Take a stock New-Keynesian model, adding FTPL with short-term debt. The model is an IS curve with a “demand” shock, a Calvo Phillips curve with a “supply” shock, an interest rate rule, and unexpected inflation = the revision in present value of future surpluses. With sticky prices, the real interest rate can vary. Interest costs on the debt can vary, and the present value of surpluses is lower when real interest rates are higher.

Here is the response of that model to an unfunded fiscal expansion—a decline in surpluses—with no change in interest rate. Inflation surges, but then goes away. In the long run the price level rises. Bondholders lose by a period of low real interest rates — inflation above the nominal rate. In the short run the present value relation B/P = present value of s holds, though B and P have not changed, because the lower real interest rate balances the lower surpluses s. Output surges, following the Phillips curve.

That’s old news. The supply shock:

This is an AR(1) shock to the Phillips curve, with no change in interest rate and no change in surplus — no change in monetary or fiscal policy. A “supply” shock is really just an inflation shock. Inflation = expected inflation + (constant) times output + shock. So, no surprise, inflation surges. Output declines. It’s a stagflationary shock, and we move away from the Philips curve.

Here is a “demand” shock to the IS curve, again with no change in monetary (interest rate) or fiscal (surplus) policy

The inflation is exactly the same. This time, following the Phillips curve, inflation produces a strong output response as it did in response to the fiscal shock.

A lot of papers invert the model solution to find which shocks caused inflation in 2021-2022. As you can see, since the inflation pattern is broadly similar, that hinges on the joint behavior of output and inflation. I won’t delve in to that issue here.

Nominal anchors

What about the nominal anchor? When people say “supply” or “demand” (or “greed” or “monopoly” or “price-gouging”) cased inflation, I, like many economists, respond: Don’t confuse relative prices with the price level. The price level always in the end comes from monetary or fiscal policy. But here we have “supply” and “demand” shocks moving inflation, though there is explicitly no change in monetary or fiscal policy.

You can see a big difference in the fiscal shock vs. the supply and demand shocks: only the fiscal shock permanently changes the price level. Not shown, higher interest rates also raise the price level in the long run. So it seems that the nominal anchor is a weak force, that applies in the long run. Supply, demand, and other relative-price shocks can move inflation around in the short run. Maybe inflation is, for a while, just the sum of price changes. When A raises a price, maybe it takes a while for money supply or fiscal theory to drag B’s price down.

That’s tempting, but it’s false. Remember discount rates. With sticky prices, the real interest rate or discount rate part of the present value formula changes. Higher discount rates, or higher interest costs on the debt, lower the present value of surpluses and raise the price level.

Look for example at the response to the demand shock. The period of negative real interest rates (inflation above nominal rate) is initially balanced by the later period of positive real interest rates. There is, initially, no change to the present value of surpluses and no change to the price level. Later, some of the period of negative real interest rates has passed. Now higher real interest rates dominate the present value. The (still unchanged) surpluses are discounted at a higher rate. The price level is higher. Real interest rates eventually revert, so the present value and the price level eventually go back to where it started.

So the price level is always controlled by the nominal anchor, even in these simulations. Real and relative-price shocks do not of themselves change inflation. We don’t go back to thinking of inflation as just the sum of price and wage decisions. But the nominal anchor is the discounted value of surpluses, not surpluses themselves. Other shocks, by inducing changes in the real rate of interest, induce changes in the nominal anchor. Monetary and fiscal policy would have to actively offset those changes if they wished to produce a steady price level.

You could still view the undiscounted nominal anchor as a long-run attractor. The discount rate soaks up other shocks so that the present value relation still holds. In that way you could still think of supply and demand shocks themselves causing inflation, and the real interest rate just soaking up variation so that the present value relation holds. But equalities are equalities and it’s dangerous to think about which one causes which, which equation is stronger than another, and which direction causality runs.

The importance of discount rate variation in the present value formula in all of thse responses offers a good reason why fiscal theory is not immediately noticeable to practical people.

The situation is a bit like that in monetarist thinking based on MV(.)=PY. without a change in M, you think, there can be no change in PY. But if there are shocks to V, then though M still controls PY, PY can change with no change in M. In this situation, however, we have much less modeling just how V does depend on other events. It does look a lot more endogenous in the short run, and M a longer-run weak nominal anchor. My new-Keynesian model is much clearer about how real interest rates enter the present value of surpluses. But perhaps the endogenous-velocity sort of intuition is more important in reality.

Shock Accounting

I initially offered the first graph as the central story of 2021-2022 inflation. The huge unfunded fiscal expansion of the pandemic and post-pandemic years caused a surge of inflation. Later (see “Inflation,” I don’t want to repeat all the graphs) the Fed raised interest rates, which brought inflation down more swiftly at the cost of the persistent small inflation which we see now.

But the first graph predicts a surge of output as well. Well, said I, the government did this fiscal expansion precisely to stimulate output, because other shocks were lowering output. I left that vague. Supply and demand shocks offer a chance to be more precise about that.

The inflation path in the supply and demand shock is exactly the same. So, imagine a simultaneous positive demand and negative supply shock. You can add up the responses. I call the pandemic a snowstorm shock. People don’t want to go out to dinner, and the restaurants are all closed anyway. The two inflation paths cancel, leaving a huge output decline. The government responds to that output decline with the unfunded fiscal expansion. Now we get the inflation of the first graph, with a moderated output decline.

Shock-accounting exercises offer a nuanced version of that story. A larger demand shock comes first, so there is a little bit of deflation. The supply shock comes second, setting off inflation. Most of those efforts count fiscal policy as a passive response, so don’t call it a shock, but it’s there.

But in the end, these miss the point. In our episode, the price level rose 20%. The only way the price level can rise permanently is with a monetary or fiscal policy shock. In this case, the fiscal expansion is clearly the culprit. Or the savior. The government did trade off more inflation for less output decline (see first graph).

***

The model:

I use theta = 0 and ui = 0 to make these graphs.

***

New Federal Reserve chair Kevin Warsh wants to make fundamental reforms to the central bank. Fixing financial regulation should be high on his list.

The U.S. financial regulatory regime failed catastrophically in 2008. The financial crisis was, at its heart, a classic bank run. Financial institutions lost some money on their assets. People ran to pull their deposits and other short-term investments, leading to a wave of failures. Only a $475 billion bailout from the Treasury Department kept the biggest banks from failing and avoided complete financial collapse.

In the wake of this disaster, leaders had the decency to admit that regulation failed and reforms were needed. But the resulting changes — the Dodd-Frank law and the Fed’s subsidiary regulation — simply piled on the previous approach that focused on managing asset riskiness.

The focus should instead have been on run-prone liabilities. Corporate assets such as data centers and rockets are far riskier than bank assets such as loans and debt securities. Why are the safer assets so much more heavily regulated? Because tech companies are financed by equity. When shareholders lose money, it is not a systemic crisis. Banks are financed with short-term debt (deposits) that can suffer contagious runs and invite government rescues.

The Dodd-Frank reforms were supposed to end bailouts. But in the turmoil of 2020, skeptics were proved right when the Fed and Treasury undertook a second bailout. The central bank intervened in Treasury markets, bailed out money market funds, lent directly to cities and states, and put a floor on corporate debt prices.

…

The rest here, and full version in a month.

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As the new CPI data came out hot, I can’t resist updating the comparison to the 1970s. Is it fair? Much is different. Much is not.

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Don’t kill the golden goose

It’s easy to reduce income inequality: Imprison the billionaires. Burn the evil capitalist businesses that generate their wealth and seduce us with wonders—iPhones, software, electric cars, Amazon, Walmart, miracle drugs, and so on. There, feel better?

Our billionaires kept a fraction of the benefit they generated for us by starting these innovative businesses. Their great wealth remains reinvested in those companies to serve us even better in the future. Just what is the problem?

It is right to worry about people of lesser means. But how does a kid who works at a carwash in Fresno even know how many billionaires there are, or what their net worth is?

We should worry about opportunity. Teachers’ unions destroyed his schools. Construction restrictions make moving to good jobs impossible. Business regulations, taxes, minimum wages and occupational licenses limit his opportunities. Social programs trap him by taking away a dollar of benefits for each dollar of earnings. To provide opportunity, start by getting out of the way.

Many people who worry about inequality hope to improve this kid’s life by taxing the innovators to send him a few more government checks—so long as he stays poor. But there aren’t enough billionaires to make a dent in the government’s ravenous appetite. And what a horrible vision: entrenched misery and idleness, in a stagnant society devoid of innovators, made only a bit better by a dwindling government check and dysfunctional social-service programs.

Others who decry inequality want taxes to reduce the political power of the wealthy. But that hands even more power to the government. Fairly won inequality does not threaten democracy. Confiscatory taxation does. Don’t kill the golden goose.

*****

Forgive my brevity, there was a severe word count limit on this one. For an older and more comprehensive view, see this essay.

The other contributors were Emanuel Saez: “Tax the billionaires,” (to whom my first sentence is dedicated, with initially more colorful options), Raj Chetty: “Focus on upward mobility” (yes), Heather Boushey “Break monopolies” (Unions, more government spending), and Glenn Hubbard “Retrain workers for an AI-dominated economy” (I like Glenn a lot, but it was only 5 years ago that there was huge enthusiasm for retraining everyone to learn to code.) But you’ll have to go to WSJ for those.

