A recent headline exclaimed: “Central Banks Should Raise Rates Sharply or Risk High-Inflation Era, BIS Warns.” The Bank for International Settlements is owned by 61 central banks, so they should know better than to equate higher interest rates with lower inflation.

Countries with the lowest central bank interest rates (below zero) include Switzerland and Japan, according to the BIS.

Those with the highest policy rates include Argentina and Turkey, with rates of 49% and 14% respectively.

Should we conclude that Argentina and Turkey are valiantly fighting inflation with high interest rates while Switzerland and Japan are pursuing wildly inflationary easy money policies? That would be preposterous. The latest year-to-year CPI inflation was 2.9% in Switzerland and 2.4% in Japan, but 60.7% in Argentina and 73.5% in Turkey.

Even within the Euro bloc, countries which share the ECB below-zero policy rate face higher 10-year bond yields if their inflation is higher: France his 5.2% inflation and 2.3% bonds; Greece has 11.3% inflation and 3.9% bonds.

Irving Fisher of Yale (1867–1947) taught that nominal interest rates consist of a relatively small real rate (linked to the real return on capital) plus an inflation premium. That is why countries with high inflation have high interest rates, and why periods of low inflation in the U.S. also had a low federal funds rate. It would be paradoxical to expect high nominal interest rates to result in sustained low inflation.

The Federal Reserve used to focus on holding down “core” personal consumption expenditure (PCE) inflation. The median FOMC projection of core PCE inflation at the June meeting was 4.3% for this year, for example. But the last three reports were well below the FOMC’s expected norm for 2022. Core PCE prices rose at an annual rate of only 3% in February, 3.3% in March and 3.4% in April.

A comparable core PCE figure for May will not be out until June 30. But impatient Fed officials have moved on to new games with new and mysterious rules –such as “find and seek the Quixotic neutral rate.”

Meanwhile, Fed Chairman Jerome Powell has been busily changing the subject and hiding or moving the goal posts.

The Wall Street Journal reports, “While the Fed typically pays greater attention to core prices, which exclude volatile food and energy prices, Mr. Powell has said the central bank must place more focus for now on overall inflation [he explicitly mentioned ‘spikes in commodity prices’] because of concerns that consumers and businesses are anticipating price pressures to continue. Fed officials believe expectations of future inflation can be self-fulfilling. If those expectations are rising, the Fed could be required to lift rates to levels that push even harder on the monetary brakes.”

Raising central bank interest rates in response to spikes in commodity prices is certainly not a new idea. As I recently documented, every recession since 1957 was preceded by a dangerous mix of rising oil prices and a rising federal fund rate. Few economists believe oil price spikes alone would have sufficed to knock down the agile U.S. economy; the Fed’s assistance was required.

Always ready to help, the Fed Chairman is now redefining what he might be willing to consider as unmistakable evidence of slowing inflation. Such evidence apparently now excludes any good news from Core PCE inflation in favor of “spikes in commodity prices.” Such spikes are, he acknowledges, “beyond our control” yet they somehow justify all interest rates hikes. Why? Because they might affect expectations about future inflation.

So, there it is. The target seems to have shifted, for the moment, from actual core PCE inflation to estimates of expected future inflation.

But why? Expected inflation does not cause or predict actual future inflation, nor does it explain past inflation. To see why, look first at the Cleveland Fed’s sophisticated estimate of the inflation estimated five years ahead. Recent 5‑year expectations have not yet reached 2.5% inflation. And the estimates are so obviously cyclical that they have no predictive value at all. If rising oil prices and interest rates create yet another recession as in 2007-09, then expected inflation will indeed fall amazingly fast until the recession is over but no longer.

The second graph shows the University of Michigan monthly survey of expected inflation one year ahead. How much inflation people expect a year from now depends on what they have recently read in newspaper headlines or experienced at the supermarket or gas station. In fact, as the red line shows, next year’s expected inflation clearly rises and falls with today’s price of gasoline.

