Tuesday, March 8, 2016

Deflation Puzzle

Larry Summers writes an eloquent FT column "A world stumped by stubbornly low inflation"
Market measures of inflation expectations have been collapsing and on the Fed’s preferred inflation measure are now in the range of 1-1.25 per cent over the next decade.

Inflation expectations are even lower in Europe and Japan. Survey measures have shown sharp declines in recent months. Commodity prices are at multi-decade lows and the dollar has only risen as rapidly as in the past 18 months twice during the past 40 years when it has fluctuated widely

And the Fed is forecasting a return to its 2 per cent inflation target on the basis of models that are not convincing to most outside observers. 

Central bankers [at the G20 meeting] communicated a sense that there was relatively little left that they can do to strengthen growth or even to raise inflation. This message was reinforced by the highly negative market reaction to Japan’s move to negative interest rates.

So why is inflation slowly declining despite our central banks' best efforts? Here is a stab at an answer. I emphasize the central logical points with bullets.

  • Interest rates have two effects on inflation: a short-run "liquidity" effect, and a long-run "expected inflation" or "Fisher" effect.  

In normal times, to raise interest rates, the central bank sells bonds, which soaks up money. Less money drives up interest rates as people bid to borrow a smaller supply, and less money also reduces "demand," which reduces inflation.  In the long run, higher inflation and higher interest rates go together, as they did in the 1980s.

However, we are now in a classic "liquidity trap." Interest rates have been zero since 2008. Money and bonds are perfect substitutes. The proof of that is in the pudding: the Fed massively increased excess reserves from less than $50 billion to almost $3,000 billion, and inflation keeps trundling down.

  • In a liquidity trap, the liquidity effect is absent. 

The liquidity effect will remain absent as the Fed starts raising interest rates, and would remain absent if the Fed were to cut rates or reduce them below zero as other central banks are doing. You can't have more than perfect liquidity.

The Fed isn't even planning to try. It plans to keep the $3,000 billion of excess reserves outstanding and raise interest rates by raising the interest rate on reserves. There will be no open market operations, no "tightening" associated with this interest rate raise.  But even if it did, we're $2,950 billion of excess reserves away from any liquidity effect, so it wouldn't matter.

  • When the liquidity effect is absent, the expected inflation effect is all that remains. Inflation must follow interest rates. 

Central banks thought they were raising inflation by lowering interest rates, following experience from the normal-times liquidity-effect correlation between lower interest rates and higher inflation. But that experience does not apply when its liquidity effect is turned off.

With no liquidity effect, lowering interest rates further below zero can only, slowly, lower inflation further. Central banks desiring inflation may have followed a classic pedal mis-application.

Do I "believe" this story? Belief has no place in science. It is the simplest coherent story that explains the last few years, not needing lots of frictions, irrationalities, and other assumptions. I have some equations to back it up. But we don't "believe" anything at least until it's published and has survived critical examination, replication and dissection. Still, I think it merits consideration.

Shh. I like zero inflation. If central banks have the wrong pedal but are driving the right speed anyway, why wake them up? Even Larry seems to have given up on the Phillips curve:

...suppose that officials were comfortable with current policy settings based on the argument that Phillips curve models predicted that inflation would revert over time to target due to the supposed relationship between unemployment and price increases.

There is no sign of the dreaded "deflation vortex," any more than there is any sign of dreaded monetary hyperinflation. We're drifting down to the Friedman rule. As Larry emphasizes, don't get excited over forecasts from models that rather spectacularly did not forecast where we are today. 
Central banks' desire for 2% inflation, and the Fed's rather puzzling interpretation of its "price stability" mandate to mean perpetual 2% inflation may also be relics of the bygone liquidity-effect regime. 

Appreciate the first half of the column which turns the signs around. It's a great bit of rhetoric.

I have to register mild disagreement with Larry's "solution" to the supposed "problem," 

In all likelihood the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates and, in extremis, further experimentation with unconventional monetary policies.

He doesn't say which monetary policies would work, given they have not done so yet. But these are topics for another day.

(Note: If quote and bullet formatting doesn't show up, come back to the original.)


  1. Minor quibble:

    "Interest rates have two effects on inflation: a short-run liquidity effect, and a long-run expected inflation or Fisher effect."

