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This edition was written by Chesapeake Dowdy, Chase Parry, Zixun Tan, and David Wessel
In a recent paper, Jens H. E. Christensen and Glenn Rudebusch find that monetary-policy news does not explain the recent rise in the natural rate of interest, r*. Paul Beaudry of the University of British Columbia and co-authors suggest that Christensen and Rudebusch’s focus on windows around FOMC meetings may overlook other news that shapes expectations of monetary policy. Examining three-day windows around releases of payroll employment data and speeches by senior Fed policymakers since August 2020, they find that these windows capture about 91% of the increase in both the 10-year Treasury yield and the five-year rate five years ahead, despite covering only 24% of trading days. They interpret this as evidence that long-term real rates may be less firmly anchored to r* than conventional economic theory implies. In a separate paper, they explain why this might be so: persistently higher rates of return can allow households to save less for retirement and consume more today, offsetting the usual contractionary effects of higher interest rates. As a result, policymakers who overestimate r* and keep rates elevated need not trigger a sharp slowdown that would reveal their mistake. Instead, the economy’s resilience could reinforce their mistaken belief that the neutral rate had risen, so policy rates, and with them long-term rates, stay high.
Left-leaning populist governments have historically leaned on their central banks to finance deficits, and that history may still shape monetary policy today. Using data on 47 advanced and emerging economies from 1960 to 2008, Luis I. Jácome of Georgetown and co-authors find that central bank lending to the government rose a cumulative 300% on average in the 10 years after a left-wing populist took office, while right-wing populists had no significant effect. That lending was in turn associated with higher inflation: a one-standard-deviation increase in central bank credit left prices about 4% higher after a decade. The authors then estimate how 32 inflation-targeting central banks set interest rates. On average, policy rates rise about 20 basis points for each percentage point that one-year-ahead inflation expectations exceed the target. Central banks in countries with past episodes of heavy deficit financing respond roughly twice as strongly, and about three years of left-wing populist rule—the sample average—raises the response by 30%. The effect holds after controlling for a country's past inflation and is larger when forecasters disagree about where inflation is headed. The authors interpret the finding as evidence that central banks with a populist past need to send stronger signals of independence to keep inflation expectations anchored.
Stimulus checks are a popular way to prop up spending during recessions, making it difficult to separate the economic effects of the checks from those of the recession itself. Joao Guerreiro of the University of California, Los Angeles, and co-authors study a natural experiment: lump-sum payments to veterans after World War II whose timing was unrelated to the business cycle. These payments, mostly dividends from a government life-insurance fund, were large; the biggest, in January 1950, equaled 4.3% of quarterly GDP, about twice the size of the 2008 checks relative to output. Using newly assembled monthly data on these transfers and smaller, temporary Social Security payments, the authors find that the spending response continues to build well after the transfers themselves fade: cumulative consumption matches the transfers within six months and exceeds twice the transfers within a year, with a small, statistically insignificant increase in the price level. A standard heterogeneous-agent model with rational expectations can't reproduce that delayed response. The authors argue it reflects households at first underestimating the broader income gains generated by the checks and later overestimating them. Their results suggest that the macroeconomic effects of stimulus checks depend in part on how households perceive and learn about their broader economic consequences.
“Since the experience of the 1970s, the oft-stated intuition has been that central banks should ‘look through’ supply shocks and only respond if they start to have secondary effects on other industries or begin unanchoring inflation expectations. Lately, though, we seem to have entered a period where large supply shocks—from wars, tariffs, weather, supply chain disruptions, oil shocks, and so on—have become a regular feature of the economy. My argument is that in this new environment, there are some supply shocks that central banks should not simply look through—namely, the persistent ones,” says Austan Goolsbee, President of the Federal Reserve Bank of Chicago.
“So what’s a central bank to do if the economy is hit by an unending string of supply shocks that push inflation up persistently and keep it above target? Well, the first answer is, don’t do nothing. Looking through won’t work. But it’s important to recognize that the response to a persistent cost shock does not need to mirror the response to a demand shock, even for an identically sized imbalance between supply and demand. That’s partly a function of the tools the central bank has. ...
“For an economy to rebalance after a lasting negative supply shock, people would need to adjust to a new, less favorable equilibrium, and wages would need to fall. If wages adjusted instantly, the central bank’s response to supply shocks and demand shocks would be the same. But wages adjust slowly. Forcing inflation back to target in the short run means pushing employment below target and output below potential.
“In the short run, supply shocks force a difficult trade-off for the dual mandate that demand shocks simply don’t. That’s why the central bank may not react as aggressively to a supply-driven imbalance as it does to a demand-driven one. But again, if the shock is lasting, it can’t simply be ignored.”
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