Krugman: Fed rate hikes didn't plunge inflation, post-COVID adjustment did

[The world will shine with light in our nightmare]

"The more I look at that claim, the less plausible it seems," Krugman wrote. Giving credit to the Fed for disinflation strikes him as "at least mostly wrong," he added.

The retired Princeton and MIT professor said it was more likely that the COVID-19 pandemic discombobulated the economy. Now markets have adjusted those disruptions, "recombobulation" has taken place, he said.

He pointed out that higher rates typically curb inflation by discouraging spending, hiring, and investing. That leads to higher unemployment, which weakens demand and eases upward pressure on prices. But inflation has cooled without joblessness spiking, indicating other factors are at work, he said.

Krugman highlighted that business closures, lockdowns, and travel restrictions shifted demand to goods from services. That roiled global supply chains and sent everything from shipping costs to used-car prices skyward.

More importantly, the work-from-home boom ignited demand for houses, which had the knock-on effect of lifting rental costs. Those forces plateaued more than a year ago, but have only been reflected in recent months due to lags in inflation measures, Krugman said.

The economist also underscored that the surge in workers quitting their jobs during the pandemic — dubbed "The Great Resignation" — has dissipated. As a result, labor shortages have eased and wage growth seems to have waned.

Business Insider

For NYT subscribers, Krugman's full piece is here.

I've jokingly called the last few months a "jobs recession" in light of all the reports that seem to have proved the pessimistic economists wrong (at least so far!), but Krugman's arguments make sense to this layman. COVID was a first-of-its-kind hiccup and the economy had been doing fine before the pandemic struck, so there weren't any bubbles or other foundational problems to create something like most financial crises. Hopefully the Fed takes notice.

[WalterWhite]

I think interest rate increases did contribute to slowing down inflation at least a bit. Turkey DECREASED interest rates, and their inflation rate skyrocketed.

As to why Turkey would decrease their interest rates, I can only assume my product has made it all the way to Turkey.

[Benjamin Frank]

"The more I look at that claim, the less plausible it seems," Krugman wrote. Giving credit to the Fed for disinflation strikes him as "at least mostly wrong," he added.

The retired Princeton and MIT professor said it was more likely that the COVID-19 pandemic discombobulated the economy. Now markets have adjusted those disruptions, "recombobulation" has taken place, he said.

He pointed out that higher rates typically curb inflation by discouraging spending, hiring, and investing. That leads to higher unemployment, which weakens demand and eases upward pressure on prices. But inflation has cooled without joblessness spiking, indicating other factors are at work, he said.

Krugman highlighted that business closures, lockdowns, and travel restrictions shifted demand to goods from services. That roiled global supply chains and sent everything from shipping costs to used-car prices skyward.

More importantly, the work-from-home boom ignited demand for houses, which had the knock-on effect of lifting rental costs. Those forces plateaued more than a year ago, but have only been reflected in recent months due to lags in inflation measures, Krugman said.

The economist also underscored that the surge in workers quitting their jobs during the pandemic — dubbed "The Great Resignation" — has dissipated. As a result, labor shortages have eased and wage growth seems to have waned.

Business Insider

For NYT subscribers, Krugman's full piece is here.

I've jokingly called the last few months a "jobs recession" in light of all the reports that seem to have proved the pessimistic economists wrong (at least so far!), but Krugman's arguments make sense to this layman. COVID was a first-of-its-kind hiccup and the economy had been doing fine before the pandemic struck, so there weren't any bubbles or other foundational problems to create something like most financial crises. Hopefully the Fed takes notice.

This is still all to the good in the long run because the Fed funds rate had to be normalized (higher than the inflation rate.)  Since the Great Recession the Fed rate had been lower than the rate of inflation, I think it led to an asset bubble in crypto, but that market still largely disagrees with me.

The only thing left - and it's a big thing - to remove monetary policy distortions in the economy is for the Fed to reduce its balance sheet through 'quantitative tightening.'

However, when inflation gets back to the 2% target range, the Federal Reserve will be in a position to decrease its interest rate, but not back to the near zero levels.

Of course, on the fiscal side, the U.S still has enormous government budget deficits, but that continues to be sustainable as long as the U.S $ remains the world reserve currency/petrodollar.

It will be interesting to see what the U.S federal deficit is with full employment and interest rates back to normalized levels.

