Thank you very much for coming today. This is being livestreamed, I understand, so everybody has to look at the camera and look very smart and pleasant and handsome, particularly our great speaker, Austan Goolsbee. I'm very pleased to introduce Austan, who is now the president of the Federal Reserve Bank of Chicago and has been in the job now for three years. He's going to be talking to us about the present state of affairs of US monetary policy, with a big emphasis on the supply side. All of this is totally on the record. It is being livestreamed, as I said earlier. Now, Austan has had a very distinguished career also in the academic area and is a professor of economics at Chicago, the Booth School of Business. But before that, he was working for President Obama. He was the chairman of the Council of Economic Advisers for a year or two, and even more importantly, I would say, a seminal time when you were working with Paul Volcker, when you were the chief of staff and the chief economist at the Economic Recovery Board in the days of 2008. So you really do go back a long time in terms of crisis fighting, crisis management. A lot of that around at the moment. Looking forward very much to what you have to say. You've got a talk of 10 or 12 minutes, and after that, there'll be some Q&A with me in the chair, and then Q&A with the audience, whereby we would like the Q&A to be restricted to people who come from the professional analytic community. There'll be a time for a press conference with it's going to be all done virtually afterwards. So ladies and gentlemen from the press, please hold back during the Q&A. Now, over to Austan. Thanks for coming to London.
Thank you, David, and what a treat to be here. You said I've been at the Chicago Fed for three and a half years, and it reminds me, my mother-in-law, her mother-in-law would treat her very badly. And she used to say that if the doctor told her she had two weeks to live, she would choose to go spend it with Grandma Sophie so it would feel like forever. And there is an element, there is an element to the last three and a half years, there have been a lot of challenges, as you know. It always brings relief to my colleagues before I say anything: all of my views that I will express are my own. I do not speak for anyone else on the FOMC or for the committee today. I wanted us to think a little bit about the nature of supply shocks versus demand shocks.
Normally, when we think about the central banking challenge of economic stabilization in the business cycle, we're thinking about fluctuations in demand. So that at a fundamental level, kind of in modern macro thinking, the Fed or the central bank is responding to the inflationary pressures that are coming from the imbalance between aggregate demand and aggregate supply. When the demand is high relative to supply, that creates inflation pressures that are ones that the central bank can deal with. And the Fed, as you know, has a dual mandate to stabilize prices and to maximize employment. So it raises rates to try to bring the overheating back into balance.
In the last several years, though, we've now lived through a repeated set of supply shocks that have illustrated, or to some extent, highlighted the limits to the line of thinking that is about aggregate demand and kind of forced some new considerations about supply shocks from the experience of the 1970s. The oft-repeated intuition has been that central banks should largely look through supply shocks directly and only respond if those supply shocks start to have secondary effects on wages, on other industries, or start unanchoring inflation expectations.
But in our latest episodes, we seem to have entered a period where big supply shocks from wars, from terrorists, from weather, from supply chain disruption, from oil shocks, whatever, they've become a regular and repeated feature. And my argument today is going to be that in an environment like that, there are some supply shocks that the central bank should not just look through. And namely, they are the persistent ones that won't go away on their own.
Now, in a mechanical sense, the economy can generate the same size gap between supply and demand from supply going down as from demand going up. So where does the standard wisdom come from that we should not react the same way even if the gap is the same size, that we should instead look through the supply shocks and respond only if there are secondary effects? I think that much of that intuition to look through comes from the reality, the historical reality, that the shocks to aggregate supply that we've seen over the decades have been much more transitory inflation shocks than the demand overheating has been. So the weather events, supply bottlenecks, the original big oil price shocks, these often resolve relatively quickly. And even when they don't resolve, they don't fully reverse. They're frequently one-time level shifts, not persistent inflation shocks. So they don't change long-run potential growth. And since monetary policy takes months or years to work its way through the economy to begin with, it seems somewhat pointless and probably prone to timing error to try to use monetary policy to respond in the short run to shocks like that. Why bother fighting something that's going to go away on its own?
