Tuesday, March 7, 2017

Target the spread

What should the Federal Reserve do, to control inflation, given that

nominal interest rate = real interest rate + expected inflation,

and that real interest rates vary over time in ways that the Fed cannot directly observe? In this post I  explore an idea I've been tossing around for a while: target the spread between nominal and indexed bonds, leaving the level of interest rates to float freely in response to market forces. (It follows Long Run Fed Targets and Michelson Morley and Occam.)

Indexed bonds like TIPS (Treasury Inflation Protected Securities) pay an interest rate adjusted for inflation. In simple terms, if a one-year indexed bond offers 1%, you actually get 1% + the rate of CPI inflation at the end of the year. So, with some qualifications (below), markets settle down to

nominal interest rate = indexed rate + expected inflation  

The Fed already uses this fact extensively to read market expectations of inflation from the difference between long-term nominal and indexed rates. 

My modest proposal is that the Fed should (perhaps, see below) target the spread, and thereby force expected inflation to conform to its will. 

A quick note to my fellow free marketers: The Fed (or some agency) has to do something. The price level is in the end our standard of value, and someone has to decide that we use feet instead of meters. Or, vice versa, but make up your mind. If we're going to use government debt -- dollars -- as money, then the government has to do something to establish its value, be it set a money supply, set an interest rate, promise a conversion rate to gold, to foreign currency, or, as currently, set a nominal interest rate.  (We'll leave bitcoin and private money for another day.) Or target the spread. 

By targeting the spread and ignoring the level of rates, however, the Fed could focus on inflation control, and leave real rates to their natural market level. 

One could argue whether real-rate floating is a good idea. For this post, I want to think about whether letting real rates float is possible. It's an interesting question under a general free-market prejudice that prices should be left alone where possible. The Fed and many economists seem to lean towards macroeconomic dirigisme (they call it "stabilization" or "management") rather than just inflation control, i.e. that the Fed knows better than markets what the right short run real rate is, and should actively control it to offset booms and busts, as it should more and more actively control bond prices, stock prices, real estate prices, and credit, even if inflation is stuck at 2%. I acknowledge that debate, but let's have it another day. For now, could the Fed target the spread, and let real rates float? 

There are many kinds of "target" and monetary economists use the same word in many different ways, in an apparent attempt to confuse outsiders. First, a target could be like the target of an arrow, the thing you aim for not the thing you control. In this sense, the Fed could use its short run "target," or its "instrument" the nominal rate, together possibly with other "tools," to control the nominal-indexed spread. If the spread widens, indicating higher expected inflation, then raise nominal interest rates, and keep going until the spread settles down. 

That's actually pretty much what the Fed does now, and "target the spread" means only doing it more aggressively, and focusing more on inflation and less on everything else. But, one problem, as in Michelson Morley and Occam, we're actually not that sure about the link between short nominal rates and the spread. Perhaps to lower expected inflation the Fed should lower rates, and promise to keep them there? 

So, the second, and more radical idea, which is the centerpiece of the post. Perhaps the Fed should abandon manipulating the level of short-term rates all together, and simply target the spread directly. If it wants 2% inflation, offer to exchange, say, one-year treasury bonds in return for one-year indexed treasuries at a  2% premium, in any quantity you wish. Bring in a 1% indexed treasury, and you get a 3% non-indexed treasury, no matter what the going market rate or non-indexed treasuries. And leave the interest rate alone entirely. 

Better yet, the Fed will enter a swap contract between indexed and non-indexed debt at a fixed 2%. That means you can go to the Fed, put no money down (but collateral), and at the end of the year you pay them $1 plus the rate of inflation, and they will pay you $3, or vice versa. 

Will this work? That depends entirely on whether the central equation 

nominal interest rate = indexed rate + expected inflation  

is stable or unstable. The standard, old-Keynesian, way of thinking about it is that it is unstable. If the Fed targets the difference between nominal rate and indexed rate, the slightest puff of wind will set expected inflation spiraling away. This view would allow my first idea -- you can use this as a target, so move nominal rates aggressively to control the spread -- but not my second -- that fixing the spread expected inflation would follow.

The same question holds of standard monetary policy.  If the Fed raises the nominal interest rate and keeps it there, once real = indexed rates settle down (monetary policy does not affect real rates in the long run), does expected inflation settles down or explode? The standard view is, it explodes -- the Fed must actively move nominal interest rates to keep inflation from spiraling out of control.  Like so:

But the last 8 years of globally quiet inflation with rates stuck at zero, and Japan's 20 years, really challenge that view. Inflation seems mighty stable with no movements in interest rates. And, modern new-Keynesian, rational-expectations theory also predicts exactly that outcome.  So, perhaps 

nominal interest rate = indexed rate + expected inflation  

is not 
seal's nose = (constant) + ball.

