Inflation Explainer

Bari Weiss asked me to write a short post for her substack offering some inflation explanations on the occasion of post-Thanksgiving shopping.  

It’s Black Friday, ‘70s-Style

Black Friday begins tonight, and Americans, after emerging from our collective turkey coma, will dive into our sacred, national ritual: shopping. 

Those who haven’t shopped lately are in for a rude awakening: Many items will be out of stock, delayed or cost a lot more than they used to. Welcome to inflation, back from the 1970s!  

As you look for a deal on a Peloton to work off your pandemic paunch, here is a brief explanation about what’s going on with our economy, why so many things are becoming more expensive, why this hurts all of us, and why the government can’t spend its way out of this mess.

Why are prices rising? 

The news is full of “supply chain” problems. Shipping containers can’t get through our ports. Car-makers can’t get chips to make cars. Railroads look like the 405 at rush hour. 

What’s underlying many of these problems is the fact that businesses can’t find enough workers. There aren’t enough truck drivers, airline pilots, construction workers and warehouse workers in the “supply chain.” Restaurants can’t find waiters and cooks. There are 10 million job openings and only seven million people looking for work. About three million people who were working in March 2020 are no longer working or looking for work.

But supply chains wouldn’t be clogged if people weren’t trying to buy a lot. The fundamental issue is that demand is outstripping supply.

Grumpy on inflation at CATO

I had a great time at the CATO monetary policy conference last week. A brief view on why we're having inflation and the chance it will continue:  

Briefly, a helicopter dropped. The Fed fell flat. And here we go. Grumpy got steamed up on this one. 

If the embed doesn't work, try the direct link or the above conference link. Greg Ip moderated well, and stick around for insightful comments from Fernando Martin, Mark Sobel, and David Beckworth.

Inflation meditation

The discussion about inflation is pretty confused. There is a lot of confusion about aggregate demand vs. individual demand, aggregate supply vs. supply, and about relative prices vs. inflation. 

My theme: Inflation is entirely about "demand," not "supply." Fixing the ports, the chips, the pipelines, the labor disincentives, the regulations, are all great and good, and the key to economic growth. But they will not on their own do much to slow inflation. We are having inflation because the government printed up a few trillion dollars, and borrowed a few trillion more, and wrote people checks. People are spending the checks. 

At a superficial level this is obvious. If people weren't spending a lot of money, the ports would not be clogged. But it's deeper than that. 

Inflation is all prices and wages going up at the same time. Relative price changes are when one price goes up and other prices go down. Reality combines the two, but let's use terms correctly for each element. 

Supply shocks cause relative price changes, not inflation. Suppose the ports clog up, and you can't get TVs off the boat from China. Then the price of TVs has to rise relative to other prices. The price of TVs has to go up relative to restaurant food, for example, so people buy fewer TVs and go out to eat more. Or the price of TVs has to go up relative to wages, so people buy less overall. 

Now the world is a bit more complex. If prices and wages moved instantly, the price of restaurant food, or wages, would go down, the price of TVs would go up, and the overall price level would not change. In reality the other prices go down slowly. So the price of TVs goes up, and other prices and wages only slowly go down. We measure a little bit of inflation, followed by a slow period of lower measured inflation. 

This is one of the mechanisms people have in mind when they refer to supply shocks, and say inflation will be transitory. But that's clearly not what's happening now. Everything is going up, though some things more than others. 

Likewise what happens if people decide in a pandemic that they want to buy more TVs and go out to dinner less? That's a relative demand shock. It drives up the price of TVs, and down the price of restaurant food with no inflation. But restaurant prices go down more slowly than TV prices go up, so we measure a bit of inflation and then less inflation. But that's not what's happening now. Restaurant prices are going up too. 

"Aggregate supply" is the question, how much more does the economy produce when all prices and wages are moving up at the same rate -- true, pure, inflation? That's a tricky and slippery concept! Sure, if wages rise more than prices, workers might work harder and produce more. If prices rise more than wages, companies might produce more in pursuit of higher profits. Since I told the same story both ways, you can see even this is slippery. But these stories are still about relative prices and wages, not both prices and wages rising together. If prices rise 10% and wages rise 10%, why does anybody do anything different? Welcome to the mysteries of "aggregate supply." 