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Independence, Structure, and Risks Ahead for Central Banks

The Hoover Institution convened its annual Hoover Monetary Policy Conference May 7-8, 2026, with scholars gathering to explore themes of Independence, Structure, and Risks Ahead for Central Banks. Michael Bordo, John Cochrane and Valerie Ramey organized the conference.

The Federal Reserve is in a period of transition and structural challenges. The chairman of the Federal Reserve’s term has ended, and a successor has been confirmed. Inflation has not fully returned to target, and new shocks, a tariff wave, and a rise in the price of oil, have pushed inflation back up. Fiscal deficits remain large. The dollar’s share of global reserves and of foreign holdings of Treasury debt has been falling for two decades. And a wave of enthusiasm about artificial intelligence has begun to reshape expectations about growth, inflation, and interest rates, including much optimism but also much fear.

The conference took up a connected set of questions about whether central banks can remain independent, necessary, and accountable all at once, as risks old and new continue to appear and recede.

Where are the legal and institutional foundations of central bank independence strong and where are they exposed? How are fiscal pressures and the changing status of the dollar reshaping the environment in which monetary policy operates? What mandate, what tools, and what accountability framework should a central bank have? How should financial stability and bank supervision be recalibrated after the great inflation of 2021 and 2022 and the bank failures of 2023? And what does an era of localization, geopolitical competition, and an anticipated AI boom imply for inflation, growth, and interest rates?

Opening Remarks

Hoover Senior Fellow Valerie Ramey welcomed participants to the conference, which John Taylor and George Shultz launched more than a decade ago.

Condoleezza Rice, Hoover Institution director and the former secretary of state, spoke of the international setting. The world, she said, is in transition from one international economy to another. Eighty years of a system the United States and its allies built after the Second World War is being left behind. It was a positive-sum system in which wealth was produced by trade and cooperation, protected by American military power. Through the Cold War, she said, the international economy and national security ran on parallel tracks, because the Soviet Union was a military giant, but limited in an economic and technological sense. China has changed that. The two tracks have converged, and it is no longer possible to discuss the international economy without discussing national security.

The conference, she urged, should treat technology, national security, and the international economy as one conversation. She closed with a warning that the United States, long the gravitational center that held the postwar order in orbit, now seems to be one of the sources of instability. The United States, with its size and power, should at least not be a great source of global uncertainty.

Independence and Governance

Hoover Senior Fellow John Cochrane chaired the opening session, which examined central bank independence through practice, history, and present-day legal vulnerability.

Edward Nelson (Federal Reserve Board) surveyed how Fed independence has operated in practice, with a focus on the period from William McChesney Martin through Alan Greenspan. He distinguished instrument independence from goal independence. The Federal Reserve chair conferring with the executive on shared objectives is not a loss of independence, while setting the instrument under outside direction would be. On that test, he argued, there is only one clear-cut historical case of lost independence: the period before the 1951 Treasury Accord in which the Fed explicitly agreed to support the price of long-term bonds. In the years prior to 1951, the Federal Open Market Committee and the Truman administration fought openly about interest rates, with the FOMC urging higher rates in the years after World War II to curb high inflation. Nelson, looking at the extensive record, cast doubt on the oft-told story that President Nixon pressured the Fed to keep interest rates low in the runup to the 1972 election. As in many other episodes, the Fed kept policy loose of its own accord, based on Arthur Burns’s views that price and wage controls would be effective.

Gary Richardson (UC-Irvine) placed central bank independence in US constitutional history. An independent central bank is an old political idea, rooted in the founding-era debates over the First and Second Banks of the United States. The initial ambiguity over a central bank’s constitutionality was settled by Hamilton’s implied-powers argument in McCulloch v. Maryland. Richardson traced three great reforms: the quasi-private regional design of 1913, the centralized structure of 1935, and the clarified mandate and semiannual reporting of 1977. On the recent presidential challenge against Jerome Powell, he opined that the system is working as designed. The board did its job in resisting pressure, while the Senate and the Supreme Court did their jobs by doing relatively little. Little was enough, because if the Senate and the court do not act, the president cannot exercise control over the Federal Reserve.

David Wilcox (Peterson Institute for International Economics) offered a darker view. The pillars of Fed independence include the staggered terms of governors, the exemption from appropriations, and “for cause” removal protection. A current central vulnerability, he argued, sits in the reappointment of Reserve Bank presidents. Section 11(f) of the Federal Reserve Act lets the Board of Governors remove an officer or director of a Reserve Bank on language weaker than the “for cause” protection that shields governors. Also, a quirk of the system puts all governors up for reappointment in years numbered 1 and 6. A determined two-term president, guaranteed several board appointments, could in principle install governors willing to remove all dissenting Reserve Bank presidents. If a court ruled that Reserve Bank presidents lack effective “for cause” protection, he said, independence could falter by this mechanism.

Fiscal and Monetary Policy Interactions

Oliver Bush of the London School of Economics chaired the second session, on the interactions between fiscal and monetary policy. The three presenters shared a worry: that fiscal pressure is changing the ground on which monetary policy stands.

Michael Bordo (Hoover Institution and Rutgers University) covered two centuries of British fiscal history. He opened with the oldest question in fiscal policy: how should government debt be wisely used? In the UK, the classic “Treasury view” of fiscal discipline held that the government should borrow only in time of dire necessity, such as a war, but not otherwise. The government should then reliably repay, including restoring the currency to gold parity. In part, reliable repayment allows the government to borrow on good terms in the first place. Robert Barro’s tax-smoothing analysis is the basis of modern understanding of this view. The Treasury view dominated before the Great Depression and Second World War. Keynesian demand management displaced it, attaching to fiscal policy objectives that had little to do with wartime necessity or debt sustainability. Intentional deficits should stimulate the economy, with little concern over whether the expenditure was per se worthwhile or eventual repayment. The Treasury view was gradually restored in the 1980s and 1990s. The British record of very high inflation in the 1970s is a natural experiment in what happens when fiscal objectives drift from sustainability and in what it takes to recover the prior norm.

Barry Eichengreen (UC-Berkeley) documented the erosion of the dollar’s dominance as the world’s reserve currency. The US share of allocated foreign exchange reserves fell from 72 percent in 2001 to 56 percent in 2025, and foreign central bank holdings of US Treasury debt from roughly 40 percent to about 14 percent. He tied the risk of fiscal dominance to the trajectory of US debt and to political polarization. He anchored the analysis on the Bohn test, which asks whether the primary surplus responds positively to the debt ratio. Currently, low interest costs seemed to seduce our governments into borrowing, but large debts have not induced restraint.

Hanno Lustig (Stanford Graduate School of Business) argued that the special place of Treasury debt is evaporating. Before 2020, Treasuries provided a large convenience yield or liquidity premium. Investors accepted lower yields and paid higher prices than Treasuries’ fundamentals justify. In Lustig’s analysis, that convenience yield has evaporated, at least on the margin. Investors, in his reading, have moved from treating Treasuries as safe, liquid, money-like debt to pricing them as risky debt. Liquid asset provision can no longer substitute for fiscal discipline.

The session converged on the monetary policy question: how should central bankers proceed in the face of sustained fiscal pressure? There will be fiscal pressure to monetize debt and hold down both short and long-term interest rates, especially in the next crisis.

International Issues

Sebastian Edwards chaired the third session, which weighed the international issues: what the dollar’s reserve-currency status is worth, what the recent tariffs are doing to trade and prices, and what holds dollar dominance in place.

Arvind Krishnamurthy (Stanford Graduate School of Business) walked through a calibrated computation of what the dollar’s reserve-currency status is worth. The United States, he argued, exports safe dollar debt the way Taiwan exports semiconductors, and uses that exported value to buy consumption goods. If world demand for dollar assets disappeared, the dollar would depreciate by around 9 percent, and the natural rate of interest would rise by about a percentage point. The annual seigniorage, or the profit the US government or central bank earns by issuing currency, is around 1 percent of GDP. He said this seigniorage has a present value of roughly $33 trillion, almost a year’s GDP, built into bank capitalization, into housing finance through mortgage rates, and into the implicit tax burden through the value of government debt. It is worth recognizing the size of this asset, he concluded, before choosing to give it away.

Stephen Redding (Stanford University) gave a trade economist’s account of recent trade policy. The average import-weighted US tariff had fallen below 2 percent by the mid-2010s. The tariff waves of 2018 and 2019 and of 2025 and 2026 raised protection toward levels last seen under Smoot-Hawley in the 1930s. He documented a “great reallocation” of US import sourcing, with China’s share down from a 2015 peak above 20 percent to around 11 percent, substituted by Vietnam, Taiwan, and Mexico, though indirect exposure to China remains. The direct price-level effect of the tariffs, he judged, is real but modest, on the order of half to a full percentage point on the consumer price index. It has mostly been absorbed by US consumers, importers, and retailers. He noted a puzzle: tariffs should raise the exchange rate. The difference between savings and investment drives the overall trade balance, so a higher exchange rate leaves the dollar price of imports the same. But the dollar did not appreciate on the day of the largest 2025 tariff announcement. That outcome might be explained by a breakdown of the flight-to-safety pattern Lustig had described. Raising tariffs makes the United States a riskier lender, which lowers the exchange rate.

