2022 Economic Outlook with Joe Santos
The interview posted above is from SDPB's daily public affairs show, In the Moment with Lori Walsh.
IT’S ONLY MONEY
This blog post accompanies the SDPB Monday Macro segment that airs on Monday, October 3, 2022.
On Tuesday, October 4, 2022, during the Economic Outlook Seminar hosted by the South Dakota Chamber of Commerce and Industry in Sioux Falls, I will present an analysis of the current U.S. macroeconomy. On the Monday Macro segment that airs October 3rd, Lori Walsh (SDPB) and I will discuss the five principal features—or takeaways—of my presentation to the Chamber. I preview each of these features here.
 Inflation is a monetary, not a supply-chain, phenomenon.
The inflation with which the U.S. and world economies currently contend was instigated, in part, by a supply shock. Nevertheless, inflation is ultimately a monetary phenomenon: the outcome of too much money chasing too few goods. More formally, the argument that inflation is a monetary phenomenon relies crucially on the presumed relationship between the supply of money and its purchasing power and, in turn, on the relationship between the central bank and the supply of money. To understand how specifically the supply of money and the rate of inflation are related, and why reducing inflation is a macroeconomic policy that falls within the purview of a central bank, consider the following quantity equation.
M x V = P x Y
In this equation, M represents the supply of money, V represents the income velocity of money, P represents the average price level, and Y represents real income, which economists typically measure as real Gross Domestic Product (GDP). Velocity is a crucial feature of the quantity equation and the relationship between the supply of money and the rate of inflation more generally. Economists define velocity (V) as the average number of times the supply of money (M) is exchanged to purchase nominal income (P x Y). For example, suppose the supply of money in the economy is $50 (M); and during a year in the economy, 100 pens are produced, purchased, and valued at a price of $2 each (P x Y). In this example, the income velocity of money equals 4 (V): $50 of money pays for $200 of nominal income per year, because each dollar in the supply of money is exchanged on average 4 times per year.
The quantity equation explains how the supply of money affects the average price level and, thus, the rate of inflation, provided we assume why individuals hold—or, in the parlance of monetary economics, demand—money, as opposed to illiquid assets such as real estate or equity shares in corporations. Assume, as economists often do, individuals hold money in fixed proportion to their nominal income, so the velocity of money is constant over time. In this case, the supply of money and nominal income are proportional: a percentage change in the supply of money causes an identical percentage change in nominal income.
Finally, a portion of the percentage change in nominal income (P x Y) is reliably driven by non-monetary forces including changes in physical capital, human capital, the labor force, and innovation—long-run features of the macroeconomy. Conceptually, controlling for the effects of these non-monetary forces on nominal income isolates the effects of the supply of money on the average price level: all else equal, the supply of money determines the average price level; or put differently, the growth in the supply of money is the principal cause of the rate of inflation. In my presentation to the Chamber, I demonstrate the strength of this relationship in the case of the U.S. economy over the last several decades and I discuss the implications of this relationship for the current state of the U.S. economy.
 Real interest rates remain too low.
Although the Federal Reserve has been rather aggressively raising interest rates over the last several months, interest rates—and, specifically, real interest rates—remain too low relative to the performance of the U.S. economy. Put differently, the current level of interest rates in the U.S. economy is inconsistently low relative to the current (closed) output gap. And, as always, the real interest rate, not the nominal interest rate, is what matters in this discussion.
The nominal interest rate is the stated yield to maturity of a debt instrument, such as a government bond, a car loan, a credit-card debt, or a home mortgage. As such, the nominal interest rate measures the return to lenders—and, thus, the financing cost to borrowers—in terms of dollars. The difference between nominal and real interest rates is the expected inflation rate. All else equal, inflation reduces—think, erodes—the real return to lenders. In doing so, unexpected inflation rates—for which neither lenders nor borrowers bargained—redistribute income from lenders to borrowers.
This relationship between nominal interest rates, real interest rates, and expected inflation rates occurs because of fierce competition among borrowers and lenders who effectively “price” into nominal interest rates—and, thus, the terms of a loan contract—expected inflation rates; borrowers and lenders do this in an attempt to secure some desired real interest rate. This process of pricing expected inflation into nominal interest rates is called the Fisher effect, named for Irving Fisher, a leading early twentieth-century American economist.