    The Fisher equation:
    1 + i = (1 + r)(1 + pi)

    i = Nominal interest rate
    r = Real interest rate
    pi = Inflation rate

    Or abbreviated:
    i = r + pi

    The "expected" inflation rate is not in the equation. Yes I am aware of the "expectations augmented" Fisher equation described here:


    But please read how it is described:

    "Rearranged into an expectations augmented Fisher equation and given a desired real rate of return and an expected rate of inflation πe (with superscript e meaning expected) over the period of a loan, it can be used as an ex-ante version to decide upon the nominal rate that should be charged for the loan."

    So what happens when the central bank sets i (the rate they lend at) with the expectation of pi, only no one will borrow at i? Noticeably absent from the Fisher equation is the supply and demand for credit. The central bank can set an interest rate anywhere they like, but they can't force someone to take on a loan at that interest rate. And they can't force people to vote for politicians that will take on more debt.

    "Do I believe this story? Belief has no place in science."

    Except free will does not exist in the physical sciences. The earth can't chose between orbiting the sun and flying off into deep space. Gravity - a force of nature guided by a measurable relationship between the masses of two objects and the distance between them - keeps the Earth in orbit around the sun.

    Belief plays a part in the social sciences (like economics), but belief in how people will react to certain policy choices needs to be checked against reality.

    Finally - from Larry Summers,

    "In all likelihood the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates."

    Apparently Larry believes that monetary policy choices should drive fiscal policy choices. I disagree. That is like saying Reagan should have raised taxes because interest rates were super high.

    It is my opinion that:

    To preserve the independence of both monetary and fiscal policy, the federal government should never borrow - ever. Meaning it should not matter where interest rates are when implementing fiscal policy (bye, bye vigilantes).

  2. The immediate effect of raising interest rates from very low levels is to raise inflation. See the graph on http://www.philipji.com/item/2016-03-07/higher-interest-rates-benefit-the-real-economy which runs more than 40 years. Eventually higher interest rates cause a collapse in financial asset markets followed by a recession.

  3. A Mr. Robert Mugabe is an expert in creating inflation... perhaps the Fed should get some advice from him? :)

    I do think that the lack of inflation is a problem, insofar as we (Japan, US, etc) are acquiring debt with the assumption that we're paying it off with inflated dollars. The lack of inflation of course makes the real value of our debt more burdensome than we expected... if, in fact, our leaders actually think that far ahead.

  4. "...the Fed's rather puzzling interpretation of its "price stability" mandate to mean perpetual 2% inflation..."

    Surely the 2% is hardly puzzling given the dual mandate? It would only be puzzling if the Fed had just a single mandate, for price stability.

  5. Isn't the 800-pound gorilla in the room demographics? Why would anyone expect growth with a declining working population?

  6. Robert Mugabe will be splitting his sides. It beggars belief that the West’s – er – “sophisticated” economists don’t know how to raise inflation.

    1. Robert Mugabe was able to control money - at least in terms of his country's currency. The fed does not control money today. This is good because the "sophisticated" would generate a faster rate of inflation if they could to fix the economy. But it would not fix the economy.

    2. Charles, What's wrong with a faster rate of inflation, as long as it doesn't go too far above the 2% target? It's widely agreed that 2% is about the optimum rate.

  7. "Interest rates have been zero since 2008. Money and bonds are perfect substitutes."

    What about the Reserve Bank of Australia? It runs a corridor system where reserves earn 2%, which is quite competitive with 1-month bills i.e the two are near substitutes. We might say that Australia is close to being in a liquidity trap with a 2% floor. It adjusts rates by moving the corridor up and down, not via open market operations. Does this mean that there no short run effects of monetary policy in Australia? Would an increase in the RBA's deposit rate to 2.5% reduce demand and inflation, or would it only have a long run Fisher effect?

    1. The effect would be to make the banks more profitable. It would be a subsidy.

    2. In no way is it a subsidy. Many central banks, including the Fed, run monetary policy by paying interest on reserves. Remember that central banks under this system set and control the supply of reserves - so reserve volumes are adjusted so as to meet the target. But because the supply of reserves is controlled by the central bank, the banking system must hold these reserves, which are risk-free and earn a very low rate of interest.

      In this way, talking about excess reserves is pointless. All those excess reserves at the Fed merely reflect the QE programs the Fed ran. Moreover, the reserves cannot be lent out - they are essentially trapped in the interbank system (unless the public starts demanding cash holdings).