Kenneth Rogoff (Harvard University) broadened the framework to consider political economy, drawing on his recent book Our Dollar, Your Problem. Macroeconomists neglected political economy, he said. The 2010s consensus that inflation was dead and rates would stay low was a product of that abandonment. Krishnamurthy priced one advantage of dominant-currency status. Rogoff added others. Sanctions are a first one: dollar dominance allows the United States to inflict pain on other countries through sanctions, though overuse induces those countries to construct alternatives. The information that flows from so many transactions touching the dollar is another advantage. Dollar swap lines, in which the United States lends dollars to foreign central banks, are part of the dollar’s anchoring of the global financial system: we are essentially other countries’ lender of last resort. The dollar’s status carries costs too. There is the “exorbitant duty,” by which the dollar appreciates in bad times and the United States suffers losses on its foreign asset holdings, though it benefits from cheaper goods. And there is the requirement of a military, because in his view no country sustains a dominant currency without a dominant military. Rogoff read 2015 as the peak of dollar dominance. He was skeptical that artificial intelligence is disinflationary. The Fed sets inflation over the long run, he said. The real question is what AI does to the real rate of interest. Like most productivity shocks, if AI raises productivity that should push up the real rate, to induce people not to spend now riches that lie ahead, and to save in order to provide the investment funds that AI will need.

Mandate, Tools, and Regulation

Hoover Senior Fellow Valerie Ramey chaired the fourth session, which discussed interactions between the Fed chair and other officials, and focused on the scope of and nature of central bank mandates.

Thomas Drechsel (University of Maryland) discussed his research that uses meeting calendars to track how Fed officials interact with other government officials. Who do Fed chairs actually meet and talk to, and how often? A notable finding: Chair Powell met with members of Congress dramatically more than his two predecessors, most often with the leadership of the Senate Banking Committee or the House Financial Services Committee. Powell, in Drechsel’s reading, proactively built relationships with Congress. Drechsel also used presidential calendars extending back to 1933 to record the frequency of interactions between presidents and Fed chairs. He reported that President Nixon and Arthur Burns met 160 times, while President Clinton met Fed officials only six times. Inflation, however, was much less of an issue in the 1990s. Relevant to Fed independence, he found that more frequent interactions led to higher subsequent inflation even after accounting for current inflation.

Luis Garicano (London School of Economics) used the European Central Bank (ECB) example to argue that a narrow legal mandate is necessary but not sufficient. The ECB has drifted from its narrow price-stability mandate and has vastly expanded the scope of its activities. The ECB uses two open-ended rationalizations: protecting “monetary transmission” through “dysfunctional” or “fragmented” markets and ensuring “financial stability.” Garicano traced three resulting dominances: fiscal dominance through quantitative easing and spread-compression tools, financial dominance through emergency and subsidized lending, and climate dominance through treating climate risk as a price-stability risk. Moral hazard is the result. Europe expects bailouts, so politicians do not clean their fiscal houses. The November 2025 French pension-reform reversal is a clean illustration.

The ECB has greater independence but weak accountability. A central bank needs both. Though the ECB has a narrow-written mandate, the oversight committees of the European Parliament are ineffective to control the ECB’s slow expansion of that mandate to include sovereign bailouts, fiscal transfers, and other interventions.

Carolyn Wilkins (Princeton University) argued that the analytical framework for monetary policy is reasonably mature, while the one for financial stability is not. Monetary policy has a measurable mandate. Financial stability does not. Success is when nothing happens, and the costs are visible while the benefits are only counterfactual. Wilkins also argued that a central bank’s everyday balance-sheet operations should be subject to governance different from the extraordinary balance-sheet tools it deploys in financial stress or when interest rates hit the lower bound. Durable independence, she argued, rests on institutional design, citing the Bank of England’s separation of its prudential-regulation chief from its Monetary Policy Committee, and on independent external evaluation. No student, she observed, should set and grade their own exam.

Risks, Challenges, and Opportunities

Hoover Senior Fellow Ross Levine chaired the fifth session, which ranged from the forces reshaping the macroeconomy to the size of the Fed’s balance sheet to the reorientation of financial stability policy.

Marvin Barth (Thematic Markets) gave a market forecaster’s account of what drives global markets. Four forces, in his telling, are jointly pushing up potential growth, neutral rates, and inflation persistence. The first is localization, where automation makes producing near high-value customers cheaper than a global supply chain. Globalization becomes the first casualty of artificial intelligence. Second, self-fulfilling expectations: flexible average inflation targeting unhinged inflation expectations. Third, global entropy. The West forgot that power comes from the capacity to manufacture. China did not. And finally, the politics of rage, which he argued cannot be educated away. Barth pressed the issue of Fed accountability. Actual growth has outpaced the most optimistic FOMC trend estimates for over a decade, he said, and the Powell Fed has had the lowest rate of dissent since the 1951 Treasury Accord.

Darrell Duffie (Stanford Graduate School of Business and Hoover) explained that reducing the Fed’s balance sheet, now above $6 trillion, is not so easy. The balance sheet is constrained by liabilities more than by assets. Reserve balances, about $2.9 trillion, are the dominant liability. Why does the system need that many reserves when only $10 billion sufficed in 2007? Post-crisis liquidity regulation has sharply increased the minimum necessary reserves. This regulation has effectively told the largest banks not to lean on the Fed for intraday liquidity, so they must always have enough reserves to cover payments. For example, banks cannot rely on borrowing from the Fed or intraday overdrafts to match payments that come even an hour before receipts. Duffie offered four ideas for cutting the demand for reserves, in ascending order of difficulty: temporary open-market operations to smooth daily swings; getting banks to use the Fed’s intraday-liquidity facilities without stigma; building a liquidity-savings mechanism like those of other major central banks; and tiering the interest rate on reserves. In the final of the four measures, banks would earn less than the key overnight lending rate on reserves stored at the central bank, above an agreed-upon amount. Duffie did not opine on whether lowering reserves is desirable; his analysis just concerns how to do it if it is so wishes.

Christina Skinner (US Treasury) described how the Financial Stability Oversight Council has been reoriented under Secretary Scott Bessent. The council was created on the view that systemic risk could be handled by extending bank-like regulation beyond banks. That view, she said, has turned out to be a flop. Over time the council drifted into a ratchet of ever-greater precaution that became self-defeating: a system built to eliminate volatility suppresses the dynamism that makes the system resilient. The reorientation rests on two propositions: First, growth is a foundation of financial stability, not in tension with stability, so regulation cannot be judged only by its effect on measured risk inside the financial sector. Second, financial stability is inseparable from economic security, because the sources of systemic risk increasingly sit where finance and geopolitics meet.

Policy Panel

Hoover Senior Fellow Paola Sapienza chaired the closing policy panel, consisting of four Federal Reserve officials. The panelists, asked to offer big-picture structural thoughts, ranged over bank supervision and private credit, the discipline of forecasting, the rate implications of an AI boom, and the structure of Reserve Bank operations.

Michelle Bowman, vice chair for supervision of the Federal Reserve Board, set out an agenda for helping the regulated banking system to compete with private credit in corporate lending. The bank share of corporate lending has fallen from 48 percent in 2015 to 29 percent in 2025, and private credit is now about $1.4 trillion. In her view, post-2008 capital and liquidity rules went too far in places. Current rules treat bank lending to private credit funds more favorably than lending directly to creditworthy corporations. Her proposed response has three pillars: reduced capital requirements, including a proposed cut in the risk weight on investment-grade corporate lending from 100 percent to 65 percent; a preserved role for private credit; and a new data collection on the largest banks’ lending to non-depository financial institutions. Bowman also gave a candid account of the supervisory failures around the Silicon Valley Bank collapse of 2023. The bank had more than thirty supervisory findings, only a handful about the material risk that brought it down. Even those were not acted on. She reported that the Fed has commissioned an outside review.

Mary Daly, president of the Federal Reserve Bank of San Francisco, described how the San Francisco Fed disciplines its forecasting with structured data. In view of the poor accuracy of past forecasts, especially to spot inflation ahead in 2021, such reflection is welcome. After the global financial crisis, facing natural-rate-of-unemployment estimates as high as 9 percent, the San Francisco Fed built labor-market dashboards that scored each data series against its historical norm in order to see patterns spread across multiple indicators. In time, the conclusion was that the labor market was more flexible than the high estimates assumed, with the natural rate closer to 5.6 percent. After the inflation miss of 2021 and 2022, the San Francisco Fed built an inflation dashboard on the same principle. Applied to the current tariff shock, the dashboard shows little persistence, which gave her confidence that looking through it was reasonable. As of the spring data, she said, the dashboard is starting to show red. She is watching supply-chain indicators, because clogged supply chains take a long time to clear. The Fed, she said, must discipline its models and qualitative assessments with incoming information disciplined by history.

