Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Sunday, August 6, 2017

A monetary-fiscal theory of inflation

On December 17, 2015, the FOMC has raised its policy rate (IOER) from 25bp to 50bp. It has since raised the IOER rate three more times to 1.25%. Many on the committee seem convinced that further rate hikes are needed (in addition to actions designed to shrink the Fed's balance sheet, which is already shrinking relative to the size of the economy). What is the source of this enthusiasm for monetary policy tightening, given that the unemployment rate is close to target, and given a PCE inflation rate that has been undershooting the Fed's 2% inflation target for several years now?

The short answer is the Phillips curve. Or, to be more precise, a belief in the Phillips curve theory of inflation. The basic idea is that at very low rates of unemployment, competition for workers will lead to higher wages, with the associated costs passed on to consumers in the form of higher prices. Even if this wage pressure has been largely absent to date, it will (form sign of the cross here) eventually happen, and it's better for the Fed to get ahead of the curve, rather than risk having to raise its policy rate abruptly (and disruptively) in the future.

But what if the Phillips curve theory of inflation is not the best way to guide our thinking on the matter? What other theory might we turn to for guidance? Binyamin Appelbaum of the New York Times discusses a number of alternatives here (which I review in my previous post). In addition to the Phillips curve theory, he mentions explanations that I labeled: [1] Monetarist, [2] Expectations, [3] Internationalist/Technology. I mentioned in my previous post that I'd return to examining the Monetarist view, which I think is too often given a short shrift. I explain below how the Monetarist view is consistent with [2] and [3]. There is also the question of what the Monetarist view implies for policy. While the Phillips curve view has turned doves into hawks, I argue below that the Monetarist view should turn hawks into doves (given the present state of the economy).
Many people feel Monetarism has been discredited because economists who employed the theory to predict the inflationary consequences of QE were proved embarrassingly wrong. But this is along the lines of viewing scissors as a lousy tool because many barbers have used scissors to give awful haircuts.

To be fair to their critics, Monetarists sometimes overstate the role of money supply in determining the price-level and inflation. But let's also give credit where credit is due. We know how to create inflation. Just look at Venezuela today. No one can take seriously the notion that inflation is very high in Venezuela because the unemployment rate is far below its natural rate. Moreover, we know how to stop inflation. Tom Sargent's The Ends of Four Big Inflations showed us how it was done in history. Our understanding of these episodes revolve around Monetarist explanations that also take seriously fiscal considerations. Why can't the same theory be used to understand the present low-inflation environment and help guide policy? I think it can.
By the way, I've worked this all out in an open-economy version of the model I describe here. But nothing I say below hinges on this specific formalization; the basic idea is much more general. The two essential elements are: [1] safe government debt is a close substitute for central bank money; and [2] the demand for government money/debt can wax and wane over time (perhaps in St. Louis Fed regime-switching style).

The first property is important for understanding the economic consequences of open-market operations like QE. In the old days, when U.S. treasuries were yielding (say) 10% and Fed reserve liabilities were yielding 0%, an open-market swap of money for bonds could be expected to have a big effect. The same size open-market swap in a world of 1% reserves and 2% treasuries is not likely to have as great an impact. In the extreme case where reserves and treasuries have identical yields, open-market operations are not likely to have any effect at all--apart from inducing banks to accumulate excess reserves (in place of the treasuries they would have otherwise held). I think this is the main reason for why large-scale asset-purchase (LSAP) programs have had much smaller effects than what many had expected.

The fact that bonds become close substitutes for money when their yields are similar explains how the supply and demand for bonds can influence the inflation rate. Normally, we think of an increase in the demand for bonds as lowering bond yields. This is correct. But what happens when those yields approach the corresponding yield on interest-bearing money? (In the old days, when interest on reserves was zero, this limit was called the zero-lower-bound). An increase in the demand for bonds in this case must manifest itself in other ways. One way is for the price-level to fall. That is, a market-mechanism for expanding the real supply of nominal bonds is for the price-level to fall. One way this manifests itself is as China selling its goods for less USDs to acquire the USTs it so desperately wants.

The second property is important for understanding how inflation can fall even in the face of a growing supply of money/bonds. Admittedly, a bit of religion is required here, but I'm not sure what else to believe in. Suppose we can observe the supply of oil. We see a sudden increase in the supply of oil. At the same time, we see the price of oil rise. While the demand for oil is not directly observable, I think it's fair to say that most people would conclude that the (unobserved) demand for oil must have increased by more than the (observed) increase in supply. I want to apply the same thought-organizing principle to the price of money and bonds.

