really favored hard money, meaning gold (not paper money), because they thought it was a way to protect the people. It was kind of like a populist take.

They saw that big fluctuations in the value of money could have very harmful effects for the common man, who were mostly farmers back then. But it wasn’t too long after that, William Jennings Bryant, he had the same goals in mind in the sense of help the farmers, help the common man.

But he thought the way to do it is actually by having the government be able to actively manage the money supply, which requires not being on a gold standard, but having the government have the ability to inflate it. One thing I think it’s important to mention is that now we mostly just have periods of either low inflation or occasionally high inflation. But in a lot of US history, there were also these episodes of deflation, which were really important because deflation, just like inflation, can be pretty costly and can have pretty big consequences about redistributing wealth.

So, deflation, if you think about how it affects creditors versus debtors, so farmers would tend to be debtors because they would take out debt so that they could buy their seeds, their plows, things that they would need, so they would be in debt until they could harvest and sell their crops. The debts would be nominal debts, so they weren’t indexed to inflation or anything, just like most debt now. You say, I’m going to pay back $100 in one year.

And so, then if there’s deflation, if prices fall, and you have a nominal debt, that increases the real value of your nominal debt. So, it makes you worse off. Deflation makes you worse off if you’re a debtor. Inflation makes you better off. And it’s the opposite, if you’re a creditor.

So, after the Revolutionary War, after other wars, and at other times too, because of circumstances in the gold market, there would be episodes of deflation, and they would always prompt calls for some policies to help farmers. Whether that was monetary expansion, whether that was tariffs, or new regulatory policies, those were often prompted by deflationary episodes. The most famous deflationary episode being the Great Depression.

[00:16:23] Kevin

Yeah, that’s actually an interesting point, because another theme that comes up in the book is, should the Fed have an explicit mandate to control prices? That’s not in the original constitution of the Fed. The Fed was really more constructed as a ‘lender of last resort’ to help deal with financial crises and also to provide an elastic currency to meet the cyclical needs of the economy. Again, the agrarian economy had different needs for cash at different points in time.

The price mandate wasn’t originally part of the Fed’s setup. But there were movements at different times to say, hey, the Fed should actually explicitly control prices. And again, what I found that was interesting is those seem to be driven, in your telling, initially by deflationary episodes.

There was deflation in the 1920s, there was the Great Depression in the 1930s, and that was driving the notion that, hey, the Fed ought to explicitly control prices. But it wasn’t, actually, until the inflationary episode of the 1970s that we finally got an explicit mandate for the Fed to control inflation.

So, I guess my question to you is, should we take some meaning from that? Should we take something that actually, for whatever reason, the politics of inflation resonate more strongly and resulted in a change, or was that just my overanalyzing the situation?

[00:18:01] Carola

Oh, that’s a really interesting question. I think I have an idea about that. Most of these deflationary episodes, they happened following wartime inflations. So, after the civil war, there was a major inflation during the civil war, then there was a post war deflation. That post civil war deflation prompted the start of the Granger movement, which was farmers, in response to the deflation, kind of demanding some sort of help, and that deflation was long lasting. So, when William Jennings Bryan gave his Cross of Gold speech, it was this response to, like, the farmers are hurt by this long deflation. We need to get off the gold standard and be able to inflate.

He was influenced by economists like Irving Fisher, who were saying, yeah, there’s like (well, the US didn’t have a federal reserve at the time – it didn’t have a central bank), but Irving Fisher was like, if we could get a central bank and the central bank could stabilize prices, we could avoid all this trouble we’ve been having. And Irving Fisher tried to get bills through Congress following the inflation of the early 1920s and following the deflation episodes.

He kept trying to push this price stabilization legislation through Congress, and it never quite made it through. But you’re right that these pushes to get the central bank a price stabilization mandate tended to be prompted by deflation. And it wasn’t until the great inflation that the central bank actually got the price stabilization mandate.

I think one thing to really notice about that is the earlier big inflations were because of major wars when, like during World War one, that was the first war, when the Federal Reserve was already created. So, we had a central bank. The role of the Fed in World War one was to support the Treasury. So, the Fed just kept interest rates low because the treasury told it that it had to. It did so again in World War two and the start of the Korean War.

Congress wouldn’t have had any interest during those wartime inflations of trying to make the Fed responsible for price stabilization. What that would have done is required the Fed to raise interest rates, which would have increased the government’s financing costs right when it needed to finance a war. So, during wartime, there wasn’t really any move to say, let’s have the central bank stabilize prices.