The Fisher effect is specified as the following.
i = r + pe
In this expression, the term i is the nominal interest rate, r is the real interest rate, and pe is the expected inflation rate—the inflation rate that borrowers and lenders expect to occur during the term of the loan (for which i is the nominal interest rate). According to the Fisher effect, subtracting the expected inflation rate from the nominal interest rate yields the (expected or so-called ex-ante) real interest rate. Subtracting the current, actual inflation rate from the nominal interest rate yields the so-called ex-post real interest rate.
In my presentation to the Chamber, I demonstrate that, currently, real interest rates—and, in particular, ex-post real interest rates—remain relatively low, an indication that monetary policy remains relatively loose. Loose monetary policy stimulates aggregate demand and, thus, fuels inflation. To quell high inflation, the Federal Reserve must continue to raise real interest rates; this is to say, the central bank must raise nominal interest rates and, simultaneously, lower expected and actual inflation.
 Monetary-policy-induced demand destruction is not over.
No matter the cause of the high inflation, the instruments of macroeconomic policies, which include monetary and fiscal policies, affect aggregate demand, only. We could think of aggregate demand more concretely as the total amount of expenditures demanded by all sectors of the economy: namely, households, firms, governments, and foreign buyers of our goods and services. In Illustration 1, I demonstrate how macroeconomic stabilization policy—think, contractionary monetary policy instigated by an intentional rise in the short-term interest rate—shifts the aggregate demand curve to the left, causing the rate of inflation to fall from p* to its target—the bullseye pictured in the illustration—and causing the level of economic output to fall from y*.
Illustration 1: Macroeconomic Equilibrium and a Shift in the Aggregate Demand Curve
Thus, according to Illustration 1, and macroeconomic theory more generally, in the short run, reducing inflation—reducing p* to its inflation target as a result of a fall in aggregate demand—effectively induces a fall in output (and, typically, a concomitant rise in unemployment). Since the start of 2022, the Federal Reserve has unambiguously communicated that it is more concerned about the risk to price stability—think, high and variable inflation—than the risk to economic output—think, recession; essentially, as of now, the Federal Reserve views high inflation as worse than recession.
In my presentation to the Chamber, I demonstrate evidence that the current round of monetary tightening is working. Though this evidence is rather indirect and, as one might expect from the dismal science, rather dismal. This is to say, while the rate of inflation remains elevated, economic output, broadly defined and measured, seems to be undergoing the sort of contraction consistent with tighter monetary policy.
 This is not that seventies show.
Comparing the current U.S. economy, with its high, persistent inflation, with the U.S. economy of the 1970s, the decade of the so-called Great Inflation, is now common practice. Fixating on the comparison is understandable. For reasons I’ve discussed in earlier blog posts, high and variable inflation is pernicious in any case. Moreover, the Great Inflation ended in the early eighties with a costly double-dip recession during which, by my estimate, about 17 percentage-point quarters of real GDP were lost relative to where the economy stood before the contraction. The comparable figures for the Great Recession, which began in 2008, and the most-recent (COVID-instigated) recession are about 23 and 17 percentage-point quarters, respectively. Thus, the Great Inflation captivates us because of the high inflation rates the U.S. economy achieved; and because of the double-dip recession that effectively ended the Great Inflation. The latter was instigated by a Federal Reserve and its now-famous (or infamous) chair, Paul Volcker, who was determined to tighten monetary policy as necessary to return the U.S. economy to a steady state of low and stable inflation, something around 2 percent for example.
Empirically speaking, now may be too soon to know if the comparison is valid. Elevated rates of inflation in the U.S. since COVID have persisted for (only) about a year; whereas the Great Inflation persisted for the better part of a decade. Nevertheless, current rates of inflation are disturbingly high.
Theoretically speaking, the comparison of the current U.S. economy with that of the 1970s is valid because an aggregate-supply shock instigated each inflationary experience. In the early 1970s and to a lesser extent in the late 1970s, aggregate-supply shocks were induced by geopolitical crises when the Organization of Petroleum Producing Countries and, later, the Iranian Revolution (1979) effectively reduced the supply of oil to a U.S. economy then-heavily dependent on foreign sources of petroleum. In the recent run up of inflation, an aggregate-supply shock induced by COVID buffeted the U.S. economy, of course. During both experiences, the outcome was a rise in inflation and a fall in output, followed thereafter by expansionary macroeconomic policies—CARES Act and near-zero interest rates during the recent experience, for example—that stimulated aggregate demand.
The U.S. experience post COVID remains (to this point anyway) different than the experience in the 1970s for at least two material reasons. In my presentation to the Chamber, I demonstrate that these differences may bode well for our current situation, and one similarity may not.