Austan Goolsbee, president of the Federal Reserve Bank of Chicago, addressed a pressing question: how would a productivity boom induced by AI affect interest rates? Goolsbee presented an exercise in a standard new-Keynesian model. One important lesson: an unexpected rise in productivity growth and an expected rise have opposite implications for rates. An unexpected boom raises output above potential, but the disinflationary effect dominates and the policy rule calls for lower rates. That is the mid-1990s case. An expected boom, the case the AI consensus implies, is different. Forward-looking households start to consume immediately, anticipating their great future wealth and incomes, before capacity has expanded. Demand threatens to overheat the economy. The natural (non-inflationary) rate rises. The rule calls for higher rates. In the model analysis, it is important to act quickly, as a central bank that waits for inflation to appear makes the outcome worse. Later, he agreed that uncertainty about the productivity effects of AI might argue instead to wait to see any effects before reacting. Surveys put expected AI-driven productivity gains at roughly a percentage point a year for the next decade, so most of the boom is expected to be still ahead. Productivity growth is a boom for the economy, he said. What it means for interest rates is more subtle, and the bigger the hype, the bigger the concern.

Christopher Waller, governor of the Federal Reserve Board, spoke about the structure of Reserve Bank operations. The Fed’s decentralized regional design reinforces independence by representing a full range of views, and that should be preserved. But back-office functions like IT, human resources, and payments do not depend on geography, and there is no reason in his view to run them in twelve different ways. Waller proposed centralizing and standardizing them, with one Reserve Bank acting as a contractor to the others, the Board overseeing rather than deciding, and the Reserve Banks keeping operational control. The change requires a shift from a “bank first, system second” mindset to a “system first, bank second” one. The Reserve Bank presidents, he said, have already developed a framework along these lines in some areas of their operations such as check clearing.

Dinner Address

Tyler Goodspeed, a former chairman of the Council of Economic Advisers, delivered the dinner address, “Firefighters and Arsonists: Monetary Policy and the History of Recession.” Drawing on his new book that extends US and UK recession chronologies back to 1700—132 recessions in all—he argued that the “boom-bust” view of business cycles fails every test one can put to it. The contours of an expansion carry no information about the recession that follows.

Expansions never die of old age. No leading indicator forecasts recessions reliably over four centuries. And recessions do not cleanse: if anything they discriminate against the young, against dynamic firms, and against research and development. Each recession, in Goodspeed’s telling, is an expansion that failed in its own way.

Naming a recession after some excess in the preceding expansion is pattern-seeking where there is no pattern, and it is not innocuous: it tempts us to sedate healthy expansions in the false belief that doing so prevents recession.

However, how policymakers handle unforecastable recessionary shocks can make matters better or much worse. His illustration was 2008: in his view, the fundamental shock was the energy price surge in early 2008. That surge led to the mortgage problems, as many recessions spill over to real estate. But what could have been a garden-variety postwar energy recession became far worse when British authorities, over a September weekend, abandoned the classic Bagehot playbook. They blocked a stronger bank from acquiring Lehman Brothers. Lehman failed, and then a widespread systemic run developed which even massive bailouts could not stop.

Goodspeed closed the conference on a positive note: expansions are living longer as households, firms, and to some extent governments learn to absorb shocks. He also emphasized that growth during the years of expansion matters far more for eventual prosperity than the painful episodes of temporary contraction.

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The conference:

Independence and Governance

Moderator: John Cochrane, Hoover Institution

Presenters: Edward Nelson, Board of Governors of the Federal Reserve System
(paper)(slides)

Gary Richardson, University of California, Irvine
(slides)

David Wilcox, Peterson Institute for International Economics
(paper)(slides)

Fiscal and Monetary Policy Interactions

Moderator: Oliver Bush, London School of Economics

Presenters: Michael Bordo, Hoover Institution and Rutgers University
(paper 1) (paper 2)(slides)

Barry Eichengreen, University of California, Berkeley

Hanno Lustig, Graduate School of Business, Stanford University
(slides)

Director Remarks

Condoleezza Rice, Director, Hoover Institution

International Issues

Moderator: Sebastian Edwards, University of California, Los Angeles

Presenters: Arvind Krishnamurthy, Graduate School of Business, Stanford University
(paper)(slides)

Stephen Redding, Stanford University
(paper)(slides)

Kenneth Rogoff, Harvard University

Mandate, Tools, and Regulation

Moderator: Andrew Levin, Dartmouth College

Presenters: Thomas Drechsel, University of Maryland
(paper)(slides)

Luis Garicano, London School of Economics
(slides)

Carolyn Wilkins, Princeton University
(slides)

Risks, Challenges, and Opportunities

Moderator: Ross Levine, Hoover Institution

Presenters: Marvin Barth, Thematic Markets
(slides)

Darrell Duffie, Graduate School of Business, Stanford University
(slides)

Christina Skinner, U.S. Department of the Treasury

Policy Panel

Moderator: Paola Sapienza, Hoover Institution

Presenters: Michelle Bowman, Board of Governors of the Federal Reserve System
(speech)

Mary Daly, Federal Reserve Bank of San Francisco
(speech)

Austan Goolsbee, Federal Reserve Bank of Chicago
(speech)(slides)

Christopher Waller, Board of Governors of the Federal Reserve System
(speech)

Dinner Address: ”Firefighters and Arsonists: Monetary Policy and the History of Recession”

Moderator: Michael Bordo, Hoover Institution and Rutgers University

Presenter: Tyler Goodspeed, ExxonMobil Corporation
(slides)

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Even the Clark Center Finance Experts Survey, in which I participate, thought this interesting and plausible enough to ask:

SpaceX IPO
a) The large demand of passive investors for shares in SpaceX in the days after the IPO will cause substantial overvaluation of the stock.

b) Rebalancing of investors' portfolios to make room for SpaceX will cause measurable price pressure on other large growth or technology stocks in the days after the IPO.

Now, you ought to be suspicious. After all, in classic finance theory, every investor holds exactly the market portfolio, just like index funds do. But there is no “overvaluation.” That theory may be incorrect as a description of the real world, but it isn’t logically wrong. “Overvaluation” can’t be automatic. There must be a Modigliani-Miller benchmark in which there is no effect at all, and getting an effect must need some Modigliani-Miller violation. But just where? It wasn’t immediately obvious to me either, so I write this post.

Start with a simple case. SpaceX’s current investors own its stock, worth $2 trillion. The rest of us own $75 trillion of US stocks, or $56 trillion S&P500. The current owners sell, say $1 Trillion of their shares to the rest of us. But where do we get the money? And what do they do with the money? Well, most obviously, we get the money by selling some of our shares of other companies. And they use the money to buy shares of other companies. In the end, after this has all percolated through many trades, they own $1 Trillion of SpaceX and an extra $1 trillion of other stocks; we own $74 trillion of other stocks and $1 trillion of SpaceX. To question b, we “rebalance” towards SpaceX, but they “rebalance” to buy the stocks we sell. The prices might not be exactly the same, as we are all better diversified. But that’s a second-order effect, and not the sort of mechanical effect that was speculated here.

The economic lesson:

• Think equilibrium, watch the money all the way to its final resting place, and remember money is a veil, all that matters is the final allocations.

You might object that SpaceX is not just selling shares so its owners can diversify. SpaceX wants to raise money for new investment, to build more rocket ships. But the same logic goes through. Suppose SpaceX is currently only worth $1 trillion. It wants to sell an extra $1 trillion of shares for a total $2 trillion valuation, and use the funds to invest in more rocket ships. The founders don’t sell any shares at all. SpaceX initially takes in cash in return for shares, and then spends the cash on rocket ships. The rockets are the assets justifying the higher ($2 trillion, not $1 trillion) valuation.

Again, though, there is a natural equilibrium in which other companies invest less. The flow of our savings that was going to finance their investment goes to SpaceX instead. Again, there is no first-order change in valuation. Slightly higher marginal product of capital in SpaceX might raise all expected returns. Alternatively, the new money might come from additional savings, but that would need expected returns on all securities to rise. Both of these effects mean a small decline in prices.

There are second-order effects. But that’s not the sort of flow effect the question has in mind.

One can go on, but I think you see the point.

Now, a contrary story:

Suppose we are all good mean-variance CAPM investors, and we hold the market portfolio. If SpaceX offers 1,000 new shares, isn’t the price indeterminate? If the price is $1 per share, $10 per share, or $100 per share, we each hold that fraction of the new market portfolio. Doesn’t that mean that demand is totally inelastic — we’ll buy 1,000 shares at any price?

In classic theory, we end up holding the market portfolio. But we don’t set out to do that. We each are trying to maximize the mean/variance efficiency of our portfolios. We read those SpaceX revenue forecasts. If the market price is $10 per share (say), we offer to buy far more than the offered shares. If it’s (say) $1,000 per share, we say no thanks. The price settles down at the present value of dividends. Since we have the same information, we all settle on the same portfolio, which is why we all settle on the market portfolio in the end. But our behavior out of that equilibrium is not passive. The demand curve for SpaceX stocks is not vertical.

Here, you see the worry about passive investing. If everybody said “well, I’ll just end up holding the market portfolio, why bother doing any research,” then indeed the demand curve would be vertical and any price clears the market. Index funds are inelastic demanders. The market depends on someone out there doing the research and offering a sloping demand curve.

Is index investing therefore bad? Lots of commenters say so. I’m suspicious. (I am one!) It’s reasonable to think that “fundamental” investors make a bit more money than we do, in return for their services. (This is also the standard theory of finance.) If more of us become passive, the returns to that activity rise. Again, don’t just think partial equilibrium. If you become passive and inelastic, someone else will become active and more elastic. The overall elasticity of demand is not obviously less because people specialize in active or passive modes. That studies of active management find so little profit suggests that fundamental analysts are doing a pretty good job and we don’t miss them.