Perhaps it is instead stable, 

Top of pendulum = (constant) + bottom of pendulum

This is the point of Michelson Morley and Occam, which goes on for 120 pages to argue that stability makes sense. 

If the relationship is stable, that means the Fed can (not necessarily should) just leave the nominal rate fixed, and let expected inflation follow, after the long run real rate settles down. 

If the relationship is stable, however, that also means directly that the Fed can target the spread,  and expected inflation will follow much more directly, allowing the real rate to float up and down as it wishes. (This implication is not in the current draft of Michelson Morley and Occam, because I worried about too much apparently crazy stuff in one paper, but it will be in the next one.) 

You can also think of targeting the spread as a modern version of a gold standard. We understand how a gold standard works: The Treasury promises 1 oz of gold for every X dollars (X used to be $32). If that promise is really firm, that alone sets the price level and we don't need a Fed, at least for the purpose of setting the price level. 

Gold won't work in today's economy. It would work for the Fed to operate Fed-Mart and offer to buy and sell the entire basket of goods in the CPI in return for dollars. But that's impractical too. 

So, how about CPI futures? By offering to buy and sell CPI futures at fixed prices, it seems the Fed could nail expected inflation just as offering the CPI itself could (if it were possible) nail the price level.  Targeting the spread between indexed and non-indexed debt is exactly the same thing as targeting the CPI futures price. So we could call targeting the spread the "expected-CPI standard," and explain its functioning just like the gold standard.  

There is also nothing magic about 2%. If like me you prefer 0% inflation, then target equality between indexed and non-indexed debt. If like me you like a price level target, then the spread target must rise and fall to bring the price level back to its immutable constant. If you like more inflation, set the target higher. However, the dynamics of stability suggest that really rock-solid expectations about the future spread target are vital. Discretionary raising and lowering of the target will destroy its stability. 

On the other hand, if the relationship is unstable, activist targeting the spread rather than the level of short rates could also work. If inflation rises, then rather than keep the spread the same, the spread could rise. The spread Taylor rule could be 

(nominal rate - indexed rate) = 1.5 x (inflation rate - target)

rather than 

nominal rate = (long run real rate) + 1.5 x (expected inflation - target ) 

The only difference is whether we center the Taylor rule at the market indexed rate or the infamous r*. 

For the rest of the post I'm going to pursue the idea of stability, though, and the possibility of directly targeting the spread to equal the inflation target. 

Some important caveats, in addition to the obvious one that we should wait to really be sure that the relationship is stable not unstable. (No, if I were Fed chair I would not do this tomorrow. I wouldn't even be writing this post!) 

One obstacle is that TIPS are illiquid, spread out over many maturities, and suffer a complex tax treatment that makes them poor indicators of expected inflation. The TIPS-Treasury spread went nuts like many other things in the financial crisis. This proposal requires a much larger and more liquid TIPS market. To some extent using swaps rather than actual TIPS will help. But only big banks use swaps, and we really want everyone thinking about inflation. It would help a lot for the Treasury to issue better, more liquid bonds, including better designed TIPS, the functional equivalent of reserves, and swaps that we can all access at treasury.gov. I outlined some ideas in a new structure for federal debt. Similarly, TIPS pricing like all bond pricing involves risk premiums as well as expected inflation. For this purpose, I judge it to be a minor issue, but that is a very superficial judgement and needs investigation. 

Second, all monetary arrangements, and this one in particular, need much more attention to fiscal underpinnings. A gold standard does not depend on gold reserves, it depends on everyone's belief that the government has the power and will to borrow gold if needed, and to commit tax revenue to pay back that borrowing. 

The spread-target policy also requires solid fiscal backing. A commitment to trade large quantities of indexed vs. nonindexed bonds, or to engage in swaps, clearly is a fiscal commitment. That is, deeply, how it works. If the government -- Fed + Treasury -- starts losing a lot of money on its inflation swaps, it will raise taxes or cut spending to pay off those debts. This fiscal contraction, ultimately, lowers inflation. 

One might say therefore, that the Treasury rather than Fed should directly implement the target, offering to buy and sell bonds at fixed spreads or offering swaps at fixed prices, just as the gold standard was part of the Treasury to make clear it's commitment to find the needed gold. 

