The Fed in a hole

At the Kansas City Fed Jackson Hole symposium, the annual jamboree ‘think-tank’ for international central bankers, US Federal Reserve Chair Jay Powell announced the end of monetary policy as a tool to control inflation.  His speech of just a few minutes completely dropped the monetarist theory of inflation as proposed by Chicago free market economist Milton Friedman and pursued by his disciple and former Fed chief, Ben Bernanke. Powell also made it obvious that the Keynesian argument for inflation, namely as trade-off for full employment and rising wages, as graphically presented in the so-called Phillips curve, was also dead.

Powell noted that “over the years, forecasts from FOMC participants and private-sector analysts routinely showed a return to 2 percent inflation, but these forecasts were never realized on a sustained basis.” 

And more recently, despite falling and record low unemployment (before the pandemic), the inflation rate continued to fall.  “The muted responsiveness of inflation to labor market tightness, which we refer to as the flattening of the Phillips curve, also contributed to low inflation outcomes….. the historically strong labor market did not trigger a significant rise in inflation.”

Why does it matter if inflation is falling and is below the Fed’s 2% a year target?  Powell explained: “Many find it counterintuitive that the Fed would want to push up inflation. After all, low and stable inflation is essential for a well-functioning economy.  However, inflation that is persistently too low can pose serious risks to the economy. Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.”

What’s wrong with that?  After all, working people would be very happy if there was no inflation to cut into the purchasing power of their wages.  But the objective of the Fed is not to stop inflation hitting wages. The objective is to have some inflation, because without it “we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates.”  So low inflation means low interest rates and no room for monetary policy to cut rates further to “boost employment” or “stabilise the economy”.  In other words, monetary policy (changing the Fed policy rate and/or injecting quantities of money into banks) would no longer work.

Indeed, the reality of the last ten years since the Great Recession is that cutting interest rates to zero and applying quantitative easing (which has taken the Fed balance sheet to record highs) has done little or nothing to boost economic growth or the productivity of labour.  As Powell said in his Jackson Hole speech: “assessments of the potential, or longer-run, growth rate of the economy have declined. For example, since January 2012, the median estimate of potential growth from FOMC participants has fallen from 2.5 percent to 1.8 percent”.  So monetary policy has failed the productive part of the economy. The prices of financial assets and property have rocketed, on the other hand.

So what has Powell decided to do to justify his job?  “Our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”  The target of 2% a year has been abandoned in favour of some vague ‘average rate over time’. In other words, the Fed will sit on its hands and do nothing.

The stock market loved this because the rich-investing public (hedge funds, banks, insurance companies and pension funds) can now expect the cost of borrowing to speculate to be near zero for the foreseeable future.  But the Fed and mainstream economics provide no explanation of why inflation has slowed and so there is no guarantee that it won’t return in the future.

What are the mainstream explanations of low inflation in the last 30-40 years?  Powell commented that “some slowing in growth relative to earlier decades was to be expected, reflecting slowing population growth and the aging of the population. More troubling has been the decline in productivity growth, which is the primary driver of improving living standards over time.” It seems that inflation is not “purely a monetary phenomenon” (Friedman), but instead is “driven by fundamental factors in the economy, including demographics and productivity growth— the same factors that drive potential economic growth.”

At the symposium, some mainstream economists attempted to offer an explanation for why US productivity growth has been so weak, thus keeping real GDP growth low and, with it, inflation.  One Chicago University economist (the home of Friedman and free market economics) argued that productivity growth was low because of “slowing business dynamism.  Businesses were not innovating but had become lazy and just taking the money.  Why?  Because of the decline in ‘free competition” and the rise of monopolies. Market concentration had risen and average profit markups increased. The productivity gap between frontier and laggard firms had widened and the share of young ‘innovative’ firms had declined.

This is the argument of ‘market power’, popular among left economists as well, it seems, as among right-wing free market economists. It is ironic that usually the argument is that inflation is caused by monopolies using ‘pricing power’. Now the argument is reversed: monopolies slow productivity growth and so inflation slows.  So low productivity and stagnation is the fault of monopoly power.  The free market policy is to break up monopolies and return to (the myth) of ‘free competition’. The leftist policy is pretty much the same, or sometimes more radically, to call for the public ownership of these monopolies.

But is the problem of low growth in productivity down to ‘market power’?  I have presented several arguments against this explanation in previous posts.  

The other explanation offered for low growth in real GDP, productivity and inflation is falling population. Jay Powell referred to an ageing population that spends less, thus keeping prices low.  And one economist at the Jackson Hole symposium argued that old people are less likely to want to use innovation, so businesses will invent less.

Source: Pugsley, Karahan and Sahin (2018): Demographic Origins of the Start-Up Deficit

Does not sound very convincing does it?