Stocks are like the wine shop: I go down and buy by a $20 bottle of Cabernet. If I want really good wine I look in the $40 bin. I don’t know anything about vineyards and vintages. But thanks to the efforts of the wine connoisseurs who know what they’re doing and set the sloping demand curve, the more you pay the better wine you get, on average. Thanks.

It’s not obvious that a lot of dumb active money makes the market more efficient. People like me shouldn’t be valuing stocks, or vineyards.

The economic lesson.

• Don’t just think equilibrium, think about the forces supporting the equilibrium

Supply and Demand

It is true that when stocks are added to the S&P500, and index funds buy, their prices go up a bit. AI says the recent estimates are 4 to 5%. That’s a small change in expected return. A 5% price rise is a 5% decline in return, not a 5 percentage point decline in return. So if the average return was 6%, it is instead 5.7%. That’s not nothing, but it isn’t enough to set up a permanent short position. It’s in the range of the value of liquidity seen in other markets.

But that is a MM violation, needing some friction. A lot of finance now thinks a lot in terms of such static demand (or supply?) curves. You may have been tempted to start thinking “what is the latest estimate of the S&P inclusion effect?” And then contrast it with the opposite, “what is the latest estimate of the elasticity of demand for large tech stocks?” (The usual story is, after all, that selling a lot of stock all at once pushes prices down, not up.)

But demand curves live on top of basic budget constraints, MM theorems, and efficient markets. The practitioners of supply and demand finance do not think in such simple terms, with money piling up here and there not finding its eventual home, and budget constraints and equilibrium conditions forgotten. They understand “demand systems” live on top of these fundamental effects. But some readers may think all you need is a “demand curve” for SpaceX stock, untethered from substitutes and incomes, and an “inclusion effect.”

Corporate finance long hewed to a good methodology: State the MM violation. Sure, the world does not obey MM, but first understand the usually counterintuitive MM theorem (for example, firm value is the same whether the firm issues debt or equity), then understand why it might be false, and interpret facts with that eye. Often the MM theorem works better than practitioners thought. It’s a good discipline.

In any case, I bet on a price less than infinity.

Updates:

Thanks to many correspondents.

One points out that even the S&P500 inclusion effect is not uncontroversial. Inclusion is not automatic, and the humans in charge want companies that will stay in the index for a while rather than cross in and out for a while. Thus inclusion may reveal some information of their analysis.

Another wise correspondent writes (slightly edited)

Logically impeccable. A tad blithe about real world complexities. The melt up worriers imagine

A) many holders being locked up and unable to diversify so market cap and float diverge a lot.

B) various institutional and risk aversion constraints on shorting.

C) there being influxes of dumb and momentum money.

D) indices for agency problem reasons eg nasdaq wants the listing are violating their usual policies.

I think that when people close to a thing have a strong concern there are two approaches

A) Explain how if you understand the model they are confused.

B) Figure out why they might be right even if simplest model suggests otherwise.

The better Chicago tradition is the latter.

Put differently. Squeezes happen. People with experience think we might be setting up for one. They might be right or wrong but Modigliani Miller lectures are beside the point.

Point taken, and an invitation to humility is always welcome. As I hinted, I do think we start from MM and then think about frictions. And markets do a lot of crazy things on occasion. However, when I hear talk that ignores the MM basic logic I worry as well. It was widely believed by “people close to a thing” that actively managed money could outperform indexing. Experts outperform darts everywhere else. But it turned out not to be true. Reality is surely in between. Anyway, we shall see if the frictions or the MM wins here.

A final correspondent writes

All true, but I suspect the basic empirical point matters more: SpaceX will have a very low free float. The main indexes will weight it by free float. Even the Nasdaq index will weight it far below market cap. So in fact there won’t need to be very much selling/buying to rebalance the indexes.

To clarify: You can have the equivalent of a short squeeze if the index was proportional to total market capitalization, but many shares were unavailable to trade. (Insiders’ shares are locked up for a while after IPO.) But most indices only require a tracking fund to buy an even fraction of available shares, not those locked up in various places. Nasdaq has a bit heavier weight, but not the full and unavailable market capitalization.

Final point. Why are we bending the rules? Not because index funds are screaming “you will force us to buy this stuff at too high prices.” Because index funds want in too!

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****

When Kevin Warsh was nominated in January to be Federal Reserve chair, the monetary policy debate was over how quickly to lower interest rates. The Fed forecast that inflation would return to the central bank’s 2 percent target, already suggesting that interest rates should ease. The debate was over faster cuts. Artificial intelligence, the story goes, will swiftly raise productivity, making everything cheaper. Therefore, the Fed should quickly lower interest rates to steady prices and let wages rise.

Now, one could debate how soon and how reliably AI will create such bounty. One could also debate whether deflation (falling prices) with steady wages induced by AI-led productivity is a problem at all.Everything would become a lot more “affordable,” of course. There’s also an argument that higher real (after adjusting for inflation) interest rates are needed to induce savings and investment to build AI. Whether the Fed should act in anticipation of a productivity bonanza is another question.

But today the Fed faces essentially the opposite problem, a stagflationary shock that looks eerily like 1979. Inflation never really went away. It is now surging, thanks to tariffs and energy costs via a conflict with Iran. Should the central bank fight that inflation by raising rates, swiftly incurring President Donald Trump’s wrath and risking a weaker economy? Or should the Fed once again look through a price-level rise, hoping that the economy will stabilize at higher prices, and swiftly incurring the wrath of regular people already unhappy about today’s high prices?

…

(Read the rest at Washington Post, this link should take you past the paywall. Full version here in a month.)

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The Celebration Honoring John Taylor collects essays resulting from a one-day conference we had last fall. You can read the chapters for free at the link too, or order the hard copy. (Stanford and Hoover colleagues, I have a lot of free copies in my office if you want one.)

My contributions include the overview, “John Taylor’s Contributions to Economics and Monetary Policy” with Michael Bordo and Jon Hartley, and “The Taylor Rule in Macroeconomic Theory.” The rule went a lot further than Taylor envisioned, giving stability in old Keynesian models, local determinacy in new-Keynesian models, and buffering shocks in fiscal theory models. “The Taylor rule is always the answer, though the questions keep changing” is praise in this context. Taylor often made that point: The rule is not exactly optimal in specific models but it is pretty darn good in lots of models. The Taylor rule also recommends acting in response to actual inflation and output rather than forecasts. Given how many mistakes the Fed has made lately in reacting to false forecasts, that might be pretty good advice.

I don’t mean to slight the many other great contributions. You will learn a lot about macro and monetary economics from this lovely book.

Finishing the Inflation Job and New Challenges for Monetary Policy is the conference volume resulting from the 2025 Hoover Monetary Policy Conference with that title. The conference website has videos. Again, you can find the chapters for free at the link, and Stanford colleagues are welcome to stop by and clean out the box in my office.

The first chapter contains particularly thoughtful comments from Chris Waller on central bank independence, from Loretta Mester on the policy process, a lovely essay from Charlie Plosser, who sadly passed away just after this conference, and a thoughtful statement from Kevin Warsh that Fed-watchers will want to read. Digital assets, private credit, geoeconomic risks, fiscal pressures on monetary policy, the ever-revealing policy panel, and a lovely dinner talk on history all are relevant today. I guess monetary policy doesn’t move much faster than book publishing! My contribution, “Fiscal Constraints on Monetary Policy” packages thoughts on a substantial and unrecognized challenge ahead. It’s 1951, not 1972.

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Update: Here is an excellent summary by Marcos Falcone on the Cato substack.

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From Jesper Rangvid Disclaimer, this is thought provoking fun, not serious analysis.

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Are we headed for stagflation and recession? The parallels with the 1970s are ominous: Inflation surges and then retreats but gets stuck a bit too high. Trouble brews in Iran, and oil prices spike. In 1979 inflation surged, followed by a severe recession. Most postwar recessions were preceded by oil price spikes.

In fact, energy prices turn into recessions only if bad policies compound their effects. Price controls, credit controls, windfall profits taxes, export controls, the 55-mph speed limit, corn ethanol, cardigan sweaters, malaise, and a slow-to-react Federal Reserve all fed the misery of the 1970s. They need not do so again.

The fundamentals are also better. The U.S. imported a lot of oil in the 1970s. Now, on net, we export, thanks to fracking and the reversal of many energy restrictions. Gasoline is more expensive, but the country earns money that can be spent on other goods. The U.S. uses a lot less oil to generate each dollar of income. We are more of a service economy and less an energy-dependent manufacturing economy. There are many more suppliers to the international market than in the 1970s. While they can’t ramp up production instantly, at persistently higher prices a lot more oil can come out of the ground.

An oil price rise is like a tariff. As we have seen, tariffs, while damaging to overall growth, need not cause a recession.

The most important questions are when the Strait of Hormuz opens and how the war ends. It is hard to believe that after their lopsided military victory, the U.S. and Israel will leave Iran with a veto over oil. The end depends only on whether we have the will to accomplish what is surely in our means. But defeat has been clutched from the jaws of victory before.

Oil futures markets offer a glimpse of where things might be headed. West Texas intermediate futures are trading at $97 a barrel for late May but decline to $80 by late October and $74 next April. Futures markets expect a costly summer and resolution by fall.