It was just the opposite. It was like, we need to just keep interest rates low. If we want to stabilize prices we’re going to use price controls, because fiscal policy and monetary policy were not really on-the-table ways to stabilize prices during those big wars.

But the great inflation is sort of a different picture because it wasn’t a wartime inflation. And they did, again, they treated it in some ways like a war. It was called an emergency. Nixon kind of just made this pronouncement of price controls the way a president might in wartime.

But eventually, after all these attempted price controls, it was finally acknowledged that monetary policy was going to be the only way to stabilize prices. Once that actually happened, I think then there was also this recognition that it was possible to have the central bank stabilize prices.

[00:21:52.] Kevin

Yeah, that’s interesting, because I guess if we think about that, it’s saying that… I think your explanation totally makes sense. During wartime, there’s a different overriding objective. But if you’ve got inflation taking off, not during wartime, then people start pointing at the central bank saying, hey, hold on, you’re not doing that job.

So, in terms of the central bank’s future inflationary episodes, I suppose, like Covid, that took place not during a kind of explicit war, are, I don’t know, more dangerous in some sense to its long term independence. Would you agree with that?

[00:22:34] Carola

Yeah, I think there’s one more part of the story that I didn’t really spell out, which is the role of the gold standard in all of this. So, the United States was on the gold standard in some way or another until, well… The dollar was linked to gold, at least until Nixon ended the Bretton Woods arrangements. But the US was on the gold standard, as was much of the world, like in the interwar period.

So, giving the Fed a price stabilization mandate, at that point, would have required going off the gold standard. I mean, the gold standard monetary policy was that it was the arrangement that was the norm. And going off of the gold standard would have been really radical and not something that you would necessarily do just to end deflation.

When you’re on a gold standard, if it’s working well, you would expect long-run price stability even if you had some shorter periods of inflation and deflation. So, saying, well, we’re in a deflation, so we’re going to go off the gold standard. That’s what would be really quite radical.

That’s when Irving Fisher was trying to, at the beginning of the Federal Reserve system, convince Congress to give the Fed a price stabilization mandate. At that point, he couldn’t get that through because the gold standard was still the orthodox approach to monetary policy, and it was what countries around the world did and what they knew.

[00:24:15] Kevin

I do want to talk about kind of more modern problems, but I have, maybe as a kind of a link to that, one more theme I was curious to get your take on was this notion of the control over paper money, advancing democracy or centralizing power. We kind of talked about this a little bit, but that view has seemed to wax and wane over time.

You had this quote from Abraham Lincoln, so that’s the middle of the eighteen hundreds, saying that furnishing a safe currency will mean that money will cease to be the master and democracy will rise superior. And then, so his view is that, hey, central control over money is advancing democracy.

We had later, in the second world war, we had this office of price administration that you talk about that was in charge of price controls. They had this army of 100,000 people going around the country enforcing controls. And the way you describe it is that was seen as democracy in action.

To me, that seems like almost the opposite. The government come knocking on your door saying, hey, you’re charging too much for whatever you’re selling.

So, I don’t know, maybe I’m looking at this wrong, but it seems like those are both examples of centralizing power, yet they’re done in the name of advancing democracy. So, do you agree? Has this changed over time, whether democracy is advanced or not, by controlling money?

[00:25:52] Carola

Oh, yeah. I mean, one of the phrases about the OPA, or the World War Two price controls, was ‘big democracy in action’, which I think is ominous sounding – just what we want, big democracy in action.

So, I mean, one thing that people should be aware of is that before the national banking system, the quote you gave from Abraham Lincoln, that was about setting up a national banking system so that there would be a uniform national currency. You had paper money, but it wasn’t all uniform. It was issued by different banks.

So, during the free banking era, you could have bank notes that were pieces of paper from different banks. And it would say, you can bring it to such and such bank and get it redeemed in gold. But these, it might say it’s $1, but the bank notes from different banks would be worth different amounts.

They would be worth different amounts, depending on how likely people thought it was, that they could actually go back to the bank and get it redeemed. So, one thing is that it was just cumbersome and confusing to have all these different kinds of paper money around.

But what politicians sometimes didn’t like about it was it seemed that the banks themselves could control the money supply depending on how much paper they were issuing. And there were rules, right? They were supposed to be able to have enough capital on hand to be able to keep those notes redeemable. But at some points they would just declare, we’re not going to redeem our paper anymore.