The story is familiar to those who point to declining money (and debt) velocity. In my formal model, I have a parameter that indexes the growth rate in the demand for real money/bond balances (where money and bonds take the form of USDs and USTs, respectively). In the open-economy version of my model, I have a "money demand growth regime" originating from the foreign sector. In the model, this regime translates into persistent U.S. trade deficits, representing the foreign sector's desire to acquire USD/UST at an elevated pace. There is in fact considerable evidence suggesting a large and growing foreign appetite for U.S. money/bonds over the past decade. Japan and China have each accumulated about one trillion dollars in USTs, for example. Moreover, it is known that USTs play an important role as exchange media (collateral) in credit derivatives markets and the shadow banking sector. Lately, the demand for such securities has been enhanced by a variety of regulatory reforms targeting the banking sector.

Bringing these elements together, the story that unfolds goes something like this. For years, several forces have conspired to elevate the (growth in the) demand for USD/USTs, driving yields ever lower. The financial crisis and associated "flight to quality" phenomenon served to exacerbate this secular force (with subsequent regulatory reforms adding to it further). Given an historically normal pace of money/debt expansion, these forces would have been hugely deflationary. The effect of the large increase in USTs following the crisis was to counteract this deflationary effect. But the U.S. debt-to-GDP ratio has essentially flat-lined since 2013. In the meantime, demand for the product continues to grow. With bond yields very close to the Fed's IOER rate, the result is persistently low inflation. And it's no surprise that now, after years of low inflation, that inflation expectations remain subdued.

No doubt some of you will find holes in this story, some inconsistencies perhaps, with past episodes or other countries. But I'm not claiming that this is the story; I'm simply suggesting that it may be an important part of it. And to the extent that it is, what does it imply about the current configuration of monetary and fiscal policy?

In my model, raising the policy rate in the face of stable or declining inflation has the effect of increasing the attractiveness of government money/bonds. The model highlights a portfolio substitution effect where savers redirect resources away from private capital spending (including expenditure on recruiting activities) toward money and bonds. The effect is contractionary. Is this really what we want/need right now? Moreover, in my model, the effect a higher policy rate on inflation depends critically on how the fiscal authority responds. (As Eric Leeper and others keep on reminding us, every monetary policy action must have a fiscal consequence.) A higher policy rate will increase the carrying cost of the debt, and Fed remittances to the U.S. treasury will decline. How will this added fiscal burden be financed? If the government makes no adjustment to its tax/spend policies, then the treasury will be forced to increase debt-issuance at a more rapid pace--an effect that is likely to increase the inflation rate (a result consistent with the so-called NeoFisherian view). Alternatively, if the government goes into austerity mode, cutting expenditures and/or raising taxes, the effect is likely to be disinflationary. This is all based on standard Monetarist thinking--we do not need the Phillips curve (which, by the way, exists in my model via a Tobin effect).

To the extent that the forces I've described above are present in reality, the analysis here calls into question the need for monetary policy tightening too rapidly at this time. Low unemployment does not necessarily portend higher inflation. And keep in mind that other measures of labor market activity, like the prime-age employment-to-population ratio, are still below their historical norms. Of course, this does not mean that monetary policy makers can afford to ignore the threat of inflation. While the worldwide demand for U.S. nominal debt instruments has been robust for a long time now, this "high U.S. money demand" regime is not likely to last forever. When the growth in money demand abates, the consequence is likely to manifest itself as higher inflation expectation (and bond yields)--much like what we observed following the November 2016 presidential election in the United States, except on a much larger scale. A good policy framework should make provisions for these and other contingencies, including sudden changes in the structure of fiscal policy.

Let me sum up and conclude. An elevated demand for U.S. dollars and treasuries has put downward pressure on bond yields and the inflation rate. Both the Fed and U.S. Treasury have partially accommodated this elevated demand. The result is a PCE inflation rate averaging about 1.5% since 2009, only 50bp below the Fed's official 2% target. The economic losses (or gains) associated with this "missing" 50bp of inflation going forward are difficult to quantify, but it's difficult for me to imagine that they are very large (and especially at this point in the recovery dynamic, where inflation expectations appear roughly consistent with the actual inflation rate).

But suppose that I am wrong and that it would be desirable to raise the price-level path back to its pre-2008 trend (something that would require a few years of inflation running above 2%). Is this even economically feasible? Does economic theory and experience provide a recipe? The answer is yes: have the central bank monetize the deficit until the price-level hits its target. (If the price-level never rises, then the government can enjoy a perpetual free lunch, cutting taxes and paying for goods and services with newly-issued non-inflationary money.)

But don't hold your breath for this to happen anytime soon. The constraints in place are not economic, they are political. Many public officials and the people they represent are growing uncomfortable with historically high debt-to-GDP ratios and large central bank balance sheets. They see the large supply of government debt, but they cannot see the large demand for the product driving yields down. Instead, they interpret low interest rates as enabling a large supply. And so, political pressure is presently running in the direction of austerity and smaller central bank balance sheets. Of course, if this is what the people want, this is what the people should get. But then, let's not spend so much time fretting over a 50bp miss on inflation, or bemoan the apparent lack of a coherent theory of inflation.


