Back in January, Jeffry Frieden and I argued for higher inflation, conditioned on macro conditions, in a Foreign Policy article. The roster of economists in favor expands: Nobel laureates Rob Engle and Paul Krugman join Chicago Fed President Charles Evans, for the US.
Regarding the eurozone, the Economist has argued that Germany must reflate. Simon Wren Lewis provides another argument for a looser monetary policy based on (what I take is) a credit-based model of income determination (undergraduate level algebra here).
From Whip Up Inflation Now:
[We need] inflation — just enough to reduce the debt burden to more manageable levels, which probably means in the 4 to 6 percent range for several years. The Fed could accomplish this by adopting a flexible inflation target, one pegged to the rate of unemployment. Chicago Fed President Charles Evans has proposed something very similar, a policy that would keep the Fed funds rate near zero and supplemented with other quantitative measures as long as unemployment remained above 7 percent or inflation stayed below 3 percent. Making the unemployment target explicit would also serve to constrain inflationary expectations: As the unemployment rate fell, the inflation target would fall with it.
We believe that now is the time to act, as the US recovery sputters along, and the austerity-based approach in the Eurozone shows a need for revision. Higher inflation would serve to erode real debt, both private and public; it would also ease the adjustment of relative prices and wages, as an alternative to internal devaluation via nominal price/wage changes. Both US and eurozone inflation rates are relatively low right now.
Figure 1: Twelve month inflation rates for US Personal Consumption Expenditure deflator (blue), and for Eurozone Harmonized CPI (red). Source: BLS via St. Louis Fed FRED, and ECB.
Furthermore, we can act because inflationary expectations are anchored at low rates. Two year ahead inflationary expectations expectations for the US and the eurozone are both low.
Figure 2: Survey based expectations for PCE inflation over the next two years (blue), and for eurozone HCPI inflation (red). Source: Philadelphia Fed Survey of Professional Forecasters median, and February ECB Survey of Professional Forecasters, both February 2012.
Now, as Jim has pointed out, merely raising a target inflation rate (or declaring a nominal GDP target) does not mean that the mechanics are straightforward. But my personal view is that, the costs of enduring years of high unemployment is too high, relative to the costs of exceeding target inflation, especially if it is made clear that the target increase is conditional on the state of the economy.
If the basic economic problem is inadequate demand
I find it hard to accept that higher inflation –or just inflation expectations –will lead to
stronger growth because higher inflation would dampen real income and spending growth. It just takes you back to the original problem — inadequate demand.
excellent blogging.
Bernanke in 2010 and 2012 gave us the framework, a balanced Taylor rule: x% higher inflation as long as the output gap was -x%.
I think Evans now favors ngdp targeting, which itself is a version of conditional inflation targeting (new, improved, IMO).
I prefer ngdp targeting as a better version because of the committment to keep the output gap small over a whole path (really, minimize the variance of p*y over a path).
Evans and ngdp: http://www.theatlantic.com/business/archive/2012/05/a-rebellion-at-the-federal-reserve/256601/#
Beckworth: http://macromarketmusings.blogspot.com/2012/05/monetary-policy-change-james-hamiltion.html
I have to agree with Spencer. A consequence of high unemployment is that on average workers possess little bargaining power. Therefore inflation during a period of high unemployment seems like it should depress real incomes, which would seem to offset at least some of the benefit associated with reducing the debt burden (not to mention making the lives of millions of currently employed and soon-to-be employed people just a little more difficult). Am I missing something?
Rodrigo and Spencer: In the original Foreign Policy article, we made clear the main point would be to work on the asset/liabilities side. I have added text in italics to stress that point.
I agree, we need inflation. But how do you channel inflation into wage increases accross all sectors of the economy. Every hint at a recovery seems to trigger another round of hyper speculation on oil and other commodities. Oil has become the black hole of inflation, sucking up any hint of a wage increase someone might have. So for most, unless you work in the oil industry, inflation isn’t helping.
Menzie,
A wave of your hands and placing text in italics does not solve the problem if wages turn out to be stickier than prices.
After 7 years of 6% output price inflation the price of goods will increase by 50%!
Readers – Raise your hands if you think your employer is going to increase your wage by 50% over the next 7 years. (Add the Obama tax increases necessary to sustain the trillion dollar deficits and we will all be on foodstamps!)
Your inflation policy also aims to use monetary policy to keep interest rates low, and thus the rate paid on fixed income low. That stratgey will wipe out pensions.
So let me see if I have your inflation policy right – In order to reduce the debts of countries and individuals who borrowed more than they should have, you want to destroy the incomes/pensions of everyone else.
The statement “Furthermore, we can act because inflationary expectations are anchored at low rates.” is very misleading. Inflation expectations are anchored because monetary policy is committed to a 2% rate. As soon as you change policy, inflation exceptions will move in conjunction.
While this may be more of a problem for low-income/fixed income people, this is a brilliant way to devalue the federal government’s debt. But why be so meek? If we could inflate prices by twice, we could effectively cut the debt in half.