Now, inflation that's coming from demand-driven overheating is totally different. Historically, that's built up slowly but has persisted much longer, and hence the idea that monetary policy should respond strongly to demand overheating because there are serious dangers of escalation from letting the problems on that side of the ledger fester.
My observation is that the supply shocks these days have not just been coming more frequently, but they're also bigger and lasting longer. And with persistent supply shocks to inflation, some of the logic about looking through no longer holds. Okay. Now, that in a way that seems surprising at first glance because if the proper response to a temporary, let's say six-month supply shock is to look through it, then if it's a temporary 60-month supply shock, it seems like it should also be to look through it because as long as it's forecast to go away on its own, 10 times zero is still zero. The problem with that, of course, is that it implies that the central bank is going to fail on its price stability mandate. If the central bank says it will hit 2% inflation in the medium run and also that it will not respond to supply shocks, then repeated persistent supply shocks to the inflation rate mean that one of those two statements is going to end up being wrong. A cost shock that will last multiple years forces the central bank to revisit the rationale for looking through.
And these days when you see large supply shocks, I think it's usually more accurate to assume they're going to be persistent than that they're going to quickly go away. That's certainly been the US experience over the last six years. The COVID supply chain disruptions were supposed to heal in a matter of months. When the war began in the Gulf, futures markets projected that oil prices were going to fall rapidly. Months later, we still got oil at $100 a barrel. We've still got a large crack spread and they're potentially rising further. And tariffs have been nothing like the stylized textbook example of a one-time increase in the level of prices. They have followed a pattern of repeated escalation.
If the forecast is for large, persistent, recurring shocks, then the central bank still needs to respect its price stability mandate legally. And the only way that it has to reduce inflation rates is to reduce the gap between supply and demand, even if that's not primarily affecting the same sectors where the cost shocks are taking place. So it becomes critically important to figure out, or to at least recognize, when is a supply shock no longer temporary and should be considered persistent. And that's especially true for big shocks where, as I said, my presumption is the supply shock is going to last longer than we initially thought.
So what is the central bank supposed to do if the economy is hit by an unending string of supply shocks that drive up the inflation rate persistently and keep it above the target? The first thing is don't do nothing, because looking through is not going to work in that environment. But at the same time, it's important to recognize that the response to a persistent supply shock does not need to be the same as the reaction to a demand shock, even for the identical size imbalance between supply and demand. And that's partly from the nature of the tool that the central bank has. Okay, monetary policy works through the demand channel. So in principle, the central bank by raising rates can directly counter the shock to demand that overheats the economy and adds to inflation. It just puts demand and supply back into balance and never has to face the tradeoff between the mandate goals. But for the identical size gap between supply and demand that comes because supply goes down, that puts the central bank in a tougher position because it doesn't, the Fed can't pump oil, as they say, and it doesn't control the supply curve. So if inflationary pressure rises from a negative supply shock, the only thing that the central bank can do to close the gap and reduce the inflationary pressure is reducing demand and thereby output and employment. And there the critical fact becomes that wages are sticky. So they don't adjust instantaneously.
And to bring the economy back into balance in the business cycle sense after a lasting negative supply shock, the economy would need to adjust to the, they would need to get used to disappointment, that the new disappointing equilibrium, and the wages need to fall. And if wages adjusted instantly, then the central bank's response to the supply shocks and the demand shocks would be the same. But wages don't respond instantly. And trying to force inflation immediately down to the target in the short run would mean overshooting on employment and, overshooting on the decline in employment, undershooting on output. And so the supply shocks in the short run force this painful tradeoff for the two mandates facing the Fed that the demand shocks don't. And that's why the central bank might not, should not, react as aggressively when the supply shocks are causing the imbalance as when the demand shocks are. Which brings me to the current outlook in the United States that I think we should be paying attention to.
