Austan Goolsbee Is Worried the Economy Is Overheating

Thank you for having me.

No, no, I heard you. So you saw a bear a little while, along with some of our producers yesterday. It's very exciting. I've never seen one here before, so hopefully not indicative of anything in the broader economy.

Depends what you think the underlying inflation rate is. Let's not forget what matters is the real rate, rate minus expected inflation or actual inflation over some period. In the long run, where do we think it's going to end up? I loosely think 3% rates with 2% inflation and 1% real is kind of the eventual landing spot. The real rate, if the inflation rate is 3-plus percent, the real rate is a lot lower than if inflation is headed back to target. So I don't think you can really answer that without saying I'm okay with waiting to see, but I'm a little nervous that the inflation side has, over the last six months, not been looking great.

We jump right in.

Yes.

I love that. You know, I was an academic for 30 years, so I love saying let's get out of the world of theory. I always called r-star our Sasquatch. And you know, somehow it feels with this as a backdrop, because you can't ever see it until after it was left, and you know, here was a footprint. And when I say that, it's because I don't think r-star, while the concept exists, I don't find it helpful for me in determining, well, what should the next monetary policy move be, because it's not observable. It's even in the best of times not observable. That said, I think if you start thinking longer run, what does an increase in the productivity growth rate do to r-star? I think it increases it because faster growth, you got to have a higher steady-state interest rate. And I gave a speech last year at the last Hoover conference that was kind of thinking about if you think AI is increasing productivity, it makes a big difference to what that means for the here and now r-star. Is this expected, or is it unexpected? So if it's unexpected landing on you, then inflation goes down, and in a way, people aren't adjusting their behavior in the short run, and rates can go down. But the bigger the hype, the more we're about to have a giant bounty that's going to come from technology, you can easily overheat the economy in the short run and you have to raise the rates. And we kind of lived that through the mid-to-late '90s.

That's what we're still trying to figure out. Even before Liberation Day, as the tariffs came in, I warned—you'll remember—let's be careful. We learned during COVID that if a supply shock is supposed to be transitory, if it's big enough, it can end up taking a lot longer than we initially forecast. And that was my fear: that while one-and-done tariffs are supposed to be an increase to the price level, to do with this increase the price level and temporary inflation shock, where was the evidence that that was true? We've been dealing with that to add an oil price war-driven price shock on top of it before that one went away. That's a dicier proposition. Like some component of the increase in inflation is from those two parts: tariffs and a one-time increase in the price of oil, which hopefully should go away as inflation. But if you look at services, that's not really caused from tariffs; it's not really caused from oil prices. That's a deeper level of concern. So in my decomposition, I'm hopeful that much of it came from those temporary transitory factors—giving myself hives even using that word—and if so, then we should see it. It should go away. It can't be that each quarter we say, "Oh, yes, it's about to go away, just not yet, three months from now." And so that's why I was okay with, if we get one or two readings of inflation that are moderating, it's perfectly fine to say let's wait a meeting or two meetings or whatever, let's see if this is the heralded introduction of the temporary part.

Yeah, into its thinking, yes. I think that you're on to it. It does feel like we're getting more supply shocks. The traditional world—this is the world where shocks aren't the main thing happening. It's not commodity prices. Normally the grubby reality of the business cycle, demand-driven: unemployment goes up when inflation goes down, inflation goes up when unemployment goes down. When both of those things are moving together, like what happens with these supply shocks, there's not an automatic playbook of what to do. I do think that we at the Fed and the central banks all around the world should be contemplating, at the least, what are you going to do if we're going to get more and more shocks? That's a slightly different kind of... You raise this second point, which is with the tariffs and with the war here, I think that has piled this uncertainty on top of itself. And I think that's what's led in the labor market to this kind of low hiring, low firing, which is not a normal combination. I think it's a combination that characterizes uncertainty. So yeah, we should start thinking that way.

Yes, and you hear it from business executives. But in some ways, I feel like maybe it's too much. It's interesting that if you look at the price pressures coming from AI data centers, the build-out of very high investment, this isn't the first time that there has been high investment as an indicator of economic growth. But the overall overheating of the economy is kind of the deeper question. Sectoral AI is going up and some other industry is competing for electricians and construction and complaining bitterly about that. That's not the same thing as the economy's overheating. It has to get out of its lane of just direct competition and drive up wages, drive up prices outside of just its lane, because if this one going up leads this one to go down, in the aggregate, in a way, the national unemployment rate and the national GDP growth rate tell you a lot about where you are in the aggregate economy. That said, you hear it. You go around the Midwest—the Chicago district is kind of heart of the Midwest. We're in Cedar Rapids, Iowa. I'm like, "What's the biggest problem there?" They're like, "The data centers are buying up all the land, they're driving up the prices, nobody can do any construction, you can't get an HVAC person." So it doesn't feel like we're far from what is the sort of traditional excess demand and output above potential, and that's driving up inflation. And if it does, back to your first question, then we're not restrictive enough. If that starts happening in the aggregate, we're not restrictive enough. I don't know how to say is this restrictive or not restrictive. Everything's relative to something. And if inflation starts going the wrong way, driven by just old-fashioned investment is so high and growth is so high that we're getting that impulse, then I think it's not restrictive enough.

Exactly. So that's what I mean. That's filled into the bogeyman if you can't find an electrician. I half expected people to be like, "I need to go to the dentist. They can't see me for three weeks. Thanks a lot, data centers."