We should pass that now!
If you have savings, you need to spend it all now so that you have assets for bartering later. But if you don’t, too bad. We need to inflate prices so that it appears the economy is doing well.
We should pass that now!
If you are burdened with too much debt that you took on during a period of foolishness, make sure it is fixed rate debt and don’t do anything. When we get inflation up and running again, you don’t have to work any more to get rid of that debt much easier.
We should pass that now!
Let’s inflate wages and home prices and food prices and energy prices and we will all be much richer.
We should pass that now!
Yep! But “Unconditional higher NGDP Now!” would make a clearer slogan.
To TJ and Bruce Hall and other austerian commenters:
Your facile predictions of dire inflation (e.g., TJ’s breathless comment that “After 7 years of 6% output price inflation the price of goods will increase by 50%!”), while bordering on witty, are merely intended to knock down the various strawmen erected by the do-nothing crowd over the past four years.
Notice the word “Conditional” in the title of Menzie’s post. You can have a short-run (i.e. 2-year) inflation and put the brakes on inflation very quickly (see Volcker, early 80s). She is also not advocating 6%+ inflation – and I can’t think of a commenter who is. 4-5% would be great. I think the disconnect here is that those arguing that we must keep inflation at 2-3% are unwilling to accept (or admit) that the Fed has any real power to manage inflation over anything approaching a medium-term basis.
But why? Is it just an inexorable drive to stick it to those people whom Bruce Hall excoriates for “too much debt…you took on during a period of foolishness“? It must be exceedingly tiresome, being driven by so much animus. I guess I was “foolish” to attempt to “rise above my station” and pursue a law degree between 04 and 07 only to have the market for new lawyers evaporate – albeit without a corresponding evaporation of my $150,000 in law school debt.
I think the true foolishness, here, is that commenters like TJ and Bruce Hall think that their blithe condemnations of the metaphorical “grasshoppers” from their secure perches amongst the “squirrels” belies the myopia of those who think that living in a permanently depressed economy is any better for the well-to-do than it is for the “lucky duckies” with too little income to owe income taxes (but let’s remember, they pay a higher percentage of their income in payroll taxes than you do). Notice that the rich of the 3rd world don’t spend much time there – they’d rather fly off to Marbella, Necker’s Island, and Capri. I guess you must have travel plans.
As I understand it, Jim’s objections regarding the mechanics amount to there being some risk to the Fed using extraordinary measures (such as large scale purchases of long term debt) to try to meet higher inflation targets. So Jim suggests the Fed should only promise to use aggressive measures if inflation were to fall below 2%.
But this shouldn’t prevent them from also promising NOT to intervene unless inflation were to rise above a higher target, say 4%. I think that announcing such a range, and admitting that the Fed would need some help, for example from fiscal policy, to reach a higher target and produce a stronger recovery, would only increase credibility.
Right now, I think the concern with the 2% target is the danger that the Fed would choke off a nascent recovery, as it has too often in the past, before wage increases have a chance to take hold.
Jeff: Your certitude is admirable. I wish I “knew” things as confidently as you do.
tj: My assumption is that wages *are* stickier downward than prices, but not necessarily stickier upward. I think this is particularly true in European countries.
An alternative view to Menzie’s pro-Dem drivel:
http://faculty.chicagobooth.edu/raghuram.rajan/research/papers/FA%20May%202012.pdf
Menzie,
Regardless, the policy you promote seems extrememly distortionary. Repsonsible folks don’t want their savings destroyed just so some irresponsible borrowers can receive an indirect bailout.
The bottom line is that if the electorate in the EU and the US don’t want to finance spending growth with higher taxes, then the growth rate in spending needs to be reduced.
It’s unfortunate that the electorate in the EU don’t seem to want either higher taxes or a reduction in the growth rate of government spending.
Menzie, I know you think you’re being cute with that comment, but the truth is that your statement is just as affirmative as mine. How do you “know” expectations are anchored to something other than policy?
Rob says: “I think the true foolishness, here, is that commenters like TJ and Bruce Hall think that their blithe condemnations of the metaphorical “grasshoppers” from their secure perches amongst the “squirrels” belies the myopia of those who think that living in a permanently depressed economy is any better for the well-to-do than it is for the “lucky duckies” with too little income to owe income taxes (but let’s remember, they pay a higher percentage of their income in payroll taxes than you do).”
This has nothing to do with fixing anything. It is a blatant call to devalue the dollar and screw everyone… those who have lent money at low interest rates during this downturn… those who have attempted to save money at low interest rates during this downturn… those who have lived within their means during this downturn. All this does is make it easy for those who were irresponsible [including a federal government that spent enormous sums of money with no real plan] to escape the consequences of being irresponsible while screwing everyone else with higher inflation and costs. The ultimate passing the buck.
