How Should the Fed Respond to Supply Shocks? | Steven J. Davis, Austan Goolsbee | Hoover Institution

Steven J. Davis (0:10)

Welcome to Economics, Applied, I'm Steven Davis, host of the show, and senior fellow at the Hoover Institution. With me is my friend, longtime colleague, and CEO and president of the Federal Reserve Bank of Chicago, Austan Goolsbee.

Austan, welcome.

Austan Goolsbee (0:27)

Steve, thanks for having me back.

Steven J. Davis (0:30)

Glad to have you back. I guess the last time we chatted in this format was 13 months ago.

Five years ago, I could just walk 30 feet across the hallway and chat with you whenever I want.

Austan Goolsbee (0:42)

Great, but now you got to treat me with more respect, Steve.

Steven J. Davis (0:46)

Is that right?

Austan Goolsbee (0:47)

No, not at all.

Steven J. Davis (0:49)

I will do my best. Seriously, it's good to see you. Last time, for those who are interested, we talked about the dismal state of productivity in the US construction sector.

Today, I want to talk about a more conventional topic for a monetary policymaker. It pertains to a speech which I believe you just gave at the OMFIF in London, which is where you are sitting now, I believe. The OMFIF bills itself as an independent forum for central banking, economic policy and public investment. Okay? Sounds impressive.

I'll stop razzling you. So get the serious stuff. So this is a speech about how should central banks respond to supply shocks.

Austan Goolsbee (1:42)

Right.

Steven J. Davis (1:42)

Okay? Which has become a central issue for central banks around the world and certainly the United States.

And you start your speech by stating the conventional wisdom. And I'm just going to read a line from your speech. And then you give an argument to question that wisdom. And I'll ask you to set that forth and we'll go from there. So here's your characterization of what I think has been the conventional wisdom in many quarters. And I'm reading directly from your speech here.

Austan Goolsbee (2:11)

So I can't deny it. I was going to say I can't deny it.

Steven J. Davis (2:13)

I'm just going to quote you here.

The conventional wisdom, as you describe it, central banks should look through supply shocks and only respond, and here I think you mean by tightening monetary policy, if they start to have secondary effects on other industries or begin unanchoring inflation expectations. And I think that's a fair description of the view that many have had. So you take issue with that view, at least in part, give us the argument. Yeah.

Austan Goolsbee (2:46)

Okay. So what's behind that argument? Well, before we get into buy thesis, there's one aspect that's a little bit of a puzzle. If you just kind of set down and said, hey, isn't what matters for the central bank, the gap between supply and demand? And if output is growing faster than potential, then you're contributing to inflation. And that's the thing that the central bank is supposed to slow down. Now that could happen because demand went up or that could happen because supply went down. Why do they treat demand overheating differently from supply-induced overheating?

I think it is because up until recently, supply shocks have historically been more transitory. They don't last very long. They either unwind. If you look at weather or oil shocks or supply disruptions, they're short-lived either they are undone or even if they're not fully undone, they're a one-time increase in the price level. And so as an inflation shock, they're not persistent. In a world where this thing is going to go away on its own and monetary policy takes a year or more to affect the economy, it seems like a bit of a fool's errand to go out and try to fight something that's going to go away already.

So then comes in my thesis. Number one, the last six years have taught us that it feels like these supply shocks are coming more frequently. They're bigger and they're more persistent than that kind of conventional wisdom suggests. So I think that there are some supply shocks that the central bank can't look through. Namely, they're the ones that are persistent on inflation. And in a way, it goes back to the law, as you know, gives the Fed the responsibility and virtually all central banks the responsibility to restore price stability, which we have said is a 2% inflation target. And think of the extreme case. There's a persistent supply shock that's going to raise inflation to 4% for the next 50 years.

But you know, it's going to go away should you look through it. Well, of course, you can't look through it, because if inflation is going to be 4% for the next 50 years, you're failing on the on the inflation target. So, OK, the central bank must respond. It doesn't have to part to it shouldn't respond as strongly as you would respond to a demand shock. But you can't just look through it.