They would suspend conversion into speci, into gold and silver, and often there would be big financial panics, and the banks would be blamed for having overissued their paper notes. So, I think the idea was that we have these bankers who are sort of causing panics, or at least contributing to them by being able to issue paper notes. And the government preferred to have that power more centralized.

[00:28:09] Kevin

I see. That makes sense. It’s taking power away from the bankers and giving it to the people. And control over the money is kind of the mechanism for doing that.

[00:28:20] Carola

Yeah, but of course, I mean, the monetary arrangements we have now are not really democratic in the sense that we, or our elect officials, don’t vote on monetary policy. The president and Congress have a role in the nomination and appointment of Federal reserve officials. But the Fed does have really strong political insulation, so they can conduct monetary policy basically as free as possible from political interference.

They recognize that that’s not really democratic, but that if we did have democratically elected officials responsible for monetary policy, it would probably lead to a lot of inflation because politicians would be more short sighted and try to do monetary expansion in order to get reelected, even though down the road that would lead to high inflation.

[00:29:14] Kevin

Yeah, and I want to put a pin on that one and circle back to that in a second. But let’s maybe use that as a link to talk about some of the, I guess, more modern questions that you talk about toward the end of your book.

The Fed’s current objective is to promote maximum employment and then have this kind of average inflation target of 2%. So, the dual mandate. You actually think a different target would be preferable, and it’s what you call a nominal GDP target. And that’s an idea that’s been around for a long time, but it’s also an idea that I think people aren’t that familiar with. So, I was curious if you could just maybe explain what that is and then why you think that would be a better target for the Fed.

[00:30:02] Carola

Sure. So nominal GDP, that’s like the dollar amount of the goods and services produced per year in the United States. Another way, it’s commonly described as a nominal income target. So, you take nominal GDP or nominal income. The growth rate of nominal GDP is the growth rate of real GDP plus inflation.

So, if inflation is 2% and real GDP, the amount of actual stuff we produce, grows by 3%, then nominal GDP would grow by 5%. So, the idea is you target some path for nominal GDP, and maybe it’s 5%.

Maybe you think, okay, normally real GDP grows around 3% a year, and inflation, we’d like it to be around 2% a year. So, let’s just target keeping nominal GDP growing 5% a year. You could make that a target path. Meaning if we undershoot this year, and we accidentally get 4% nominal GDP growth instead of 5%, we’ll make up for it next year. So, we still stay on that path where nominal GDP is growing 5% each year.

What’s nice about it, one is just a single target. So, when the Fed has two targets, a price stability target and an employment target, there are tradeoffs between those two, and, at least, uncertainty at any point about what they’re going to do.

So, they have a single instrument and two targets that they’re trying to hit. So those two targets could come into conflict. So, oil prices might rise. That would lead to higher inflation and higher unemployment. Are they going to raise rates to deal with the higher inflation, or lower rates to deal with the higher unemployment? Well, we don’t really know. And it’s sort of at their discretion what they’re going to do.

If they have a nominal GDP target, it’s essentially telling them how to balance those objectives. So, I think it would be easier for people to understand that the Fed is keeping nominal income stable rather than trying to target two things at once.

[00:32:27] Kevin

How would you determine what the right growth rate in nominal GDP is? Is it 5%? Is it 6%? Because we really don’t know what the trend rate of growth in real GDP is.

It’s been coming down over time, and then now there’s talk about, well, actually, productivity might increase with AI, et cetera, so maybe it will go up. If we had been, say, targeting a nominal GDP growth rate based on our experience in, say, the seventies and eighties, would that have left us with much higher inflation because real GDP has come down, so we would be basically making up for it with higher prices? I don’t know if that…

[00:33:14] Carola

There is debate about how, exactly, you would implement it, and whether that path would kind of get edited over time to account for changes in real GDP growth. I think that, say we think that real GDP growth is going to be 4% on average. So, we pick a 6% target in GDP growth, right? Thinking that’ll give us 2% inflation. If we’re off by like a percentage point, so, real GDP is actually growing 3% on average, and we get 3% inflation instead of 2%, I don’t see that as a huge problem. We’d have to be really far off on what real GDP growth trends would be like, to get a lot more inflation than we were expecting, or to get a lot less inflation than we were expecting.