But beyond that, it won’t work. If the Fed jacks up the discount rate to 5 or 6 percent, guess what happens. Nothing. Literally. Who would want to borrow at 5 points higher than current rates when there is no payback… no demand for their higher priced output? The economy stops the anemic growth that it has and sinks like a rock into the muck. But then the government will spend billions more enlarging the “safety net” to catch the people it just kicked off the productive sector.
Why not just declare a 2-for-1 dollar split and get it done? Or is it the frog in the pot of warm water with a fire under it approach to washing away private wealth to fix the government’s debt that you think will go unnoticed?
Robert,
For an intelligent rebuttal to Raghuram’s nonsense, see Noah Smith’s blog “Noahpinion”.
Might be time for one of those Greek Euro posts again: implications of exit, additional defaults, etc. Importance for Spain, Italy, France, etc.
What silly scoffers!
Of course, inflation can be turned up and turned down just like a gas stove. We have had great success with this in the past.
All we need is to elect the right Democrat politicians who put smart Democrat economists at the controls. Everyone will then agree that just as soon as full employment is reached, the cute little bearded economist du jour will reach out, twirl the dial down and – smooth as butter – inflation will tail off and all the happy little workers will vote liberal for ever and ever.
Such a sweet story…how evil to jeer at it.
Bluntly,tiring to read the same panaceas since few lost decades.The contribution of the Phillips curve is convenient,but inoperative at this level of interest rates (please see the intersection of the LM curve and actual negative interest rates)
Banks are still technically bankrupts,central banks the same,inflation will add to their ploy.
Assets prices, financial and real estates are at Weimar levels.Private debts in France 75% of GDP,municpalities 75% of GDP public debt 85% of GDP historical height since few decades.Interesting, would be the effects of interest rates swaps with higher inflation.
All the burden of unemployment is shifted on monetary policies.Europe and USA do not even share the same domain of definition when it comes to inflation components but should implement the same monetary policies?
Prosaically,academics and politicians should use the commun transportation more often and listen.
A friend and I were discussing what economic conditions will look like in January 2013 after the election. He sent me the following comment:
If Obama wins and the Repubs keep the house, then there may be no meaningful change in the tax increases that build in for Jan. 1, 2013. That includes a big increase in Estate Tax, Cap Gains, Dividends and of course personal income tax rates as described above. It also means forced cuts in Defense and entitlement programs.
We have been discussing the austerity actions by the European governments and tax increases at the same time. Another of my friends calls this “Aztec Economics”, i.e. lots of human sacrifices to make sure the sun keeps rising, will only serve to auto-cannibalize our political economy.
In January 2013 the US will face Aztec Economics whether Obama or Romney are elected. Romney will probably do the most to reduce the pain but the die is cast. The increased taxes will cause the yield on stocks to plummet resulting in declining stock prices, and the cooked-in budget cuts, as mentioned by my friend, will add to the pain. Our government has created a very bad situation for us all, Republican and Democrat.
Collecting more statistics should be the least of our concerns.
Menzie Wrote:
tj: My assumption is that wages *are* stickier downward than prices, but not necessarily stickier upward. I think this is particularly true in European countries.
Wages are probably not necessarily stickier upward than prices, but do you think they might be in an environment with very high unemployment and lots of excess capacity?
If the mechanism through which inflation impacts wages is that workers demand higher pay in response to higher prices, but the labor market is such that workers have little bargaining power with which to gain their demands, it seems like the result of inflation should be that prices rise but real wages decline.
Am I misunderstanding the situation, or the mechanism, or possibly your assertion?
Here is a link to Noah’s piece. It’s a sad joke.
http://noahpinionblog.blogspot.com/2012/05/riled-by-wrongness-of-raghuram-rajan.html
Reading a selection from a macroeconomics text, the text says that “In the long-run, increases in the supply of money do not increase real GDP—they only lead to inflation”. Since M1 has increased by about 20% since August of 2011 and M2 has increased by about 10% since August 2011, when can we expect inflation (when do we arrive at the long-run)?
I’m fine with more easing and running a short-term deficit so long as goverment 1) Refinances current, good-standing bubble debt at near treasury rates 2) Cuts spending (not reduce spending increases) 3) Treats capital gains similar to income 4) Simplifies taxes 5) Reduces regulation, increases competitiveness (reduces subsidies and potectionism), and makes employment less risky and expensive.
1&2 are required before easing, the rest can begin soon after.
If easing is done before 1, it will only make the debt burden worse as discretionary disposable income will fall for workers.
Rodrigo,
Good point.
In relative terms, which workers stand to gain the most from inflation? The answer is anyone who has their wage pegged to the inflation rate. Most non-union private sector workers do not have an annual COLA built in to their contract.
Furthermore, many states have huge unfunded public pension liabilities. Public pensions have a built in COLA. The benefit of higher inflation on outstanding public debt will be offset by outstanding pension liabilities growing at the rate of inflation.
A better long term solution is to simply reduce the growth rate of government spending to something between 0% and 2% while GDP and the growth rate of tax revenue grow at more than 2%.
