Transcript: Are we in for a hard landing?

This is an audio transcript of the Economics Show with Soumaya Keynes podcast episode: ‘Are we in for a hard landing?’

Soumaya Keynes
We have been on an economic rollercoaster over the past few years, and there is one economist I know who has always kept his cool. Olivier Blanchard is a senior fellow at the Peterson Institute for International Economics and former chief economist at the IMF. And today, he’s here on the show to talk about the past and future of inflation. And we’re gonna ask, could a hard landing be coming?

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This is The Economics Show. I’m Soumaya Keynes in London, joined in the studio by Olivier. Hello. 

Olivier Blanchard
Nice to be here. 

Soumaya Keynes
OK, so let’s start with a soft ball. When I first met you . . . 

Olivier Blanchard
I like balls.

Soumaya Keynes
(Laughter) When I first met you, you were living in the US. And you have recently moved back to France. 

Olivier Blanchard
Yes. 

Soumaya Keynes
What’s the biggest improvement? 

Olivier Blanchard
In terms of my life?

Soumaya Keynes
Sure.

Olivier Blanchard
I see, so we get personal to start. You know, there are two dimensions to life. There’s a professional one and there’s the personal one. I think the relative weight changes over time in a predictable fashion. I care more about my personal life at this stage. And the quality of life in Paris is better than in Washington. 

Soumaya Keynes
OK, I won’t tell them. The DC residents will be horrified to hear that. 

Olivier Blanchard
They have to know. 

Soumaya Keynes
(Laughter) OK, so the other thing I was gonna bring up is that I remember when we first met in Washington, DC. I’m not sure you remember this as clearly as I do, but we went for lunch and we were talking about the economy. This was, I think it was back in 2018. And you asked me about a question that you were puzzling over, which is whether there was such a thing as an economy that was too hot, but where there wasn’t inflation. And the puzzle at the time was that we had declining employment, and inflation just wasn’t anywhere to be seen. And so I think the question was: is there such thing as too much employment? Do you remember that? And what did you conclude? 

Olivier Blanchard
I do not remember. 

Soumaya Keynes
Oh no. 

Olivier Blanchard
I can adjust. My sense is an economy is too hot when there is inflation. And as long as there is no inflation, there is no such thing as too hot an economy. That’s more than semantics. I mean, that’s how I judge it. If you can run an economy at 2 per cent unemployment and nothing bad happens, but you should. So I think that, you know, the issue is, are you generating inflation? Then you have to be careful because hot in the labour market takes the form of a very slow increase in temperature. You have to be very careful. The way economists say it is that the slope of the wage Phillips curve is very small, which means it’s a bit too hot but it doesn’t show as flames. And so you have to watch it. But in general, you know, for me, too hot is when there is inflation. 

Soumaya Keynes
So I think at the time I had this idea that you were working on maybe a new paper and you were asking for my thoughts, but maybe actually you just wanted to test me. And I think I struggled . . .  

Olivier Blanchard
I would never do that. 

Soumaya Keynes
OK, sure. All right, well, look, let’s move on to the more recent episode when, you know, obviously inflation did become a problem. And I want to ask you about the state of economics, right. In a recent interview, we had Minneapolis Fed chair Neel Kashkari on the podcast, and he said that this episode was actually a sign that there was something broken. There was a real problem with our main economic models, because in those, there were only two ways to have persistent inflation. You could have a tight labour market, or you could have unanchored inflation expectations. And we had neither of those, and yet we still had this inflation. Do you agree that something went wrong or actually, can our standard models explain it? 

Olivier Blanchard
I think that the standard models can explain it. I think Neel had forgotten one third aspect, which is that can be relative price shocks, which can be very strong and have a large, if transient, effect. So, two things. Yes. I mean, as you know, we did not predict the way inflation would go. I was right in predicting inflation, but I was wrong about the channel. I thought it would happen for the labour market. It happened through commodity markets. But once you put this back in and, you know, when we analysed for ‘70s, we had it in, then there is nothing terribly surprising. The point about expectations is more about how the price shocks tend to last or not.

So in the ‘70s there were price shocks very similar to the ones we had, mostly energy or other than food and . . . but it happened. And then people said, well, we’re going to have inflation forever. And they started asking for wage increases and so on. So it lasted much more. This time, we didn’t get that because the inflation expectations have been anchored.

But everything I’m saying is very much what you would find in my textbook if I want to be immodest. The notion that we have to start from scratch, that macroeconomics is dead, whatever, I think is just not right, as opposed to, you know, when we were earlier in Washington doing the global financial crisis, I think there, we really had missed the whole part of the macro economy, which is the financial system. I think this time, you know, I have this paper with Ben Bernanke that you probably know, and we used a completely conventional model and it seems to fit and explain things. 