I'm not sure that is necessary. Our current Fed's target of the nominal interest rate similarly pegs the level of the interest rate on all US government debt, and the Fed is taking on large fiscal commitments in its QE operations. If the Fed can peg the level of the nominal rate, it can likely peg the spread. But there is a backstop fiscal commitment from the Treasury that needs attention. If the Fed takes on a lot of swaps, and inflation rises anyway, the Treasury will have to make good on it, just as the Treasury will have to bail out the Fed if the Fed's mortgage-backed securities go bust or if interest rates rise too fast. And, the Treasury's commitment to make good on it is what stops inflation from happening in the first place. "Do what it takes" needs a big stick in the background. That the fiscal foundations of our current monetary arrangements is shaky is pretty obvious. 

It is also not obvious that a floating short-run real rate is desirable. In the long run, there is nothing the Fed can do about real rates, the famous r*, because they are set by savings, investment, the profitability of capital, and so on. In the short run, it is felt, monetary policy affects real rates because prices are sticky. Conversely, then, a floating real rate will be influenced by "sticky" prices and wages. Adam Smith principles of the desirability of free floating prices don't necessarily hold when prices are sticky. I'm personally skeptical that our Fed can determine the "right" real rate better than markets, as nobody really understands "price stickiness," but there is a case to be made that the Fed should smooth real rate fluctuations.  

But first, let's figure out whether a spread target, i.e. an expected-CPI standard, is possible. 

Finally, let me be clear this is meant to provoke discussion. Many economists like to jump from their last working paper to policy prescriptions. I'm much more reserved. Any radical idea for policy should first be written, then published in peer-reviewed journals, then dissected, then distilled, then analyzed by the general class of thinkers and commentators, and finally when well accepted make its way to policy. We're still in that process, apparently, for the benefits of free trade and whether national income identities should inform trade policy. So, no, if by magic I woke up as Fed chair tomorrow, not even I would implement this overnight. But I do think we are much less sure about how monetary policy works than the illusion of technocratic expertise emanating from the Fed suggests, and that uncertainty should affect policy today. 

But the weight of evidence and theory in favor of stability seems to be stronger, the attraction of a "standard" that can work in modern financial markets is strong, so it does seem an idea worth putting through that process. 


  1. Inflation is defacto tax on savings and fixed price contracts. Only Congress has the constitutional power to impose such a tax. When the Fed inflates the currency they are acting unconstitutionally.

  2. I think the question that underlies the stability/instability question is this: what happens to the stock of (base) money if the spread is above/below target? If the stock of money grows/declines when the spread is below/above target, it seems stable. If vice versa, it seems unstable. (Sure, as you say, long run fiscal policy must also be compatible, but it needs to be compatible with that underlying money growth rule and the seigniorage revenue it brings in.)

  3. I really prefer your proposal of interest-on-reserves as the method of implementation, and it certainly can be combined with a feedback rule to target CPI-stability. We have projects that measure consumer prices on a daily basis, and it is cheaper to simply buy that information from providers than to get it by offering arbitrage profits to bond traders.

    Also, it's useful to look at this proposal from the perspective of a market practitioner. It depends on both indexed and nominally fixed debt being available, and the policy is to make them equal. But why are two types of debt available, and how do market participants choose between them, when policy makes them equivalent?

  4. The logic works, making it hard to slip past congress.
    TIPs are a currency insurance. Treasury sells them. Treasury does accounting for congress. congress is the major source of currency risk. Treasury is stuck, it reveals inside knowledge of currency risk. Thus, in this scheme, we force congress to mark to market ASAP.

    1. Congress determines whether the inflation component of TIPs is paid or unpaid.

      And I can't recall a time I pulled a wad of TIPs out of my pocket to pay my grocery bill.

  5. John,

    Problem #1: It remains to be seen whether the inflation adjustment payments on TIPs can survive a Constitutional challenge.

    Congress wants to cut spending, and so they cancel all inflation adjustments on payments toward Social Security and TIPs. Have they violated the 13th Amendment?

    Problem #2: Quantities matter.
    Nominal Treasuries outnumber TIPS by over a 10:1 margin.

    What stops the U. S. Treasury / Congress from altering this mix to reduce total payments on it's debt and how does that affect the central bank in trying to hit a spread? The obvious example is that the U. S. Treasury buys back all of it's outstanding TIPs and sells nominal bonds to replace them.