Another good reason to discard these inflation expectations surveys as a rationale for so-called “above neutral” fed funds rate schemes is that linking interest rates to gasoline prices can be highly inflammable.

Even as many developing countries conserve their foreign exchange reserves to guard against a nasty worsening of the economic environment, the Reserve Bank of India—the country’s central bank—has sold more than $40 billion from its reserves in the last nine months to prevent the rupee from weakening further. India’s exchange rate has gone from Rs 70 to the dollar in 2018 to Rs 78 today, and threatens to cross the Rs 80 mark. That would draw jeers from the Opposition, which would accuse Prime Minister Modi of tarnishing India’s image as India nears its next general election in 2024. However, spending the country’s reserves to avoid a purely cosmetic threshold of Rs 80 makes no sense. India’s current account deficit has soared with the high price of oil and may double to 3 percent of GDP this year. The need of the hour is a competitive exchange rate, not an inflated one.

The rupee has weakened by 5 percent against the dollar over the last year. Opposition politicians say India’s prestige is being depreciated. They seem unaware that the US dollar has strengthened substantially in the last two years with global money cascading into that country. The cascade first represented a flight from risky emerging markets to the safe haven of the dollar after Covid created huge uncertainties. More recently global money has flooded into the USA because the Fed has raised interest rates to attractive levels.

Too many Indians mistake a strong dollar for a weak rupee. Even as the rupee has depreciated 5 percent against the dollar, it has risen 7 percent against the euro and 14 percent against the yen over the last year. It has risen slightly even against the Chinese RMB.

Artificially propping up the rupee will tend to make India’s exports uncompetitive even as the current account deficit widens. If markets push the exchange rate to Rs 80 to the dollar, so be it. The Reserve Bank of India should not resist.

Richard Vigilante, an old friend from the Reagan years, reminds us of another old friend John Rutledge who worked with Larry Kudlow, Dave Stockman and me on the 1981 presidential transition team. I asked Stockman to invite Rutledge because I admired his writings about rational expectations and markets but also because he was a wizard with a rare DOS laptop (I did not buy a PC until 1982).

Later that year, December 14, Rutledge wrote “Why Interest Rates Will Fall in 1982” for The Wall Street Journal. That is the article Vigilante recalls as “the most prescient prediction by an economist that I have ever read.” Arguably true, but it turned out being more prescient for 1983 than 1982. The fact that lower tax rates were not phased-in until 1983–84, rather than 1982 as Kemp-Kasten bill planned, was one big glitch in the timing. A prolonged inverted yield curves from the Volcker Fed was another.

Rutledge argued that “major changes in interest rates are usually caused by changes m how the public wants to hold its net worth. The point of this article is that the drop in inflation in the last 18 months is forcing households to restructure their wealth in a way that will force reductions in interest rates.” That is, lower inflation would make it less attractive to hold tangible assets like (houses and gold) hoping to sell them later for a capital gain and more attractive to hold stocks and bonds. Since a rising bond price means a lower yield, bond yields should fall.

Rutledge’s ingenious analysis directly repudiated conservative Keynesians (notably Stockman) who were loudly arguing in 1981 that projected future budget deficits would raise interest rates and absorb all the U.S. savings (forgetting finance is global), leaving little credit leftover for households or firms. The stubbornly fallacious argument that budget deficits raise bond yields was the reason reductions in marginal tax rates were foolishly put off until January 1983 (when tax rates were cut by 10%) and January 1984 (by another 10%).

What Rutledge could not possibly foresee at the end of 1981 was that the Fed would act as though there was no “drop in inflation” and would instead keep short-term interest rates at astonishingly high rates of 14–19% – usually higher than the yield on 10-year bonds (an inverted yield curve).