    3. It is a subsidy. Reserves ought to pay zero. IOR takes cash that would have otherwise gone to the treasury, to pay for roads and bridges, and instead incentivizes banks to hold on to reserves, instead of shoving them out the door as currency.

      Try withdrawing currency sometime. Limits and pseudo-criminal surveillance everywhere. You'd think that the central bank would want more currency circulating outside the banking system. They don't, and this shows the lie.

      The installation of IOR was an immense tightening of monetary policy, one that hands seigniorage to banks.

  8. “It plans to keep the $3,000 billion of excess reserves outstanding and raise interest rates by raising the interest rate on reserves” Yes, we can expect the West’s bankster controlled governments to dish out millions to banksters.

    There’s actually a way of raising interest rates that doesn’t involve giving banksters a single dollar: raise banks’ reserve requirement. The Chinese regularly change the reserve requirement and by substantial amounts: it rose from 7.5% in 2006 to 21% in 2011.

    1. The fed pays interest on all reserves, required and excess.

    2. You, the taxpayer, pays interest on reserves. It's a transfer from the treasury to banks.

  9. Summers' initial observation is now inoperative. Inflation expectations for the next decade are now in the range of 1.5 - 1.6%, according to TIPS breakeven inflation rates. Inflation expectations have soared in recent weeks thanks to higher oil prices. There's no longer any reason to lament the fact that inflation is "too low" and/or central banks are powerless to raise it. In fact, the annualized increase in the CPI ex-energy has been 2.0% since the end of 2002, 2.0% for the past 5 years, 2.0% for the past three years, and 2.0% for the past year.

  10. "The study of monetary questions is one of the great causes of insanity." Henry Donning MacLeod

    I pay 3.875% on a 30 year, fixed-rate mortgage loan and 2.69% on a five-year, fixed-rate auto loan. Concomitantly, I pay 3.5% on a monthly adjustable-rate loan at prime (recently raised .25%). I think this is unusual. I am not complaining.

  11. I'm not one who thinks that central banks always get what they want, but it's pretty clear that inflation is low because CBs prefer to err on that side. That's why they keep raising rates in anticipation of inflation. The ECB was first to raise rates, eventually the Fed followed. It's what you do when you consider 3% inflation far worse than 1%. If you keep up that asymmetric approach long enough, people learn and inflation expectations fall.

  12. See graphs of inflation v/s the Effective Federal Funds Rate over more than 60 years. http://www.philipji.com/item/2016-03-10/does-raising-the-fed-funds-rate-raise-inflation

    1. The plots are great. An endorsement to click on the link.
      Remember that CPI is last year's inflation and the interest rate is related to next year's inflation as you read the plot.

    2. Philip,

      It would be helpful to also include credit growth in your plots to better understand the full story. Increased nominal interest rates will generally lead to higher inflation as long as there are borrowers at that interest rate.


  13. Okay, then why not the Fed hold or lower rates, and conduct $100 billion a month in QE until the national debt is monetized?

    Seems like a tremendous opportunity to take the debt monkey off of taxpayers backs.

    1. Ben,

      The debt does not disappear as a tax payer obligation when the central bank buys it. The Fed can choose yes / no to remit interest payments to the Treasury and the Treasury can choose yes / no to accept remittances.

      And remember, those interest on reserve payments that the central bank is making to private banks are in fact the interest payments the federal government (taxpayer) is making on debt held by the central bank - the central bank is acting as a pass through entity.

    2. Frank the interest on reserves is paid by creating money "ex-nihilo" (out of thin air) by the Fed. Or at least that is my understanding. How is that any burden on the taxpayer? Thanks.

    3. Charles,

      The central bank can:

      1. Lend money into existence creating both a debt and money simultaneously (discount window lending).

      2. Buy existing bonds (open market operations). In this way the central bank changes the relative quantities of debt and money in private hands.

      Notice that the central bank can never create money out of thin air and drop it out onto the ground for someone to pick up. They must either buy an existing bond / debt or loan the money into existence.

      The implication is that the quantity of money in circulation can never be greater than the quantity of debt outstanding.

      Paying interest "ex-nihilo" implies that the central bank can pay any interest rate it likes on reserves. It cannot.