Soumaya Keynes
OK. I want to talk more about that paper now with former Fed chair Ben Bernanke. Could you talk a little bit more about what you were trying to do, and then what you found, the kind of headline results? 

Olivier Blanchard
So basically we wanted to explain inflation, and there were all kinds of stories around on the supply side, that it was Covid, that it was supply chain disruptions, it was energy prices. On the demand side, that US fiscal policy was a big thing and so on. And we just wanted a simple analytical structure in equations in which we could put all these elements in and estimate the damn thing. And that’s what we did. So as you probably know as well, we have two papers, one in which we looked at the US and one in which we looked at 11 countries with the help of the central banks. And the answer is a very common one. We could explain it and happy to do so, but there was no major surprise. 

Soumaya Keynes
So what did you find? I mean, on the way up, there was this big debate between team permanent, team transitory. Who won? 

Olivier Blanchard
So again both last. You know, in the team permanent, I can allow myself to say that team transitory said, you know, we have these price shocks but expectations are anchored. So they are going to come and go and there is no need to do anything. And I think we were basically right. I thought they were wrong at the time, but they were basically right. The only issue is that shocks kept coming quarter or month after month for the best of three years, so it was not transitory or temporary. It is that, you know, there was some truth to it.

Team permanent, which was Larry [Summers] and me and Jason Furman, I think, and surely other people, the [Federal] Reserve people, I remember, said, look, you have crazy fiscal policy, which we had and there’s no question. Monetary policy is extremely accommodating. That’s going to put pressure. Now when I went wrong, I think Larry might disagree, was that I thought unemployment would go down a lot, so much that there would be enormous wage pressure and the wage pressure would create the inflation. And that did not happen. So I think we were both wrong. But, you know, there’s a way of understanding, taking the good part of each one, putting it together, running it through the computer. And it worked. 

Soumaya Keynes
OK. So that was everyone making mistakes. But OK, what about the other big debate, you know, demand versus supply? 

Olivier Blanchard
OK. And I think that question is not fully solved. So let me describe I think what happened and why it’s not the full answer, which is, on the way up, inflation was nearly entirely due to the relative price of oil, the relative price of energy, relative price of food, supply chain disruptions. And on the way down, same thing. Just this thing is reversed. Now, when I describe it this way, it sounds like demand had nothing to do with it. But in fact, you know, why did commodity prices go up? Well, there is Ukraine, but leave Ukraine aside. It happened later. My sense is what happened is that US fiscal policy had an effect on world demand for commodities. So part of the increase in prices clearly came from demand. How much came from Covid shock, supply chain disruptions? How much came from strong fiscal policy or weak or loose monetary policy? I think this hasn’t been established and that remains to be done. 

Soumaya Keynes
Can I ask about one of the other hot debates around this time? Which was, I’m gonna call it sellers’ inflation. I think the other term for it is greedflation — this idea that corporate behaviour, you know, they saw that it was a high-inflation environment that somehow made it easier for them to get away with price increases. To what extent do you think that was a factor? 

Olivier Blanchard
So I think there’s a fact which is profit shares went up. So it’s difficult to fake that through inflation and nothing to do . . . But I think the form it took was not greed. It’s that if you’re in a market in which there are supply disruptions and you’re selling cars and you don’t have new cars because they haven’t come but there are still people wanting to buy cars, you’re not going to give rebates, right? So I think in any market in which these supply disruptions and demand is relatively inelastic in the short run, you’re going to see an increase in profit. No, it’s not greed. It’s the way the market works. You may disagree, you may hate it, but it’s the way the market works. Nobody is trying to school the consumers, right. It just happens. And I think this happened in all kinds of markets and therefore led to higher profit. Clearly, if you were in the oil production chain, you also made good money. So I think it played a role. So some mark-ups, to use another way of saying it, went up. But I don’t think it was greed. Now, did some price makers actually thought: OK, nobody understands anything, let me increase prices although I have no reason to do it? Yeah, probably. Human nature is human nature, so. But to think that it played a macro-relevant role, I’m still sceptical. 

Soumaya Keynes
OK. Well, I think we’ve mostly been talking about inflation on the way up. Now let’s focus on inflation on the way down. So did you expect that there would have to be a big recession to get inflation back to 2? 

Olivier Blanchard
No. I mean, I understood that what had gone up could go down just as easily as it went up. And that’s indeed what happened. And that had nothing to do with the labour market. It’s just that when in the end the energy price goes down, then, you know, inflation comes down. And that’s what we found with Ben.