Governments will be tempted by ham-handed policy responses. The European Union is already considering subsidies, price caps, oil profits taxes, and other controls. Ah, Europe—tax energy, send carbon-emitting industry off to China, ban domestic drilling and fracking, destroy nuclear, all in the name of climate. When prices rise, add subsidies and controls. Fortunately, many Europeans now understand how costly their energy policies have been.

With “affordability” and gasoline prices in the news, the U.S. will feel similar temptations. The administration already ramped up corn ethanol, that great counterexample of our country’s ability to run sane energy or industrial policy. China has enacted an export ban, which the U.S. tried in the 1970s. It did great damage.

Higher gasoline prices need not mean inflation. But governments will produce inflation if they hand out money so people can pay higher prices. Price controls mean gas lines, which increase economic damage. The most productive users who can’t substitute away then can’t get the energy they need, and suppliers see no incentive to help. Windfall profits taxes in bad times dampen the incentive to invest in spare capacity in good times. The first principle of economics is: Don’t transfer income by distorting prices. The first principle of politics is the opposite.

High energy prices do slow the economy. But a slowdown turns into a recession only when something financial goes wrong. The aftermath of an energy price spike depends a lot on how central banks respond. If the Fed reacts slowly, along with harmful economic policies, stagflation could again break out quickly, and then recession could follow when the Fed reacts to inflation.

The central bank will be tempted to react to supply-induced softening with demand stimulus. It will be tempted to “look through,” i.e., ignore, the transitory inflation of an oil-price shock as it looked through Covid-era inflation, until inflation reached 8%. Fed officials planned to look through tariffs as well.

But, as in 1979, people who saw substantial inflation may be quick to expect more inflation, and then the Fed will have to react strongly, as it did in 1980. I also fear that the Fed may be paralyzed during its change of leadership or may try to avoid moving interest rates by relying on quantitative tightening or credit restrictions. All that will cause needless financial turmoil.

What should government do about rising energy prices? Nothing. Or, more concretely, get out of the way, ease restrictions, and let the market work its magic of sending energy to the most economically important uses while encouraging others to save, substitute or provide new energy. Keep inflation under control, and don’t induce financial problems.

Mr. Cochrane is a senior fellow at the Hoover Institution and an adjunct scholar at the Cato Institute.

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A video and podcast interview with Darrell Duffie, based on his excellent recent article. Click here to watch/listen via Hoover’s Freedom Frequency series.

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From Sam Goldfarb at the Wall Street Journal:

What’s going on? Broadly, there are three messages bonds might be sending.

1) Directly, people might be expecting more inflation. More expected future inflation leads to higher bond yields, as people demand a greater return when they expect bonds to be paid back in devalued money.

2) People might be expecting higher short-term interest rates in the future. When one way of getting money from now to 10 years from now, rolling over short-term bonds, looks better, the other way of doing so, buying a long term bond, should get better too.

3) The end is nigh. People might be losing faith in our governments’ abilities to borrow and repay debt, and want to get out now ahead of the catastrophe.

These are all related. If people expect more inflation, then they might expect central banks to raise short-term interest rates in response to that inflation. People might expect central banks to keep interest rates low, but then to have to raise them more later on to fight larger inflation. People might see fiscal profligacy as a threat to inflation.

Which is going on now?

The FT opines:

traders rushed to bet on the European Central Bank raising its benchmark interest rate three times this year to contain an expected burst of inflation.

“Investors are starting to realise that we are moving into a mix of lower growth and higher inflation, combined with more fiscal stimulus and higher government spending,” said Tomasz Wieladek, chief European macro strategist at T Rowe Price.

Investors are betting that public finances across the Eurozone “are going to deteriorate”, said Jean-François Robin, global head of research at Natixis CIB, as countries spend “a lot of public money” to absorb the shock.

Following the start of the previous energy crisis in September 2021, €651bn was allocated and earmarked across European countries, including the UK and Norway, to shield consumers from rising energy costs, according to the Bruegel think-tank.

An oil price shock does not necessarily mean inflation. It takes government policies to turn a relative price shock into inflation. See “how to turn a price shock into inflation.” So, the bet is that euro area governments will respond to the price shock by sending people money to pay for higher oil and gas bills, and that fiscal largesse will cause inflation. I am glad to see fiscal theory being taken up :) Europe is also taking about price controls and other ham-handed interventions.

They are also betting that the ECB will react promptly to any inflation, which accords with what I have heard. The ECB took a full year to react to the last inflation, and the ECB understands that people are more attuned to inflation, and their faith that the ECB will aggressively fight inflation is weaker.

The US is a bit behind Europe on ham-handed policy, but the temptation to make things “affordable” to individuals (not to the country) will be strong. The Trump administration just announced as 60% rise in corn ethanol mandates. When someone advocates “industrial policy,” answer “corn ethanol.” It doesn’t save CO2, it doesn’t save much oil (it takes a lot of petroleum to make corn), and it uses land and drives up food prices.

The Fed will be interesting. It’s hard to see the Fed doing anything decisive in its fraught interregnum. It’s hard. Central banks are used to meeting output and employment declines with lower rates. They see lack of “demand” as the source of the problem and provide it. But sometimes, as with an oil shock, the problem is lack of “supply.” The economy can’t produce as much. Adding stimulus in the face of an inflationary supply shock gives a lot more inflation and only a little bit less bad output, at least in the conventional understanding of such things. Politically, restrictive monetary policy while governments are trying to “stimulate” is tough. I fear the Fed will try to square the circle with a big “quantitative tightening” rather than raise rates. The 1979 credit controls were a similar ill-fated effort. Darrell Duffie explains why balance-sheet reduction is hard and can cause financial damage. Much more coverage later.

To investigate a bit what’s going on, I plotted here the path of 10 year Treasurys along with 10 year indexed Treasurys. The lower line is shifted up by 2% so they fit on the graph together. This graph suggests that we are not seeing a direct inflation premium. Higher expected inflation would directly raise the Treasury yield leaving the inflation-protected yield alone. So the lower line is forecasting higher real interest rates. It may be forecasting that the Fed will raise interest rates, and prices being sticky that won’t have an effect on inflation. If it’s the end of the world, (I don’t think so) that would be an end with explicit write-down, and we are seeing a default premium, not a premium for default via inflation.

These graphs are also not suggesting a forecast recession, the point I’ve been debating with Niall Ferguson on Goodfellows lately. That would be revealed by lower real and nominal interest rates.

But first let’s get a grip. When I first made the interest rate graph, it popped up with a greater horizontal axis

What happened to the recent “spike?” It’s there, just put in perspective about just how bit it is compared to the usual ups and downs. So, hold on, maybe it’s not time to grab those gold bars and shut the bunker door quite yet. Moral: Always read the axes.

Sam Goldfarb, who wrote the Wall Street Journal graph on Saturday, added “Some fear the selling has taken on a momentum of its own, with the war-fueled market swings forcing hedge funds to shed bonds to cover bets made with borrowed money and other investors hesitant to step in while the threat of further losses linger.”

As I was looking up the reference Goldfarb posted

Yes,

Look at the axis again: another decimal point on the left, and the last day worth of data on the right.

Moral: The life of a markets reporter is not easy! Neither is the life of a bond trader. The life of a grumpy substacker is much easier : )

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Greece may benefit from a range of European Commission emergency measures aimed at tackling rising energy costs, EU Energy Commissioner Dan Jorgensen indicated ....

… Jorgensen signaled that Athens can make immediate use of a European Commission “toolbox” that includes state subsidies, tax reductions and flexible support schemes for households and businesses.

The proposed tools – including price caps on gas, expanded long-term energy contracts and relaxed state aid rules – could help shield vulnerable households and stabilize electricity costs. Jorgensen also pointed to the need to ease the link between gas and retail power prices.

Well, I’m glad that the EC has a pre-prepared “toolbox” of terrible ideas so that Member States don’t have to come up with terrible ideas all on their own.

How does a relative price shock — energy costs more than other goods—turn in to overall inflation? Largely by policy responses to the energy shock. Europe invented a doozy in the last price rise and looks set to do it all over again.

People are using 10 gallons of gas a week, at $5 per gallon (sorry, US units and California prices). Available gas goes down to 9 gallons a week. The price starts to rise to $6 per gallon. Left alone, people find ways to use less gas, with the price as an incentive.

The worst combination of these “tools” would be if the government says “we will pay for the extra cost.” So, you still pay $5 per gallon, and the government chips in the extra $1. Sounds good. Can you spot the problem?

Yes, with no incentive, people still use 10 gallons a week. There are still only 9 gallons around. Where does the price settle? Infinity.

Now, the “tools” are not quite that idiotic, though close. Suppose the government says “we’ll pay your extra expenses.” You still have to pay $6 at the pump, but the government gives you a check for $10 to cover the extra cost. People feel the marginal price, so do cut down on gas. But they use some of the extra $10 to buy other goods. That’s how a gas price rise turns in to general inflation. This is exactly how Europe responded the last energy price shock. And got general inflation.

“Price caps.” The government says, gas stations have to sell at $5. Welcome back to the 1970s. Long hair, silly clothes, and gas lines around the block.

“Ease the link between gas and retail power prices.” What do you think that means? Obviously, another witch hunt on “price gougers,” price controls and “windfall profits” taxes by another name. The emperor Diocletian tried that. It didn’t work then either.

