Regional President Speech

REFLECTIONS ON THE DISINFLATIONARY METHODS OF POINCARÉ AND THATCHER JamesBullard FederalReserveBankofSt. Louis BarcelonaSchoolofEconomicsSummerForum ExpectationsinDynamicMacroeconomicModels June17,2022 Barcelona,Spain AnyopinionsexpressedhereareourownanddonotnecessarilyreflectthoseoftheFOMC. 1

Introduction 2

INFLATION NEAR 1970S LEVELS Inflationisrunningnear1970slevelsintheU.S.andtheeuro area. HowwilltheFedandtheECBreturninflationtothetargetlevel of2%? 3

INFLATION IN THE U.S. AND THE EURO AREA 16 U.S. PCE 14 euro area HICP Germany CPI 12 France CPI 10 tn 8 e c r e 6 P 4 2 0 2 1960 1970 1980 1990 2000 2010 2020 Sources:EurostatandBEA.Lastobservations:May2022andApril2022. 4

DISINFLATION AHEAD RhetoricfromtheFedandtheECBsuggestsdisinflationary monetarypolicyahead. TheFedisraisingitspolicyratesharplyandallowingitsbalance sheettodecline,whiletheECBlookssettopursuerelated actions. Withinflationnear1970slevels,willtheFedandtheECBbeable todisinflaterelativelyeasilyandquickly,orwillasubstantial recessionoccuraswasthecaseoftheFedunderVolcker? Manyfinancialmarketobserversandparticipantsarearguing thatasubstantialrecessionislikely. 5

INCREDIBLE DISINFLATIONS Thistalkreviewsselectedliteraturepost-Volckeroncredible versusincredibledisinflations. TheVolckerdisinflationwasincredible: Initially,fewbelieved thattheFedwasseriousaboutreducinginflationafteranentire decadeofallowinginflationtobuild. Forinstance,seeLindsey,OrphanidesandRasche(StLFed Review,2005),Nelson(workingpaper,2022),Goodfriendand King(JME,2005,“TheIncredibleVolckerDisinflation”),and Sargent(Goodfriendconferencevolume,2022,“Rational ExpectationsandVolcker’sDisinflation”). 6

CREDIBLE DISINFLATIONS Thepost-Volckerliteratureturnedtoanalyzecredible disinflations,inspiredbySargent(1982,“TheEndsofFourBig Inflations,”and1981,“StoppingModerateInflations:The MethodsofPoincaréandThatcher”). AvailableinSargent(2013),RationalExpectationsandInflation,3rd ed.,PrincetonUniversityPress. Thisliteratureexploredtheideathatcredibledisinflationsdonot havelargeoutputcosts. Rather,becauseofrationalexpectations,theycanbecostless. Theapparentreal-world“cost”onlycomesfromhavingto“earn credibility.” “Ifyouhavetocutoffthetailofadog,don’tdoitoneinchata time.” 7

LESSON FOR THE COMING DISINFLATION ThecurrentsituationfortheeuroareaandtheU.S.seemstofall morecloselyundertherubricofa“credibledisinflation,”rather thanthe“incredibledisinflation”experiencedbyVolcker. Sincemoderncentralbankshavemorecredibilitythantheir counterparts50yearsago,itappearsthatboththeFedandthe ECBmaybeabletodisinflateandachievearelativelysoft landing. 8

Pure Phillips Curve Disinflation 9

DISINFLATION AND UNEMPLOYMENT Let’ssupposewebeginwithapurePhillipscurveanalysis(not somethingIadvocate). CurrentestimatesfortheU.S.pointtoanessentiallyflatPhillips curve. Forinstance,StockandWatson(JMCB,2020)reportaslopeof 0.03forbothcoreandheadlinePCEinflationpost-2000. (cid:0) Strictlyspeaking,usingthismechanismalonewouldrequire unemploymenttogotoveryhighlevelstogetinflationtoreturn to2%intheU.S. Whilenumberscouldvary,thisisthegenesisoftheideathat therewillhavetobealargerecessiontogetinflationunder controlintheU.S. Butthisisamechanicalcalculationthatsaysnothingabout inflationexpectations. 10