But yeah, that would be the challenge. What path should we pick, and then should we go back and edit it, and what would be the procedures for doing that? But there’s always information problems in monetary policy.

Monetary policymakers have to set their policy despite a lot of unknowns: unknowns about what’s the natural rate of unemployment, what’s the neutral rate of interest, unknowns about is the inflation that we’re experiencing mostly demand driven or mostly supply driven? So, there’s so many unknowns that they’re dealing with when they’re setting policy. And that’s going to be the case pretty much whatever policy kind of rule they pick.

I think those information problems would be a little less with NGDP targeting because they wouldn’t have to be trying to figure out the natural rate of unemployment while they’re setting their policy. There would still be uncertainty about the potential growth rate of the economy. But I think if you’re a little off on that, you just end up with a little bit higher or a little bit lower inflation, which maybe isn’t such a big deal.

[00:35:21] Kevin

Thanks for that. I think that’s a good explanation. What’s your view about incorporating asset prices or thinking about asset prices as a central bank? One of the criticisms that we wrote about in our book, and a lot of people have talked about, is targeting consumer price inflation has meant interest rates have been very low, and that’s blown asset price bubbles. There are two problems with that. Number one is asset price bubbles increase the risk of a financial crisis, which is bad. So that’s creating instability. Targeting stable inflation actually leads to instability because of the asset bubbles.

But also, and this is something that I think we were writing about, before it wasn’t quite as well known, but I think it’s generally accepted now that it also reinforces wealth and income (or wealth inequality, in particular) because of the asset ownership distribution is very skewed. Maybe rich people own stocks, so stocks go up. Basically, you’re making wealth inequality worse.

So, there have been some pretty influential economists, we had Andrew Smithers on the show talking about how you need to target both savings or desire to save, and also the asset prices if you want a stable economy.

How do you feel about that? Where do you come down in terms of incorporating asset prices into central bank decision making?

[00:36:56] Carola

Yeah, I don’t have a really strong or well thought out opinion about that. I still like the idea of having, if possible, a single target, at least a clearly defined target.

So, if they were to do something like that, it would be about picking a different measure other than the PCE; a different inflation measure. One that included whatever asset prices they were interested in, and targeting that measure, rather than saying, okay, we’re going to actually not have a dual mandate, we’re going to have a triple or quadruple mandate, and we’re going to… You’re in New Zealand, right? Didn’t the reserve bank of New Zealand start also to add house prices as another side of their mandate?

[00:37:45] Kevin

I think they did. I have to say, I’m not sure, but certainly house prices have been… It’s a good question because house prices in New Zealand are probably the most expensive in the developed world. So, that was starting to be seen as a real, almost kind of like a social justice issue. Young people priced out of the housing market, and the same thing we’ve had in the US, but even more extreme. So, I think there was a lot of pressure to like, hey, this needs to be part of your decision-making process.

[00:38:19] Carola

Yeah, I mean, where I get uncomfortable is when the central bank is trying to target relative prices rather than aggregate prices. So, saying we’ll have a 2% inflation target and a target for house prices is (if I have it right, what they’re doing), essentially, targeting some relative price for housing, rather than just targeting aggregate prices and letting the market determine relative prices based on supply and demand.

Yeah, I understand housing as a social justice issue, but I think social justice issues are the ones that it’s especially important to have them be democratic; have it be something that is part of the democratic process rather than outside of it with the central bank, even though there’s more of a tendency to say, well, the central bank can actually do something. So, let’s put it…

[00:39:13] Kevin

Let’s have them do it.

Yeah, that’s fair enough. You can’t pile everything onto the plate of central bankers.

One more question about asset prices and then we’ll move on. If, presumably, they would get folded into your nominal GDP target, if, I don’t know, a stock market bubble bursts, then that affects GDP, nominal GDP. So, maybe they become part of the equation through the impact on GDP.

[00:39:47] Carola

Sure. Yeah. If a stock market crash reduces GDP, then that would lead to, the rule would say you need expansionary monetary policy at that point. There are different variants of nominal income type policies, including some that would just target nominal wage income. So those would all work slightly differently. But yeah, if it was just overall a nominal GDP, then yes.

[00:40:27] Kevin

You said, right at the beginning, that your research focuses, to some extent, on measuring inflation expectations, and that’s a really important issue currently. It’s important because inflation expectations have remained remarkably stable by a lot of measures, despite the burst in inflation we had during COVID. But then there’s people saying, well, it’s very difficult to know what real inflation expectations are now. I mean, when you try to gauge them, what measures do you use?