First, when the Bretton Woods System of exchange rates collapsed in the early 1970s, central banks, including the U.S. Federal Reserve System, were suddenly forced to operate monetary policy without the usual rules of the (fixed-exchange-rate) game, no matter that many central banks broke these rules from time to time. Absent gold convertibility or a nominal anchor such as a fixed nominal exchange rate, the credibility of the central bank’s strategic framework and the precision of its day-to-day policy tactics suffered, potentially contributing to high and variable inflation. The current Federal Reserve System enjoys far more credibility as an inflation-fighting central bank than it did in the 1970s. Thus, this difference between then and now bodes well for our current situation.
Second, the Federal Reserve entered the 1970s in the final heydays of Keynesian macroeconomic stabilization policy based on the intellectual norm that a so-called Phillips curve—a trade-off between the unemployment rate and the inflation rate—existed and could be exploited by managing aggregate demand policy: ostensibly, policymakers thought they could essentially choose an unemployment rate and an inflation rate by simply managing aggregate demand accordingly. Of course, policymakers assumed they would stimulate the economy to full employment, but not beyond it—where, by definition, higher inflation lurks. The problem, then as now, is knowing where economic output is relative to full employment. Throughout the 1970s, the Federal Reserve very likely maintained—unknowingly, to some extent—a policy that was too loose for too long.
For several quarters during the 1970s, the output gap was substantially positive, implying the U.S. economy was overheating, as it were, because macroeconomic policy in general—and monetary policy in particular—was inappropriately loose. By contrast, if the current output gap is to be believed (because these data are to be revised), the current U.S. economy is not in the overheated state it was in during the 1970s. Thus, this difference between then and now bodes well for our current situation.
Third, the current 10-year ex-post real Treasury yield to maturity is substantially negative, much as it was during the Great Inflation. This similarity between then and now does not bode well for the current U.S. economy, because a negative real interest rate of such magnitude indicates an excessively loose monetary policy, one that could push the U.S. economy past its full-employment level of output, driving the output gap positive and price pressures higher. Indeed, if there is any feature of the current U.S. economy that indicates we might repeat the errors of our Great Inflation ways, it is our current relatively low level of real interest rates.
 Property markets are not immune to Fed policy.
Real estate and the institutions—including credit allocation mechanisms and zoning rules of law, that govern real-estate markets—are inextricably linked to macroeconomic theory and policy. As a recent article in the Economist magazine emphasized, land, which so preoccupied 18th and 19th century economists, is cool again. As an asset class, real estate comprises roughly two thirds of the world’s non-financial assets. Economists ignore land and lending at their peril.
Indeed, in recent years, economic research has linked real-estate-price fluctuations to credit and productivity cycles, for example. According to this work, banks favor collateralized—but not necessarily creditworthy—borrowers; thus, banks allocate credit to borrowers who own highly valued real estate, whether or not these borrowers have productive uses for the credit.
More generally, the value of real estate is tied to the level of interest rates, the very same interest rates the Federal Reserve and other central banks around the world are determined to raise further. Essentially, the interest rate determines the present value of the income flows that real estate generates; a relatively high interest rate reduces the present value of these flows.
In my presentation to the Chamber, I demonstrate that, nationally, the housing market in particular seems to be softening. For example, the number of months it would take for the current inventory of single-family homes on the market in the United States to sell given the current sales pace has recently risen from 1.5 months in January 2022 to 3.3 months in June 2022. Meanwhile, the comparable figures for new homes are 3.4 months in September 2020 and 10.9 in July 2022. To put the July-2022 measure in some context, the comparable figure during the worst of the Great Recession was 12.2 in January 2009. Finally, in June 2022, the widely cited S&P Case-Shiller U.S. National Home Price Index registered month-to-month growth of (only) 0.33%—relatively weak, though not abysmally so.
On balance, the U.S. economy undergoes a period of macroeconomic transition, as the Federal Reserve works hard to tighten monetary policy to quell high inflation. The central bank is right to assume this important role; after all, inflation is a monetary phenomenon. And the central bank’s work is not done, because real interest rates remain too low. Consequently, if we believe the qualitative interpretations of our standard models of aggregate demand, monetary-policy-induced demand destruction is not over; property markets, to which we have looked throughout the pandemic for a sign of economic strength, are not immune to Fed policy. The good news is this episode of intentional and somewhat aggressive monetary-policy tightening need not be a replay of that very painful seventies show.
For more on all this, join us for the Economic Outlook Seminar hosted by the South Dakota Chamber of Commerce and Industry in Sioux Falls on Tuesday, October 4, 2022.