THE ROLE OF EXPECTATIONS TheNewKeynesianPhillipscurve(NKPC)hastwoarguments, anoutputgaptermaswellasaninflationexpectationsterm. TheNKPChasacoefficientnearunityontheinflation expectationscomponent,whichtheoreticallysuggeststhatthe relationshipbetweenactualinflationandexpectedinflation shouldbeveryclose. Thefollowingchartseemstoconfirmthatthisrelationshipholds inbroadterms. Theseconsiderationssuggestthatinflationexpectationsmay playalargeroleinthecomingdisinflation,asopposedtothe sizeoftheoutputgap. 11

ACTUAL AND EXPECTED INFLATION 6 5 year breakeven inflation rate 5 Core PCE inflation 4 3 tn e c 2 re P 1 0 1 2 2005 2010 2015 2020 Sources:St.LouisFedandBEA.Lastobservations:May2022andApril2022. 12

THE ROLE OF EXPECTATIONS TheNKPCinflationexpectationstermisfornear-terminflation expectations—strictlyspeaking,oneperiodahead. Whenexpectationsarediscussedinpolicycircles,theemphasis isoftenonlonger-terminflationexpectationsandthenotionthat longer-termexpectationsremain“wellanchored.” Nearer-terminflationexpectationsintheU.S.maybeonthe precipiceofbecomingunmoored. 13

SURVEY-BASED INFLATION EXPECTATIONS MOVED HIGHER 4 1 yr U.S. CPI inflation SPF forecast 1 yr euro area HICP inflation SPF forecast 3 tn e c2 r e P 1 0 2019 2020 2021 2022 Sources:PhiladelphiaFedandECB.Lastobservation:2022-Q2. 14

MARKET-BASED INFLATION EXPECTATIONS MOVED HIGHER 4 1yr 1yr fwd. U.S. CPI inflation swap 1yr 1yr fwd. euro area HICP inflation swap 3 tn e c2 r e P 1 0 Jan 2020 Jan 2021 Jan 2022 Source:Barclays.Lastobservation:June7,2022. 15

Costless Disinflations 16

SARGENT ON THE IMPORTANCE OF EXPECTATIONS Importantargumentsconcerningtheroleofexpectationswere goingoninmacroeconomicsduringtheearly1980sdisinflation. Sargent(1981,1982)emphasizedtheroleofexpectationsina credibledisinflationaryprocess: Itisthecredibilityofthefuture policythatcausessubstantialadjustmentininflation expectations. In“MethodsofPoincaréandThatcher,”hedrewacontrast betweenthesuccessfulandrapidmonetary-fiscaladjustmentof PoincaréinFrancein1926andthethen-proposedslowand gradualistapproachofthemonetaristThatchergovernmentinthe U.K.circa1980. In“TheEndsofFourBigInflations,”hedocumentedhowongoing hyperinflationscametosuddenendsfollowingcredible monetary-fiscaladjustmentsinpost-WWIeconomies. Sargentemphasizedbothmonetaryandfiscaladjustment. 17

FURTHER SARGENT COMMENTARY GoodfriendandKing(2005)stressedtheideathatVolckerhadto takeactionstoearncredibility. InrecentcommentsonGoodfriendandKing,Sargent(2022) notesthattherecanbelittleconceptofearningcredibilityunder rationalexpectations. Infact,the“communism”oftheREmodel—allactorsforecast thesameway—makesithardtoattributeoutcomestoparticular playersatall. Thesubtextisthatonehastobackoffoftherationalexpectations assumptiontodiscusshowapolicymakercouldbeearning credibility. 18