[00:41:03] Carola

Mostly I’ve been using the two major inflation expectations surveys in the US, which are the Michigan Survey of Consumers and the New York Fed’s Survey of Consumer Expectations. But a lot of my research agenda has been about what are these surveys actually measuring?

They ask, well, what do you expect inflation to be over the next twelve months? Or what do you expect to happen to prices, in general, over the next twelve months? And people give a number. But can we actually interpret that as inflation expectations is kind of a different question.

In some cases you know that you probably can’t because people give numbers like 100. If somebody says that inflation will be 100%, you would expect their consumption and investment habits to be pretty different than they actually are. So, in some sense, I mean, it could be that people don’t understand the question sometimes. It could also be that they are just kind of voting with the survey.

So, I have a recent paper with another Berkeley alum, Rupal Kamdar, and another co-author, Jane Ryngaert, where we show that there’s this huge divergence between Republicans and Democrats inflation expectations, especially in the Biden presidency.

So normally, people who support the president have lower inflation expectations and people who are of the opposite party have higher inflation expectations. And that’s still true, but the gap just widened so much that, during ’21, 2022, when inflation was rising, Democrats expectations didn’t budge and the whole rise in expectations came from Republicans.

And we think partly that is a real phenomenon, meaning if you look at the news channels that Republicans are viewing, like Fox News, they were saying this inflation is not transitory. Powell says it’s transitory, but he’s crazy, things like that. Saying, how can this fiscal stimulus not lead to massive inflation?

So, they might have been exposed to news that really did convince them that inflation was going to be high. They might also have just kind of a way of saying, like, I really think things are just on the wrong track in this country, saying a high number when you report inflation expectations on the survey. I think it’s some of both going on.

That big partisan divide in inflation expectations, as reported on surveys, should lead people to kind of at least pause when using that data because there is some also partisan difference in spending and investment. But you would expect it to be just massive if people really did have such drastically different expectations of inflation.

[00:43:49] Kevin

So, they’re sort of using the inflation survey as a way to express a political opinion about whether they approve or not of the current presidency. To some extent, maybe that’s not all of it.

So basically, that’s saying, hey, we need to be careful about how we interpret that inflation expectation data. Yet, at the same time, it’s such a crucial idea. When we talk about the inflation of the 1970s, it got out of control because inflation expectations “became unanchored”.

This time around, inflation expectations still seem anchored, but there’s rumblings, tremors that maybe they’re not. So, when you’re looking at it, when you’re trying to gauge the degree of anchoredness, I suppose, how do you do it? Do you trust, say, breakeven inflation rates from the markets?

I guess when I say trust, I mean to the extent that the Fed is so actively involved in buying Treasury bonds now, it influences the ten-year bond rate. Can we really look at the difference between the ten-year bond rate and TIPS and say that’s the inflation expectation? I don’t know. It seems like a very important idea right now and were kind of grasping for the right number.

[00:45:15] Carola

Yeah, it is. And I don’t think there’s any perfect, true measure of inflation expectations. There’s also no one true inflation expectation.

Every person has their own expectation of what inflation is going to be. I look at all the measures. I look at TIPS. I look at the survey of professional forecasters. There are new surveys of firms, business owners and business managers, people who might be price setters, and there’s the consumer surveys, and they’re all telling us different things, and they all have some downsides to them, like you mentioned with TIPS.

The consumer ones, the reason you look at it is because consumers don’t have the same expectations as participants in financial markets. But it’s still really important for the Fed to know if people find the Fed’s inflation target credible.

But then the downside is that we don’t always know that people are actually reporting inflation expectations on the survey or that they even necessarily understand the question that they’re being asked on the survey. So, I look at all the measures. I think that having different surveys out there that ask the question in different ways is also useful.

I know the Fed looks at all of these different measures also, and just has to use them to get a big picture of what’s going on. For the 1970s, we could even just tell, based on the movement of nominal interest rates, what the markets were expecting about inflation. So even though there weren’t many good surveys to use, just interest rates themselves are used to say that expectations were clearly unanchored then.

[00:47:09] Kevin

So, I guess when you (kind of the last inflation expectation question), when you kind of pull all that together and I put you on the spot and I say, well, have inflation expectations risen in a kind of meaningful way over, lets say, from now to pre-Covid, what would your answer be?