The commissioner stressed the crisis is driven by high prices rather than supply shortages, noting Europe has significantly reduced reliance on Russian energy imports.

And dear commissioner, where did the high prices come from? Is there nothing going on in the Persian Gulf of note?

This is a media report. I sincerely hope the commissioner is misquoted. The point of my post is simply to remark on the fallacy of the ideas, which are pretty common.

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Last week was the 250th anniversary of the Wealth of Nations. For the Hoover “weekly rants” I looked up what must be the top two Smith quotes:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.

Looking at it again, I particularly like the second sentence. That proves the point, we all understand what motivates butchers, bakers, and brewers.

Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. …By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”

(my emphasis). Though intending only private gain, the butcher, baker, and brewer (and even the banker) promotes the interest of society, and does so far more effectively than with philanthropy and other intentional measures.

Adam Smith Allegory. © Sally Fama Cochrane

The painting is a gift from my daughter Sally when she was in high school. (She has gone on to become a supremely accomplished artist IMHO.) Find the allusion to the butcher, baker, brewer, invisible hand, pin factory, and a subtle foreshadowing of trouble in the arrangement of the tools.

The Smith quotes attract my attention for their moral vision as well.

To this day, the ethics of the Bay Area hold that making money is a grubby business. Billionaires can only earn some forgiveness for their evil wealth accumulation by their philanthropy. After you’ve made your grubby money, do something good for society by giving it away. Mackenzie Scott is the saint, Jeff Bezos the sinner. Even the Stanford Business School is apologetic about making money.

Those ethics are still rooted in the view that one person can only get wealthy by taking things from another. For thousands of years, that was not a bad approximation. Roman emperors did not gain half the income of the empire by inventing iPhones.

But Smith points out that this is exactly backward. The billionaire who invents a personal computer, an iPhone, or Walmart and then Amazon’s logistics, creates hundreds of billions of value for the rest of us. He or she keeps a tiny fraction. And that fraction is usually left reinvested in the company, churning out more products and employment. Here is where he or she contributes to society, far more than in billionaires’ usually ham-handed efforts at Philanthropy. (They should buy more art, and less political doo-goodism.)

We celebrate Smith for his foundation of economics as a cause-and-effect discipline. Want greater national prosperity? Here’s what works: Economic freedom, under the rule of property rights and law, and disciplined by the competition that freedom engenders.

And wow did it work. Note the log scale. Average income is up a factor of 20 from Smith’s time. And GDP is a vast understatement of the benefits (consumer surplus) of growth. Lifespan and child mortality alone make the point. From thousands of years of misery, just a little economic freedom has brought us wonders. Even Smith’s Britain was full of restrictions on who could be in what business, what price they could charge, and so on. And the imperfect freedom we have now gives one hope that even more freedom can provoke additional wonders.

I generally stick to the practical case, not the moral case. We do not have to argue freedom vs. prosperity. We are lucky that the cause and effect is devastatingly true. But the moral case for freedom adds to its practical case. And underlies it as well. Societies that genuinely believe all wealthy people are evil, and the act of running a profitable company reprehensible, that instead prize redistribution especially of other people’s money, will not long allow economic freedom to prosper.

Freedom is also the only “ism”, the only vision for the economic organization of society, that is not in the end predicated on violently taking from A and giving it to B.

This year is also the 250th anniversary of Declaration of Independence. Our country’s founders shared a similar vision: rather than build a country around the hope that people and especially politicians would act benevolently, in a way they have not done for the last hundred thousand years or so, instead design a political system that channels self-interest to decent public outcome, as Smith points out that a free economic system does. That worked out pretty well too.

If we can keep it.

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For fun, here is as of Friday the history of oil prices (West Texas Intermediate Crude) stapled to oil futures prices. The red line is the price that you can pay today to lock in future oil, and it represents a market expectation of what will happen.

The runup has been sharp. But it is still less than the runup following the Russian invasion of Ukraine. The futures market sees a relatively swift return to about $65.

Expectation means average, and it will surely be wrong. Things will be worse or better, with about half a chance of each. Markets are presumably betting that the US, Israel, Saudi Arabia, Gulf States, and everyone who buys oil and LNG from the gulf will not let the straits stay closed for long, nor effectively decide to lose the war by handing Iran this perpetual trump card. But we have cut and run many times before.

Still, doom and gloom is not forecast by traders, so it represents a bet that things will be much worse than they foresee, for either political or economic reasons. Markets often are wrong and do not see major crises until they come. Still, it is a contrarian view.

To give a longer history, here is the real oil price (I deflated with the CPI) over a longer history. The current runup is not yet the size of the 1970s oil shocks, The big rise in 2008 is generally credited to “demand” not “supply,” but preceded a recession just as in 1973 and 1979. (See Jim Hamilton here.) Still, the current rise is in the same ballpark, just playing in the minor leagues so far.

Economists like me are usually quicker to look to substitution in demand and elasticity of supply than most people looking at such things. There is a lot one can do to use less oil when the price rises. And there is a lot of production capacity that is not worth tapping at $65 but very worth turning on at $100. I don’t know enough about oil to know how long it takes to turn on that supply. Paradoxically, the swift decline of futures prices reduces the incentive to turn on the taps. If futures prices were above $100 for years, people with marginal wells could turn them on and sell the expensive oil forward, risk free. I gather the strategic reserve is buying a lot of oil on futures markets, which is smart both financially and from a public policy perspective.

Over a long enough horizon of a few years, I presume that the “supply chain fragility” types will notice that running 20% of the world’s supply through an unstable choke point is not a great idea. More pipelines across Saudi Arabia, bringing Venezuela back on line, allowing fracking in Europe (sorry to harp on that) plus other energy sources, could basically make the straits irrelevant if they are not secured.

Recession? The US is much less dependent on both oil and imported oil and gas, thanks to fracking. (And over the loud objections of our energy policy establishment. What a good thing they didn’t have the power to ban fracking, as Europe chose to do, and the ban on LNG export terminals was overturned.) Prices still affect us, but we gain income. It is a much worse problem for importing countries. I still rate the economic effects as “headwind” not “recession” without some follow-on: an induced financial problem, or a ham-handed policy response. Ham-handed policy response is likely! Remember the 1970s for that, please. Subsidies so people can pay higher energy prices, as Europe did in 2022 turn oil prices into general inflation quickly. Price caps lead to gas lines. Rationing is worse than high prices. Price caps with government chipping in the difference leads to demand permanently above supply. Prices are a signal wrapped in an incentive, and with oil you want the signal screaming loudly to use less and produce more.

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Disclaimer: My comments are thus those of an “outsider” to the little sub-literatures, and I surely get some things wrong.

I’ll only make some points here of interest to general readers. The other papers were great, but their points are more technical, at least for my translating abilities.

Complete Pass-Through in Levels by Kunal Sangani Northwestern makes a dramatic empirical point: Companies pass along the dollar cost of their inputs, not the percentage cost.

Suppose a company sells widgets for $100 each, and the cost of materials is $50 per widget. Suppose cost of materials goes up $10. How much does the company raise its price? The empirical work came from commodity prices, but you can see the great relevance to tariffs.

Some say 0. The company absorbs the costs from lower profits, a lower markup of price over cost. (In my example, the markup is 2, price is twice marginal cost.) Much current economics says the company raises its price to $120, keeping its price a constant percentage markup over marginal costs (double here). The fact is $10. Within a few months, companies fully pass on the cost, but dollar for dollar not in percentage terms. The paper is, to me, utterly convincing on this fact.

Point: Retail coffee prices move dollar for dollar, not percent of, coffee bean prices.

Point: When rice prices went up, fancy rice and generic rise went up by the same dollar amount (lower graph). They did not go up the same percent, so rice inflation (measured as a percent) is lower for fancy rice. This is “cheapflation,” the tendency of lower priced goods to see more good-specific inflation rates in response to cost shocks.

Of course, you might say, if costs go up a dollar, companies charge a dollar more, not the log of a dollar more. How could you ever have thought otherwise?

Indeed, suppose raw coffee beans are only 1% of the cost of your double mocha Frappuccino. If the beans go up from 10 cents to 20 cents, it would be insane to think the cost of the Frappuccino should double from $8 to $16. And economists aren’t that dumb. The proposition is that firms charge a constant proportional markup over the sum of all their marginal costs. The graphs are actually, misleading as they show the response to a particular cost, not all marginal costs.

The proposition of proportional markup rather than dollar for dollar markup looks just like a classic mistake in units. Of course firms pass on dollar costs not proportional costs. But in fact proportional markups are pretty much the standard baseline adopted by people who look at this sort of thing.

We had a fun discussion. Proportional markups come from the convenient constant elasticity of substitution demand. So, more complex “demand systems” came up, and many comments about behavioral pricing behavior.

I find it hard to believe that something so simple needs more complexity. It looks to me like a much simpler explanation holds: to first order, perfect competition. The goods at the point that makes pricing decisions — the individual coffee shop or gas station — are pretty good substitutes. Intense competition drives prices down to costs quickly. Firms raise prices by the minimum they need to in order to stay in business.