Modern readers may be surprised that inflation had dropped for 18 months by December 1981. The historical hoax that stubborn inflation in 1982 “forced” Fed Chair Paul Volcker to keep short rates far above inflation may persist because the public and press in the 1980s mistook foreign oil price shocks for domestic inflation, just as they do today. The Iranian revolution from January 1978 to February 1979 decreased global oil supply by 4 percent and led to an oil price increase of 57 percent; then starting in September 1980 the Iran-Iraq War decreased global supply by 4 percent and led to another price increase of 45 percent.

Core inflation does not remove all effects of such oil price spikes on the cost of producing and transporting goods and people (such as air fares). But core inflation is less misleading than all-items “headline” inflation. The Consumer Price Index, unlike the PCE index, also miscounted higher mortgage interest rates as housing inflation until 1983, so even the core CPI for 1980–82 is misleading.

As the graph shows, the Core PCE index of inflation rose at an annual rate of 10.1% in the first and fourth quarters of 1980, but that dropped to 7.3% by the last quarter of 1981 (as Rutledge noted), then to 5.5% in the second quarter of 1982, 3.1% in the second quarter of 1983, and 1.6% by December 1986.

Falling inflation confirmed the Rutledge forecast, yet the yield on 10-year bonds remained relatively high as the blue line indicated. Why? Because the Fed kept the federal funds rate (red line) as high or higher than the bond yield. The fed funds rate even remained above 14% from February to June 1982. Finance professors will tell you that is a recipe for recession, and this case it was a recipe for two recessions from 1980 to 1982.

While the Fed kept the yield curve inverted, or nearly so, the high fed funds rate kept the interest rate on money market funds so high it was almost foolish to shift into 10-year bonds whose value could fall with another round of fed funds rate hikes (which happened in 1983–84).

Once all tax rates were finally cut by 10% in 1983 and again in 1984, the Rutledge Model overwhelmed the Volker model even though the Fed put the fed funds rate back up with each tax rate cut. Real GDP grew by 4.4% a year from 1983 to 1989 (before interruption by another oil shock and renewed tax hikes). Inflation moderated most in those high-growth years and stocks did extraordinarily well, as Rutledge suggested. It is still a great read, but I might retitle it “Why Interest Rates Fell After 1982, Despite the Fed.”

Today, inflation has reached a 40-year high, in response to fiscal profligacy and accommodative monetary policy. Direct cash payments to individuals and businesses in 2020 and 2021, which totaled more than $5 trillion, along with the rapid growth of base money—under the Fed’s large-scale asset purchase program (also known as quantitative easing or QE)—-have combined with global supply-chain disruptions to generate inflation rates that are substantially above the Fed’s long-run goal of 2 percent (Figure 1).

John Cochrane (2022), a Senior Fellow at the Hoover Institution, makes a convincing case that, although inflation generally can be understood as a monetary phenomenon, its roots often can be traced to fiscal dominance—that is, to political pressure to use the central bank to accommodate government deficit spending. Both debt monetization and fiscal helicopter drops—or what Cochrane calls “fiscal inflation”—need to be recognized.

This article examines the fiscal and monetary sources of the current inflation and emphasizes the importance of fiscal rectitude and monetary control in shaping expectations about future inflation. Without sound fiscal and monetary institutions that are transparent, constrained by the rule of law, and trusted by the public, the danger of future inflation will persist.

Fiscal Stimulus and Monetary Accommodation in Response to COVID-19

The U.S. economy came to an abrupt halt in March/​April 2020 as the COVID-19 pandemic resulted in the lockdown of normal commercial life. Businesses shut down and millions of workers became unemployed overnight. With unprecedented uncertainty about the future, the demand for cash balances increased and the velocity of money took a sharp downturn, which led to a concomitant decline in nominal GDP. The recession was deep, but short-lived, compared to the Great Recession stemming from the 2008 financial crisis, as Congress and the Fed moved quickly to pump up aggregate demand.