I think Menzie is concerned with reducing the real value of private debt like mortgages and student loans so debt service becomes less of an economic drag, rather than with public debt.
tj, excellent points.
On the pension liability, I wonder if this greatly increases the long-term budget risk for government and union companies.
Rodrigo and tj
the labor market is such that workers have little bargaining power with which to gain their demands, it seems like the result of inflation should be that prices rise but real wages decline.
Please explain how you think it might be possible to have sustained inflation without an increase in unit labor costs? Workers have little bargaining power because of large scale unemployment, not because of inflation. If you want to give workers more bargaining power, then fix the unemployment problem.
Most non-union private sector workers do not have an annual COLA built in to their contract.
And what makes you think pubic sector workers have built in COLAs? Federal workers do not. In fact, pay for federal workers is frozen through 2014, with the House Republicans pushing for an across-the-board 5% pay cut. You seem to make a lot of sweeping statements based more on stuff you might have heard third hand from your ex-brother-in-law’s second cousin. And you keep making these contradictory arguments…one day you claim that retirees on pensions will be hurt most by inflation and the the next day you argue that retirees on public pensions (e.g., Social Security) will come out ahead because their benefits are indexed to inflation. Which is it?
There’s a rather disgusting fake morality play here. The Fox News storyline is that those in debt deserve their fate because they borrowed too much and got in over their heads. They deserve what they got. Except that most people who have been impacted by the Great Recession did not get into trouble because of too much borrowing on their part. If your neighbor loses his home because he borrowed too much that affects the value of your property. And the value of your property affects demand for other commodities. What we end up with is some homeowner in Nevada gets evicted and this leads to a manufacturing worker in Ohio losing his job. If the actual story followed the Fox News storyline then we would see a bad economy only in those states with high foreclosure rates. But the Great Recession cut across the whole country. In some sense it might be unfair to put some of the weight of the recovery on those who did not overborrow, but continued debt overhang also hurts those who were completel responsible. The idea that the effects of the recession were targeted to just those irresponsible bums is a Fox News fiction.
Bruce Hall and tj:
I think the expectation of supporters of additional monetary policy, including possibly a higher inflation target, is that this is not solely about devaluing the currency, it is that they expect an actual increase in demand.
TJ worries what will happen if prices of goods increase, but wages don’t. But how would prices of goods increase then? Doesn’t the price increase have to come from increased demand? And where would this demand come from, if wages are stagnant?
I think we have to separate two possible causes of inflation here:
1. currency devaluation, which causes relative price changes in relation to other currencies, could increase prices of imports and raise demand for domestically produced goods
2. increased demand due to lower real interest rates could cause a greater benefit to spending rather than saving
As it happens, right now the US could use both. We still have large trade deficits, especially with China. Meanwhile, China has no trade surplus with the rest of the world, so maybe it’s not China’s currency which is mis-valued, it’s ours.
But at the global level, we are seeing a global shortage in demand. And that’s not going to be helped by global currency adjustments. There isn’t any other intelligent life out there in the universe for us to trade with, as far as we know.
So ultimately we are really counting on the second effect, a real increase in demand. If monetary policy can’t accomplish that, then we will need fiscal policy as well to do the job.
acer, devaluation means higher import costs. Which means higher input costs. This means lower margins. This means less demand for new capital and even shutting off some production. An example is cattle, higher feeding costs, fuel costs, etc. caused farmers to reduce their heard sizes.
Higher production costs will also put pressure on prices, pushing down demand.
Wow, another Academic In Wonderland!
Menzie,
Please reconcile this major and blatant error of yours: How is increasing the expenses of a household going to improve its debt servicing capabilities?
Inflation, a.k.a CPI is defined as follows: A consumer price index (CPI) measures changes in the price level of consumer goods and services purchased by households[…] (Wikipedia)
This could only work if wages rise faster than expenses, and the environment, high unemployment rate and low productivity gains, are not conducive
to such an outcome.
Another question to ponder over: How exactly ZIRP and high inflation in a combination are going to encourage deleveraging? Deleveraging is exactly what you mean by reducing the debt burden in relative terms.
It looks you and many of your academic colleagues are so entrenched in ‘high’ level thinking that you have totally forgoten the basics of economics.
🙂
This post above wasn’t me ->
Posted by: tj at May 9, 2012 11:50 AM
The poster probably inserted ‘tj’ into the name box, but meant to address the post to me.
2slugs,
COLA – google public employees COLA and you will get lots of hits for various public employee contracts that contain a COLA. Granted, some are temporarily frozen, but nonethless they are common.
The larger point is that using inflation as a blunt instrument to reduce real debt is highly distortionary and punishes the majority of households and governments who acted responsibly.
Spencer, and TJ, you guys are missing something.
