IMFS Working Lunch with Athanasios Orphanides
"The Forward Guidance Trap"

The economic recovery from the Covid-19 pandemic was faster than had been anticipated. However, central banks delayed adjusting policy for a time, even after the improvement in the outlook had become evident and inflation reaching high levels not seen in a long time. In an IMFS Working Lunch on November 8, Athanasios Orphanides, IMFS Research Fellow and Professor of the Practice of Global Economics and Management at the MIT Sloan School of Business, described how the Fed and the European Central Bank (ECB) fell into a forward guidance trap when this delay in normalizing monetary policy led to high inflation.

Orphanides, who served as Governor of the Central Bank of Cyprus between 2007 and 2012 and during that time forming part of the ECB Governing Council, argued that the Fed, the ECB and the Bank of Japan provided appropriate accomodation during the pandemic, but the Fed and the ECB failed to unwind this accomodation in a timely manner.

As the post-pandemic recovery was unexpectedly strong, supply constraints created spikes in inflation. However, in many advanced economies, „instead of normalizing monetary policy, we saw a surprising delay in beginning to normalize monetary policy“, Orphanides described the situation in 2021. As he pointed out, the Fed and the ECB fell into a foward guidance trap. „They wanted to communicate information about future interest rates in order to enhance the effectiveness of monetary policy. But instead of communicating a policy rule, the Fed and ECB opted to communicate explicit information that was consistent with the baseline scenario of the economy and not contingent of the evolution of the economy.“

Following chronologically the central banks‘ monetary policy decisions and their communication after the pandemic, Orphanides examined the time frame when the central banks fell behind the curve. In this context, he pointed out the importance of the inflation outlook and focusing on real interest rates instead of nominal rates. „It’s not enough for a central bank to look at actual inflation. It’s more informative to look at the outlook.“

Regarding the situation in 2021, as the economy recovered and inflation expectations picked up, real interest rates kept falling. In Orphanides‘ opinion, both the Fed and the ECB acted too hesitantly. „Central banks should raise interest rates in order to make up for that pick-up in inflation expectations. This is not tightening,“ he said.

As far as the central bank communciation is concerned, Orphanides pointed out that central banks didn’t want to raise interest rates as long as they hadn’t started reducing asset purchases. „When the ECB saw energy prices rise, they didn’t communicate.“ In his view, raising interest rates only after net purchases ended – an explicit commitment by the ECB and implicit for the Fed – was an additional mistake.

Orphanides argued that central banks should act rules-based. „Monetary policy works best when it’s systematic.“ But many central banks prefer to remain discretionary, he criticized. „Good monetary policy is a rules-based policy. And most of the times, an interest rate rule is sufficient“.

Regarding an approach following data as maintained by the ECB, Ophanides seemed even more critical. „A lot of central banks talk about being data-dependent without telling what that means,“ he said. „In my view, this seems even more discretionary.“

IMFS Working Paper 190 "The Forward Guidance Trap" (PDF)

Book Presentation with Nouriel Roubini

„A few years ago everything was going up but now we’re going from boom to bust,“ economist Nouriel Roubini is convinced. In a book presentation on March 23, the professor emeritus of economics at New York University nicknamed Dr. Doom in the course of the Global Financial Crisis, outlined a series of medium to long-term potential challenges the world is facing – „megathreats“, the title of his book. With the current private and public debt levels reaching unprecedented levels, he warned that the „debt crisis may be the worst we’ve ver seen but it’s just one of the megathreats coming toward us“.

Among these megathreats, Roubini also includes deglobalization and protectionism. „There is less cooperation and more confrontation“, he said. In his view, the rising economic and geopolitical rivalry between China and its allies and the United States might lead to new cold war and could have severe repercussions in various respects. According to Roubini, governments will spend more on defense but also upgrading technological systems against cyberattacks will cost billions of dollars. Furthermore, the aging population in developed and also in emerging markets causes financial pressure. At the same time, restrictions on migration will accelerate wage inflation.

Roubini warned that the geopolitical tensions also impede action against another megathreat: the global climate change. „My view is we have to fight five wars, not one,“ Roubini concluded, lining up the so-called hot wars and the global climate change with new global pandemics, the end of globalization and the rising income and wealth in equality. „Because of this, you get a structurally higher budget deficit.“ In Roubini’s view, „this pulls a pressure on central banks to monetize“. He sees central banks in a trilemma between inflation, stagflation and financial instability.

Regarding another important development, the technological advances in AI machine learning, Roubini argued that this might lead to potential growth but there are also side effects as the AI affects jobs across many industries, destroying overall jobs and wages.

In sum, after a long period of Great Moderation, „now there is the era of stagflationary instability“, Roubini warned. Whether there is a way out of this situation, Axel Weber, President of the Center for Financial Studies, who moderated the event, wanted to know. „There are solutions but all have pros and cons,“ Roubini said. In view of the looming threats, „my book is a bit of a wake-up call.“

IMFS Working Lunch mit Joseph E. Gagnon
"25 Years of Unemployment in Advanced Economies: Lessons for Monetary Policy"

Central banks should raise their inflation target to 3 percent. This is the conclusion Joseph Gagnon, Senior Fellow with the Peterson Institute, draws from his research on the development of the unemployment rate and inflation. „I don’t think Americans would reject 3 percent inflation if that meant less unemployment“, Gagnon said during his IMFS Working Lunch on March 1.

In his paper, Gagnon analyzed the unemployment rate in advanced countries in the time span from 1997 to 2019, observing the shape of the Phillips curve. Based on his findings, he argues that even without a higher inflation target, central banks need to use a broader range of economic models and should verify their estimates of the natural rate of unemployment by running the economy hot from time to time in order to see nascent inflationary pressure before throttling back. „Central banks could have done better“, Gagnon said. The Federal Reserve System, along with other central banks, has adopted a dual mandate, pursuing the economic goals of price stability and maximum employment.

„For more than 25 years, central banks in advanced economies allowed unemployment to be higher than needed to keep inflation low, resulting in trillions of dollars of lost output.“ According to Gagnon, this error arose from an incorrect model of inflation combined with inflation targets that were too low. As Gagnon suggested, central banks should also place less faith in any one model and instead experiment occasionally to learn how fast economies can grow without high inflation.

Regarding the current situation with inflation rates rising, Gagnon expects inflation in Europe to come down faster than in the United States. In his opinion, it’s a puzzle why macroeconomists didn’t see inflation coming in the U.S. with the massive stimulus package of the Biden administration as a measure against the corona pandemics.

PIEE Working Paper 22-17
Joseph Gagnon and Madi Sarsenbayev
"25 years of excess unemployment in advanced economies: Lessons for monetary policy"

Book Presentation with John H. Cochrane
"The Fiscal Theory of the Price Level"

Slides of the presentation (PDF)