A Fiscal Helicopter Drop

A rush of legislation was passed by Congress and signed into law by President Trump in 2020 to mitigate the ill effects of the pandemic. The “Coronavirus Aid, Relief, and Economic Security Act” (CARES Act) was signed on March 27. It appropriated $2.3 trillion for making direct cash payments to individuals, expanding unemployment benefits for workers, and assisting small businesses and industries. On December 27, President Trump signed a second piece of legislation, the “Consolidated Appropriations Act” (CCA), which provided additional relief of $900 billion. In March 2021, when the economy was growing at a healthy pace, Democrats poured fuel on the spending spree by passing the “American Rescue Plan Act of 2021,” which added $1.9 trillion of new spending. Individuals who earned less than $75,000 per year were eligible to receive direct cash payments of $1,400, plus another $1,400 per dependent. (For a summary of these laws, see Alpert 2022.)

John Cochrane likens the more than $5 trillion of COVID-19 relief spending to a fiscal helicopter drop that was sure to generate inflation as the economy quickly recovered from the pandemic. According to Cochrane (2022):

Starting in March 2020, in response to the disruptions of Covid-19, the U.S. government created about $3 trillion of new bank reserves, equivalent to cash, and sent checks to people and businesses. (Mechanically, the Treasury issued $3 trillion of new debt, which the Fed quickly bought in return for $3 trillion of new reserves. The Treasury sent out checks, transferring the reserves to people’s banks.

The Treasury then borrowed another $2 trillion or so and sent more checks. Overall federal debt rose nearly 30 percent. Is it at all a surprise that a year later inflation breaks out? It is hard to ask for a clearer demonstration of fiscal inflation, an immense fiscal helicopter drop.

A key assumption in Cochrane’s analysis is that the debt will never be repaid. Thus, one can treat the debt as a hypothetical bond with a notional, not real, value. Kevin Dowd describes such debt as a “perpetual bond with a zero coupon.” Strictly speaking, the expression “helicopter drop” should only be used when the Fed is literally giving money away to the public (see Friedman).

More importantly, in the post-2008 “floor system,” there is no necessary link between the size of the Fed’s balance sheet and inflation, since reserves can always be sterilized by increasing interest on reserves (more on this later).

Deficits and Money Dance Together

The COVID-19 transfers to households and businesses widened federal deficits, which were financed primarily with accommodative monetary policy. The Fed lowered interest rates, kept them lower for longer, and continued to purchase a large share of Treasuries and mortgage-backed securities. Total assets held by the Fed now stand at about $9 trillion compared to $4 trillion in 2019 (Figure 2). The reserve component of base money more than doubled from March 2020 to August 2021 (Figure 3) as the Fed acquired assets.

The Fed’s decision in 2008 to begin paying interest on reserves—was an alternative to sterilizing its emergency lending during the financial crisis. When the Fed raises the IOR rate above other short-term lending rates, banks have an incentive to lend to the Fed rather than to the market. That policy reduced the multiplier effect of base money (also known as high-powered money) on both M2 (i.e., currency held by the public, demand deposits, certain time deposits, saving accounts, and money market accounts) and NGDP (Figure 4). However, as the economy gained steam in 2021, banks began to increase their private-sector lending, leading to a slight increase in base-money multipliers (see Williams 2012).

Figure 5, based on the work of Fernando Martin at the St. Louis Fed, shows the close relationship between federal deficit spending and M2 in a monetary regime of near-zero interest rates, QE, and forward guidance designed to keep inflation at 2 percent over the long run. As Martin notes, “Both series track each other well, suggesting that the expansion of money in the economy has a fiscal origin.”

During the pre-pandemic years (2016–2019), M2 grew at an annual rate of 5.6 percent. However, money growth accelerated to 15.6 percent between February and May 2020 once the CARES Act became law in March and the lockdowns took place. A one-time jump in the quantity of money along with a negative supply shock was bound to increase the price level, but long-run inflation requires a sustained increase in M2 (see Thornton 2022). Looking at the data, Martin points out that, following the initial sharp increase, M2 continued to grow at a much faster rate (12.5 percent) than prior to the pandemic. He concludes that, unless money growth slows, inflation can be expected to continue. But, for that to happen, “future deficits need to be persistently large.” From Cochrane’s perspective, it means that the public must expect that the debt will never be repaid. Yet, once again, whether there is future inflation will depend on whether the Fed fails to raise its administered rates soon enough and high enough.