Since we are at the zero lower bound, ST nominal rates can’t be cut, so the only way to cut ST real rates would be to raise the inflation rate. Usually this is done by cutting the Fed Funds rate, but that’s tapped out. The key issue is that higher inflation means more lower real rates, more borrowing and a loosening of monetary policy. More borrowing means more investment, which leads to more jobs and more bargaining power for workers. A second channel is that it automatically reduces the real value of debt, which should lead to more consumer spending. A third channel is it weakens the overvalued dollar, which also raises aggregate demand.
Everything you’ve said so far applies to conventional monetary policy. That the Fed shouldn’t, in general, try to to increase inflation in recessions b/c it penalizes households who were responsible. But of course, the other effects of looser monetary policy include higher employment, GDP, and asset values.
The Dept of the Treasury has significant amounts of short-term debt outstanding: as of Sept 2011, 59% of the US public debt had maturities less than 4 years. (TIPS forms a small portion of that amount.) Consequently, US public interest costs would rise rapidly as an adjustment to any increase in inflationary expectations as new notes issuance coupons would immediately reflect the rise in inflation expectations. (Data can be found at the treasurydirect.gov website in the GAO annual reports.)
A policymaker facing the decision on whether to inflate therefore risks exacerbating US gov’t fiscal problems if a policy increasing inflation is matched only by a limited increase in personal & business income and, consequently, modest increases in tax collections. Inflation might have very destructive consequences for personal balance sheets, which is a complex, dynamic topic in and of itself.
For that reason, I believe inflating is something that no actual policymaker will consider outside of brainstorming sessions. It has a possibly moderately beneficial upside but a certain very negative downside. Not a good bet.
I’d like proponents of this idea to actually address the mechanics of interest payments in their argument, because details like that are very important.
TV writes: “A second channel is that it automatically reduces the real value of debt, which should lead to more consumer spending.”
This assumes a country’s private and public debt issuance is fixed-rate debt with limited rolling over as existing debt matures. Neither assumption is correct. A rise in inflation expectation is at best a short-term free lunch at the expense of creditors.
TV,
Capital investment is typically a 10+ year expenditure. The real rate of interest on 10+ year borrowing has been negative for several quarters. Where is the borrowing? Where is the boom?
tj: As of April, Moody’s Aaa corporate bonds are 1.9 ppts above 10 year Treasurys. Baa bonds are 3.14 ppts above. Hence, real rates for corporates, when they are not rationed out, are not negative.
jult, IIRC, the average term of treasury debt used to be about 3, if that’s correct it is getting longer.
Menzie, Isn’t the historical average for inflation over 3%? Last year it was 3.2%.
CPI-U has increased 2% since December for an annualized 8%. The Dec-March for last year was 2.4%, but I think the unusual weather probably explains most of that. I think we can expect ~3.2% this year as well unless the economy stalls more than last year. With falling gas prices and oil prices this isn’t likely.
If we get inflation with falling oil and gas prices, then we should probably ease (so long as easing doesn’t cause oil and gas prices to accelerate above core). The rising margins would spur investment.
That increased investment will put upward pressure on wages and income, but will put downward (dampening) pressure on core prices since supply will increase.
aaron: CPI-U (FRED code CPIAUCSL) was 229.098 in March, while that in December 2011 was 227.033. Doing the division, I find that March CPI was 0.91% above December levels. To me, this works out to an annualized 3.7%, not 8%.
“jult, IIRC, the average term of treasury debt used to be about 3, if that’s correct it is getting longer.”
Aaron: The point isn’t about change of the maturity distribution, which has been reasonably stable over time. The point is that the maturity distribution is short in an absolute sense, and government finances will be affected immediately – due to the fact that bond yields reflect inflation expectation and not actual inflation on the ground – while the effect on the real economy will take time to bring results, with the results also being uncertain.
I can’t imagine that an actual policymaker would look at the sequence of events connected to increased inflation and conclude that it wasn’t a risky, even reckless idea. Note that central bankers across the world seem to be rejecting the idea.
@jult52.
You wrote: “This assumes a country’s private and public debt issuance is fixed-rate debt with limited rolling over as existing debt matures. Neither assumption is correct.”
Fixed rate mortgages actually are quite common in the US. http://www.freddiemac.com/pmms/release.html
And I believe adjustable rate mortgages are often fixed over periods of time.
I also assume that when a corporation issues a bond, they often agree to pay a fixed coupon payment. When Goldman Sachs issues a bond, they don’t say, hey, inflation rose unexpectedly, so, you know what, we’re going to give you higher coupon payments than what we had agreed to.
Another point — if wages and prices all doubled, clearly consumer debt would fall, even if that was the only thing that happened. But if prices doubled from the Fed raising inflation expectations, this would happen b/c consumers were bidding up prices and employers were bidding up wages. So, it couldn’t happen without lowering unemployment and raising consumption. Unless it came from a supply-side shock, then all bets are off. The issue now is that banks have $1.5 trillion of excess reserves. If they loaned that money out, it would cause inflation, but only because it would increase demand. If inflation were higher, banks would be more likely not to sit on huge piles of cash.
