speeches · September 8, 2009
Regional President Speech
Charles L. Evans · President
O ce of the President Money Museum
Last Updated: 12 01 09
The Great In ation 2.0 Debate
Council on Foreign Relations
New York, NY
Thanks for inviting me and thanks for that kind introduction You'll note that I became president and CEO of the Federal
Reserve Bank of Chicago exactly two years ago While I can assure you there's no correlation, this period has been among the
most interesting and extraordinary in the history of the Federal Reserve System So much of what the Fed has done in the last
two years has been under scrutiny from the government, the media, the general public and various others And while the
debate has been loud and at times far ranging, our mandate from Congress has remained quite clear: the goal of the Fed and its
monetary policy arm, the Federal Open Market Committee FOMC , is to promote monetary and nancial conditions that
facilitate the attainment of maximum employment and price stability For about the last 30 years, there has typically been no
con ict in pursuing each of these goals with a single tool—the short-term interest rate This is because rising in ationary
pressures are often accompanied by unsustainably high growth, and economic slowdowns are typically associated with
disin ationary pressures
Nevertheless, this simple description of the way monetary policy responds to growth and in ation prospects belies the fact that
discussions within the FOMC often touch on a wide range of drivers for in ationary pressures A small set of relevant factors
should include money growth, resource slack, in ationary expectations, energy and commodity price shocks, and assessments
of the credibility of future policy commitments And there is a surprising amount of disagreement and uncertainty over the
exact roles forces play I'm not talking out of school on this issue: A careful reading of FOMC transcripts over the last 20 years
will reveal many di erent views on in ation Perhaps this is not surprising The economics community itself continues to
debate strongly the importance of di erent transmission channels for in ation Policymakers who are informed by these
developments—and, in many cases, have contributed to the scholarly research in this area—continue to have a healthy discourse
over the issues and facts
During normal times, in ation evolves gradually, and this debate rarely spills over into major disagreements about policy But,
today, we are not in normal times The in ation debate on the determinants of in ation has broken out on the front pages of
newspapers, with major disagreements among distinguished experts For example, in recent New York Times op-eds Paul
Krugman said that large resource gaps have made him worried about de ation, while Allan Meltzer said that massive growth in
1
the monetary base has made him worried about in ation
Certainly, the stakes could not be higher We have ample evidence of the harm that de ation can cause The history of the U S
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economy in the 1930s is a case in point, where the price level fell by over 25 percent, contributing to the severity of the
Great Depression But, history also shows us the damage that high in ation can wreak on the U S economy From 1965 to
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1980, in ation rose from about 1-1 2 to 10-1 2 percent Many economists refer to this period as the "Great In ation " The
costly process of breaking the Great In ation and then, subsequently, the achievement of price stability took the better part of
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the next 17 years So it is quite disconcerting when highly regarded analysts talk about the possibility of another debilitating
de ation while others—just as highly regarded—suggest that even though we have avoided the Great Depression 2 0, the U S
economy may be facing the Great In ation 2 0
This morning, I would like to frame these two extreme views on in ation risks within the language economists and
policymakers use to discuss these issues After highlighting the terms of these disagreements, I will provide some commentary
on the "lessons learned" from the historical record on in ation In brief, I think neither a harmful de ationary episode nor a
repetition of the Great In ation is very likely Stimulative policies combined with the economy's resilient market forces will,
over time, reduce resource gaps De ation has been averted And as the economy continues to improve, and when we see rising
in ation pressures, Fed policy will respond aggressively Having said this, the main threat to these outcomes would be if clear
danger signals were ignored or if central bank independence were compromised
As always, my remarks today re ect my own views and do not re ect those of my colleagues on the Federal Open Market
Committee or the views of the Federal Reserve System
Two articles of faith