The Failure of the Fed’s New Monetary Framework

In August 2020, the Fed announced several changes to its Statement on Longer-Run Goals and Monetary Policy Strategy. Most importantly, the Federal Open Market Committee (FOMC) adopted “flexible average inflation targeting” (FAIT) that would allow inflation to be “moderately above 2 percent for some time” to make up for past shortfalls. It also redefined its maximum employment mandate as “a broad-based and inclusive goal.” Although that goal is “not directly measurable and changes over time owing largely to nonmonetary factors,” the FOMC‘s “policy decisions must be informed by assessments of the shortfalls of employment from its maximum level” (emphasis added). By substituting “shortfalls” for “deviations,” and by moving to FAIT, the Fed signaled that its employment mandate would take precedence over price stability.

The Fed’s new monetary framework is asymmetrical: it deals only with undershooting the target rate, not with overshooting it. It is also vague: the starting and ending points for FAIT are not specified—that is, there is no clear range over which inflation would be allowed to exceed 2 percent. That uncertainty could lead to selecting a higher average inflation target, which would lead people to expect more inflation in the future.

Earlier, in October 2008, in response to the financial crisis and a near-zero nominal policy rate, the Fed abandoned its traditional “limited-reserves regime” for conducting monetary policy in favor of an “ample-reserves regime.” Instead of using small changes in the supply of reserves to move the fed funds rate in line with the Fed’s target rate, the new framework uses QE to pump up reserves, so that the supply of reserves lands in the flat portion of the demand curve. Meanwhile, the Fed’s target rate is implemented by having the Board of Governors, not the FOMC, administer two rates—the interest on reserve balances (IORB) rate (often shortened to interest on reserves or IOR rate) and the overnight reverse repo (ONRRP) rate. The new operating arrangement means that the Fed’s asset purchases (and thus the size of its balance sheet) can be separated from the stance (i.e., position) of monetary policy (see Plosser 2017; Beckworth 2018; Selgin 2018).

The “divorce” of money (reserves or base money) from the stance of monetary policy (i.e., the Fed’s target range for the federal funds rate) in an ample-reserves regime can be seen in Figure 6. Once reserves are in the flat portion of the demand curve, shifts in the supply of reserves will not affect the fed funds rate, as they did in the pre-2008 framework (see Ihrig and Wolla 2020). Under the new regime, the stance of monetary policy depends primarily on where the Board sets the administered rates it pays on bank reserves and reverse repos.

Todd Keister et al. (2008) nicely summarized the key implication of the ample-reserves regime (also known as the “floor system”) in an article for the New York Fed:

A floor system “divorces” the quantity of money from the interest rate target and, hence, from monetary policy. This divorce gives the central bank two separate policy instruments: the interest rate target can be set according to the usual monetary policy concerns, while the quantity of reserves can be set independently.

What this means is that the Fed can pump up its balance sheet without causing inflation provided it sets its administered rates high enough and soon enough. But there are political limits on how high the IOR rate can go. The public will not look favorably upon large banks receiving high rates on their reserves at the Fed while rates for most people on their bank deposits lag behind. Likewise, Congress won’t like the fact that as the Fed pays higher rates on reserves; remittances to the Treasury will fall. Finally, large increases in the Fed’s balance sheet via asset acquisition—without corresponding increases in the IOR and ONRRP rates—heighten the risk of inflation. The current inflation is testimony to the risk of the Fed waiting too long to raise its administered rates.

