Wednesday, August 22, 2012

Should the Fed risk inflation to spur growth?

The New York Times asked me and two others this question for its "Room for Debate" blog. My answer follows. Not news for readers of this blog, but maybe a fun concise summary

Should the Fed risk inflation to spur growth? The Fed is already trying as hard as it can to spur growth, and to create some inflation. The Fed has created about two trillion dollars of money, set interest rates to zero, and promised to keep them there for years. It has bought hundreds of billions of long-term government bonds and mortgages in order to drive those rates down to levels not seen in a half a century.

The fact is, the Fed is basically powerless to create more inflation right now -- or to do anything about growth. Interest rates can't go below zero, and buying one kind of bond while selling another has minuscule effects. Which is just as well. While preventing deflation in the recession was vital -- and the Fed did it -- the idea that a deliberate inflation is the key out of our policy-induced doldrums makes no sense.

 Tight monetary policy is not the source of our problems. Monetary policy is loose by any measure. Anti-growth policies are our problem. Our economy is being stifled by over-regulation, chaotic taxes and policy uncertainty. You make money now by lobbying regulators for special treatment, not by starting companies. We fix that with growth-oriented policies that remove the source of the problem.

Inflation remains a danger, but not so much because of what the Fed is doing. U.S. debt is skyrocketing, with no visible plan to pay it back. For the moment, foreigners are still buying prodigious amounts of that debt. But they are mostly buying out of fear that their governments are worse. They are short-term investors, waiting out the storm, not long-term investors confident that the US will pay back its debts. If their fear passes, or they decide some other haven is safer, watch out. The inflation some are hoping for will then come with a vengeance. It's not happening yet: Interest rates are low now. But so were mortgage-backed security rates and Greek government debt rates just a few years ago. And inflation need not happen, if we put our fiscal house in order first. But if it happens, it will happen with little warning, the Fed will be powerless to stop it, and it will bring stagnation rather than prosperity.

Followup thought (more on the last paragraph):

Yes, interest rates are low, and there is little sign of inflation. I hate to use the word "bubble," but US government debt strikes me as a "bubble," meaning "whatever it is you thought was going on with houses, mortgage backed securities and Greek government debt in 2006, or internet stocks in 1998,  and used the word "bubble" to describe, is going on with US government debt now."

More precisely, an asset can have a high value (government bond prices are high, interest rates are low) because people think its "fundamental" cashflows are high, or because people are willing to hold the asset for a year or two, and they think they can get out and sell it before its value falls.

It's hard to make a story that US long term debt has a high price (low interest rate) because investors are really impressed with the huge budget surpluses in a credible long-term US fiscal commitment. (!) If you don't buy that story, then the admittedly huge demand for US debt is must be a short-term demand, a low required return, a "flight to quality" that can easily evaporate. It can also easily increase for a few years before it evaporates. Europe does seem to be going down the tubes.

It has to be one or the other though. People (you know who) who say "interest rates are low, inflation is low, the government can borrow huge amounts and blow it on preparations for an alien invasion, don't worry, it's not a bubble, it can't burst" have to assume that markets really trust the government to pay back those debts.


  1. Prof Cochrane -

    What did the fed do to prevent deflation during the recession, and why can't it continue to use those tools now?

    Interest rates are at zero, so they can't use that lever, but they can still continue to do QE right? I know QE doesn't affect long term inflation (only deficits can do that) but it can still create temporary inflation now at the expense of inflation later by changing the term structure of US debt, right?

  2. John, two questions:

    1) you're assuming that we can't have a huge surprise on the positive side. But we are basically in the infant stages of the data and information technology revolution. Surely, there is a good chance of positive surprises in terms of productivity, etc. generated by all the byproducts of that revolution, no ?

    2) have you given up on the efficient market hypothesis and rationality of investors ? Greek bonds were rich before the crisis, but surely, they were never as liquid as US bonds and the market was never as deep. If markets anywhere were efficient, surely US treasury market is the prime candidate for efficiency due to its depth, liquidity and reach ?

  3. I would disagree with your assertion that 'monetary policy is loose by any measure'. Friedman believed (and Bernanke does also) that the appropriate measures of monetary policy were to look at nominal variables like inflation or NGDP. Inflation has averaged well below normal since the crisis. NGDP is well below trend. The only indicators that matter all point to tight monetary policy. If you are using interest rates to determine whether money is tight or loose ... you are using the wrong indicator.