It is natural to start by considering the factors that a ect in ation What do economists say? Well, macroeconomists are a
contentious bunch The most accomplished scholars in this eld share two overpowering attributes First, they are highly
intelligent; and, second, when the subject is monetary policy and in ation, they appear to agree on very little Nevertheless, I
think that there are two strongly held articles of faith that are, in fact, shared by the vast majority of macroeconomists
First, large, sustained and explosive growth in money is associated with high and variable rates of in ation The logic and
evidence are overwhelming Economies that are running the printing presses on overdrive, usually to nance unsustainable
scal de cits, generate great instability in prices and high in ation We saw this in post-WW1 hyperin ations in Germany and
Austria, and, more recently, in high-in ation episodes in Portugal, Italy, and Argentina In addition, numerous studies have
documented that when sustained over long periods of time, even moderately high rates of money growth are often associated
with signi cant in ation However, it's important to note that over shorter time frames, and at lower rates of money growth,
other factors can intervene to signi cantly weaken the strong positive relationship between money and prices that we see in the
5
high in ation examples and in long run studies
The second article of faith is that high unemployment rates and slack capacity utilization—which we refer to as resource gaps—
are often associated with falling in ation A prime example of this is the 1981-82 recession, when unemployment rose to
nearly 11 percent as the Volcker-led Fed broke the Great In ation But, similar to money growth, the evidence regarding the
in uence of resource gaps on in ation is strongest when considering extreme economic conditions—when there is either a
large degree of slack or, on the ip side, an excessive strain on productive capacity
Clearly, these two articles of faith can help frame the current discussion of in ation risks On the one hand, the explosion of
the Federal Reserve balance sheet has led to an enormous increase in bank reserves and the monetary base Left unchecked,
these monetary facts seem to scream "in ation risks " On the other hand, the unemployment rate is 9 7 percent, and
manufacturing capacity utilization is currently only 65 percent, which is the lowest level since this statistic started to be
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computed in 1948 These resource gaps suggest that disin ationary winds are blowing with gale-force e ect
In trying to assess in ation risks from monetary conditions and resource slack, we must remember that these factors are strong
predictors only in relatively extreme cases So it is the fact that we currently nd ourselves in a situation with competing
extreme cases—both large resource gaps and big expansions in the monetary base—that leads to today's Great In ation 2 0
debate
In a few minutes I'll return to how I see this con ict turning out But these two articles of faith provide only a partial
understanding of the factors that determine in ation during more usual times So it is useful to rst describe a relatively
mainstream view on how in ationary pressures emerge under more typical circumstances
First-order forces of in ation determination
Although in ation is ultimately a monetary phenomenon, many factors come in to play when thinking about its evolution over
the medium term The most important ones are: changes in resource costs, wage and price setting behaviors, and in ation
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expectations As we'll see, these forces are related to both articles of faith that I just discussed However, there are
disagreements over how much weight to place on each factor, and also how to interpret the fundamentals underlying each of
them
Let me begin with resource costs When rms set prices for the products they sell, they pass along current and expected future
changes in input costs, including labor costs As a result, market prices and in ation move in the same direction as these
resource costs Resource costs, in turn, move with changes in demand and supply And everything else equal, expansionary
monetary policy will increase demand
It's natural to use movements in measures of aggregate resource utilization, such as unemployment and capacity utilization, to
capture changes in the supply-demand balance In this way, resource costs are linked to resource gaps, which was the focus of
our second "article of faith" about in ation determination Unfortunately, for a host of theoretical and statistical reasons, these
measures of resource utilization are imperfect proxies for supply and demand pressures, and as such, have an uncertain
relationship with price determination As a result, economists will disagree on the importance of these measures for in ation
determination at a given point in time I will return to these uncertainties in a few minutes