@tj. You wrote: “The real rate of interest on 10+ year borrowing has been negative for several quarters. Where is the borrowing? Where is the boom?”
So, you are arguing here that investment is not a function of the real interest rate? Who told you that the full-employment real interest rate must be positive in a severely depressed economy? The trouble in a liquidity trap is that b/c of the zero lower bound, nominal rates can’t be lowered to the full-employment interest rate. That’s why we need higher inflation to get us there. See Japan.
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt
Meant to link this in the original comment but forgot to paste.
Dec 2011, 224.9, March 2012 229.4. 2% for 8% annual.
Jult, I agree, but also thought it relevant that increasing the maturity will reduce risk some.
“Nobody advocates an inflation in which he would be on the losing side.” – Ludwig von Mises
From 2000 to 2003 there was modest inflation, but there was a recession 2000-2001.
There was little complaint.
In 2004 oil and gasoline prices started rising.
It became an issue in 2005, and the media was baffled by it becoming an issue since the economy was growing and inflation wasn’t too high.
There was good reason for the concern that was obvious, inflation was focused on the rich (a smaller population with more discretionary income) during the early 2000s. In the lower brackets, income was flat, but spending actually declined (prices didn’t rise, and the ones that did were easily substituted. eg., generic product were easily substituted for brand names and consumers usually found the quality was as good or better). After 2003 it was more focus on the broader population and especially lower incomes.
http://cumulativemodel.blogspot.com/2006/04/whats-worst-thing-about-being-poor-in.html
http://cumulativemodel.blogspot.com/2006/05/whats-big-deal-about-gas-prices.html
“Fixed rate mortgages actually are quite common in the US.”
The US public and private sector funds itself through a mix of floating and fixed-rate debt. Much of the fixed-rate debt will mature in the next year or two. Increased inflation will immediately be reflected in the significant percentage of floating rate debt and over time in the fixed-rate debt, as I mentioned above.
“I also assume that when a corporation issues a bond, they often agree to pay a fixed coupon payment.”
Corporations also fund themselves through a mix of floating and fixed rate debt. This is Finance 101. The way to think about this is maturity structure.
So the Conditional Inflation proposal assumes the following will hold:
1) Most importantly, wages will rise at least as much as inflation. This is problematic.
2) The Fed will be able to stop surging inflation without provoking a severe recession. As we all know, Volcker was forced to precipitate a steep and painful recession to break the increased inflation expectations in the 1980s, a period when the US was not an external debtor.
3) That the immediate response in interest rates will not provoke a US public and private debt crisis before any possible positive effects of increased inflation are realized. (Menzie’s Foreign Affairs article explicitly assumes that the Fed can fully control interest rates. I consider that to be likely false, if you include private and consumer debt into the equation.)
4) That the increase in inflation will not significantly decrease the value of assets. Let’s all remember that the early 1970s burst of inflation brought US equities to a devestatingly low point. The relation between inflation and debt prices is mathematical. The capacity to service debt depends on both cash flows as well as the assets backing the debt. Inflation might possibly have a positive effect on cash flows but will almost certainly have a negative effect on asset values.
The Conditional Inflation proposal seems to rest on a set of unexamined assumptions that are problematic. I’m trying to be polite here.
My comment on the early 2000s reminds me of something.
I graduated undergrad at the end of 2000. In my area, IOE, I took a popular path of looking to analysis, optimization, and financial engineering. At the time, we were very popular for investment banks. My path was supposed to be that (then possibly on to a hedge fund). My fall back was consulting.
The recession hit new grads hardest. Most people kept their jobs, but hiring stopped for us. People who graduated in the spring and had job offers had them recinded. This also left gaps in resumes, making people persona non grata when hiring resumed (that’s how I ended up working as a government bureuacrat).
Anyway, my point is the reason I didn’t get along in my path was that the .com bust sent business majors back to IB and consulting (and the consulting market evaporated after Y2K and fraud revelations). The MBAs from the .com’s fled back to wallstreet.
I wonder if this contributed to the crisis. MBAs intead of quants doing trades and making decisions and plans. MBA who have a very superficial understanding of the math and economics and were also the risk takers that staked the .com bubble.
aaron: You have cited the not seasonally adjusted CPI series (FRED series CPIAUCNS). It doesn’t make sense to annualize a 3 month inflation rate for a nsa series.
Seasonal adjustment doesn’t make sense becaue of our unuasual winter.
I compared this years to last years (4 months). Last years increase was higher for the same period. I wasn’t suggesting we are on the road to 8% inflation, in fact I suggested close to 3.2% again (energy goes down, me might see higher inflation since the really real economy will grow increasing investment in physical capital and the velocity of money).
I do have some confusion that needs to be settled though. Does this measure include energy and food? (If it does, core probably went up more than headline this year.)
I expect headline to stay low (be slightly lower than last year). I expect core to rise if energy prices decline or rise significantly slower than core, but I expect core to fall if food and energy rise faster than core.