Predicting both fiscal deficits and inflation is difficult: forecast errors are common and often large. Top Fed and Treasury officials were caught by surprise with the recent run-up in inflation to a 40-year high. They predicted inflation would be transitory, not that it would now be running at 8.6 percent. They fundamentally ignored the risk of inflation. Indeed, after President Biden signed the $1.9 trillion American Rescue Plan into law on March 11, 2021, Treasury Secretary Janet Yellen, when asked, “Is there a risk of inflation?,” responded: “I think there’s a small risk and I think it’s manageable.” She now admits her forecast error and thinks inflation will “remain high” and should be “our number one priority.”

The failure of the Fed’s post-2008 operating system (see Selgin 2018), and its move to FAIT in 2020, should be addressed if future inflation is to be avoided (see Plosser 2022).

Drawing a Clear Line between Fiscal and Monetary Policy

To stem inflation in the long run, we need moderate levels of monetary growth, for a start, and a clear line of demarcation between fiscal and monetary policy. Since the 2008 financial crisis, the Fed has engaged in credit allocation in close coordination with the Treasury. George Selgin, in his book, The Menace of Fiscal QE (2020), warned against using the Fed’s balance sheet under the floor system to fund projects that may not muster a majority vote. Such “backdoor spending” is facilitated by the Fed’s power to engage in large-scale asset purchases, and the Board of Governors’ authority (since 2008) to pay interest on reserves.

Charles Goodhart, emeritus professor at the London School of Economics, gets to the crux of the problem of fiscal QE in his inside-cover quote for Selgin’s book:

The current “floor system” of money market management in the USA allows the size of the Fed’s balance sheet to be divorced from its mandate to control inflation. This opens the way for some, usually on the political left, to advocate using the Central Bank’s balance sheet to fund all kinds of (idealistic) expenditures, “quasi-fiscal” quantitative easing, thereby avoiding the need for legislative approval and often (mistakenly) perceived as a “free lunch.” George Selgin advocates a return to a “corridor” system of money management to avert such dangers.

Likewise, Cochrane (2022) warns that, “Whether inflation continues or not depends on future monetary policy, future fiscal policy, and whether people change their minds about overall debt repayment.” As he explains:

If the government borrows or prints $5 trillion, with no change in its plan to repay debt, on top of $17 trillion outstanding debt, then the price level will rise a cumulative 30 percent, so that the $22 trillion of debt is worth in real terms what the $17 trillion was before. In essence, absent a credible increase in future surpluses, the deficit is financed by defaulting on $5 trillion of outstanding debt, via inflation.

Cochrane’s message is that, if the root cause of the current inflation is fiscal profligacy, then reforming the fisc is a necessary step toward monetary reform. Government spending needs to slow while economic growth needs to rise; markets, not government bureaucrats, need to set prices; and monetary and fiscal policymakers need to be guided by rules rather than pure discretion.

Conclusion

To say that “inflation is always and everywhere a monetary phenomenon” is not to say that fiscal policy doesn’t matter. “Fiscal inflation” is indeed “a menace,” as Cochrane and others have argued. Few experts predicted the shift from low inflation before the pandemic to nearly 9 percent CPI inflation today. Policymakers largely ignored the implications of the post-2008 operating system, the close dance between cumulative federal deficits and M2 growth, and the risk of adhering to the Fed’s “lower for longer” recipe for its policy rate in the hope of stimulating asset markets and the economy without causing high inflation. The impact of FAIT on inflation expectations was also underestimated. The goal of FAIT was to make up for periods of low inflation with periods of high inflation, but in doing so the FOMC elevated its maximum employment goal and downplayed its price stability mandate. With inflation now at the highest level in 40 years, there could be pressure for increasing the average inflation target to 3 or 4 percent. To do so would be another step away from long-run price stability.

Also, it is important to remember that persistent inflation depends primarily on a continuing excess supply of money, the likely cause of which is fiscal profligacy—and, in the case of the current inflation, large cash transfers directly to individuals and businesses from the U.S. Treasury. Supply-chain effects, to the extent they are a part of the story, should still be effects only on the price level, not the inflation rate. Thus, they should be transitory, not permanent (see Thornton 2022).