[jaichind]

This is still all to the good in the long run because the Fed funds rate had to be normalized (higher than the inflation rate.)  Since the Great Recession the Fed rate had been lower than the rate of inflation, I think it led to an asset bubble in crypto, but that market still largely disagrees with me.

The only thing left - and it's a big thing - to remove monetary policy distortions in the economy is for the Fed to reduce its balance sheet through 'quantitative tightening.'

However, when inflation gets back to the 2% target range, the Federal Reserve will be in a position to decrease its interest rate, but not back to the near zero levels.

Of course, on the fiscal side, the U.S still has enormous government budget deficits, but that continues to be sustainable as long as the U.S $ remains the world reserve currency/petrodollar.

It will be interesting to see what the U.S federal deficit is with full employment and interest rates back to normalized levels.

The world reserve currency/petrodollar benefit vis-a-vis USA federal debt is not the advantage it used to be.    Foreign holding of US Treasury Securities reached $4 trillion in 2012.  It is now $3.8 trillion.  In 2012 total federal debt was around $12 trillion but is now $31.2 trillion.

Interest rate normalization does mean that the USA federal government will have to pay a real positive interest on debt.  Interest on the federal debt was 3% of GDP in the 1980s and 1990s and will rise to over 5% of GDP or higher over the next couple of decades.  This means the USA will have to run a primary surplus in the future to prevent a federal debt spiral or inflationary spiral.  Totally doable but will require real cost cutting.  The USA will have to pick between guns and butter but will not be able to have both in the future. 

[Benjamin Frank]

This is still all to the good in the long run because the Fed funds rate had to be normalized (higher than the inflation rate.)  Since the Great Recession the Fed rate had been lower than the rate of inflation, I think it led to an asset bubble in crypto, but that market still largely disagrees with me.

The only thing left - and it's a big thing - to remove monetary policy distortions in the economy is for the Fed to reduce its balance sheet through 'quantitative tightening.'

However, when inflation gets back to the 2% target range, the Federal Reserve will be in a position to decrease its interest rate, but not back to the near zero levels.

Of course, on the fiscal side, the U.S still has enormous government budget deficits, but that continues to be sustainable as long as the U.S $ remains the world reserve currency/petrodollar.

It will be interesting to see what the U.S federal deficit is with full employment and interest rates back to normalized levels.

The world reserve currency/petrodollar benefit vis-a-vis USA federal debt is not the advantage it used to be.    Foreign holding of US Treasury Securities reached $4 trillion in 2012.  It is now $3.8 trillion.  In 2012 total federal debt was around $12 trillion but is now $31.2 trillion.

Interest rate normalization does mean that the USA federal government will have to pay a real positive interest on debt.  Interest on the federal debt was 3% of GDP in the 1980s and 1990s and will rise to over 5% of GDP or higher over the next couple of decades.  This means the USA will have to run a primary surplus in the future to prevent a federal debt spiral or inflationary spiral.  Totally doable but will require real cost cutting.  The USA will have to pick between guns and butter but will not be able to have both in the future.  

Not sure where you get your numbers from.
This is what I find: Foreign holders of United States treasury debt
According to the Federal Reserve and U.S. Department of the Treasury, foreign countries held a total of 7.4 trillion U.S. dollars in U.S. treasury securities as of April 2023.

Not being a foreign exchange trader or a finance person, I assume the main benefit for U.S based private treasury bond holders of the U.S $ being the world reserve currency/petrodollar is the greater stability it provides, i.e not having to hedge against currency risk.

[jaichind]

Not sure where you get your numbers from.
This is what I find: Foreign holders of United States treasury debt
According to the Federal Reserve and U.S. Department of the Treasury, foreign countries held a total of 7.4 trillion U.S. dollars in U.S. treasury securities as of April 2023.

Not being a foreign exchange trader or a finance person, I assume the main benefit for U.S based private treasury bond holders of the U.S $ being the world reserve currency/petrodollar is the greater stability it provides, i.e not having to hedge against currency risk.

Oops.. you are right.  I got my numbers wrong.  The narrative is similar though

Where growth in foreign holdings of treasuries has slowed last few years


Even as total debt surged.


My main point is that the total external funding of USA federal debt has fallen as a % of total debt and it seems it will continue this decline in the future.  So counting the USD as a reserve currency to help get external funding for USA federal is a benefit but a declining benefit in practice.

[Torie]

Excellent thread, thank you, and for once I think Krugman got it right here. His observations seem very plausible to me.