Another factor a ecting in ation is inertia in wage and price setting behavior Businesses, workers, and households typically
make changes to their wages and prices in an orderly fashion For example, rms tend to stick to their pricing plans, and
workers' wages are typically revisited only on an annual basis This sort of pricing behavior makes in ation inertial However,
these behavioral regularities are not always well understood and we don't really know whether this sort of inertia will continue
to characterize in ation in all future economic conditions
In addition to direct cost pressures, price setting is in uenced by expectations of future underlying in ation Many things can
in uence peoples' expectations about the future path of in ation—it is a veritable kitchen sink In addition to the resource costs
I just talked about, other important in uences are: changes in money growth, scal factors, and central bank credibility and
independence Higher money growth today may lead people to conclude that in ation will increase in the future
Unchecked scal imbalances can also lead to higher expected in ation if the public believes that at least some of the scal
de cit will be paid o by printing money And in ation expectations can increase if everyone believes that a central bank will
refrain from increasing policy rates for political reasons, even in the face of in ationary pressures
Expectations are clearly a powerful determinant of in ation, but they are inherently unobservable Expectations re ect a
con uence of both objective market data and subjective beliefs of market participants Similar to other important economic
forces—like the output gap—the lack of observability and di culty in measuring in ation expectations represent a powerful
challenge for monetary policymakers Here is how I approach the issue Initially, we can attempt to directly assess each
important force for future in ationary pressures This approach could construct a risk assessment for in ation pressure
indicators and would include all of the factors cited above, at a minimum, along with an assessment or weighting of their
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importance Although there will be disagreements, I nd this constructive approach facilitates rigorous and robust debate
An alternative approach is to be agnostic about the factors that in uence how in ation expectations are formed Instead, we
would simply try to infer expectations from surveys and nancial market data Although this is intriguing, there are limitations
in using this approach to the exclusion of more direct measures of in ationary forces In particular, if monetary policy is so
fully credible that everyone believes in ation will not deviate from its goal, in ation expectations will not respond to changes
in the economic environment For example, many believe that the European Central Bank's commitment to price stability over
the medium term is so strong that measures of euro-zone in ation expectations rarely move But this sort of stability in
expected in ation does not mean that the central bank can relax its vigilance against in ationary forces On the contrary, this
stability is a consequence of that very vigilance We cannot rely solely on direct measures of expected in ation without some
sort of risk assessment that monitors indicators of in ation pressures Fortunately, these two approaches for assessing in ation
expectations are not mutually exclusive; indeed, they are complementary
One of the big questions, however, is to ask what the historical record says about the importance of these di erent factors So
now would be a good time to turn to a couple of quite salient historical examples
The Great In ation 1.0: 1965-82
The Great In ation in the U S from 1965 to 1982 provides a good example of how a long, sustained increase in money
growth tends to increase both contemporaneous in ation and expectations of future in ation Over this period the price level
more than tripled, with the in ation rate peaking at over 11 percent in 1980 This rise in the price level was accompanied by
strong growth in both narrow and broad monetary aggregates The monetary base, like the price level, more than tripled over
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this period, with a growth rate peaking at nearly 10 percent M2, which is a broader measure of transaction money, more
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than quadrupled during this period, and its growth rate topped 11 percent It is important to note that this broader measure
of money, M2, largely consists of the liabilities of the private banking sector, so an expansion of broad money can be triggered
by an increase in base money only if there's an associated growth in bank credit provision Increased bank lending was a key
factor in broad money growth and the Great In ation
To see how this works, note that an expansion of base money implies an increase in both a bank's deposit liabilities and—at
