Transcript: Are we getting inflation right?

This is an audio transcript of the Economics Show with Soumaya Keynes podcast episode: ‘Are we getting inflation right?’

Soumaya Keynes
Just a note, this episode was recorded on May 27th, so before the Fed’s blackout period.

Neel Kashkari is the president of the Federal Reserve Bank of Minneapolis, a position he has held since 2016. He is a former candidate for governor of California. He directed the Troubled Asset Relief Program, which helped wind down billions of assets in the wake of the financial crisis. And he is one of my favourite people to talk to. Today on the show, we talk with Neel about inflation, interest rates and chopping wood.

[MUSIC PLAYING]

This is The Economics Show. I’m Soumaya Keynes in London, joined by my colleague today, Chris Giles, economics commentator for the Financial Times. Hello, Chris.

Chris Giles
Hello.

Soumaya Keynes
And hello, Neel, who is in the studio as well.

Neel Kashkari
Hello. Great to be with you.

Soumaya Keynes
So chopping wood. Tell us about that.

Neel Kashkari
Well, it’s gotten some attention after I was at Treasury for three years and during the financial crisis, when I left Treasury, after the stress tests had come out and things had calm down, I went back. I then had a home in the mountains in California, and I kind of secluded myself. And one of the things I did to recover mentally was chopping wood. I like chopping wood. And I had a wood-burning stove, and I found it very therapeutic.

Soumaya Keynes
OK. That’s weird.

Neel Kashkari
Well, you haven’t tried it. So you can declare that it’s weird after you tried it, but I’m guessing you haven’t tried it.

Soumaya Keynes
I haven’t tried it. The satisfaction of splitting it. I mean, do you still do it?

Neel Kashkari
A little bit. I have some, a little bit of property in Minnesota where we live now. And we do have trees that die and fall over. And I have a chainsaw and I chop them up. I’ve tried manually splitting wood in Minnesota. So in California the wood tend to be pine and fir, which is very soft and quite easy to split by hand. In Minnesota, it’s often maple and oak and it’s much harder. So lately I’ve been going to Home Depot and renting a hydraulic log splitter, which I can accomplish weeks of work at about one hour using a hydraulic log splitter. So I cheat, but the wood’s a lot harder and I’m a lot older.

Soumaya Keynes
Yeah, I might just revise my opinion. When you said chainsaw, I was sold by that, kind of fun. (Laughter) OK, well, let’s return to economics. I want to start by talking about inflation. And so there has been some debate, you know, among economists about what exactly caused this episode of high inflation. What’s your story?

Neel Kashkari
It’s a combination of factors. So when the pandemic hit, we saw the services side of the economy shut. So people were disproportionately, in advanced economies, spending on goods. And at the same time, the good supply chains were disrupted for those very same items. That caused very high inflation. You also had a lot of stimulus — fiscal stimulus and monetary stimulus — flooding those same goods markets. And then on top of that, you had Russia invading Ukraine, which sent a shockwave through oil markets and commodity markets. All of those were inflationary individually. Collectively, that’s what led to the very high inflation on the run-up. Now, the run-down, the disinflation is some of those factors unwinding. But I think it’s even more complicated than that.

Chris Giles
Could I just interject here and just ask you, what did we really get wrong in the way we understand inflation across the world?

Neel Kashkari
Well, we got a lot wrong. And I’ve been spending a lot of time with my economists trying to reflect on this, to understand what we learned from it and take going forward. If you look at the way most economic models that we use at the Fed work to forecast inflation, there are two primary sources of a high inflation. One is if inflation expectations get unanchored to the upside or second, through a very tight labour market and what we call Phillips curve effects — tight labour market leads to high wage gains leads to high inflation. If you go back in time in the US in April, May of 2021, core inflation first ticked above 2 per cent and yet we had 6 per cent unemployment. Very hard to see how in a 6 per cent unemployment environment, the labour market is gonna generate high inflation.

And we had long-run inflation expectations that appeared to be well anchored. So by those two factors, it should have been impossible using our traditional models for high inflation to hit us. Yet we saw very high inflation. And so I think we need to have a lot of serious reflection on what our models are missing in terms of possible sources of inflation.

Soumaya Keynes
OK. But hang on there, because the models do allow for economic shocks, right?

Neel Kashkari
They do. But usually if you look at forecasts, we run lots of different scenario analyses. The staff run a lot of different scenario analyses at the Fed. Usually a shock hits the economy, and one of those two things doesn’t happen. High inflation or exceptionally tight labour market. The shock passes very quickly with no lasting imprint on inflation or the path of the economy. And that is obviously not what happened here. Inflation ended up being much higher than we expected, and it has been much longer lasting than we expected. And I would go so far to say, even if we’d been able to write down all the shocks exactly in advance, our models would have come nowhere close to forecasting the actual inflation that has hit us.