    1. I think you're confusing cause and effect, the position of the accelerator pedal and the speed of the car. NGDP and inflation are things that monetary policy tries to control. When it can, which I think it now can't.

      Interest rates are zero, inflation is two percent, so real rates are negative two. I recall Friedman saying something about money being important to inflation. Excess reserves went from 6 billion to two trillion. Other aggregates are huge too.

      The measures that count are the Fed's actions, and the pedal is on the floor by any measure of what is the Fed doing

      Suppose the Fed says, "we want to control global warming, so we'll do QE5 until temperature goes down." They buy $5 trillion dollars of debt. And nothing happens to global warming. Do you say that policy is not loose because the temperature is still rising?

    2. Professor,

      If the Fed controls inflation doesn't that also imply that it controls NGDP? Inflation is a monetary phenomenon and they control the money, right?

      As for global warming, I don't really get that argument. Global warming is not a nominal variable, but inflation and NGDP are.

    3. Although you may believe that the Fed doesn't control inflation, but that would be very hard to defend.

    4. With respect, I still disagree. Friedman said "As an
      empirical matter, low interest rates are a sign that monetary policy has been tight". Your observation that interest rates are low is just supporting my argument.

      The goal of the Fed is to hit a certain macro target (say inflation). If it falls short of that target, that is a very good indicator that policy is too tight. If inflation is too high, that is a very good indicator that policy is too loose. Looking at interest rates will just confuse you. Are those rates low because policy is so loose, or because tight policy has driven the economy into a depression?

    5. "NGDP and inflation are things that monetary policy tries to control. When it can, which I think it now can't."

      Inflation is always and everywhere a monetary phenomenon, except when it's endogenous? What's driving inflation now then if not money creation? wage-push?

      I am honestly puzzled.

      What if the Fed says that:"we want precisely 2 % inflation, and we're going to create a lot of money, but if inflation gets above 2% inflation we'll take it all back". How would such a world look? Is the policy then loose or tight?

    6. To use your analogy of the car, the Fed's job is to make sure the car goes at a constant speed. The problem is, when it comes to monetary policy, it is difficult to know if we're driving on flat terrain or if we're driving up a hill. Even if we can tell we are driving up a hill, we don't know how steep it is. Because of that, how hard we are pressing on the gas pedal doesn't tell us much. We could be pressing the pedal down farther than normal, but if the hill is steep enough, we are not pressing it down far enough, i.e. policy is 'tight', and the car will slow down. The only sensible way to measure the stance of monetary policy is to measure the speed of the car and see if it is above or below target.

    7. I think the point is that the Fed does not have any tools that it can legally use which will do much of anything to generate inflationary pressure. You would have a difficult time arguing that 10 basis points off 10yr treasuries will have sizable effects.

      Furthermore, Bernanke's criticism of Japan involved their deflationary+very very low inflationary environment. The Fed has prevented a deflation and inflation has been within any reasonable estimate of the Federal Reserve's implicit price stability mandate.

    8. "I think the point is that the Fed does not have any tools that it can legally use which will do much of anything to generate inflationary pressure."

      The only tools they need is QE. If the Fed monetized the entire U.S. debt that would SURELY create inflation, would it not?

    9. Excess reserves have ballooned because the Fed is paying interest on them. That is a contractionary policy. As Hume said of specie locked in chests, you really shouldn't count that as part of the money supply (relevant for inflation).

      We've had stupid regulations, taxes and lobbying for a long time (we had them under LBJ, with strong growth anyway). All that should reduce real GDP. What we've had recently is a recession which got us off our nominal GDP track. If it were just a real/supply issue we would have recovered on the NGDP path (which is what seems to happen typically, inspiring the "plucking model") but the shortfall would have been made up for with inflation. But that clearly hasn't happened! Whatever real problems exist, there is an aberrant nominal issue in recent years.

    10. anthony juan bautistaAugust 24, 2012 at 1:38 AM

      @JSR~For two decades low interest rates in Japan were no indicator of tight monetary policy; just the opposite. It is possible to have loose money and low interest rates--just follow the velocity of money. We will all be awash in oodles of low velocity cash here in the USA, and we will be sunk. Look to Japan and see our future....