least for the moment—its excess reserves at the central bank Banks may choose to put these excess reserves to work by making
loans, which will further increase the aggregate balance sheet of the commercial banking sector through the standard money
multiplier story This increase in broad money, in turn, can increase in ation
During normal times, an increase in the monetary base results in an increase in broad money because banks generally lend out
almost all of their excess reserves But if, for some reason they choose not to do so, then broad money will not increase as fast
as the monetary base, and the likelihood of an increase in in ation is greatly diminished An example of this occurred during
the early part of the Great Depression, when base money grew signi cantly but the broad money stock actually fell by a
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third We also nd a disconnect today between the monetary base and broad money Over the past year, the monetary base
has nearly doubled as the Fed has rapidly expanded its balance sheet But, given the sluggish growth in bank credit, broader
money has risen much less—by only around 8 percent So, we'll need to see much more expansive bank lending if the
monetary base expansion is to trigger an in ation response And we have yet to see this happen in the current economic
downturn
1979 to 1982 provides a di erent example of the tenuous link between money and in ation Between 1980 and 1982 the
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in ation rate declined from its peak at 11 6 percent to 4 8 percent Yet this disin ation was accompanied by an increase in
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broad money growth, with M2 growth rising from 7 8 to 8 8 percent It is noteworthy that a decline in money growth was
not essential for reducing in ation The explanation is that this was a period of restrictive credit, with real interest rates
soaring to over 10 percent Partly as a result of this tight credit environment, economic activity weakened considerably,
generating substantial resource gaps Restrictive credit conditions and resource gaps dominated the in uence of relatively high
rates of money growth This episode constitutes a caveat for the monetary explanation of in ation pressures: you need to
consider both demand and supply pressures for money—you can't ignore the prices of liquidity and credit Indeed, empirical
research has found that outside of extreme cases money growth generally does not have much predictive power for in ation
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over the short and medium runs
Measures of resource slack may be misleading
History also cautions us about relying purely on resource slack as the sole guide to in ation pressures For example, although
high rates of unemployment are typically viewed as disin ationary, the stag ation of the 1970s serves as a counterexample A
problem here is that measures of resource slack can be misleading One popular measure of resource slack is the output gap,
which is the di erence between actual and potential output Here, potential output is de ned as the maximum level of output
that can be produced without generating in ationary resource cost pressures The problem is that potential output changes
over time Furthermore, it is not directly observable and must be estimated If our estimate for potential output is o , then so
is our measure of the output gap This mismeasurement could confound policy Athanasios Orphanides argues that something
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of the sort happened in the 1970s
According to his story, economic weakness was interpreted by the Fed as evidence of a substantial output gap This apparent
gap prompted the Fed to expand monetary policy in an e ort to attain maximum sustainable growth But this period of
economic weakness coincided with a major structural slowdown in productivity growth and rising structural unemployment
So the sluggish economy represented not so much an output gap as a slowdown in the growth rate of potential output In
e ect, the resource and output gaps were overestimated, leading to an overly accommodative monetary policy
Is this sort of dynamic likely to be a factor in the current situation? Although some of these forces may be present, I am
skeptical of their quantitative signi cance Recent studies done at the Chicago and San Francisco Feds nd little evidence that
sectoral reallocation or other factors are increasing the unemployment rate or reducing measured output gaps on a very large
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scale So I believe that resource gaps remain substantial today That's a signi cant mitigating factor against in ation pressures
Fiscal de cits and weak central banks
Before concluding, let me turn to the relationship between central bank independence, scal policy, and in ation outcomes