What core does will determine if the really real economy grows (if core grows faster than energy, easing will stimulate the economy). If core grows less than energy, the really real economy won’t grow and we may near a recession, especially if we ease.
It depends on producer prices relative to consumer core.
(Growth in discretionary disposable income is required in the lower income quintiles for there to be good reason to invest in more production. If income isn’t freed up, they won’t have money to spend on new products and investment won’t make sense. Right now, the rich aren’t don’t seem to be spending their income/profits.)
The crisis also makes seasonal adjustment obsolete. We are in a new economy and the old algorithms don’t apply.
In past years, people spent much less at the beggining of the year and binged harder in November/December.
Thing might be moving back towards normal if people are achieving more discretionay income and getting their balance sheets and cash flows in order without defaulting.
And this year might be a bit of an anomoly. If people are borrowing more out of necessity, we could have problems. If automotive is driving our growth, both in GDP and inflation, things could be bad in a year. Many people may be buying cars out of necessity due to age rather than desire. That will decrease spending on other things and hit investment and balance sheet repair going forward.
aaron: There are surely better ways of dealing with the issue you mention than using nsa data (the series you used was CPI including energy and food, by the way). I would explicitly apply a seasonal adjustment factor, and either omitting the Great Recession data, or explicitly dummy out. Even under your presumption that the BLS’s ARIMA X-12 is doing something “wrong”, you wouldn’t do what you did.
I think that still bodes well for easing, I’m pretty sure energy prices, particulars gasoline and oil rose much more during that period last years. I think they may have fallen this year, plus we are using less gasoline this years.
Hmmm… I’m actually beginning to lean in favor of some more monetary stimulus. I’ve been highly skeptical ’til now.
Unfortunately I don’t the time, practice, or education to do that. I simply did a quick google search and picked the first reputable infation data set I found that showed this year and historical comparable data.
While I’m less concerned about possible easing now, I still suspect that easing may increase oil prices more than core as it will devalue the dollar, push up foreign demand, and current producers are not incentivised to increase production and new producers are constrained by politics, technology growth rates, and distribution infastructure.
The current and expected price declines are due to refineries coming back online, easing political tensions reducing demand for inventory, lower futures prices lowering demand for inventory likely caused by poor economic expectations.
@Jult.
First you wrote that US debt is “not fixed”. Then you conceded that it is a mix of fixed and adustable. That would be an improvement, except then you argued that most of the fixed debt matures in the next 1-2 years, and still conclude that higher inflation would not reduce the real value of debt outstanding.
Yet, according to the Fed, a majority of mortgages in the US are fixed (see link) — “One of the notable features of the current U.S. mortgage market is the predominance of fixed-rate mortgages.” In the past few years, adjustable rate mortgages look to have fallen below 10% of all conforming mortgages.
http://www.frbsf.org/publications/economics/letter/2010/el2010-03.html
I have a hard time believing that most mortgages in the US will mature in the next 1-2 years. Perhaps you could link us to the website where you are getting your information? I suspect you just made it up.
It’s good you are interested in economics, but you should try to get your facts straight. You also need to work through an undergraduate economics textbook to learn how prices are set.
jult52:
“A policymaker facing the decision on whether to inflate therefore risks exacerbating US gov’t fiscal problems if a policy increasing inflation is matched only by a limited increase in personal & business income and, consequently, modest increases in tax collections. Inflation might have very destructive consequences for personal balance sheets, which is a complex, dynamic topic in and of itself.”
I think what you are missing is this:
Every cost for one person or business is revenue for another. Likewise, every increase in borrowing has to be offset by someone else’s increase in savings.
If you exclude the foreign sector for a moment, and just think in terms of the private sector and public sector, then what happens if private sector balance sheets only improve modestly? Then public sector balance sheets will only deteriorate modestly. What does it mean when the government is running a $1T deficit? It means the private sector is running a $1T surplus.
There is really no concern about any potential impact of rising interest rates on public finances. Interest won’t increase unless inflation increases. And inflation can’t increase unless aggregate demand increases (since we are not facing any supply side constraints right now). So none of this happens without us ending up in a far better place than we are today.
If you are worried about the the cost of government interest payments, you should be aware that right now federal interest costs as a percentage of GDP are the lowest they’ve been since 1975. Yes, that will increase in a recovery, from very low levels (under 1.5% of GDP) to more normal levels (over 2% of GDP), as interest rates increase. So what?
http://research.stlouisfed.org/fred2/graph/?graph_id=48583&category_id=0
Now, if you want to add in the foreign sector, we know that we are running a trade deficit, which improves foreign balance sheets at the expense of domestic balance sheets. We know that any currency devaluation will cause that to shrink, improving domestic balance sheets. So no problem there either.
That’s not to say that these policies could never cause a problem. At a certain point yes, if you overstimulate demand, then the problem is no longer on the demand side, and you start running into constraints on the supply side. But we really haven’t had that problem since about 1979. When you start to see high inflation, interest rates, and capacity utilization, yeah then you can have the Fed tighten and deal with that.