PS. This post was motivated in part by Noah Smith, who tweeted:

I discuss the case of Japan in greater detail here: The failure to inflate Japan


  1. David: this sounds reasonable to me. Reminds me a bit of old stuff by Brunner & Meltzer, or maybe Tobin. Monetarism, but where the demand and supply of the stock of bonds matters too.

  2. I'm not an economist but this pretty much exactly describes the mental model that I ended up with reading the econo-interwebs in the past few years.

    One aspect that I find is key: "The model highlights a portfolio substitution effect where savers redirect resources away from private capital spending (including expenditure on recruiting activities) toward money and bonds."

    A lot of people seem to prefer a tighter monetary stance as a way to prevent too much investment and bubbles in private markets. However this doesn't remove the need for investment to underlie people's savings but shifts savings towards government paper and puts the responsibility on the government to generate the returns and the production capacity necessary for these savings to be redeemable for stuff later. Is the government up to the task? What will happen when a cohort of boomers switch from being savers to consumers and investment haven't necessarily been made to produce the things they want to buy? Is the plan just to redeem IOUs from the next generation, even though the youngsters were underemployed while the boomers were saving because these savings were not properly making their way into capital?

    "For years, several forces have conspired to elevate the (growth in the) demand for USD/USTs"

    Could this just be marginal investment in new private capital having lower real returns (can't reproduce the growth of the 20th century) pushing savers to find alternate ways to store their wealth and finding short term government paper having above private market returns on a risk adjusted, liquidity adjusted basis because they are pushed up by tight money?

  3. "An increase in the demand for bonds in this case must manifest itself in other ways. One way is for the price-level to fall. That is, a market-mechanism for expanding the real supply of nominal bonds is for the price-level to fall."

    Am struggling to understand exactly how this works. Once bond yields are equal to yields on money, the two are substitutes. Subsequent investor demand for bonds is now just as likely to manifest itself as a demand for money as it is for bonds. And that portion that is expressed by purchases of money can push the price level down if it accommodated by the central bank? Maybe you have something else in mind?

    1. JP, all I have in mind is the following. When the yield on bonds falls to yield on money, they are essentially perfect substitutes. What is relevant for the price level now is the total money supply, not its composition between money and bonds. Hence, an increase in the demand for bonds is like an increase in the demand for money, and is disinflationary.

  4. David, assume the central bank can credibly commit to a permanent expansion of the monetary base and this expansion is not sterilized via something like interest on reserves. In this case, the yield on monetary base and treasury bills would not be the same (because of expected inflation) and they would cease to be perfect substitutes.

    This scenario is unlikely in our world, but it is not impossible. Given this possibility, what does this imply about why the demand for treasury securities matter for spending and inflation?

  5. My major is economics. But I didn't get this point:

    "An increase in the demand for bonds in this case must manifest itself in other ways. One way is for the price-level to fall. That is, a market-mechanism for expanding the real supply of nominal bonds is for the price-level to fall".

    I would be grateful if you could possibly guide me about it.

    1. Ahmad, please see my reply to JP above. Thanks.

  6. Inflation: back to basics
    Comment on David Andolfatto on ‘A monetary-fiscal theory of inflation’

    David Andolfatto argues from a sophisticated model: “In my formal model, I have a parameter that indexes the growth rate in the demand for real money/bond balances (where money and bonds take the form of USDs and USTs, respectively). In the open-economy version of my model, I have a ‘money demand growth regime’ originating from the foreign sector. In the model, this regime translates into persistent U.S. trade deficits, representing the foreign sector's desire to acquire USD/UST at an elevated pace.”

    Basically, in this model deflation/inflation is driven by what happens on the UST market. This is in line with the commonplace Quantity Theory which holds that a smaller or broader composite called ‘quantity of money’ determines the price level.

    Now, it is well-known that the familiar models, which are either from the Walrasian type (= microfoundations) or the Keynesian type (= macrofoundations), are axiomatically false. Because of this, monetary theory has to be based upon entirely new macrofoundations.#1

    In order to go back to the basics, the pure consumption economy is for a start clearly defined by three macro axioms (Yw=WL, O=RL, C=PX), two conditions (X=O, C=Yw) and two definitions (profit/loss Qm≡C-Yw, saving/dissaving Sm≡Yw-C).#2

    Money is needed by the business sector to pay the workers who receive the wage income Yw per period. The workers spend C per period. Given the two conditions, the market clearing price is derived for a start as P=W/R. So, the price P is determined by the wage rate W, which has to be fixed as a numéraire, and the productivity R. From this follows the average stock of transaction money as M=kYw, with k determined by the payment pattern. In other words, the quantity of money M is determined by the AUTONOMOUS transactions of the household and business sector and produced out of nothing by the central bank. The economy never runs out of money.