    4. Charles,

      But don't take my word for it. Read here:

      Where does the money come from to pay the interest on reserves?

      "To answer this question, keep in mind both sides of the Fed’s balance sheet. The reserves in the banking system (which are liabilities of the Fed) were created when the Fed made large-scale purchases of interest-bearing securities (the corresponding Fed assets). The interest received by the Fed has thus far been much greater than the interest it has paid out. The difference between interest received by the Fed and the interest paid to banks—over $550 billion since 2009—is turned over to the US Treasury."

      And so, the interest paid on reserves is a fraction of the interest the Fed has received on the US debt that it holds. The remainder has been remitted to the U. S. Treasury department.

      Now what happens when the Fed tries to raise the interest it pays on reserves? The first thing that happens is that remittances shrink. But they can only shrink so far before all of the interest the Fed is receiving from the government goes out in interest payments on reserves.

    5. Frank thanks for your thoughtful response. Now I think I see. So paying interest on reserves reduces the interest paid back to the Treasury, which increases the deficit which, in principle, could represent a future taxpayer burden.

    6. Frank Restly:

      Yes, the Fed has to pay banks the IOER, and if the Fed raises rates, then the IOER rises.

      I contend there are koo-koo accounting rules that apply to central banking. A central bank should have the power to "print money." It is a power of the sovereign and very useful at times. Let the Fed print money and pay IOER.

      But even without that direct ability, the Fed can always print money and buy even more Treasuries, or other debt-yielding instruments and increase its balance sheet, thus essentially monetizing debt.

    7. Ben,

      "But even without that direct ability, the Fed can always print money and buy even more Treasuries, or other debt-yielding instruments and increase its balance sheet, thus essentially monetizing debt."

      1. The central bank (Fed) by law is not permitted to bid on government debt at auction.

      2. To buy U. S. government debt, the central bank must find a willing seller of that debt. The central bank cannot force someone to sell their U. S. debt holdings.

      And so no, the central bank can't always print money and buy more U. S. debt. It can run out of willing sellers for that debt.

    8. Frank,
      The Fed can overpay for treasuries, thereby by creating arbitrage opportunities and so ensuring an endless supply of willingness. Also, it can roll over its purchases into perpetuity, effectively sterilizing government debt. So back to Ben's original and correct comment....

    9. Dustin,

      "The Fed can overpay for treasuries..."

      The Fed is limited to paying no more than the sum of the interest and principle payments that a government bond offers. Any more than that, and the Fed is purposely buying government bonds at a loss which it is not permitted to do. For instance, the Fed cannot pay $1 million for a bond whose interest and principle are worth only $100.

      "Also, it can roll over its purchases into perpetuity..."

      The Fed can roll over it's purchases as long as there are willing sellers for the debt. There is nothing to guarantee a perpetual supply of government debt for the central bank to purchase.

    10. Can the fed buy stocks? Private debt ? Although Pople here believe money and bonds are substitutes, they're not. Have the Fed buy up to 10-year maturity treasuries, and the treasury to issue only perpetual bonds. Put money on the hands of anybody who might spend it, and have the issuer to take advantage of invstor demand lengtening mauturities. I doubt the liquidity effect will be absent if this is an open ended program ...

    11. government bonds owned by the Fed are still counted as part of the outstanding public debt.

  14. Great article Professor!

    Would you mind further explaining the logic between interest rates and inflation? Specifically how in the long run higher interest rates & higher inflation go together. I'm still a little hazy on that connection.


  15. May be there is no liquidity trap maybe banks are very risk adverse and the very low interest rates does not compensate risk

    1. VG,

      Bingo you have hit the nail on the head. For any loan you need both parties to agree to the terms (including the interest rate). Notice there is no credit growth rate in the Fisher equation.

      And so before jumping to the conclusion that lowering interest rates will lead to lower inflation and higher interest rates will lead to higher inflation, you must be able to determine the effect of interest rates on the supply and demand for credit.

      If the central bank raised it's overnight lending rate to 20% but could not find any borrowers at that interest rate, what would happen to the inflation rate?

      Would the inflation rate jump up to something close to 20% or would the inflation rate remain where it is or collapse?