Number one, I start especially attuned to elevated inflation in the service sector industries and any evidence that AI data center construction is jumping out of its own lane and driving up aggregate output more than the economy can handle. These would be suggestions of old-fashioned overheated demand. And when demand overheats, there's no ambiguity about how the Fed needs to react. Both of those are areas of concern in the recent data. On the supply side, oil, tariffs, commodity prices, etc., forecasters have spent more than a year now pushing back the date when inflation was supposed to peak and start falling. So originally that was supposed to happen in the fourth quarter of 2025, then Q1 2026, then Q2, then Q3, then Q4, and now it's sometime in 2027. That is not a comfortable pattern for identifying what is supposed to be a temporary inflation shock. Now whether you attribute that to a steady stream of new supply shocks or you think the old supply shocks are just proving more persistent than we originally thought, this has definitely not looked like the one-and-done pattern that, as I said, underpins the case for looking through the supply shock. So I want to see actual evidence that these shocks are fading, or I find it hard to see a credible path back to 2% inflation that would justify continuing to look through them.
Our policy response, any central bank's policy response to persistent supply shocks may not be as large, as I said, as if the inflation is coming from demand overheating, but it's unlikely to be painless. And it's exactly the kind of painful tradeoff between employment and inflation that stagflationary shocks always impose on the central bank. Unfortunately, in an environment like that, the only way back is the hard way. So, I remain somewhat optimistic that we don't have to have a persistent supply shock, but it's certainly the highest danger we face.
Thank you very much, Austan. That was an incredibly useful speech, I think, to take us through your thinking and also with a bit of history in there on what's happened in the past. I deduce myself from this idea that the look-through question has somehow been replaced now by a follow-through question. That seems to me, how many times are we going to have to do this? That's one point I've got in my mind. The second point is that you made the point that the assumption is that you're going to get back to the 2% target. The assumption has also been that you do look through supply shocks. That has been the standard assumption, you say.
An assumption or a promise?
Well, it is a thought out there, hasn't it? A thought, a promise. But so the question is to you now, how big a likelihood is it that neither of those promises would be held? You will indeed refrain from looking through, but you will still not manage to meet that target because, as you said, life is pretty tough out there.
The rules forbid me, I can't speak for the committee, but for myself, I would highlight that in the discussion where I said why the response to supply shocks might be different than demand shocks is the recognition that if you have a dual mandate, you would respond, but it won't get you to 2% immediately because you have to think about, to get to 2% rapidly would overshoot unemployment and then everyone would say you made an error that way. So in that sense, when you face stagflationary supply shocks, I think the likelihood that you fail to deliver on both promises in the short run, for sure, goes up.
This issue that we mentioned, Paul Volcker, who was a mentor, something of a hero to you as he was to many people, he did achieve the inflation target in the late 1970s. He did cause a lot of pain. People used to send him baseball bats through the post. You've got a president of the United States now who, like many presidents, does not like high interest rates. How likely is it, do you think, in the course of your tenure, Austan, that you are going to cause real pain and also that the Fed as a whole, not just you, the Fed as a whole, will run into really big unpopularity?
Was there a time when we had high popularity that we're going to lose? I don't... when you were lowering interest rates... in the polling, when I started at the Fed, I checked the polling and a large majority of people in the United States said they were familiar with the Federal Reserve, but they did not know what it does. But an even bigger majority said whatever the Fed was doing, it was doing a bad job at it. And so, not only did they send Paul Volcker baseball bats, they would send him pieces of 2x4 in construction because construction is one of the most interest rate sensitive of all the industries. So when the Fed funds rate goes to 20%, you're going to hear about it.