    The transaction formula reads M = (k/rhoE)*P*O, with the ratio rhoE defined as C/Yw, and this yields the commonplace correlation between quantity of money M and price P, except for the fact that M is the DEPENDENT variable.

    The market clearing price is given in the general case with the price formula P = (rhoE)*(W/R). An expenditure ratio rhoE greater than 1 indicates credit expansion = dissaving, a ratio rhoE less than 1 indicates credit contraction = saving. In the initial period rhoE = 1, i.e. the household sector’s budget is balanced. The ratio rhoE establishes the link between the product market and the money/capital market.

    Now we have: deficit spending, i.e. rhoE greater 1, yields a price hike. If deficit spending is repeated period after period the price remains on the elevated level but there is NO inflation. No matter how long the household sector’s debt increases, there is NO accelerated price increase.

    The price formula makes it clear that inflation only occurs if the wage rate W increases in successive periods faster than productivity R. This can happen at ANY employment level. It is NOT a precondition that employment is close to the capacity limit. This is merely a false interpretation of the Phillips curve.

    The current deflationary trend is caused by the fact that (worldwide) wages lag behind productivity growth. To turn this trend around it does not matter much what happens on the market for UST, what matters is that goverments/central banks engineer a coordinated world wide increase of the average wage rate.

    Egmont Kakarot-Handtke

    #1 First Lecture in New Economic Thinking

    #2 For the detailed description see ‘How the intelligent non-economist can refute every economist hands down’

  7. I find this post strange. You begin by writing that your model is Monetarist but then give reasonable arguments that could have been made just as easily by someone using one of the other three models.

    Your explanation that the increase in demand for bonds coincided so closely with the increase in the monetary base that it caused neither high inflation or deflation is possible but implausible. Yet the Monetarist framework seems to require this.

    As you have pointed out several times, the unemployment rate is a very imperfect proxy for slack in the labour market and other measures like the employment rate tell a different story. The Phillips Curve Model allows for almost exactly the same conclusions as the Monetarist regarding the situation we are in. So why use the Monetarist Quantity Theory? What does it add?

    1. It adds this: that policymakers should not expect labor market tightness to generate *inflation* (as opposed to real wage gains) without accommodation from the monetary and fiscal authorities.

  8. David A-

    Hmm. Let's look at this backwards.

    A decrease in the unemployment rate, even to 3%, may have little or no impact on the reported rate of inflation.


    When Blanchard wrote the 2016 paper, unemployment was higher. Looks like the unemployment rate (as measured) fell by a few percent, with no effect on reported inflation. For that matter, inflation has hardly budged since 2008.

    I suspect quite a bit of output has been given up, possibly even enough to bring us back to the 2008 LT and trend, just to squeeze 1% out of inflation.

    BTW, from 1982 to 2007, the average US GDP real growth rate was 3+% and the average rate of inflation just under 3%. That is recent history in the US, not theory. So perhaps a lot of real output, profits and wages is being given up to squeeze out the last 1% of inflation.

    Maybe, as a practical if not theoretical matter, we live in a 3% inflation for 3% real growth or 2 for 2 world.

    If so, is 3% inflation a good policy goal?

    Egads, I can remember when the WSJ opined Volcker was too tight, that inflation was under 5%. Milton Friedman chastised the Fed for being too tight in 1993, when inflation was more than 3%.

    Is a peevish fixation on inflation a good monetary policy?

    Benjamin Cole

    1. " I suspect quite a bit of output has been given up, possibly even enough to bring us back to the 2008 LT and trend, just to squeeze 1% out of inflation."

      What makes you say that?

      The answer to your last question in my view is yes, at least, in the sense of establishing an inflation corridor. There is little else one can (or should) expect from a central bank. Fiscal policy must take more responsibility during a severe downturn (by increasing transfers, cutting taxes, or both). Much of this already happens naturally via automatic stabilizers. As for secular slowdowns, once again, it is the government's responsibility to review the nature of the regulatory environment and ascertain what if any reforms are needed. This is not a job for the monetary authority.

  9. David-

    An inflation corridor, or inflation band is used by the Reserve Bank of Australia, with arguable success. If you must target inflation, then go with an inflation band, and keep it loose, like 2% to 4%.

    And what role then for QE?

    Adair Turner says we should ponder money-financed fiscal programs. I agree.

    As for the regulatory quagmire that is every developed nation, I am always eager and ready to cut regulations.

    The first thing to cut and the largest structural impediment: Property zoning.

    I hope to see a series from you on the depravity of property zoning.