  16. Eventually, the effect of low rates, deflation is protectionism. As this is a symptom of economic problems, consumers borrow more as they have this low cost buffer. But this creates more bondage tied to the nation in which it occurs. Therefore, the effect is to affect migration and globalization to some degree.

  17. Frank,
    I doubt that the fundamental economic principles that Prof Cochrane asserts are bound by legalism. Anyway, the FRB has already acquired trillions in assets that it could effectively extinguish. There is also no obvious limit to how much further the FRB could go.

    How can anyone seriously claim that vaporizing all of this debt wouldn't cause inflation despite low-to-zero nominal rates? Indeed, rates wouldn't stay low for long.

    1. Dustin,

      "I doubt that the fundamental economic principles that Prof Cochrane asserts are bound by legalism."

      Sure they are. See property rights, contract law, bankruptcy law, etc., etc.

      What does an interest rate even mean without these legal underpinnings?

      Central bank makes a loan at 5% interest to me and I decide I just won't pay them back. What effect does that 5% interest rate have on the inflation rate when I am in effect paying 0% interest on the loan - actually negative interest since I am not repaying principle either?

      There is nothing "fundamental" or "natural" about a lending arrangement. It is a man made contrivance that we as voters have decided should be regulated by government.

      I know John espouses free market principles, but I have yet to see anything from him to suggest that he is in favor of eliminating property rights or tearing up bankruptcy and contract law.

  18. The models that Prof Cochrane uses do not account for changeable, man-made laws. That is why he didn't mention them in his post. To recap:

    1) Interest rates have two effects on inflation: a short-run "liquidity" effect, and a long-run "expected inflation" or "Fisher" effect.
    2) In a liquidity trap, the liquidity effect is absent.
    3) Because there are excess reserves, we are in a liquidity trap.
    4) When the liquidity effect is absent [such as in a liquidity trap], the expected inflation effect is all that remains. Inflation must follow interest rates.

    These are asserted as economic truths. There is no mention of what the US Congress in 2016 allows or does not allow the Fed to do. I contest this. If the Fed were to buy assets and roll them over into perpetuity (even just the trillions they already hold!!), then the debt is effectively extinguished. There are 2 consequences - either:

    1) inflation will rise despite a low nominal rate target and presence of excess reserves, or
    2) we have a free lunch

    1. Dustin,

      "...then the debt is effectively extinguished..."

      No, it is not. The federal debt is an obligation of the government. Only the federal government can extinguish that obligation.

  19. If the FRB guarantees to continually re-up asset purchases when the current securities it holds mature, then the debt is effectively extinguished. It is equivalent to a debt that never matures. Taxes would never be allocated to retire this debt. It would be notional. New debt will pay for the old debt, forever. In an extreme case, all government expenditure could be financed this way. Just one asset (reserves) swapped for another (T securities), right?

    Obviously, this would lead to inflation even if the Fed has a low nominal rate target and is holding excess reserves. I question any model that suggests otherwise. To be sure, market rates would rise, right along with inflation, as a result.

  20. Dustin,

    Key phrase:

    "If the FRB guarantees..."

    First, it is not the Federal Reserve Board (FRB) that conducts open market operations, it is the Federal Open Market Committee (FOMC). These are not the same:


    Second, neither the FRB nor the FOMC can guarantee anything into perpetuity. Both are made up of men and women who are appointed, serve their term, and then replaced. Joe can vote to purchase government bonds today and Jane can vote to sell government bonds when she replaces Joe.

    So, like I said. The only body can can extinguish the federal debt is the federal government.

  21. Since the Fed is unable to accurately predict how their policies are affecting inflation, does that mean the fundamental economic theories as related to modern economics need to be revised?

  22. Frank, Yes I meant to use the term "Fed". You haven't addressed Prof Cochrane's model, which doesn't account for credibility.

    1. Dustin,

      His model is incomplete. A nominal interest rate with no borrowers / lenders at that interest rate will tell you nothing about the inflation rate.

  23. Melissa,
    The Fed's predictions have proven unreliable, which shouldn't be a surprise (EMH), yet the Fed continues to believe in their own power of prediction.

    The Fed should rely on market predictions. Market participants determine the path of inflation via their market actions (save, invest, consume), and their market actions are informed by their expectations. The Fed could easily accomplish this but is reluctant to value market expectations.

    I fear that until the Fed comes to this realization, monetary policy via the interest rate channel will continue to confound.


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