Now the issue is that behind the scene, the labour market was not irrelevant. The labour market was putting pressure on wages, right. It became tighter. And in nearly all countries, the labour market is tighter today than it was in 2019. So there was some pressure on wages and then there was some response to inflation expectations. So what happened as the shocks went away and inflation went down, we were left with the unseen part of the iceberg, which is the wage growth, which was too high as a result of the history of the previous three years. That’s what we have now. So I would say until now, the decline had nothing to do with monetary policy. The up, that didn’t have much either. The fact that it was transient had to do with the stability of expectations and the credibility, but with no particular measure being taken at the time.

Now, basically, we got the easy part, right. And we have in a number of countries wage growth, which is too high to achieve the 2 per cent that central banks dream about. And so there, monetary policy may have to be used if the central bank wants to go to 2 and there is no good break, then it implies using monetary policy to slow down the machine. 

Soumaya Keynes
So it’s almost like you were right about wage growth in the labour market being a problem. You were just way too early. 

Olivier Blanchard
Yeah. No, I (inaudible). It’s very nice of you. (Laughter) No. The truth is, I thought that I was more sceptical of the credibility of central banks. And I really thought that if we went to an unemployment rate of 3 — which we didn’t go to, we stayed above there because people saved a lot of their cheques, inflation expectations were not anchored — then they would react and would get much more wage inflation than we got. We got the soft, slow version of it, which for most of the time didn’t much matter. All the action was somewhere else. But now is what matters. 

Soumaya Keynes
OK, but now we’re looking at, as you say, wage growth being too high. So now the big open question is, are we going to need to inflict damage to get inflation back down to 2?

Olivier Blanchard
So it depends on the country. There are countries where the labour market has played nearly no role. For example, the Eurozone in principle can go back to 2 without tightening. Same thing in Japan. But there are two countries where at least the baseline is that wage growth is too high, which is the UK and the US, of the countries I’ve looked at. I’m sure there are other countries somewhere.

So if you take the US, we have wage growth, which is probably 1 to 1.5 per cent too high to get to 2 per cent price inflation. So if nothing unusual happens, you know, we may be stuck at 3 per cent. But good things could happen. It could be, for example, something which seems to have some validity is productivity growth is higher. So for a given wage growth, the higher productivity growth, the lower the inflation rate. And that seems to be happening. So if productivity growth continues to be really strong, good.

This other issue which is more technical is how we measure tightness in the labour market. And traditionally people use the unemployment rate. In the work we did with Ben, we did what I thought was the right thing, which was to use the vacancy unemployment ratio, because it basically captures how firms look at the market and how people look at the market. And this went up a lot. Looked like an incredibly tight labour market, but it has shifted back a lot. So vacancies have come down. We’ve had unemployment increasing. If this continues, then that’s good news because the labour market gets quieter without the large increase in unemployment.

So I would say my best guess is that we probably need a bit of slightly higher unemployment to get to 2. But the Fed is not in a hurry to get to 2. It wants to send the signal, but it doesn’t want to do it next quarter. And we could get good breaks. So I still think the probability is that we have to have a high unemployment. I don’t want to give a number, but I’ll give a number — say, between 4 and 4.5 for some time. But maybe we can avoid it altogether. Not sure, but it’s not impossible. 

Soumaya Keynes
I mean, even that worst scenario that you just outlined in some ways could be seen as quite optimistic, just because this soft landing that we appear to be experiencing in the US is historically very unusual. Mostly when the Fed starts hiking and slowing down the economy, you know, you start off slow, but then you really start falling off the cliff and things go very badly wrong. Are you worried about that happening? 

Olivier Blanchard
Anything can happen. But again, I still think that they are not hawkish to the point of saying we want to get to 2 next year. And if they’re relaxed about it and expectations remain very anchored, which they are, then I think we don’t need a whole lot of unemployment. Now, it’s true that, you know, according to the algebra and the estimated equations, you need a lot of unemployment to settle things down. But again, we are not very far from the goal. They are not eager to go too fast. So I would be surprised — absent other shocks, which they will come — if we had to go to much higher unemployment numbers. 

Soumaya Keynes
Do you think that there are any bigger lessons that economists should take away from this episode? I mean, you know, you’re the author of one of the main economics textbooks. Is this, is it going to be updated for this episode in any way? 

Olivier Blanchard
Yes, somewhat. I have a sense — maybe it’s just reflex or big ego — that understand what has happened when my textbook gets called. But again, the inflation did not come from where I thought it would come. I think we thought of labour as the factor which puts pressure on. And what we learned this time, it was not labour, it was other. So, for example, the role of commodity prices in response to demand, I think, is more important than I thought. So I would say I’ll keep the chapter, but I may rewrite a section, but no more than that. 