    11. @anthony juan bautista: What makes you conclude that monetary policy in Japan has been loose? Have you seen any of the symptoms of loose monetary policy? Is there an overheating economy? Is inflation rampant? Are there speculative asset bubbles?

      I look to Japan and I am afraid I do see our future, because we are making exactly the same mistakes they did. Every time Japanese QE policies have shown signs of actually improving their economy, they have decided the job is done and stopped buying assets. What they need to do is continue easing until the price level there has been reflated. Sorry, but monetary policy in Japan has been overly tight for most of the past two decades, which is a large part of why the Japanese economy has barely grown during that period.

    12. As a side-note, a low velocity of money is yet another symptom of tight monetary policy. In a loose-money world, the supply of safe assets would be larger than optimal. People would value their dollars (or yen) less, and would be more inclined to spend them, increasing the velocity. That is clearly NOT happening, either in the US or in Japan.

  4. 'It has to be one or the other though. People (you know who) who say "interest rates are low, inflation is low, the government can borrow huge amounts and blow it on preparations for an alien invasion, don't worry, it's not a bubble, it can't burst" have to assume that markets really trust the government to pay back those debts.'

    Yes ... I think markets really trust the government to pay back those debts. And I think market participants (correctly) believe that moderate inflation will make paying back those debts easier. There's a lot of room between our current stagnation and low-inflation economy and the hyper-inflation/government default situation you seem worried about. When the 'flight to safety' premium vanishes, there's no reason the bond price has to crater to alarming levels. It seems more likely to me bonds will revert to more recent historical norms as people start to put their money in riskier assets. For all the debt-hysteria, we have historically had higher debt-to-gdp than we do now and lived to tell the tale. As you are fond of saying, what we need is growth! If monetary policy can help give us that growth via higher inflation, we should seize it.

  5. "It has to be one or the other though. People (you know who) who say 'interest rates are low, inflation is low, the government can borrow huge amounts and blow it on preparations for an alien invasion, don't worry, it's not a bubble, it can't burst' have to assume that markets really trust the government to pay back those debts."

    I certainly agree that the fiscal position of the U.S. government is hugely relevant to the interest rates our government will face and the ability of our government to borrow money in the short term. I can agree that if nothing is done to assure investors of our credit-worthiness, then we may face a serious problem, i.e. a collapse in the government treasury asset bubble. However, this says very little about whether or not we should 'borrow huge amounts and blow it on preparations for an alien invasion.' The federal government's fiscal position is mostly determined by future deficits and surpluses, not deficits over the next five or so years. I think most economists, including 'you know who' agree that something has to be done about runaway medicare costs and future deficits.

  6. John
    In your earlier work you associate what you called bubbles with extraordinarily high trading volume. for example, I remember a very nice graph you had correlating price and trading volume levels of tech stocks. Is there any evidence that trading volume in US Treasuries is extraordinarily high currently?

    BTW, paper is "Stock as Money: Convenience Yield and the Tech-Stock Bubble"

  7. Professor Cochrane,

    I'm extremely confused. First you say that "Fed is basically powerless to create more inflation right now." Then you say "If [inflation] happens, it will happen with little warning, the Fed will be powerless to stop it, and it will bring stagnation rather than prosperity."

    With all due respect, these statements completely contradict everything I have ever learned about monetary economics.

    Recently, because of the 100th anniversary of Milton Friedman's birth, I found myself going through youtube videos of his TV program. One of the best ones was called "inflation." In that video, he explained that inflation is ALWAYS a monetary phenomenon. He ridiculed President Nixon's vain attempts to control inflation through price controls, because the ONLY way to change inflation was to change the rate at which the government printed those special pieces of paper that our society treats as money. To my knowledge, the ability of the central bank to determine the price level is widely accepted as true.

    In light of this, how can you claim that the federal reserve can't control inflation, neither pushing it up nor down? If the people running the printing presses in a fiat money economy don't control inflation, who does?!

    I'm a student, not an economist, so I rely on the blogs of professional economists to learn more on the subject. Thank you for responding to previous questions I've posted on your blog. I'd be very interested in hearing further explanation.