Of course, the same is partially true of the fiscal and monetary stimulus. As my colleague Jeff Miron noted (in a recent email):

If we don’t repeat the Covid-19 spending burst, and the spending goes back to its prepandemic level relative to GDP; and/​or, if the Fed reverses policy, as it has been doing for past few months, then the fiscal and monetary stimulus should also turn out to have been transitory, and so inflation should subside to a significant degree. But, the key difference is that the debt path has been implying future inflation for years now. The recent fiscal outburst was, at one level, small potatoes relative to the existing path. But maybe it reminded everyone that the fiscal iceberg is out there.

The dangers of fiscal QE, debt monetization, fiscal helicopter drops, and fiscal inflation are real. They need to be taken seriously by policymakers and the public. The FOMC’s 2020 Statement on Longer-Run Goals and Monetary Policy Strategy calls on the Fed “to undertake roughly every five years a thorough public review of its monetary policy strategy, tools, and communication practices.” The FOMC also “seeks to explain its monetary policy decisions to the public as clearly as possible.” Yet, in its policy statement, the Committee specifically says that its goal of maximum employment “is not directly measurable” and that shortfalls from it are therefore difficult to observe. Likewise, there is no specific information regarding the timeframe for achieving an average inflation rate of 2 percent, and no guarantee that the Fed can hit that target. Nor is there any evaluation of how well the floor system has worked or what alternatives would better promote the Fed’s dual mandate as well as provide for moderate long-run interest rates.

If the Fed really wants to be transparent and keep the public informed about the nature of monetary policy, a broader discussion needs to take place, preferably to include alternatives to the present discretionary government fiat money system—and sooner than 2025.

[Cross-posted from Alt‑M.org]

According to CNN, “The Producer Price Index, which measures wholesale prices before goods and services reach consumers, rose 10.8% in May compared to where it stood a year ago.”

The PPI is not in any sense a measure of “wholesale” prices and has not been called that since 1978 (it was much narrower and simpler in the old days).

An AP headline declares, “US Producer Prices Soar 10.8% in May as Energy Costs Spike.” No, the PPI is not a measure of business costs for energy or anything else. The price businesses receive for their sales may at times be a cost for other U.S. businesses ­–if that is who they are selling to– but it is gross income (revenue) for businesses making the sale.

The PPI typically rises and falls with crude oil prices simply because big U.S. oil companies receive (not pay) higher prices when the global oil price goes up. The PPI is, in fact, overly sensitive to global oil, grain, and metals prices, and therefore to the effects of Russian war and sanctions on such prices. And no “core” measure can fix that. 

The PPI is a measure of what business get paid, which importantly includes what they are paid for U.S. exports by foreign buyers. The high prices U.S. producers of oil and LNG collect from Europeans and other foreigners has lifted this year’s PPI numbers considerably.

A CNBC report says, “The [PPI] data is significant in that prices at the wholesale level feed through to consumer prices.” None of that is right. The prices are not wholesale, they are not costs, and they do not simply feed through to consumer prices.

The PPI uses profit margins to estimate prices received in wholesale and retail trade, which is so peculiar that the PPI for trade services is excluded from the inexplicable core PPI. Retail profit margins vanished in the 2020 pandemic and recovered when economies reopened, but that was recovery not inflation.

The PPI for carbon steel scrap fell 11.7% in May while prices for steel mill products rose 10.7%. Some portion of that cheaper or more expensive steel may be used to make consumer goods, rather than business parts and equipment, but those consumer goods might be exported.

Because prices received by business are from foreigners, governments, and other businesses (foreign and domestic), rather than just domestic consumers, there is no reason to expect prices that producers receive to cause or predict future prices paid by U.S. consumers. There is no evidence that today’s PPI can be used to predict tomorrow’s CPI, nor any reason to expect that would work.

The prices producers received for meats fell 6% in May, while prices producers received for cars and trucks rose only 0.3%. Try using that information to predict retail consumer prices at your peril.