    Problem #3: Central bank policy consists of the both open market operations as well as lender of last resort operations. With the central bank targeting the spread between short term inflation indexed government debt and short term nominal government debt, how is the overnight rate the central bank lends at set?

    Problem #4: TIPs don't accurately reflect inflation / deflation expectations.


    "What happens to TIPS if deflation occurs?"

    "The principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same. You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal."

    Losses on TIPs in the form of lost principle are not realized until the bonds are sold prior to maturity. In the event of deflation, trading in TIPs would likely freeze up and the central bank would lose control of the spread.

    Problem #5: Limitations placed on the central bank open market committee.


    "To buy and sell, at home or abroad, bonds and notes of the United States, bonds issued under the provisions of subsection (c) of section 4 of the Home Owners' Loan Act of 1933, as amended, and having maturities from date of purchase of not exceeding six months.."

    "To buy and sell in the open market, under the direction and regulations of the Federal Open Market Committee, any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States."

    You must realize that for the central bank to hit a spread between TIPs and nominal bonds, they must be able to both buy and sell TIPs. The potential for loss of principle on TIPs sold prior to maturity should preclude the central bank from entering this market.

  6. "What should the Federal Reserve do, to control inflation?"

    The federal reserve members (open market committee and board of governors) should all quit their jobs and do something productive with their lives.

    The question you should be asking is:

    How does the central bank get anyone to knowingly borrow at a positive real rate of interest? If the central bank lends at a nominal rate of interest, how does it convince borrowers not to raise prices on goods to cover the interest expense?

  7. John,

    "Any radical idea for policy should first be written, then published in peer-reviewed journals, then dissected, then distilled, then analyzed by the general class of thinkers and commentators, and finally when well accepted make its way to policy."

    You mean like the Laffer Curve?

    1. "...should first be written..."

    "In this meeting, Laffer, arguing against President Gerald Ford's tax increase, reportedly sketched the curve on a napkin to illustrate the concept."

    Does sketching on a cocktail napkin count as writing?

    2. "...then published in peer-reviewed journals..."

    "The Laffer Curve, by the way, was not invented by me. For example, Ibn Khaldun, a 14th-century philosopher, wrote in his work The Muqaddimah: It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments."

    I am not sure that "The Muqaddimah" qualifies as a peer-reviewed journal.

    3. "...then dissected, then distilled, then analyzed by the general class of thinkers and commentators..."

    ""The term Laffer curve was reportedly coined by Jude Wanniski (a writer for The Wall Street Journal) after a 1974 dinner meeting at the Two Continents Restaurant in the Washington Hotel with Arthur Laffer, Wanniski, Dick Cheney, Donald Rumsfeld, and his deputy press secretary Grace-Marie Arnett."

    I suppose Wanniski, Cheney, Rumsfeld, and Arnett qualify as general class of thinkers, but I have to wonder how much dissecting, diluting, and analyzing went on during that meeting.

  8. John,

    You write: "A quick note to my fellow free marketers: The Fed (or some agency) has to do something..."

    I understand the point here but there is something I am missing. Certainly, if the money supply is to be determined by central planning, then there are better and worse plans. Maybe targeting the TIPS spread is the least bad central plan. That's the point you are making, right?

    But the people at the Fed really could do nothing in the sense that tomorrow Janet Yellen could make a public statement like "After much consideration we have determined that central banking is as misguided as central planning of agriculture and industry. We cannot even measure the impact of monetary policy on variables such as inflation, unemployment and output in hindsight, let alone forecast the consequences of our actions. Therefore we have decided to permanently cease all transactions. We will auction off all assets on our balance sheet and give the proceeds to the Treasury, after which we will permanently cease all purchases and sales of financial assets."

    Since this option exists, why advocate for any central plan at all? To be clear, I am assuming that the difference in outcomes between abandoning central planning vs implementing the best central plan is probably much larger than the difference in outcomes between implementing the best central plan vs implementing the average central plan.

  9. John, great post, but I think you should give credit to Bob Hetzel for this. After all he was the first to suggest this all time ago. In fact that is why there are TIPS today.

    See here: https://marketmonetarist.com/2014/06/22/bob-hetzels-great-idea/

    You will also see that Friedman supported the idea in Money Mischief....but that a UoC econ professor obviously already knows...or?

    1. Yes, thanks. I'm sure many of the ideas are even older. This being a blog post I didn't try to give proper references, credit, or history of thought. That's a paper all of its own!