LEARNING AND CREDIBILITY AliteraturesubsequenttoSargent(1981,1982)investigated credibledisinflationsinmodels. Credibility:Ireland(JMCB,1997),GoodfriendandKing(2005), Sargent(2022),BonomoandCarvalho(JMCB,2010),Walsh (workingpaper,2022). Learning:BarnettandEllison(JMCB,2013),Cogley,Matthesand Sbordone(JME,2015),Nunes(MD,2009),Schalingand Hoeberichts(DE,2010),Bomfim,Tetlow,VonzurMuehlenand Williams(workingpaper,1997),NicolaeandNolan(JMCB,2006), GibbsandKulish(EER,2017),Lu,KingandPasten(JME,2016), Wieland(bookchapter,2009). Asoneexample,GibbsandKulish(2017)consideramodelwith learningalongwithevolvingcredibility,andtheyfitthemodel toarangeofobserveddisinflationsacrosstimeandplace. Their modelattributesthecostofdisinflationtothedegreeof credibility. 19

Disinflation Today 20

THE MONETARY-FISCAL MIX TODAY TheCOVID-19pandemicinducedlargedeficitspending combinedwithaccommodativemonetarypolicy,including large-scaleassetpurchases. Thiscouldbethoughtofasakintoanintentional,temporary, high-inflationregime,asthemonetaryauthoritydidnotattempt tooffsettheinflationaryimpulseunleashedbythefiscal authority. InkeepingwiththespiritofSargent(1981,1982),whatisnow requiredisaregimeswitchbacktotheprevious,pre-pandemic regimethatfeaturedinflationneartarget. Issuchaswitchoccurring? 21

DISINFLATION TODAY Theregimeshiftbacktothepre-pandemicfiscal-monetarymix doesappeartobetakingshapeintheU.S. FiscalsituationintheU.S.: Additionallarge-scaledeficit spendingmaybelesslikelyduetothepossibilityofdivided governmentfollowingthe2022midtermelections. MonetarysituationintheU.S.: TheFediscommittedtoan inflationtarget;ithastakenactionstoincreasethepolicyrate andtobeginquantitativetightening(QT). Consequently,medium-andlonger-terminflationexpectations currentlytendtobelowerthanshorter-terminflation expectations. Asimilarnarrativefortheeuroarea? 22

MEDIUM- AND LONG-TERM INFLATION EXPECTATIONS LOWER THAN SHORT-TERM EXPECTATIONS 4 1yr 1yr fwd. U.S. CPI infl. swap 5yr 5yr fwd. U.S. CPI infl. swap 1yr 1yr fwd. euro area HICP infl. swap 3 5yr 5yr fwd. euro area HICP infl. swap tn e c2 re P 1 0 Jan 2020 Jan 2021 Jan 2022 Source:Barclays.Lastobservation:June7,2022. 23

Summary and Conclusion 24

SUMMARY Hereisa2x2matrixintendedtoillustratethespiritofthe post-Volckerliterature: Fedactions Enhancingcredibility Reducingcredibility Private-sector High Poincaré:costlessdisinflation; Erosionofcredibility assessment softlanding 1970s:Highandvariableinflation ofFedcredibility Low Volcker:costlydisinflation &volatilerealeconomy 25

CONCLUSION CurrentinflationintheU.S.andtheeuroareaisnear1970s levels. TheVolckerdisinflationwascostly,butitwasnotcredible initially—Volckerhadtoearncredibility. Sargentinitiatedaliteratureoncostlessdisinflationthat emphasizedinflationexpectationsasthekeyvariable,notthe Phillipscurve. Subsequentliteratureillustratedhowcredibilitymightbeearned inmodelsthatdepartfromrationalexpectations. TheFedandtheECBhaveconsiderablecredibility,suggesting thatasoftlandingisfeasibleintheU.S.andtheeuroareaifthe post-pandemicregimeshiftisexecutedwell. 26