First the Fed cut interest rate to zero quickly in March and they restarted the quantitative easing and eventually using
forward guidance they ensured that the market understand that the Fed will provide as much liquidity as the financial system
needs. And furthermore the Fed quickly set up seven emergency facilities and those facilities prevented the
credit markets from seizing up. And it also kept credit to households and businesses. So I think on hindsight it's pretty
clear that the decisive and swift action by the Federal Reserve as well as by
fiscal response over at the U.S. Treasury Congress and the White House
these actions prevented a complete collapse of the economic system.
If I were to point to one thing as as as as a culprit for for the Fed making the inflation forecast mistake I would think it
would be mainly institutional groupthink. And the institutional I mean the Fed has done a lot in introducing diversity into the
staff at the staff level but along the dimension of gender and racial background. But the other kind of group think
is political and also economics training
versus the economists and the Fed are trained in a certain fashion from a standard PHC economics program. And that's not
really the Fed's no
mistake. It's more of a economics profession as a whole. And the Fed is in the business of hiring from these programs. And so
although the economists kind of had these tools standard tools in there in a hand and brain and thinking about this problem
Phillips Curve and Phillips Curve is flat in just two years before the pandemic.
Always S.D. hosted a working group and tried to understanding whether Phillips curve is as flat or dead. And the consensus is
is that yeah it's flat. And so when the Fed looks at the inflation from the lens of a flat Phillips curve they would
think that even a very hot job market would not produce any inflation pressure. And we now know from actual wage data that
doesn't seem to be the case. Second the idea that inflation expectations is the most important thing in keeping
inflation low. I remember in the spring of twenty twenty one. This is to the Fed's credit. The upper management directors were
instructing staff to think more deeply about how inflation expectations
affect inflation. And what kind of indicators should we be looking at to to to to gauge whether expectations are on
anchoring. And I remember that the answers from the staff is like nobody really have a good handle of that. But yet even
despite not having a good handle of the exact mechanics of how expectations influence actual inflation that measure those
measures continue to play an outsized role in the forecast in generating that complacency about inflation. And it is not until
later last year and early this year that you know now as an outsider looking in I think that the Fed staff thinking on this
is evolving. I've seen increasing research coming out of the Fed clearly attributing demand as play a role in the high inflation.
I've seen a paper from Jeremy Rose who actually acknowledge that we don't know how inflation expectations
influence inflation. In fact he downplayed the confidence that anybody should pay into any
complicated mathematical equation that you know feed expectations into inflation. In fact he pointed out that it's
simpler than that. It's really a function of whether you know inflation is on your radar or not. And that kind of statement in
order to carry any authority and our weight in the Fed's process needs to be coming from somebody fairly senior. So I think the
culture in the Fed is you've got a half a paper under way or publishing in order for your view to be taken really seriously.
And we when we are at times like the pandemic where everything is unusual where any models that fit it on data from the past 20
years don't really apply then then and you are making decision based on you not with a very high threshold of publishing
quality. It's kind of hard to be swift and agile in. Tailoring your response. So I. And on the on the political group thing
side as I was saying I worked for a year in a Republican CIA. And when I came back to the Fed I clearly observed the
differential weight that the organization placed on thinking about the possibility that this fiscal stimulus might be too
much.
I think it played a role in Bloomberg Economics. We put out a piece last December showing that if you look across countries US
inflation is uniquely high and higher by about 3 percentage points. That before the Ukraine or
and I can see that increasingly Fed staff is coming to that view as well. There's been research from San Francisco Fed
from the board of governors that point to 2.5 to 3 percentage point as as being contributed by fiscal stimulus.
I think that share power has been very clear in his recent community occasion that price stability is the priority of the
Fed right now that if the Fed were to lose price stability that the impact on
the lower income quintile of American households would be even worse than if there were to be a recession. So from a cost
benefit angle the Fed has come to a conclusion that the cost of losing the inflation anchor is higher than the cost of having a
recession.
One culprit of the mess on inflation is that the model based approach to inflation forecasts. Those models have some
assumptions that appear to have broken down during the pandemic. So if a central bank relies excessively on only one particular
framework of inflation forecasting such as using a Phillips just relying on Phillips curve approach of inflation forecasting that
would be misleading. So I think the lesson is that while no one should be incorporating a range of different approaches of
forecasting inflation that would involve bottom up top down and a risk based approach where you're forecasting the entire
distribution. The thing is I do feel that the Fed already have those toolkits even during the pandemic.
And partly it is because you know those toolkits all three to toolkits failed because
the data in the last 20 years just do not indicate those kind of inflation risk.
I guess you know it could be the lesson could be as simple as maybe extend the sample period to 50 years rather than 20 years.