Chris Giles
Doesn’t that then mean that there’s something going on with the way that committees — monetary policy committees — across the world have been thinking, or not allowing their thinking to be broad enough?

Neel Kashkari
I think so. I mean, I took criticism of myself as much as it is of anybody else that is forcing me to recognise and confront the narrowness of my appreciation of the sources of inflation. And I want us to be much more open-minded going forward that there are many possible different avenues that inflation could come.

Soumaya Keynes
Yeah, I mean, it does just speak to a big kind of fundamental failing within macroeconomics, I think. But I want to just move us further back to a kind of earlier failing, because when I first met you, I remember you were pretty unhappy with the state of thought in the US. Right? You, I suppose, were dove, sort of super dove, very concerned that we were underestimating the potential of the US economy to grow. Policy, you know, was a bit too tight. That was the problem then. And now, you seem to have moved towards this actually relatively hawkish position, where now you’re more concerned about inflation being more of a problem. What changed your mind? Were you wrong back then or have circumstances changed?

Neel Kashkari
Circumstances have changed dramatically. Your memory is correct. I joined the Fed in 2016, and probably for the first four years at the Fed, I was one of the most dovish members of the committee. And the reason was, it’s actually related to my more recent comment. You look at 2 per cent inflation as our inflation target and maximum employment. We were running at about 1.5 or 1.6 per cent inflation year after year after year. And we kept saying, oh, we’re at maximum employment. Inflation is about to come. So my conclusion from that, at the time, was that we were misreading the labour market, that we were not, in fact, at maximum employment. And that’s why inflation didn’t come. So why are we raising rates? We should keep policy softer or less tight so that the labour market can tighten and eventually we can get to 2 per cent inflation.

So I think that diagnosis of hey, we were missing inflation and we’re missing our labour market, that was a correct assessment of where we were. Now we look at this and my basic takeaway is, in both cases, the labour market was a lousy indicator for forward inflation. So in one case, back in 2016 to 2020, we thought the labour market had inflation about to come. I thought we were misreading the labour market. Now, when inflation was at 6 per cent in May of 2021, we still saw high inflation coming. The common takeaway is that in both cases, the labour market was not a good guidepost for us to be focused on on inflation. The circumstances were different, but that is one common factor in both environments.

Chris Giles
So if we look at the US economy right now — if the labour market were put to the side, it’s not a great guidepost — what is a good guidepost for where the US economy is right now?

Neel Kashkari
I’m looking at real economic activity. I would have thought that with the Federal Reserve raising interest rates as rapidly and as high as we did over the past couple of years, that we would effectively be slamming the brakes on the demand side of the US economy, and we’d see a lot of evidence of that slowing demand. Many people forecast that the US would have been in recession by the end of last year. The second half of last year, we had very strong growth. Strong growth has continued largely into this year as well.

So consumption has held up remarkably well over this tightening cycle. GDP has held up remarkably well. The labour market, the unemployment rate has ticked up to 3.9 per cent. That’s still a very low unemployment rate by US history standards. The housing market has remained remarkably resilient. So if I look at real economic activity, real economic activity in the US looks quite robust and more robust than very tight monetary policy would have suggested.

Chris Giles
So that sort of suggests that monetary policy at a rate of five and a quarter to five and a half per cent isn’t very tight in your view.

Neel Kashkari
It’s a question that I have. It appears like it may not be having as much downward pressure on demand than I would have otherwise thought. And the question that I’m raising publicly and to my colleagues is perhaps some of the dynamics of the reopening economy have elevated what we call R-star, at least in the short run, the neutral interest rate. Maybe that is elevated for some reason in the short run. And so policy is not as restraining as we otherwise would have expected.

Chris Giles
And if policy is not as restraining, demand is strong, inflation’s coming down but may be sticking a little bit too high, what does that then suggest to you is the appropriate stance for monetary policy? That you leave it where it is for a long time and just wait and see?

Neel Kashkari
I think right now my best guess is we would leave it here for an extended period of time until we get a lot more data to convince us one way or the other. Is underlying inflation really on its way down? At the middle of last year, I started raising questions. I’m not sure how tight policy is. Maybe we’re on track for a soft landing to 2 per cent, or maybe we’re landing softly at 3 per cent. Then the second half of last year, we saw rapid disinflation, much faster disinflation than I or I think most people had expected. And so that looked very positive while the labour market remained strong. Then that appeared to stall out in the first quarter of this year.