A much better explanation can be found using Marx’s value theory.  In a previous post, I have spelt out a theory based on value creation. If new value created by labour power (divided into profits and wages) accelerates, purchasing power will accelerate and so will inflation of goods and services over time – and if new value growth slows, so will inflation.

Source: Federal Reserve, author’s calculations

The growth in the productivity of labour will slow if the growth in investment in productive assets slows. And investment growth ultimately depends on the profitability of capital.  The movement in productive investment is driven by underlying profitability, not by the extraction of rents by a few market leaders.

The very latest corporate profit figures for the US economy provide strong support for the view that slowing productivity and inflation is driven by slowing profits and thus falling profitability of capital.  The US rate of profit peaked in the late 1990s and has not recovered from a 30-year low in the Great Recession.  And now the rate of profit in 2020 could end up at levels not seen since the deep slump of the early 1980s (and perhaps even lower).

Source: Penn World Tables, AMECO

US non-financial sector corporate profits have been falling since 2014, and now in the pandemic lockdown, have dropped another 20%-plus, to reach levels not seen since the depths of the Great Recession.

Source: BEA NIPA

No wonder monetary policy has failed to restore economic growth, even to rates achieved before the Great Recession, let alone back to the years of the Golden Age of the 1960s.  Low inflation may be a product of ‘slowing business dynamism’, but that in turn is a product of slowing investment in productive assets because of low and falling profitability.

12 thoughts on “The Fed in a hole

  1. The expansive phase of the globalisation is over. Now comes the pauperissation of the proletarians around the globe. And when the imperialist powers have pauperized not only the masses in the colonies but also the population in their home countries they will find that the only wortwile investing area is military robbery – from other imperialists? we can expect an arms race like in the 1890-ies? And another WWI?

  2. Thanks for your interesting recent posts on inflation. Your theory seems to be demand-driven, though please correct me if this is not right: an acceleration in purchasing power in the form of the creation of new value will raise the inflation rate. This acceleration is in turn driven by a growth in investment in new productive assets. And this is dependent on profitability.

    Can you relate this to Anwar Shaikh’s theory of inflation in his book ‘Capitalism’? In my reading of the latter, a rise in profitability will tend to put downward pressure on inflation, other things being equal. And a fall in the investment share in total profits will do likewise, from the supply-side. An increase in net purchasing power on the demand-side will tend to raise it.

    I think any comprehensive theory of inflation must surely take into account the interaction between the commodity aggregate demand-supply interaction, even if one side comes to dominate over a particular period.

    In the current epoch, for me, the inflation of financial asset prices alongside the low inflation of commodity prices is affected by the weakness of demand for the latter driven by high levels of inequality, which constrains consumption and investment, while increasing the savings of the rich which in turn helps to drive the demand for financial assets and unsustainable asset bubbles. This is based somewhat on the savings glut hypothesis of Michael Pettis and others, which I know you disagree with. But I would be interested in your take on this.

    1. Nick – very good questions. On Anwar’s approach: Shaikh’s theory has merit in rejecting full employment as the cause of inflation, as the Keynesians argue; and for using the rate of profit in a Marxian way. Could VTI and Shaikh the theories be reconciled? If the falling rate of profit (net or otherwise) is due to the slowing of value growth and a rising OCC, then there is a connection. In the value theory of inflation, total and new value growth falls over time as does the rate of profit, so in that sense, the VRI and Shaikh’s theory can be related. But the net rate of profit should be seen as the result of value changes. I think that is lost in Shaikh’s theory.

      And Shaikh does not really account for the money factor. Shaikh’s theory does not see inflation as being caused by the relation between changes in value and changes in money supply – and thus he actually comes to an ‘excess demand’ theory. VTI argues that there is downward pressure on prices because value falls over time relative to physical units. Money provides a counteracting factor. In the final paper, these distinctions will be developed more clearly, I hope.

      I dont agree that low inflation in goods and services is the result of weak demand caused by high levels of inequality. It is caused primarily by weak growth of value in productive sectors. It is true that this weak growth is partly the result of capitalists switching investment into financial assets, but that in turn is the result of falling profitability in the productive sectors. As you say, I dont accept the lack of demand or savings gluts thesis of Keynes-Pettis etc.

    2. The situation is more complicated on the demand side. The top 10% spend as much on consumption as do the bottom 80% of US society. According to Personal Consumption Expenditure data published by the BEA, since 2011 there has been a constant rise in PCEs as speculators cashed in their capital gains. Annual capital gains have tended to be over ten times larger of any increase in wages. The conclusion to be drawn, is that US GDP has grown because of the growth of this personal consumption, not because of investment. An unhealthy expansion vs a healthy expansion.