    1. Cochrane has written before that yes "helicopter drops" of currency (I think an analogy of Friedman) create inflation.

      I don't think that would be within the Fed's authority I think that would be the treasury department -someone correct me if I'm wrong!

      Either way the Fed's ability to influence the price level is limited by the zero lower bound.

      Open market operations and quantitative easing depend on a market ... or at least on an auction. The fed for instance says i will pay you 1000 dollars in three months, then people bid : i will pay 998.92 or maybe 999.03 for that debt the highest bidder gets the rate they want. But people don't usually say they will pay 1002 now for 1000 later on which would correspond to paying a negative nominal interest rate on that bond. I doubt if this example is the main one that creates zero lower bound effects, (I imagine most of it comes from secondary market stuff) but I meant it to illustrate the point that the Fed is not in complete control in a liquidity trap.

  8. Dear john:

    Your statement that the fed is basically powerless to increase inflation seems clearly wrong. If the fed increased we to buy out the entire outstandick stock of treasuries in the market, you don't think inflation would budge?

    A separate argument is that more we is dangerous because if the velocity of money started to increase, it would make the resultant inflation harder to control. But that would be a completely different argument.

  9. I can't believe what I'm hearing from a U of C economist of all people. :-) First off, Nominal Rates don't matter-period. How many times must Milton Friedman and Scott Sumner make the point that low interest rates can be associated with "tight money" rather than loose money? Second, its crazy to think that the Fed DOESN"T control NGDp, the Fed controls the monetary base, which influences both inflation and RGDp. (Because of sticky prices. Add inflation and RGDP and you get NGDP.

    Thirdly, I am so, so so TIRED of hearing the "they've done enough" fallacy, and its sad that a bright economist like you believes, it. They haven't done anything CLOSE to enough! A deadly infection requires 100 doses of antibiotics. The doctor, a hyperconservative sort, gives 50 doses, more than he's done ever before. When the patient returns after feeling slightly better, the doctor is bewildered, and says, "ive given you more than I've ever have before, why do you want more...?"
    Get the picture? Its not the historical precedent that matters, Prof Cochrane. What you are saying is manifestly false. The Fed can buy as many securities as it wants, and The people who receive that money won't spend it. Do you realize that what you are saying in essence implies that the demand to hold money is essentially infinite, that no matter ho much money people receive, their consumption won't change? Lets perform a thought experiment for a moment. What do you think would happen if the Fed announced plans to buy up the entire national debt? And then keep buying private sector debt until the NGDP leveltarget has been reached? Would it really fail? ...
    I rest my case.
    P.S. I would have the Fed buy tens of trillions, precisely because the demand to hold money is so astronomically high. And this is important. Conduct QE the way normal monetary policy is conducted in the buying of short term interest rates. Announce a forward path and KEEP buying, stick to it, until you target is reached. THEN you can say that the Fed has done enough, but not before.
    P.P.S. Hysteresis is also a problem when it comes to aggregate demand. Thats why we need level targeting of NGDP
    P.P.P.S. Charles Plosser, Jeffrey Lacker, and Richard Fisher, are the types of people who if they were transported back to 1929, would have counseled the Fed to do nothing, precisely the type of people Milton Friedman were against. I just hope you aren't too.

  10. You really think the Fed could buy up all existing debt and tear it up, without causing any inflation? And what statements by the Fed indicate they want inflation to exceed two percent? They more often congratulate themselves for not exceeding that.

    "have to assume that markets really trust the government to pay back those debts"
    I must have a lot more faith in the markets than you, because I don't go around calling everything a "bubble" (prices go up and prices go down all the time, but who talks about anti-bubbles?). The rates of return the government gets on its debt REFLECTS THE TRUST MARKETS HAVE IN BEING REPAID. If you think the markets are wrong, I hope you're betting against them so you can wind up a rich man. Otherwise it sounds like a bunch of cheap talk we shouldn't take seriously.

    1. Well, I think the point is that US Treasuries are only safe in a relative sense. Risk aversion is high and investors buy what seems the least risky. But as we move forward, the investing comunity will notice that 1.6% on a 10 year treasury is far too low given huge current account and budget deficits in the US and that's when the 30 year down-cycle in interest rates will reverse.