Independence of the central bank is always important Periodically, the central bank at times must take tough actions that are
needed for future and medium-term prosperity, even though these actions are painful in the immediate short-term The classic
example is the need to increase policy rates on early signs that in ation could be rising substantially even though the real
economy remains weak In this situation, there may be pressure for the central bank to inappropriately re-weight its dual
mandate objectives and postpone the monetary tightening until matters in the real economy improve further A central bank
that lacks independence and therefore opts to postpone tightening policy has e ectively abandoned its low in ation goal As a
result, both expected and actual in ation can increase
Fiscal pressures can also pose problems for central bank independence if large de cits are expected into the foreseeable future
Even if the central bank pursues a tight monetary policy, both current and expected future in ation can still increase if the
public believes that the central bank will be forced to monetize the government debt sometime in the future Tom Sargent and
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Neal Wallace coined the term "Unpleasant Monetarist Arithmetic" for this process In principle, very large debt levels could
compromise the independence of even the strongest central bank if the choice is between monetizing the debt or, inducing a
costly monetary contraction
Here again, the historical link between scal pressures and very high in ation is clear As I noted earlier, the major hyper-
in ations in Austria, Hungary, Germany and Poland during the inter-war years, and more recent high-in ation episodes in
Argentina, Portugal and Italy, all involved to varying degrees large structural scal imbalances combined with some lack of
central bank independence The key take-away is that rising, unsustainable scal de cits can derail the low in ation plans of a
weak central bank, and can test the souls of the strongest central bankers Unpleasant monetarist arithmetic argues that scal
discipline is a necessary component for favorable in ation outcomes There is no reason to think that this conclusion does not
apply to the U S While signi cant scal stimulus was an appropriate response to a very large recession, it is essential that the
nation show that it has a plan for restoring long-run scal balance
Policy conclusions
I started today by describing two extreme views for the future of in ation One view, motivated by the expanding Fed balance
sheet, has in ation greatly increasing in the future, while the other view, motivated by a sluggish economy and large resource
gaps, has strong disin ationary forces My view is that large resource gaps have been met by a large growth in reserves: In an
e ort to prevent a repeat of the Great Depression, the Fed acted quickly and decisively over the past year to provide liquidity
to markets and to prevent systemically important institutions from failing These are things that the 1930s Fed did not do It is
precisely these actions that have greatly expanded our balance sheet So, the co-existence of the motivating observations for the
two extreme in ation views is not very surprising
Now for the hard part: Just as the Fed acted responsibly to prevent a potential de ation, it will do so to prevent a future
increase in in ation above our price stability objective Unfortunately, this sounds too much like, "just trust us to do the right
thing " This is uncomfortable for everyone, but it is a natural dilemma at this point in the economic cycle when it is yet too
soon to actually begin removing policy accommodation
I am con dent that the Federal Reserve will achieve the price stability component of our mandate Our response will embody
three principles; prepare, monitor, and act Chairman Bernanke recently testi ed on the tremendous preparations that the
FOMC is undertaking in order to be sure our balance sheet can be reduced and that appropriately restrictive monetary policies
can be implemented when necessary And the FOMC is monitoring economic and in ation conditions for the signs that
adjustments in policy are needed I hope my comments on in ation expectations and direct assessments of in ationary
pressures have been helpful in this regard Finally, the Fed will act in a timely and appropriate manner to achieve our dual
mandate objectives of maximum employment and price stability
Note: Opinions expressed in this article are those of Charles L Evans and do not necessarily re ect the views of the
Federal Reserve Bank of Chicago or the Federal Reserve System
I would like to acknowledge the help of the following Chicago Fed sta in preparing these remarks: Dan Sullivan, Spencer
Krane, Hesna Genay and David Marshall and Ed Nosal
1
See Krugman 2008, 2009 and Meltzer 2009
2
According to Friedman and Schwartz 1963 , the implicit price de ator level fell by about 25 percent between 1929 and
1933
3