    1. The value theory of inflation applies first and foremost to the imperialist economies, where the impact of import prices and currency devaluations are much less. Inflation will be higher in the EMs, because of higher (dollar) import prices and continually weakening local currencies. But if we measured the VRI in, say Brazil, it would be in local currency terms. So we might be able to identify where the higher inflation is sourced – research!

  3. Well spotted. Powell gave a buy signal to Wall Street. The relationship between inflation and interest rates will be made more elastic, meaning that it will take higher inflation rates to effect the FED rate. But why now. Could it be that Powell is being disingenuous. Is inflation on the rise? Appears to be. A loss of value production compensated for by rising debt has to be inflationary in the end. In my latest post I present evidence that inflation may be on the rise. It appears the FED has but one mandate, a hidden mandate, keep the bubble afloat. The bubble is too big to fail without cratering capitalism.

    While I agree with you that behind all of this is the rate of profit, and its fall, I question your use of the Penn Tables. As you are aware, total profits have fallen by nearly 50% since 2014 in real terms (my post has more accurate data) and yet you show a fall in the rate of profit during this time of about a tenth to 6.8%. How can this be? In my post I estimate the fall in the enterprise rate of profit from 7.0% in 2014 to 3.6% in Q2 2020, which is commensurate with the fall in the mass of profits and the rise in total capital since then.

  4. “The other explanation offered for low growth in real GDP, productivity and inflation is falling population. Jay Powell referred to an ageing population that spends less, thus keeping prices low. And one economist at the Jackson Hole symposium argued that old people are less likely to want to use innovation, so businesses will invent less.”

    It is customary to hail the demographic transition to a barely reproducing/slowly declining population (neglecting for immigration) as a sign of prosperity. But isn’t it also a consequence of progressive immiseration where large sections of the population cannot afford to have many children, if only for the costs of setting them up in an appropriate adult life?

    “The growth in the productivity of labour will slow if the growth in investment in productive assets slows. And investment growth ultimately depends on the profitability of capital. The movement in productive investment is driven by underlying profitability, not by the extraction of rents by a few market leaders.”

    Given people are the most important force of production, aren’t the trends in educations, social investment in reproduction of labor power, also distorted, as badly as health care, by relying on the market for guidance? In some places, one could argue schools are run as if they were meant to create a reserve army of unemployed.

    Unfortunately the VRI theory is very confusing. Perhaps it is because I tend to think of “inflation” as a decrease in the value of money as a store of wealth. Deflationary pressure from falling profits, given a world where fiat currency is the norm and the traditional money commodity, is both too scarce and too monopolized by a handful of states, leads the capitalists to seek commodity substitutes. First goal is, it seems to me, land. But also financial assets deemed to serve as claims on future production can serve. In other words, asset inflation is inflation, period. CPI as the one true indicator of inflation seems to assume price competition in an atomized market is the norm.

    Is it possible that??? Price levels of consumption goods are not just set by capitalists selling at a price to clear the market. Restricting the production can serve to partly, wholly or more wholly compensate the deflationary pressure. Reconfiguration to production of capitalists’ consumption can serve as well. Use of inelastic demand goods such as services, especially heavily monopolized ones like health, can also reconfigure. Lastly, lowering prices makes losses obvious in a way slow sales at a too high price does not, making a systemic bias in all reporting, internal to enterprises and to the state.

  5. It is embarrassing to see how badly written this is. In the third question, “deflationary pressure” means capitalists responding to fall in profits by lowering prices because they need any income at all to continue. But when capitalists are trying to respond to falling profits from enterprises by finding assets that keep their are not falling in market value is not quite the same kind of deflationary pressue, is it? But my third question somehow conflated them

    Perhaps another way of expressing this was inspired by the last post from Sam Williams. Williams thinks (as near as I can tell anyhow,) that there is just so much real money, i.e., gold, so therefore government t-bond sales must be a zero-sum competition with bank borrowing for investment in production. But doesn’t investment depend on profits, real and projected? But t-bond purchases are driven by a perceived need to preserve wealth against loss, including the loss from not engaging in production? That in fact, genuine hyperinflation is really a function of state collapse, as in defeat in war, or economic warfare against a neo-colonial dependency? It seems to me the notion government is competing for scarce funds is as much a bugbear as the “wages fund” was once upon a time.

  6. Why is there no discussion about the role of technology in the economy and on its deflationary effects? Economists have done nothing to resolve the Technology Productivity Paradox — they can’t find any evidence that tech improves productivity and too much will harm productivity. Yet we see tech’s benefits everywhere, and it cuts the costs of business otherwise companies would not invest in it. No company buys tech to increase their costs of business.

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