In the short run, it's probably not that different, just in the business cycle sense of there are many different ways you could go. We've seen overheating from housing construction getting out a lot faster than the economy can handle. We've seen consumer spending, savings rate go to zero, consumer spending is faster than the economy can handle. We're seeing a business investment-driven threat to more than the economy can handle. In the short run, if it's demand-driven, I kind of think it's not. The Fed has a very unsophisticated tool: we can raise the interest rate, lower the interest rate. What makes it work is that usually the most cyclical industries are the most interest-rate-sensitive industries. So it kind of does make sense that the Fed be the tip of the spear. If by that question you're asking the deeper thing of, well, what does it mean long run, you hope that the investment will enhance potential output in the future. So then it would be different down the road five years, ten years, if productivity growth remains high. But then we're also sort of back to our discussion of, well, what does that mean for rates long run? I actually think rates could be higher if the growth rate is higher, for all the best reasons. I mean, that's the manna from heaven productivity position that people want.

Yeah, we would love that normalization if we could grow 3% a year and incomes are growing without inflation because of productivity growth. At the same time, let's be a little wary. I've been from early on highlighting maybe some of this technology is raising the productivity growth rate, but we've now gotten six months in a row of pretty crummy productivity growth. So let's not all conclude before it's actually manifested that we've had a change of era.

Interesting. I thought you were going to go a different way back to the old how much was supply and how much was demand in the rise up in inflation. But what you did—aggressive rate hikes—the shoe that did not drop... I think that supply was a major driver of the run-up to inflation, and the healing of supply eventually was a major component of the drop in inflation, as long as you say that, as long as you're not trying to have it both ways. And both sides, it feels like in that debate, want to have it both ways in the sense they want to blame the run-up on fiscal policy and the monetary policy, that it was all about stimulus, and then they didn't say, well, why did it come down? Then they want to say, "No, no, they don't deserve any credit for that. That was all from supply chain healing." I think it was loosely two-thirds supply and one-third demand. I wasn't there when it went up, so you can't blame me. But I do think that the Fed's aggressive action permitted the one shoe not to drop that was hugely important. And that is, at the peak—side note for Odd Lots listeners: you will know that historically CPI of 2.3%, we kind of think correlates with a PCE of 2.0%—even as CPI was pushing close to 10% inflation, if you looked at inflation compensation in the TIPS, it remained steadily at 2.3% CPI, so exactly 2% inflation target. To me, that was a piece of evidence that having a 2.0% inflation target was exactly the anchor that its advocates said. And I think it was critically important that the Fed not lose control. If they had lost the anchor, I think we would have had a heck of a time trying to get rid of the inflation. So I think the Fed deserves a lot of credit at that moment. And then, if you had plugged into ChatGPT or some AI trained on all the data through history and said inflation is double, triple the target, what should the Fed do? It would have said jack the interest rate up to 20% and have a huge recession because that's the only way you ever get rid of inflation. And I do think the Fed's understanding that there was a component that was not going to be permanent, and that the much-maligned or mocked immaculate disinflation was in fact possible, I do think that the Fed deserves credit for recognizing that. To this, on the other side, they were slow out of the gate. There's no way you can't look back and say they weren't. They clearly were.

Don't get into every blip in Twitter of the bond market. I kind of think you need a little bit of time to sort out what's driving it. Long yields going up could be people are expecting inflation; could be people think that the Fed is going to have to be on a path that rates would be higher; could be there's a lot more competition in issuance, that just more bonds getting put out. And it's probably some combination of all of those. I don't put that much credence on the argument that there's a general freakout about the creditworthiness of the United States, because if you really think that a country is going to experience default, the rates are whatever, 5%, 5.25%—that's a historically pretty normal rate. So I think, look, we're watching that it does have an impact on the economy. But whenever you're looking at market reactions, you've got to think a little bit about this reflection problem: that part of it is what do they think the Fed is going to do. Paul Volcker used to tell me our job is to act, and the market's job is to react, and let's not get the order mixed up. And that's kind of where I start.

I think you learn a lot from bond markets. As you know the rules, I don't speak for anybody else or weigh in of what somebody else's message is. Personally, speaking only for myself, I agree with it, and I think it's healthy in a general way to refresh every once in a while what any organization is doing and have a rethink. But on the specific thing of should we have less forward guidance of saying here is where we think rates are going in the next six months, if X thing happens, then I promise I'm going to vote for an increase, a cut of blah, blah, blah—I think that adds to volatility and threatens to get us into a tying of our hands that I don't think is healthy. So I have embraced this: let's engage in less forward guidance. That's different from should the market tell us what to do. I'm not a fan. The Federal Reserve Act says by law what we're supposed to look at: maximizing employment, stabilizing prices. Doesn't say anything about stock market; doesn't say anything about bond markets. So gathering information from them, I'm totally for using that, that that's what we should do.

Yeah, I think there's room for plenty of stuff on that table. All of that should be on the table. We have this outside task force headed by outside folks that's contemplating a lot of these issues about communication. I think it's healthy. Let's rethink all of those. You're right to remind the history. We were at zero; the interest rate was at zero. And if you plugged into the formulas what should the interest be, it was like -6%. And so the Fed at that time was facing unprecedented challenges, and they were trying to think of what do you do when the interest rate is already zero? And giving forward guidance in an environment where you're at the zero lower bound, where you're like not only is the rate not going to go up, it's not going to go up for years, it's not going to go up until the unemployment rate comes down—all of those things... your predecessor Charles Evans with the Evans Rule, each of those is kind of a creative solution to a problem that they were facing. We're in a totally different environment, and so we should think through all of those.