[00:47:27] Carola

I would say that they did rise with inflation, but they have gone basically back to normal. I don’t know that means that they’re perfectly anchored. I think people are much more aware of inflation now and are likely to be sensitive to it. Before COVID, CPI reports would be covered in the Wall Street Journal, but maybe not make their way to cable news. And maybe people wouldn’t care that much about what’s the latest CPI report. Now, cable news covers the CPI reports more than before. More people know about CPI reports.

And so, in the past, if we were to get one kind of surprisingly high CPI report, maybe nobody would really care. But now, if in a month or two, if we get a surprisingly high CPI report, it’s going to be a big deal. So, people could have become kind of more sensitized to inflation news in a way that could make it more challenging in the future to just keep expectations stable in the face of the inherent noise in inflation.

On the other hand, the fact that we had this terrible inflation in 2022, and now it’s basically back to normal without the big recession that we were all afraid of, maybe that actually helps. Next time inflation is rising, people are more confident that the Fed can get it back under control.

Even though inflation is back down, you also hear the story that the price level itself is not back down. So, people feel like inflation is high. What they mean is prices are still high.

That difference between a level and a rate of change is not very clear to a lot of people. So, people still feel like prices are really high, and so they’re going to kind of be dissatisfied about that no matter what happens with inflation.

[00:49:34] Kevin

Yeah, well, I appreciate that there’s no right answer, but I think it’s important, especially to hear from someone like you, who studies this so carefully. My own take is that I can see why the price level makes people unhappy, and that will probably just be something that gets gradually adjusted to, over time.

I want to end our conversation. We’re talking about inflation, thinking about what is the likelihood of it becoming unanchored, or inflation expectations becoming unanchored. You have a quote in your book from Irving Fisher, who you’ve mentioned, a prominent economist and one of the people who was advocating for using an index as a price target for the central bank.

Let me just read it out. He says, “Sad experience teaches that irredeemable paper money, while theoretically capable of steadying prices, is apt, in practice, to be so manipulated as to produce instability. In nearly every country, there exists a party consisting of debtors which favors depreciation. A movement is therefore at any time possible tending to pervert any scheme for maintaining stability into a scheme for inflation.”

You talked about that: debtors prefer inflation. My question is, given the vast amount of debt now and the class of debtor is actually the government, and the government is the one in control of the money supply, control of the monetary regime. So, the debtor class, the class that ought to benefit and favor inflation, is also the class that’s in charge of controlling it. And does that imply or does that portend a period of higher inflation, no matter what the government actually says?

[00:51:26] Carola

Well, that’s why, luckily, we have Federal Reserve independence. You do see the Fed and other central banks under a lot of political pressure for looser monetary policy. Luckily, the Fed seems to be able to resist that kind of pressure.

But, yeah, in countries where the central bank is not so independent and the government gets into a lot of debt, the way out of it often is to monetize the debt to have a lot of inflation. I have a different paper called Political Pressure on Central Banks that’s about this topic, where I measure political pressure on central banks across the world. And the kind of pressure that politicians put on central banks is almost always for looser monetary policy, especially if there’s concern about the government’s indebtedness.

[00:52:21] Kevin

You recognize that pressure, but you don’t worry about it kind of leading to looser monetary policy in the US?

[00:52:30] Carola

Not in the near future, not while we have the central bank with its reputation and its independence that it has now. And I don’t see the Fed really losing that political insulation anytime soon.

I think it’s something that the Fed takes great pride in and that also, like the international community recognizes and would kind of be so shocked and horrified if we were to lose that, that I think there would be too high of a reputational cost. It’s always a possibility down the road, but it’s not like a big worry of mine right now.

[00:53:08] Kevin

Okay. Okay. Well, thanks so much for joining the show. If you’re interested in the kind of the history of inflation, if you’re interested in how inflation interacts with democracy, it’s a great book to kind of trace those cycles. So, Carola, thanks so much for joining the show, and I encourage everyone to go out and get her book and follow her work.

[00:53:34] Carola

Thank you so much. It was great to be here.

[00:53:36] Kevin

All right, so, thanks for listening, everyone, and please make sure you follow Carola’s work. As you can tell, I think from our discussion, some of these ideas haven’t been discussed enough on mainstream media. We appreciate you listening. And for all of us at Top Traders Unplugged, we’ll see you next time.

[00:53:58] Ending

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