Soumaya Keynes
OK. Very good. 

Olivier Blanchard
Coming from somebody who has been quite willing to change his mind on many things, this one, no, I don’t lose sleep. 

Soumaya Keynes
OK. Well, do you think policymakers should be losing sleep? Do you think they should be learning any lessons from this? 

Olivier Blanchard
Well, I mean, the the great lesson is that inflation expectations remained amazingly grounded, which was not obvious in the light of a very large increase. So it’s clear that the investment in credibility that central banks have made has paid off. I think that’s a big . . . that’s a big lesson. I was surprised at how little, even one-year expectations didn’t move at all, as much as actual, and five- to 10-year, even less so. So I think that’s the lesson. I think that central banks have really much more credibility today than they used to be. And therefore these shocks can, you know, they have effects, but they go away. I think that’s the lesson. 

Soumaya Keynes
How worried are you about a potential Trump presidency kind of undermining that credibility, undermining the independence of the Fed? 

Olivier Blanchard
Clearly, there are many measures you can take which have an influence on the economy, obviously. But with respect to that one, he can put at the Fed somebody who will obey orders and keep rates too low when it’s not appropriate. I think that’s quite possible. The names which are bandied around, I think more or less reasonable. But clearly the temptation to call the Fed and say you keep the rates low is a temptation he may not be able to resist. 

Soumaya Keynes
OK. We’ll shoo in it there. OK. But more concretely, I mean that the Fed is about to go through its next review of its framework. There was the Bank of England that is thinking about how to respond to Ben Bernanke’s review of its practices. Do you think that these central banks’ frameworks should be updated at all or not really? 

Olivier Blanchard
I have not worked on it. I have kind of reactions from somebody who has not thought very, very hard about it. I think that the Fed in general, I think the central banks did a good job this time. So I don’t see any reason to start from scratch. I think the kind of inflation targeting model seems to work, and this was a fairly tough one. And we went through it. It was not catastrophic. I think we all have mixed feelings about the use of quantitative easing, which is a lot of money for not much. We have probably some side effects which we do not love. So I think this has to be looked at again, which leads to the question of, you know, how likely are we to hit the zero lower bound again? And I don’t think the danger is gone. I think Japan is still very much flirting with it. I think in Europe it may also happen again with some positive probability. In the US for the moment, we’re going, you know, full speed. So it’s not an issue now. But again, it’s a dangerous tool. I think it was useful, but thinking about it is clearly essential. 

Soumaya Keynes
Do you think that central bankers should revise or rethink their attitudes to inflation versus unemployment? So, you know, one of the possible interpretations of this recent episode is that people really, really hate inflation. Maybe even more than central bankers thought. Now that there is, I think, a very reasonable argument that actually that’s not the conclusion that we should take. But what’s your view? 

Olivier Blanchard
It’s very interesting. But, you know, when inflation was running at 10 per cent or so, we didn’t like it, but we had adapted to it. It was fine. I mean, it was not great, but we didn’t lose sleep. I think now people have gotten used to a much lower rate, and any increase is perceived as terribly costly. Now is it, you know, a transition, if we went back to much higher inflation we would again adapt? Or is there something deeper? Yeah. My sense is people dislike, very much dislike inflation. So I would say that keeping a, you know, a low target is still of the essence. Now there’s a discussion about the target. I think again, the lower the target, the more you play with the risk of being at the zero lower bound. And so my sense is the target could be a bit higher. But . . .  

Soumaya Keynes
Is now the time to change the target? 

Olivier Blanchard
No, most definitely not. I mean, when you have a goal, first you satisfy the goal, then you say, well, maybe we should have designed the race differently. So I think it’s very important to go back to 2 and then have a discussion. Going back to 2, but not full speed, which is a discussion we had earlier. I think we can take time. 

Soumaya Keynes
OK. Well look, why don’t we cut to a break now. But when we get back, I want to ask you about other tools we have at our disposal in case there is a hard landing.

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OK, we are back from the break. We have mostly been talking about monetary policy, but there is this other big beast over there called fiscal policy. If we do get a hard landing, if the monetary policymakers do mess this up by accidentally trying too hard to get to 2, and unemployment shoots up, what should fiscal policymakers be thinking about? 

Olivier Blanchard
First of all, hard landing may not come from monetary policy. It may just come from the fact that consumers get scared or whatever. I mean, in this case, we have, at least on paper, the whole set of fiscal tools we can use, right? We can give tax breaks to firms. We can give tax breaks to investment, can give tax breaks to consumption. So the set of tools we have is nearly infinite. And the question is: is there a way to use that in such a way that it really stabilises the economy?