Yes, was the answer, but that doesn’t explain the markups we observe. Really, say I? Markup is price in excess of marginal costs. How did you measure marginal costs? The markup literature thinks these markups are big, but profits are not huge because someone has to pay fixed costs. What’s really a fixed cost? In the end, to serve another Frappucino you need more baristas, more or bigger stores, as well as more cups, sugar, milk and so on.

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Monopsony, Markdowns, and Minimum Wages by Ester Faia, Benjamin Lochner, and Benjamin Schoefer comes next in my review. Now we’re looking at “markdowns,” not “markups.” This is the alleged ability of the same Starbucks to pay wages substantially below the marginal product of baristas. Adding another Barista might make $25 an hour additional profit for the company, the story goes, but the local Starbucks can exploit workers by paying $10. Lack of competition among coffee shops stops another shop from opening up next door, paying $12, or charging less (see markup above). So, the story goes, minimum wages force companies to pay something more to employees out of that same “markup.” Again, I’m not sure how that adds up, as there is no pool of “profit” and Starbucks has to pay a competitive return to capital too.

Not so fast, says the paper. Imposing a minimum wage did nothing to change the “markdown.” Maybe there wasn’t much of one to start with (the latter is my conclusion).

This is a great paper in part because it offers a negative result.Journals usually only publish positive results, papers that find an effect consistent with a model. Journals are typically also disposed to results that support the minimum wage narrative.

Germany, surprisingly enough, did not have a minimum wage. Then in 2015, they imposed one.

What you happens to the distribution of wages when you raise the minimum wage?

Clearly, firms stop paying less than minimum wage. And we see a sharp hump right at and just above the minimum wage.

Here is my favorite graph of what happens to the measured “markdown.” The paper scales the result by what should happen according to the monopoly model, which is that the markdown rises from 0 to 1. Instead, the markdown goes nowhere after the minimum wage is imposed.

A null result! Like other negative result papers, they jump through hoop after hoop to show it’s robust.

Pandemonium erupted. Well, not pandemonium but an apparently devastating critique by Simon Mongey.

You can see the first issue in the above graphs. The wage distribution graph seems to answer the question right there: Look at all those people who used to be paid minimum wage, and now are being paid more. How could the estimate have missed that? The authors have a good reply: Don’t assume that the workers now being paid more than minimum wage have the same marginal products as the workers that used to be paid less than minimum wage. Even when they are the same people at the same firm, employers make people work harder, make schedules less flexible, hire different workers, invest in more equipment, and in other ways make marginal products rise to match wages. Mechanically, that’s how the estimates work: They estimate that the marginal products rose with the wages, so the markdown, if there was one, remains the same.

The second issue is that the authors assumed that employees who benefited from the minimum wage are then paid their marginal products, with no markdown at all. But minimum wage may not have fully raised their wage to the marginal product. If their marginal product was $12 per hour, they were paid $8, and the minimum wage is $9, they are still being “underpaid.” On the other hand, the minimum wage may have raised others’ wages to above their marginal product. A long discussion whether it matters followed.

So what does it mean? One answer is that markdowns are just badly measured. And they are. A business hires a young person to sweep up and see if he works out. How do you measure how much extra the firm makes per hour from this employee? The authors, like everyone else in this business, does it with heroic assumptions. They write a production function at the firm level, and then estimate the marginal product of all workers.

But if markdowns are badly measured, how do we know the supposed stylized fact that started this all, the notion that employees are systematically paid a lot less (60 - 80%) of their actual marginal products? That’s the message I take.

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A lot of macroeconomics now is concerned with these markups and markdowns. It is said that companies, even small stores, routinely charge prices as much as 50% above their marginal costs. They are able to do this because each store’s product is special. Where are all the profits from such high prices? They get dissipated in fixed costs, and the owners only get the competitive return to capital (which we measure). But clearly, distinguishing fixed from marginal costs is hard. It is said that companies, even small stores, pay employees a lot less than their marginal products, again because competition between stores is weak. Where are all the profits from the yawning gap between marginal product and wage? They get dissipated too though I’m not sure where. But clearly, measuring marginal product of an employee is hard.

You can see the general pattern. We write economic models to try to decide what prices should be. Prices are something else. We declare a puzzle that markets are not functioning. But Hayek taught us long ago that it’s nearly impossible to determine what a price should be. Finance incorporated this fact long ago, recognizing that investors have more information than we do. So modeling what stock prices “should be” and then declaring a puzzle is a fraught business, and usually labeled fallacy.In microeconomics we call it “unobserved individual heterogeneity.” We can’t model all the ways in which one person is different than another, or one price is different from another. It is still interesting to try to measure what a price should be, and to be periodically reminded how hard that is. But I’m slower to think when it fails that something is wrong with the world.

The view that even coffee shops are routinely described as having a lot of pricing power—the ability to charge twice the price that would hold with perfect competition—and wage-paying power—the ability to pay people only a bit more than half what a fully competitive market would pay—pervades today’s macroeonomics. It entered as a convenience. In the real business cycle era, macro models wrote perfect competion, in large part because that was easier. The new-Keynesian economists introduced imperfect competition at the firm level, but a lot of that was for convenience. It let them write down models in which firms could set prices in a “sticky” manner, but still let markets clear rather than deal with who is rationed as in the much harder earlier Keynesian literature (Barro and Grossman). Then micro-macro economists go out and try to measure markups, and came back with surprisingly high markups.

I grant that I go to a conference precisely to catch up. Maybe there is a web of convincing evidence about markups, and against the perfect competition view, that I have not considered. That was the sense of what people said to these comments at the conference, and conferences tend not to synthesize work for outsiders.

I was interested to note that an “Economic Fluctuations and Growth” conference had zero papers on fluctuations and only one tangentially related to growth. No recessions, no inflation, no central banks. It looks like what macroeconomists do these days is more “economy level industrial organization.” A colleague pointed out the need for the adjective: in his view real IO looks at each market in isolation and thinks of then as all different. That’s not good or bad, it’s just an observation on what people seem to do. In principle, estimating markups, markdowns, and so forth are ingredients to a larger macroeconomic view and inform macroeconomic policy, but nobody is making those connections. It seems to mostly inform microeconomics policies, such as competition and minimum wages.

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A minor point has been irritating me lately, and I’ll illustrate by picking on Aggregate Productivity with Heterogeneous Agents by David Baqaee and Ariel Burstein. This is a sophisticated paper on how to measure welfare effects of policy and other changes with and without transfers, by measuring an equivalent change in aggregate productivity. Its major contribution is to theory.

The authors include the following table evaluating the effect of the China shock on the US, modeled here as an increase in China’s productivity. More A is better. The calculation uses a detailed model including “9 regions (Canada, China, France, Germany, Great Britain, Japan, Mexico, U.S., and the rest of the world) and 30 industries in each country.” The model considers the question whether people who work in losing industries get compensated or not. With “tariffs and lump-sum transfers”, China becoming more productive is a benefit to the US (0.008). With “Laissez-faire,” no transfers and tariffs, it is bad for the US (-0.235)

This calculation echoes much of the common discussion of China shocks, trade shocks, and so on. Unless the federal government protects categories of newly unproductive industries with tariffs, or transfers money to people who were hit by the China shock, we can’t say that something obviously good for the economy as a whole is a good thing to do.

At this point in the usual conversation, I object. The China shock is a tiny fraction of the turbulence in our market economy. Must we give protection and cash payments to rustbelt industry workers when the south became more productive? Must we protect taxis and pay them subsidies when Uber comes in? Must the employees of Yahoo be compensated, and tariffs imposed, when Google comes along with a better product? How does the government know who is hurt by what shock anyway? Some individuals suffer more, others not at all or even end up better off with new jobs. How long must tariff protection for outmoded industries go on? Should we have imposed tariffs against Guternberg’s darn moveable-type printing press that threatened all the monk’s jobs of copying manuscripts, and should they still be in place now their great great great great grandchildren inherited the jobs because we protected the industry? More seriously, should we have kept Volksvwagen and Toyota out of the US because there aren’t even more subsidies to union auto workers?

Most of all, we have a social safety net. Is not the answer to provide a social safety net, that calibrates incentives vs. job risk insurance, for people hit by all sorts of shocks and not just China, rather than try to identify who got hit by what shock? Why should an ex steel worker who used to be paid $80,000 get more than an ex warehouse worker who never earned ore than $40,000 anyway?

With these thoughts in mind, I notice that the model in the above table does not include a safety net in its “laissez faire’’ calculations. But we do have a safety net. The all-in marginal tax rate implicit in our social programs is between 50% and 100% from $0 to about $60,000, and then continues through regular taxes and phase outs as income increases. Equivalently, the US provides about 50 cents to a dollar extra income per dollar of lost market income. Computing costs of policies, based on the harm to the losers, while completely ignoring the tax and transfer system we already have in place to buffer losers seems profoundly misleading.

So my larger complaint, which has shown up in half of the workshops I’ve attended lately, is that authors compute “policy simulations” that they don't take seriously. On the basis of Table 1, I’m sure the authors would not in public say this is how bad the China shock was, given that we did not have tariffs or payoffs. So why make such computations? We should take economics more seriously.

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Update on a graph I’ve been following for a few years, most recently last year, this one courtesy of Niall Ferguson.

Of course, this is just for fun. It’s easy to find spurious patterns like this in all sorts of data. And everything is calm in Iran today, unlike the Feb 1979 revolution and consequent oil price spike.

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