That's what they do in Chicago. That's what they're for. And the original piece that he got, his widow gave me when he died. And he kept it in his office and now I keep it in mine. And it's scribbled on the 2x4, it says, 'Lower these insane interest rates.' Okay, that's... and I keep it there because what happens at the FOMC is not an academic game. It affects real people. And because the Volcker experience shows you sometimes it's the Fed that has to make the toughest call. So what happened is we had a series of supply shocks pile in the 70s, piled on top of overheated demand, and inflation expectations became unanchored, and that's really painful. The only way back is the hard way. It can't, the central bank needs to be independent of political interference. If it's not, it's not a guarantee, but if you want inflation to come back, that's how you do it. You take away the independence of the independent thinking at the Fed or at the central bank. So I hope we are not in an environment. It's entirely conceivable that the environment will make the Fed deeply unpopular. It might already be deeply unpopular. Inflation is not without cost, as we can see, that also makes the central bank unpopular for good reason. The job is price stability. If I think if we or any other central bank have to confront overheated demand or unanchored inflation expectations, we must have the fortitude to do that. And if that makes the central bank unpopular, then so be it. I mean, that was one of the key lessons of the Volcker era. And if the central bank is not allowed to have that fortitude, you've got a real problem. Inflation will come back and will not go away.
Good. Just one last question from me following on this issue about independence, and then let's open it up to the audience. There's a roving mic so people can just raise their hand and we'll have, we've got quite a lot of time for questions because we've got until 12:30, so we can go through this in a good way. I think this independence issue, it's obviously been studied a great deal over the ages. Now, Wim Duisenberg, he used to say, and I think this expression probably sounds better in Dutch or in German than it does in English, but he used to say the Bundesbank is like whipped cream. The more you beat it, the tougher it becomes. I think it's a fairly good phrase really and it's got an agricultural element to it that you might enjoy too. Is this the case in the case of the United States Fed, but it has become more independent almost by definition because Chairman Powell is still on there. Normally they leave. This is the first time for 75 years he's stayed on. One can only assume to make sure that the Fed does keep to its mandate. And also if you are getting beaten up from time to time by various characters in politics, does that actually make you more steely, more defiant?
Yeah, look, I think in any country, if you're going to become a central banker, you can't be afraid to take a punch in that business. That said, I want to just distinguish what, when I'm talking about independence, what do I mean is a very narrow form of independence. It is independence from political interference when setting the interest rate. That's the only thing. It's not like a pirate flag or we're going to declare the republic of something. It's just that. And before I was ever at the Fed, I was a professor for 30 years at the University of Chicago. Economists are virtually unanimous on the importance of central bank independence by that narrow definition. My experience on the FOMC is that there are 19 policymakers sitting around the table and they come from very different backgrounds and have different histories, and some from business and some from finance and some economists and some others. And everybody, in my experience, everybody takes the job extremely seriously. You're out of the elections business. You're in the business of the dual mandate. The law gives the job. It says when you're setting the monetary policy, you're stabilizing the prices, maximizing employment, and that's what you need. That's what we're required to do. And that's the only thing that we're required to do. It doesn't say anything, as I highlight, doesn't say anything about make sure the market isn't upset or it doesn't say anything about make sure the politicians get what they want. It's just about stabilizing price and maximizing employment. And I think people are, that's what they do. And you can see in the minutes and you'll see when the transcript comes out, word for word, you can see what everyone says. And it's about the economy and that's what it should be.
I'm obviously straying into ground that I shouldn't really trespass on, but I'm very interested in the psychology of monetary policy committees. And so I would just like you to say in just a couple of words, how would you phrase, just in a couple of adjectives, the way that former Chair Powell behaved on the committee these days. This is rare. It's the first time for 75 years.
I'm not really allowed. You're asking me to do something that we're forbidden to both talk about other people and reveal something of... you could say something quite innocuous like respectful. Okay. You know, I'm in public many times a big fan of Chair Powell. I think he was, former, former Chair Powell, and I think his chairmanship, I thought he had to confront a lot of really difficult issues and he did so in a successful and admirable way. That was the only chair that I had seen before Chairman Bernanke, who was a friend and I worked fairly closely with back in the financial crisis when he was a governor and I was at the Council of Economic Advisers, and I have been a friend and a fan of Chairman Bernanke ever since. I don't know if it is historically unusual to have a former chair sitting at the table, but I have nothing to compare to know is that weird or not weird.