So the object isn’t to cause inflation. It’s to increase demand, which we know will increase wages, and thus will cause inflation. And all we really need then is for the Fed to not step in and cause an economic slowdown when this starts to happen, out of excessive fear of inflation.
TV
I’m not presenting esoteric facts. US public and private sector debt is a mix of fixed and floating rate debt. You are right that many mortgages are fixed, but that is only a portion of the US debt load. I don’t think any of this is very controversial.
I’d lay off the derogatory comments given your posts about financial markets above.
“A consequence of high unemployment is that on average workers possess little bargaining power. Therefore inflation during a period of high unemployment seems like it should depress real incomes,”
No, this is quite wrong. An increase in NGDP will increase earned incomes, because of the effect on hours worked. The Wages/NGDP ratio will in fact fall, but the effect on real wages is not as clear; it depends on how much of the NGDP increase breaks down into inflation wrt. real growth. In a deeply depressed economy, real growth should be high.
@Jult
You wrote “I’m not presenting esoteric facts.”
No, you just straight made stuff up to justify your anti-inflation bias. First you wrote that most borrowing in the US has adjustable rates. Faced with evidence to the contrary, you wrote that most debt matures in the next 1-2 years, so if interest rates rise due to inflation, the real debt burden doesn’t rise.
Both claims are completely false.
2slugs wrote: Please explain how you think it might be possible to have sustained inflation without an increase in unit labor costs?
I think that’s maybe the question I’m really trying to ask. In the presence of high unemployment, a sluggish economy and extremely low interest rates, how might it be possible to generate an increase in unit labor costs through monetary policy – one that will go to workers?
I don’t know, maybe that’s a trivial question.
It doesn’t seem obvious (to me) that having the fed snap up assets to depress yields will lead to more investment. You have to figure that any project that can’t get financed until real yields on safer investments are negative (or more negative) has to have a pretty bad risk/return profile, and at least among the people I talk to few are willing to risk a lot of money on a bad deal even if the alternative is to accept the reality that their capital will lose some value over time.
All that is to say that I’m not sure the fed can cause much of a bump in investment to stimulate employment (and raise wages) when real rates are so low already. When the projects you’re trying to get funded have a risk-adjusted return of “well, at least you’re losing LESS money” you’re asking people to scrape the very bottom of a deep barrel.
I guess the wealth effect could stimulate people who benefit to go out and spend more, which would boost aggregate demand, but the people who benefit most from that should generally be people who are pretty well off already, and they’ve largely been doing fine. They don’t seem likely to go splurge more than they are because their financial assets are worth more.
That’s how I’m thinking through the question, and maybe I’m wrong, but the proposition that the fed can raise wages (or, I guess, inflation in general since labor costs are such a big component of costs) in this environment doesn’t seem obvious to me.
jult52:
“1) Most importantly, wages will rise at least as much as inflation. This is problematic.”
Inflation IS wage increases. There is no other kind of inflation related to monetary policy. Asset prices, as you seem to recognize in the rest of your post, tend to move more in the opposite direction.
2. “Volcker was forced to precipitate a steep and painful recession to break the increased inflation expectations in the 1980s, a period when the US was not an external debtor”
But today the US is an external debtor, precisely because today we have had the opposite problem of too low inflation. It took decades of Keynesian policy to get from the 1930s to the point in 1980 when inflation and interest rates were high. Today after 30 years of inflation hawkishness we are back where we were in the 1930s.
Moreover, if you acknowledge that the Fed could cause a recession through lowering inflation in 1980, why can’t you acknowledge that it could be causing a slump now in exactly the same way? If stopping inflation can cause a recession, then allowing it can prevent or end one.
3. “That the immediate response in interest rates will not provoke a US public and private debt crisis”
Again, too low inflation is already causing a debt crisis for some. Allowing a normal level of inflation will end it.
4. “That the increase in inflation will not significantly decrease the value of assets.”
Yes, a gradual increase in inflation could bring about a gradual decrease in asset values. But that’s part of the point.
http://research.stlouisfed.org/fred2/graph/?g=7cf
The red line is 1 year treasury interest rates.
The blue line is the ratio of investment to consumption.
The pink line is CPI inflation.
The green line is wages to corporate profits.
The orange line is total household assets as a share of potential GDP.
In the real world, when inflation and interest rates have been higher, we have had:
1. higher levels of investment rather than consumption
2. higher wages rather than profits
3. lower asset values
With where we are right now, corporate balance sheets are fine, they are still sitting on record levels of cash. Our biggest concern ought to be household income. With where we are now, we are recovering from asset bubbles, but asset values are still relatively high. We need to worry less about protecting asset values or reinflating those bubbles, and more about increasing wages, investment and economic growth.
Strong balance sheets are a disincentive to both work and investment. The problem right now is weak income statements, not weak balance sheets. An entire economy can’t survive on capital gains alone, we need increased output and new capital investment. That is going to go along with wage inflation, not asset inflation.