The PCE personal consumption expenditures chain price index increased 1 7 percent between December 1964 and
December 1965 and 10 5 percent between December 1979 and December 1980
4
Year-over-year PCE in ation did not consistently fall below 2 percent until May 1997 It remained below 2 percent until
December 1999
5
See, McCandless and Weber 1995 , Fischer et al 2002 , and Stock and Watson 1999, 2003
6
Manufacturing capacity utilization was 65 4 percent in July 2009, which is the lowest reading since January 1967 when the
NAICS-based capacity utilization series start NAICS is North American Industry Classi cation System Before 1967, capacity
utilization is available on an SIC Standard Industry Classi cation basis; at no time between then and its rst reading in
January 1948 does this measure fall below 70 percent
7
These ideas are embodied in macroeconomic analyses from Friedman 1968 and Lucas 1972 to current generations of
dynamic stochastic general equilibrium models like Christiano, Eichenbaum, and Evans 2005
8
These weights could be informed by the performance of formal statistical in ation forecasting models that use these
indicators
9
Between 1971 and 1980, the monetary base grew, on average, about 8 percent per year
10
Growth in seasonally adjusted M0 from Jan 1965-Dec 1982 = 238 67 percent; growth in SA M1 over the same period =
195 46 percent; growth in SA M2 over the same period = 346 62 percent
11
Friedman and Schwartz 1963 , p 299, also Table B-3
12
These are December-to-December changes in the PCE chain price index
13
Year-over-year growth in M2 was 8 0 percent in October 1979 and 8 8 percent in October 1982
14
See Stock and Watson 1999, 2003
15
See Orphanides and van Norden 2002 and Orphanides 2004
16
See Valletta and Cleary 2008 , Fernald and Matoba 2009 , and Rissman 2009 In contrast, Weidner and Williams 2009
estimate a large decline in potential output during the current recession
17
See Sargent and Wallace 1981
References
Christiano, Lawrence J , Martin Eichenbaum, and Charles L Evans, 2005, "Nominal rigidities and the dynamic e ects of a
shock to monetary policy," Journal of Political Economy, Vol 113, No 1, pp 1-45
Fernald, John, and Kyle Matoba, 2009, "Growth Accounting, Potential Output, and the Current Recession," Economic Letter,
Federal Reserve Bank of San Francisco, August
Fischer, Stanley, Ratna Sahay and Carlos A Vegh, 2002, "Modern Hyper- and High In ations," Journal of Economic Literature,
Vol 40, pp 837-880
Friedman, Milton, and Anna Jacobson Schwartz, 1963, "A Monetary History of the United States, 1867-1960," Princeton:
Princeton University Press for the National Bureau of Economic Research , p 299 and table B-3
Friedman, Milton, 1968, "The role of monetary policy," American Economic Review, Vol 58, pp 1-17
Krugman, Paul, 2009a, "Smells like de ation," New York Times, July 2, blog, available online
Krugman, Paul, 2009b, "Falling wage syndrome," New York Times, May 3, available online
Lucas, R E , 1972, "Expectations and the neutrality of money," Journal of Economic Theory, Vol 4, No 2, pp 103-124
McCandless, George T , Jr , and Warren E Weber, "Some monetary facts," Quarterly Review, Federal Reserve Bank of
Minneapolis, Vol 19, No 3, Summer 1995, pp 2-11
Meltzer, Allan H , 2009, "In ation nation," New York Times, May 3, available online
Orphanides, Athanasios, 2004, "Monetary Policy Rules, Macroeconomic Stability and In ation: A View from the Trenches,"
Journal of Money, Credit and Banking, Vol 36, No 2
Orphanides, Athanasios, and Simon von Norden, 2002, "The Unreliability of Output Gap Estimates in Real Time," Review of
Economics and Statistics, Vol 84, No 4, pp 569-583
Rissman, Ellen R , 2009, "Employment growth: Cyclical movements or structural change?," Economic Perspectives, Federal
Reserve Bank of Chicago, Vol 33, No 4, forthcoming
Sargent, Thomas J , and Neil Wallace, 1981, "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank
of Minneapolis, Vol 5, No 3, Fall, pp 1-17
Stock, James H , and Mark W Watson, 2003, "Forecasting Output and In ation: The Role of Asset Prices," Journal of Economic
Literature, Vol 41, No 3, pp 788-829
Stock, James H , and Mark W Watson, 1999, "Forecasting In ation," Journal of Monetary Economics, Vol 44, pp 293-335
Valletta, Rob, and Aisling Cleary, 2008, "Sectoral Reallocation and Unemployment," Economic Letter, Federal Reserve Bank of
San Francisco, No 32, October 17
Weidner, Justin, and John C Williams, "How Big Is the Output Gap?, Economic Letter, Federal Reserve Bank of San Francisco,
No 19, June 12
Cite this document
APA
Charles L. Evans (2009, September 8). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20090909_charles_l_evans
BibTeX
@misc{wtfs_regional_speeche_20090909_charles_l_evans,
author = {Charles L. Evans},
title = {Regional President Speech},
year = {2009},
month = {Sep},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/regional_speeche_20090909_charles_l_evans},
note = {Retrieved via When the Fed Speaks corpus}
}