This year marks the thirteenth time since 1954 that the Federal Reserve Board’s policy-making Federal Open Market Committee (FOMC) began gradually ratcheting up the federal funds rate on bank reserves in a series of recurring steps. Eventually, however, the rate increases always stopped and the FOMC began bringing the “fed funds rate” back down.

The inevitable series of interest rate reductions most often did not begin until recession had already begun, or too shortly before, so those monetary policy experiments are now looked back on as “hard landings.”

Whenever the rate increases stopped in time to avoid a recession, we call that a “soft landing.” Among postwar Federal Reserve interest rates cycles only four have been four soft landings, leaving eight hard landings so far.

It is important to note that soft landings always required bringing the federal funds rate back down, not merely stopping the rate increases:

• The fed funds rate was increased from 3.9% in January 1965 to 5.8% by November 1966, but then it was reduced to 2.9% by July 1967.

• The fed funds rate was increased from 8.5% in February 1983 to 11.6% in August 1984, but then it was reduced to 7.5% by June 1985.

• The fed funds rate was increased from 3.1% in January 1994 to 6% that June, but then it was reduced to 4.6% by January 1999.

• The fed funds rate was increased from 1% in July 2017 to 2.4% in July 2019, but then it was reduced to 1.6% in February 2020 (just before the COVID-19 pandemic struck).

Recessions dates are the shadowy grey vertical bars in the graph.

The federal funds rate is red, the unemployment rate is gold, PCE inflation is blue, and the price of crude oil is black.

Aside from West Texas Intermediate crude oil prices (expressed as a year-to-year percentage change) all other data is in real time – when it happened. Inflation (at an annual rate) and oil prices are quarterly for visual smoothing; the others are monthly.

The red line shows that the fed funds rate peaked in September 1969, July 1974, April 1980, June 1981, March 1989, June 2000, and June 2007. That marked the end of the rising phase of Federal Reserve interest cycles – before rates were reduced.

The black line shows that, like today, we were suffering through 50–100% increases in world oil prices during six of the recessionary fed funds rate peaks (not counting the milder Suez Canal crisis of 1957–58).

The gold line shows that unemployment is an extraordinarily sluggish “lagging indicator” which provides no warning of recessions and usually peaks after recessions have ended. Unemployment was only 4.7% the month before the Great Recession started but 10% four months after it ended.

The blue line is the all-items PCE measure of inflation. It would be inappropriate to use the CPI for long-term historical comparisons The CPI treated fluctuations in mortgage rates as changes in inflation until 1983, making CPI estimates incomparable before and after 1983 (including journalistic comparisons of recent CPI numbers with those of 1980–81).

Since FOMC interest rate cycles always end with the fed funds rate being substantially reduced –often to a rate lower than when the rate increases began– it should not be surprising that significant reductions in inflation commonly ended when the recession ends, with unclear long-term effects (meaning effects from induced recessions rather than from higher interest rates themselves, since they were always reduced).

Since nearly all fed funds rate spikes were also associated with oil price spikes, what happened to overall inflation largely depended on what happened to world oil prices – such as the end of the Iran-Iraq war and the end of Gulf War.

Even core measures of inflation track oil and natural gas prices surprisingly closely because the indirect impact on production and distribution costs is pervasive (such as fertilizers and air fares). Yet changes in the fed funds rate often appear more sensitive to oil prices (or unemployment) than to core inflation per se.

The year-to-year increase in core PCI was 1.7% in June 2000 when the fed funds rate peaked at 6.5% and in November 2002 (a year after the Fed’s first anti-NASDAQ recession) core inflation was still 1.7%. Yet the fed funds rate had fallen to 1.2%. The same measure of core inflation was 2% in July 2007 when the fed funds rate peaked at 5.3%, but it was still 2% in December 2011 when the fed funds rate was 0.1%.

It is impossible to pack so much economic history and so many variables into a single graph, of course, so I am working on a longer narrative covering each fed funds rate cycle in some detail, with references.