    2. Again, if someone think the market is inefficient and ignoring publicly available information, I hope they are exploiting it as far as their access to funds can take them, and that when the market comes around they become very rich. If you are not in fact making that bet, that sounds like cheap talk.

  11. I have to agree with Edward.

    1) What is your definition of tight or loose money? According to what measure. You cannot measure how tight or loose money is by the level of the money supply or interest rates.

    2) What's stop the FED from purchasing non-government bonds, or devaluing the US currency in the foreign exchange market, or lowering the IOR?

    3) Why not raise expectations and therefore velocity by a announcing a higher inflation target, or price level target, or NGDP target? Every time the FED has announced or even hinted of QE in the last 4 years, the markets have skyrocketed.

    Are you actually arguing that if the FED announced targeting higher prices or NGDP that the markets would not soar in response?

  12. "Our economy is being stifled by over-regulation, chaotic taxes and policy uncertainty. You make money now by lobbying regulators for special treatment, not by starting companies."

    What is the evidence that this has gotten worse? Are you going to say Solyndra? Are they worse than Haliburton? The US is a pretty good place to do business by most measures. It is a right wing fantasy that there are a host of regulators walking around trying to suppress free enterprise.

    On the issue of policy uncertainty, whose fault is that? If Obama was dictator, we know what his policies would be. There wouldn't be uncertainty. On the other hand, you have a republican legislature of which a majority doesn't find the evidence for the theory of evolution convincing. They beg for stimulus in 2002 and then denounce it in 2009. You want uncertainty? Try guessing what Mitt Romney believes. He is on record supporting both sides of almost every major issue.

    You want more uncertainty? How about a president under whom you don't know when the next trillion dollar war might be declared?

    1. I agree that it is hard to explain the change in our economic situation based on the change in policy (which wasn't great before). But Halliburton just isn't comparable to Solyndra. Halliburton is still profitable even after splitting off Kellog, Brown & Root (which did lots of government contracting). Solyndra was never profitable and took out federal loans which it could not repay, leading to its demise.

  13. Professor Cochrane,

    I am a little confused. I certainly remember you advocating some years ago that the Fed can purchase safe debt and should be doing it beyond the housing market. I also have noticed that on this blog you have seemingly mocked violations of the zero lower bound.

    Why is it that you have seemingly changed your standpoint on this?

  14. Funny, not a single word in the post or in the comments that the problem may be that there is too much debt outstanding in the private sector. Not just that the debt isn’t backed by sufficient collateral, but also simply too much debt service for individuals and companies.

    So getting people and companies to take on more debt by increasing inflation seems an indirect route to reducing debt. Reducing debt levels means one can start borrowing all over again.

  15. John - I would like to read your comments.

    I am a retiree who lived through the inflation of the 70's and 80's.

    It seems like history is repeating itself with Obama / Brenanke QE3 looks like the redux of Nixon / Burns increasing the money supply to help a president get reelected, which in turn was a cause of the stagflation fought by Ford and Carter and finally brought under control by Reagan.

  16. Those points are valid but they almost always stop short of including the role of imbalanced "free trade". The late financier and billionaire Sir James Goldsmith testified before congress in the early '90s as to what would become of our economic growth if we entered into lopsided trade agreements (GATT, at the time). Cannot we plot most of the difficulty with "competition" to the fact that we are in fact suffering the impact of completely disparate currencies trying to "trade" as if all factors were equal when they are anything but? To take it a step further, cannot the pressure on Wall Street to engage in risky derivatives trading be tied to the weakening of the underlying "real" economy, and that weakening has gone hand-in-hand with what can only be described as unfair advantage insofar as our trade partners DO tamper with currency values and DO benefit from lower costs thanks to weaker environmental and labor laws? I must ask why we continue to force the issue of economic decline and currency devaluation (or inflation) through a nationalistic lens, when the elephant in the room is quite global in scale. Clearly the common denominator is a rather naive, too fast implementation of "free trade" before the basic rules of play — similar labor and environmental standards — were at play. Economic notions of "comparative advantage" do not work when a resource or strength is not exploited as much as a comparative weaknesses become a tool of de facto economic warfare. It's time to take "Free Trade" back to the drawing board. Trade is not "free" without equality of participants.


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