I'll leave all this to future historians. I do remember that book called The Secrets of the Temple which came out 30, 40... Anyway, who'd like to... please, yes. You've got your hand up first, and then the gentleman, Chris, next to you. You could have the next question to save handing the microphone around too much. So, please say who you are. Would you mind just standing up? I always think this is a nice bit of decorum. Everybody can see who you are.
Thank you very much, David. President Goolsbee, I should say who I am. Bro Capital. So my question is about, you know, the statement last week said that the hike should serve for a timelier return to target. And I was wondering, you know, in your personal view, what that means. Also because you were saying you're talking about stagflation, but the reality, and you know, the potential conflict of the two sides of the mandates, but the reality seems that the economy is doing really well, so the problem is only on the inflation side. So wouldn't that suggest a fairly speedy response and maybe return to target? Thanks very much.
Okay, those are, there are two, it's great to see you again, yeah. There are two questions in that, both are important. I think there's always an element of we're trying to figure out the through line. So if it's what I highlighted in the opening statement, the parts of inflation that are harder to rationalize as being from temporary supply shocks, namely services inflation and all of the AI data center buildup adjacent driven inflation, those in my mind correlate more strongly with overheating demand. And I think you're, I think the premise of the question is quite right. If the unemployment rate is barely 4% and core inflation is above three on an extended basis, there's not a conflict of mandates. There's just an inflation problem. And we know what has to happen in that circumstance. But to back out, I still said I'm optimistic that we could get back onto a path to 2%. If we start to see progress, if in those areas there isn't evidence, there isn't more evidence of demand overheating, then I think it wouldn't be in that situation. So the case for aggressive addressing is the same thing as we have to figure out in the through line, is this demand...
overheating or is this coming from a supply shock? And for me personally, I'm still sorting that out. There's conflicting evidence. And I always say, and you know, and we've talked about it before, when I arrived, there's always the new person arrives and they try to figure out are you a hawk or a dove. And I said I don't even know if I like birds. I don't aspire to be a bird. I just always wanted to be one of the data dogs. And the first rule of the data dogs is that there's a time for walking and a time for sniffing, and it's important to tell the difference. And this is the time for sniffing when you can't. We got to figure out is this supply or higher demand. Sniff, sniff, sniff, you know, and sniff sniff it all.
Well, dogs do do other things as well, but we won't get into that. Polite company. We won't expand that. So, Chris, your question, please.
Okay, if you wouldn't mind, I'm just saying to everybody who you are, just hi, it helps. Hi. Chris Crow from Capular Investment Management. Thanks very much for being here, President Goolsbee. I was very impressed by the way that you were quite early sort of talking about the demand shock elements of data centers, etc., AI. I thought that was an impressive piece of intellectual leadership. I wonder what...
Well, I always think... now he's setting here comes, but I always think when someone's visiting our country we need to be nice to them. So yeah, here's the but. We have another potential source of strength in aggregate demand in the US economy which could also be pushing up inflation and supporting financial conditions, which is persistent fiscal deficits of the order of 6% of GDP which appear to be going on as far as the eye can see. Is that a source of demand in the economy that you worry about and you think that could be inflationary and requires some sort of monetary policy response?