And so I don’t know. Is the disinflationary process in train, it’s just taking more time, or is it, in fact, stalled out? I don’t feel that we need to make a rush to judgment right now. Because the labour market is strong, we have the luxury of taking time to get more evidence before we reach a firm conclusion.

Soumaya Keynes
So we are recording this on Monday, May 27th, and . . . 

Neel Kashkari
Which is a holiday. Thank you for coming in on your holiday.

Soumaya Keynes
We’re all just very dedicated to the podcast. Well done, us.

But between now and when we publish this, there’s gonna be another inflation print, right? We’re gonna get information on PCE inflation. How are you going to kind of revise your views according to what that is?

Neel Kashkari
Well, we think we have a lot of evidence — because of the CPI numbers that have already come in — that we think we know that PCE inflation will come in marginally better than it had the first three months of this year, but probably not all the way back down to where we needed to get to. So assuming that’s not what happens, then that reinforces for me that we should be in wait-and-see mode to get a lot more evidence. You know, if things settle out at what that next inflation print comes in at and if it comes in as expected, that’s closer to a 3 per cent inflation rate or higher than a 2 per cent inflation rate. So that certainly is not where we need to get to.

Chris Giles
And when you say we want to be in wait-and-see mode and we need to get a lot more data before we’re comfortable, just define it for us what this sort of roughly means. And I know, not to the minute.

Neel Kashkari
Yeah, it’s very hard to know because we have to look at the constellation of data. I mean, there are a bunch of different scenarios. If inflation looks like it’s trending back down and the disinflationary process is well under way and we get several months of that in a row, that could give me confidence that disinflation is we’re on track. Or if it goes sideways and then we have to look at the labour market. So we’re always having to balance the two sides of our dual mandate to get a read of where’s the underlying economy headed. And so it’s hard for me to answer that because there’s so many different factors that are gonna contribute to that assessment.

Soumaya Keynes
Could you talk a bit about how you see the relative risks of mistakes on either side? Right? I mean, if you keep policy tight for too long, the risk is that we have a recession; unemployment shoots up. If you keep it loose for too long, the risk is that inflation is embedded at too high a rate. How do you see the relative balance of those two things?

Neel Kashkari
I think the US economy has benefited tremendously by the achievement of anchoring inflation expectations in the early 1980s, by the very painful recession that the economy went through in order to bring inflation back down in the Volcker disinflation era. And I think that that anchoring of inflation expectations has been a foundation of a lot of the economic prosperity that America has enjoyed in the ensuing 40 years.

I would be very cautious about putting that at risk. We have taken some risk with the very high inflation, but fortunately the Federal Reserve acted aggressively and has reinforced the point that we are dead serious about getting inflation back down. So I am still in the position of saying that the risk of loosening too soon is a costlier risk than the risk of keeping policy somewhat too tight for too long, because I don’t want to risk damaging the long-run credibility of the Federal Reserve, because I think that that credibility has really paid dividends for the American people and the American economy over 40 years.

So better to air on being a little bit too tight for a little bit too long than they’ll loosen too quickly and then have to go chase it again and raise rates again in the future.

Chris Giles
Are you at all surprised that when we’re thinking about anchoring of inflation expectations, we know from many surveys that the public is very unhappy with the inflation that we’ve just seen, but a lot of that seems to be directed at the government rather than the Federal Reserve. Does that surprise you and are the public wrong? Should you be taking some more heat at the moment?

Neel Kashkari
Well, I think it’s hard for, you know, people are busy with their daily lives. And when I travel around my region and I talk to constituents, you know, the first thing I’m doing is explaining the difference between fiscal and monetary policy and what role the Fed has and what role, of course, the executive branch and the elected leaders have with tax policy and spending. So I don’t expect people to understand all of the details as a matter of their daily lives.

I think there’s blame all the way around. I think, as we talked about earlier in this podcast, we didn’t understand the dynamics that led to the high inflation, and that is on us. By the way, I don’t think that if we’d raised rates six months earlier, it would have made a profound difference in the path of inflation either. So I’m critical of our analysis, but I’m also realistic about what effect we could have had in keeping the inflation bottled up. So, you know, there’s blame to go around. A lot of it was out of anybody’s control, I think realistically. But I also have learned that the American people and maybe people in Europe equally, really hate high inflation. I mean, really viscerally hate high inflation.