    2. Though, now that I read the very nice blog post, not even Hetzel went this far. He advocated controlling the spread by money growth:

      "if market expectations for, for example inflation two years ahead were below the 2% target then the central bank would automatically expand the money base.."

      The "soft" version just uses the spread as an indicator, which is pretty much what the Fed is doing now.

      "In the soft version of Bob’s idea the central bank will not directly target market inflation expectations, but rather use the market expectations as an indicator for monetary policy"

      Of course what happens to an indicator when you try to control it is an interesting question.

      But not even Bob has the crazy idea of mixing target and instrument -- of simply offering to buy and sell securities at a fixed spread. I suspect that is because 1990s vintage models (and Friedman's), this would have been unstable.

    3. Lars,

      The earliest reference to inflation indexed securities that I can find is here:


      I believe the British were the first to begin selling inflation linked securities primarily as a pension fund vehicle.

  10. There are two problems here:

    1) It's not clear that the Fed really cares about inflation levels as a top priority.

    2) Managing the spread would put the Fed directly head-to-head with markets. That means they would run out of money before they could meet their mandate.

    The only way it could work is if they set their "targets" based on the current spread. So they would pretend they are leading, but actually just following.

    1. Fish,

      How can the Fed run out of money?

    2. James, we like to say that the Fed cannot run out of money because there is no technical constraint on inflation. That is what Prof. Cochrane is trying to introduce with his method above of targeting inflation expectations. Using his preferred theory of inflation, we might say that this regime breaks if the federal government runs of out fiscal capacity. That's why he describes this scheme as a fiscal commitment: it requires the federal government to pay off its debt through taxes and not by inflating it away. Though the commitment isn't very strong because the costs of reverting to the previous regime aren't very high.

  11. In principle, Treasury could implement a poor man's version of this by allocating more/less issuance to TIPS based on BEIs. (A similar point has often been noted for Fed's LSAPs, vs Treasury allocating long/short.) So I guess what I'm wondering is, do these sorts of ideas for monetary policy - if taken face-value, and if indeed they would 'work' - pin down Treasury debt management policy? If Fed is constantly doing these switches/swaps does that leave room for consolidated debt management to have any goals that are independent of monetary policy, or is there no point in that?

  12. Bob Hall and Ricardo Reis have a related idea of using interest on reserves to target the price level directly: http://web.stanford.edu/~rehall/CBPR161016 Given an initial price level, it is equivalent to targeting the spread. In theory one could target the real return on any nominal asset with a liquid enough market. Should it be reserves or bonds?

    1. I like these interest-on-reserves plans as a way to set the price level, because they influence expectations in a way that makes clear sense economically. They adjust the monetary base directly, with the understanding by the public that this is how government debt is re-denominated. The scheme proposed by Prof. Cochrane above is described as "targeting the spread" which suggests that it will influence inflation, but if the real rate and inflation expectations are both exogenous, then all this scheme does is provide a way for the nominal interest rate to adjust accordingly.

      Quite a few people do believe that we are now in a regime of exogenous, or "adaptive" inflation expectations. Prof. Cochrane seems to deny this, suggesting instead that equilibrium between indexed and non-indexed bonds will influence price-setting behavior in the economy. But the economic intuition for this is not very clear, because swapping one type of bond for the other doesn't have any obvious effect on real constraints faced by economic agents.

      This only changes when the government hits the limit of its fiscal capacity. In that case, bondholders might run towards TIPS because they make a promise that is fixed in real terms, with priority over the remaining bonds which are residual claims to government assets.

    2. Anwer,

      "This only changes when the government hits the limit of its fiscal capacity. In that case, bondholders might run towards TIPS because they make a promise that is fixed in real terms."

      And government might run the other way by selling fewer TIPs and more nominal bonds.

      Also, TIPs are marketable securities. They ARE NOT fixed in real terms - the fixed rate offered on these securities floats with market demand and has on occasions gone negative.

      Additionally, Congress retains the right to change the inflation benchmark used to calculate the inflation component of TIPs. The bureau of labor statistics maintains several different CPI benchmarks:


      Chained CPI-U

      In fact, there is a bill before Congress to change the inflation benchmark used for COL Social Security payments from the CPI-U to the Chained CPI-U.


      Stands to reason that the inflation benchmark for TIPs can be changed by Congress as well.

      Finally, the CPI calculation method itself has gone through numerous revisions including the 1983 replacement of housing prices with owner's equivalent rent and the 1995 Boskin Commission inclusion of hedonic adjustments into the CPI.


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