And so, you know, the one which is already in place in many countries is unemployment benefits are made, the function of the level of unemployment. That seems fine. You can think of things which work at different margins. For example, you may have a decrease in the VAT in general, which gives an incentive for people to buy now rather than later. You can narrow it. You can have a decrease in the VAT on durables, on cars. That works very well because it really, if your car is cheaper by 10 per cent for a month, you’re going to do it. The question is how to put this in place in a way in which it’s automatic and doesn’t have that side effect. I think it can be done, and I think it should be done because, again, the zero lower bound is not this impossibility we thought it was 15 years ago. It can happen.

And fiscal, on paper, fiscal is a much better set of instruments. I mean, if you think this part of a consumption is weak, you can actually help that. Now the question is it tends to be abused because of the politics. And therefore you want to put in place things which are automatic and come in at the right time and stop at the right time. And so I’ve been working on this issue, and I think that we should consider it. We should consider variations in the VAT, for example, as a way of stabilising the economy. 

Soumaya Keynes
OK. Yeah. I mean the UK did that. I remember in the financial crisis in the Great Recession there was a temporary reduction in VAT. 

Olivier Blanchard
Yeah. Now, it has been used. But why not make it a regular tool which will work in most recessions and takes a bit of the weight away from monetary policy? 

Soumaya Keynes
OK. Well, any policymakers listening? You’ve had it here now. Time to put it in place. 

Olivier Blanchard
Yes. I can give my address, you know. 

Soumaya Keynes
(Laughter) Maybe no. OK. Well, before I let you go, I want to just to come back to one thing, you know, you’ve moved back to France. And a week ago now, there was this big announcement, which is Macron is calling an election. What’s the thinking behind that? And what effects do you think it could have? 

Olivier Blanchard
The thinking behind that is that the Rassemblement National and the other extreme-right party are clearly gaining by basically being opposed to everything. And if we let it happen for the remaining three years of a Macron presidency, there’s a very good chance that they will win the next election, right? So the question is, if you don’t like that scenario — and I’m going to be honest, I really don’t like it — what can you do? And I think that the idea of basically calling the bluff, which is what I think Macron has done, is the right strategy, which is to say, OK, we’re going to have elections. We’re going to see your program, not with respect to Europe, where you (inaudible), but for France, maybe we’re not going to do as well as you think. Maybe. In which case you’ll have to keep quiet. Or quite possibly you will actually do well. And I will name you, Mr Bardella, Madame Le Pen, prime minister. And then I’ll give you three years to make a mess.

And the reason I think that’ll make a mess is that the characteristic of these extreme-right parties is not so much that they’re extreme right. It’s that they’re totally — I’m going to use two words — incoherent and incompetent. The whole position that I put these parties, they just accumulate the anger. So they have a program which is totally unfeasible and further are stupid. And so I think that it may well be that the way we get this out of our system is actually to give them the reins for hopefully not for years, but some time to basically show their incompetence.

I mean, I have a sense, with a lot of adjustments, that’s what has happened in the UK in which, you know, the Conservatives have made, have messed up and at some stage Labour looks good. Now, I don’t think it was intentionally done this way, but I think there’s a sense in which Europe has to get that form of populism out of its system, and we may not be able to do it without giving them a chance. And that seems like the right time to say, you know, put up or shut up. Clearly it’s risky, but it may still be the best way to actually have a good president next time. 

Soumaya Keynes
Yeah. I mean, I guess in the US, you know, Trump did get elected. 

Olivier Blanchard
So there are plenty of counter-examples, I mean, plenty of cases in which this was tried and didn’t work: Hindenburg and Hitler, and Trump I and maybe Trump II. It is a risky strategy, but I think in the absence of that, Macron would be unable to do much for the next four years, and we would probably have the Rassemblement National as the major party in the presidential elections. So it’s not whiskers, but nothing is.

Soumaya Keynes
Olivier Blanchard, that is a great note to end things on. Thank you so much for being with me. 

Olivier Blanchard
Not sure it’s a great note, but that’s we face . . . 

Soumaya Keynes
Well, it’s a good way to finish . . .  

Olivier Blanchard
It’s what we face. Thank you, Soumaya. Always a pleasure. 

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Soumaya Keynes
That is all for this week. You’ve been listening to The Economics Show with Soumaya Keynes. This episode was produced by Edith Rousselot with original music from Breen Turner. It is edited by Bryant Urstadt. Our executive producer is Manuela Saragosa. Cheryl Brumley is the FT’s global head of audio. I’m Soumaya Keynes. Thanks for listening.

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