You know, I do a lot of roundtables with small businesses and labour groups and workers. And one of the most profound comments that I’ve heard over the past couple of years was with a group of labour leaders in my region and a labour leader who represents low-income service workers. So these are not autoworkers. These are not welders, really highly paid people. These are low-income service workers who work in grocery stores and hotels. She said to me, inflation is worse than a recession. That is contrary to conventional economic thinking. And I said, I don’t understand that, how can inflation be worse than a recession? In a recession, you lose your job. Inflation, you just pay higher prices, you still have a job. She said, because her members are used to dealing with recessions, and the way they get through a recession is they rely on friends and family. I lose my job, I lean on my sister or my parents or my friends, and they help me through it. But high inflation affects everybody. There’s no one I can lean on for help because everyone in my network is experiencing the same thing I’m experiencing. That was a profound comment for me to hear, and that really flies in the face of conventional economic thinking. And it led me and our economists at the Minneapolis Fed to debate this a lot. But she was on to something.

And if you look now, the economy is — in the US — quite strong. The labour market is strong. Inflation is coming down. And many, many people are deeply unhappy about the status of the economy. I think it’s because of the high inflation that they’ve experienced.

Soumaya Keynes
OK. Well we are going to throw to a break now. But when we get back, I’m going to ask Neel about where he thinks rates are headed.

[MUSIC PLAYING]

OK, we are back from the break. So, Neel, how do you think about the long-run outlook for rates?

Neel Kashkari
So the neutral rate is a rate that we think neither stimulates nor restrains the economy. And there are a bunch of dynamics happening in the US economy right now. But ultimately when these dynamics fade, we think that rates are gonna settle into some type of long-run level that is what we consider to be neutral. And prior to the pandemic, I had that very, very low. We think that those rates are being set by factors like demographics and productivity growth that the central banks don’t control. And my best guess is we’re gonna go something back down to that kind of a low level once we’re through this period. And that on a real rate is around 0.5 per cent for me, which implies the federal funds rate of around 2.5 per cent where we would settle over the long run. But that’s very uncertain. That’s gonna depend on what happens to productivity growth, among other things. And for example, like what impact AI ends up having on the economy? There’s just great uncertainty about that right now.

Soumaya Keynes
Can I just ask why you think that neutral now — neutral in the short run — might be higher than neutral in the long run?

Neel Kashkari
Based on what’s happening on the real side of the US economy. So when we raise interest rates so quickly over the last couple of years, most forecasters, including many of the Fed, including me, expected to see a sharp slowdown in economic activity that would have manifested itself in low real GDP growth, maybe even a recession, would have manifested itself in an uptick in unemployment, a real softening in wages, a real slowing in the housing market. You know, the housing market should be the most sensitive, interest rate-sensitive sector of the economy. And yet, in the US, GDP has been remarkably strong, very strong. The labour market has been resilient. Wage growth has been mostly resilient. And we’re seeing even the housing market has shown signs of resilience. So if I look at this resilience and economic activity, that does not look like an economy that is under pressure of very high, very tight monetary policy.

Soumaya Keynes
But then the question is why that would be different in the long run, right? I mean, if the economy is remarkably resilient today, how could it then sustain much lower rates in the future?

Neel Kashkari
Well, we’re trying to understand what’s causing that resilience right now. So for example, in the housing market in the US, we know that after the great financial crisis, the US underbuilt homes, housing units. So there’s a structural shortage of housing units. Then you had the pandemic, which people wanted more housing than they wanted before. More people are working from home, they want more space.

We’ve also, in the last couple years, seen a huge uptick in immigration. The long-run effects of immigration on inflation are really unclear. But I do know that when new immigrants have come over, they need a place to live. So they are exerting some demand for housing, even in the immediate short run. What are those dynamics going to be two years from now or five years from now? Are these high immigration levels gonna be sustained? I have no idea.

Are preferences for housing going to change? Is there going to be a lot of new supply coming online? I could tell a story of some of these dynamics are not going to be long-lived, and that could lead us back to the type of neutral environment that we had in the past.

Soumaya Keynes
What are you looking at to kind of inform your view on where neutral is? Right? I mean, are you looking at market indicators?

Neel Kashkari
I’m looking at market indicators, for example, the long-run Tips, the 10-year Tips, it’s not purely set by the Fed. It’s partly set by where the market is assessing these rates are going to settle out in the long run. And it’s confusing because a lot of times we look at market indicators and what we’re really doing is looking in the mirror because markets are looking at us. And so how much independent signal should we be taking from markets. It’s a little bit of an art. It’s a judgment call.