It's part of aggregate demand. Fiscal is part of aggregate demand. What Chris is referring to, what I said about aggregate demand from AI data centers was essentially the bigger the hype, the bigger the risk of short-run overheating. Because even if it's going to be a big increase in productivity growth, if much of it's in the future, then it's going to go into equity prices today and it's going to go into trying to spend. We're going to invest and spend out of our stock market wealth before the capacity has actually expanded, then that could overheat it today. So I'm still worried about that. The question of fiscal deficits is part of aggregate demand. This is one of those where it goes into the conditions. There's no bad weather, there's only bad clothing. Monetary policy, we're staying in our lane. We don't weigh in an opinion of here's what taxes should be, here's what spending should be. That's the choice of the Congress and the president. If it's going to drive up prices or affect employment, then the law says we have to think about it. So to me that goes into the external conditions. I do think in an accounting sense much of that impact is what's the delta from last year. So high deficits that are persistent and not increasing have a different impact than even if you started at low deficits if the deficit is getting bigger and bigger. That would have a different short-run business cycle implication.
Just on that, I mean, I thought you were going to say something else at the end of that sentence, but heaven forefend that you should tell the federal government what they should be doing any more than the president of course would ever dream of telling the Fed what to do. But if you and your fellows on the FOMC were simply to maintain a steady drum beat of saying well look if you did tackle this underlying problem about the fiscal deficit, you know, the body politic as a whole, it would make our life a bit easier. Do you think that would have any impact on your steeliness and your...
Oh on our steel? I thought you were going to say on them.
Well on them as well, but well I should add that as well. What would the effect be? Were you to do it in the most decorous fashion possible?
I don't, it doesn't sound to me like it could be anything good. You know, as I say, for my thinking about the fiscal-monetary tradeoff, I try to stay in the lane of monetary policy and that goes into the conditions. If we analyze it and feel like deficits are driving up inflation or driving up interest rates for a given level of demand, then it's relative. The law says we have to think about that. That's different than asking for why won't you make our life in the central bank easier by changing fiscal policy in XYZ way. For me, that's not the, then you're out of the Fed's lane.
Great. Okay. So, Marica, you've got a question.
Marica of Italian Central Bank. You just basically answered my question, but let me put it...
Put it in another way, an even better way.
Let me put it in another way. So, at the beginning of the talk, you said that basically you depicted an unconstrained maximization function. So, max employment and price stability. But from what you just said yours is not an unconstrained maximization function, it's a very very constrained maximization function because you need to think about fiscal deficit, external balance and everything. So my question is how constrained is your maximization function at the moment and is it, based on your experience, is it more or less constrained than in the past? Thank you.
The word constraint is doing a lot of work in that sentence. So there is an economist kind of mathematical definition of constraint and then there's a popular definition of, you might call influences. You know, are there things that are influencing the decision? I think that what in that formulation you would call unconstrained maximization is largely coming from when the shocks are coming from aggregate demand, that the imbalances are arising because the economy is overheating or not overheating. And the central bank, as you know, has only one tool and the reason it works, that's sort of the divine coincidence as the economists like to call it, is that the two sides of the mandate are not in conflict in certain circumstances like when aggregate demand is driving things up or down. Normally the most interest rate sensitive sectors are also the most cyclical sectors. And so it kind of works that the central bank, if the business cycle is booming, it tends to be booming in sectors that are very interest sensitive. And so when the central bank tightens rates, it brings it back into balance. I think we are in a pretty constrained environment or potentially constrained environment because a lot of the shocks driving inflation right now are not coming from demand. They're coming from these supply shocks and that inherently makes it a constrained optimization if you want to think of it that way because you're going to have those conflicting. The fiscal, not that I'm saying it's a red herring, but I'm saying it's a little bit of a red herring to call fiscal the constraint because in my world the fiscal is just part of aggregate demand. You can still do optimal monetary policy factoring deficits and spending levels and the change from the last year thinking of that as part of aggregate demand. I would caution people from thinking, sometimes lately there has been the argument that the Fed should cut the interest rate to make the issuance of debt cheaper. Okay, now let's be a little careful because that is the canonical reason why you want monetary independence. That is the monetize the debt argument. So if you start thinking in that way, now you've got a weird optimization problem I guess I'd say.