But there’s no question that before the pandemic, 10-year Tips was at zero and now it’s a little bit above 2 per cent. Some of that is clearly because we have been sending hawkish policy signals. We’re shrinking our balance sheet. It’s showing up in these long real rates. And some of it is the market saying, hey, we think this is where rates are gonna head in the long run. And so that’s one indicator that I’m looking at. But then I balance that by looking at real measures of economic activity, whether it’s GDP, the labour market, consumption, housing market as well.

Chris Giles
OK, Neel. So the Fed is now currently thinking about a new review of its framework. What should that entail? Where should the Fed be going in the way it thinks about and undertakes monetary policy?

Neel Kashkari
In our framework, I hope we step back and reflect on what the experience has been like for us in the economy and what we got right, what we got wrong over the last few years, and learn from that to try to always improve our policymaking apparatus going forward. You know, my quibble with our own performance over the last few years is that our workhorse economic models only considered two possible triggers for high inflation: an unanchoring on inflation expectations, or a very tight labour market and Phillips curve effects. The inflation that we saw this time and why it surprised us and every other central bank, advanced economy central bank in the world, is that it was neither of those. It was through supply effects, supply chains that were gummed up, services economy with commodity shocks all hitting at the same time. I’m not saying we should get a pass because of that. I want us to examine that with open eyes and see what we can learn so that we’re better going forward.

Soumaya Keynes
I mean, at the last framework review, the Fed moved from kind of straightforward inflation targeting to flexible average inflation targeting. Do you think another change of the target is on the table?

Neel Kashkari
You know I don’t want to rule anything in or out at this point. You know, some people have said that that new framework is what led us to miss on this inflation. And that criticism is 100 per cent wrong, because our framework that we adopted in the last review basically said, hey, we don’t need to raise interest rates if inflation is not a problem just because we think the labour market might be tight. But once inflation crosses the 2 per cent level and we have high inflation, the new framework was the old framework. It was an asymmetric approach to monetary policy. So, anyway, I just wanted to say that some people say that it’s that framework that led to the high inflation. That’s totally wrong. And I hope we don’t abandon some of the good features that we embedded in the most recent framework. Even though they weren’t relevant this cycle, they’re still good concepts that I think we need to hang on to.

Chris Giles
I have a question about changing minds. You have clearly changed your mind from the 2016 to 2019 period to how you see the economy now. And yet when we were talking about the balance of risks, you saw how dangerous it was to change your mind and for the Fed to be seen to be flip-flopping in terms of its credibility. So when you think about this, when is it that it’s legitimate to change your mind? And when is it that our changing minds is problematic?

Neel Kashkari
Well, I think, what have I not changed my mind about? I have not changed my mind that the Fed has a dual mandate, that we have an obligation to achieve both sides of our dual mandate, and that achieving low and stable inflation expectations was a foundational benefit to the US economy over the last 40 years. I believed that then, I believe that now. I think all of my colleagues certainly believe that. And I think that’s true in most advanced economies’ central banks as well.

So I think changing our mind on that or changing inflation target from two to three . . . some people have said that we’ve got high inflation now, just declare victory. I think that’s a terrible idea because the next time we have a high inflation period, you might say, well last time they settled at three, maybe this time they’ll settle at four and you’ll see a gradual unanchoring of inflation expectations. I think changing your mind as the data changes and as the economy changes, I think that’s the job policymakers are supposed to do, as opposed to dogmatically saying, I’m always gonna be dovish or I’m always gonna be hawkish. I’m gonna be dovish or hawkish. I’m gonna read the data relative to these goals that we’ve all agreed on, and we’re not changing the goals.

Soumaya Keynes
OK. Last question. Could the next rate move be a hike?

Neel Kashkari
Well I guess the question is: Is no move, do you consider that to be a move? Meaning if the committee decides to stay, I view that as an active decision that the committee is making to stay at a current level. So my best guess, based on where the economy seems to be headed, is that we’re gonna sit here for an extended period of time until we get convinced that inflation is either well on its way going back down or it’s not. And that might tell us, hey, we need to actually go up from here. So I would never want to rule out taking the policy rate higher. But I think more likely we’re going to sit here for an extended period of time. That’s an active decision that the committee will end up making.

Soumaya Keynes
Neel, thank you so much.

Neel Kashkari
Thank you for having me. I really enjoyed it.

Chris Giles
And thanks from me.

[MUSIC PLAYING]

Soumaya Keynes
That is all for this week. You have been listening to The Economics Show with Soumaya Keynes. This episode was produced by Edith Rousselot, with original music from Breen Turner. It is edited by Bryant Urstadt. Our executive producer is Manuela Saragosa. Cheryl Brumley is the FT’s global head of audio. I’m Soumaya Keynes. Thanks for listening.

[MUSIC PLAYING]