It only makes sense if you think prices or wages were sticky and one or the other was stuck at too low a level. Then a bit of inflation can unstick one of the two, getting the economy back to a more productive level. Aggregate supply is about sticky prices and wages, not about the actual productive capacity of the economy. Another way to see it: Why was the economy not already producing as much as it could, so that money raises output rather than immediately raising inflation? Well, something had to be wrong that inflation could fix, and in macro theory that's "sticky prices." 

Yes, this is slippery, but let's not get too far down the rabbit hole. The central point, as intuitive as it sounds, it is not true that unclogging the ports will soak up demand and stop pure inflation. It will lower the relative price of TVs, but that "more supply" doesn't do much about all prices and wages rising together. 

All prices and wages rising together means that one thing is falling in value -- money, and government debt. Inflation is a change in the relative price of money and government debt relative to everything else. Inflation comes thus, fundamentally, from the overall supply vs. demand for money and government debt. 

We seem, sadly, to be repeating all the confusion on these affairs that prevailed in the 1970s. Oil price "supply" shocks will surely be "transitory." President Biden is sending the FTC to hound the oil companies to lower prices.  Can "guideposts" be far behind? For a thousand years, inflation has led to a witch hunt after "speculators" and "middlemen" and price rising conspiracies. Here we go. 

Transitory Inflation: A Fisherian Fed?

Should the Fed raise interest rates fast? Or should it leave them alone, figuring inflation will be "transitory?" 

Lots of models, including ones I play with, predict that a constant unchanging interest-rate peg leads to stable inflation. If there is a fiscal shock, it leads to a one-period price-level jump, but no further inflation, so long as the interest rate stays where it is. The models in the first few chapters of The Fiscal Theory of the Price Level have this feature, also "Michelson Morley, Fisher and Occam.'' Martin Uribe has also written about this issue, here for example. 

The simplest example is \[i_t = E_t \pi_{t+1}\] \[(E_{t+1}-E_t) \pi_{t+1} = -(E_{t+1}-E_t) \sum_{j=0}^{\infty} \rho^j \tilde{s}_{t+j} \] where \(\tilde{s}\) denotes real primary surpluses scaled by the value of debt. If the interest rate \(i_t\) does not move, expected inflation does not move. A fiscal shock (negative \(\tilde{s}\) ) gives a one-period unexpected inflation, devaluing outstanding debt; essentially a Lucas-Stokey state-contingent default. Sticky prices smooth all this out over a year or two. 

You can replace the latter with standard new-Keynesian equilibrium-selection rules if you want. This isn't really about fiscal theory; the key is rational forward-looking expectations in the first equation, which also hold in the standard sticky-price extensions. This "Fisherian" property is a common though widely ignored prediction of most new-Keynesian models. 

It certainly seems plausible that we are seeing an inflationary fiscal shock, from trillions of money printed up and sent to consumers, while interest rates stay fixed. These models predict that such inflation will indeed be transitory if the Fed does not raise interest rates, and will rise if it does!  

However, like all lower-rates-to-lower-inflation arguments, there are lots of warnings here. In particular, the "transitory" inflation could last a long time once we put in sticky prices. The trick only works if the Fed is completely committed to not raising rates, to waiting as long as it takes for inflation to settle back down on its own.  If people suspect the Fed will raise rates, inflation rises. There are lots of temporary forces that go in the other direction. And there may be more fiscal shocks -- I sort of see one brewing in Congress -- so we may not be done with the unexpected inflation term. 

FTPL section 5.3 has a long discussion of all the preconditions for lower interest rates to bring down inflation, which still obtain. But we haven't been talking about this issue much since the low-inflation zero-bound era ended, and the discussion that maybe determined, permanent, pre-announced interest rate rises could eventually bring up inflation. The opposite sign works as well. 

In these models, with a few more ingredients than I show above, the Fed can also lower inflation by raising rates. Raising rates gives a temporary inflation decline before going the other way. So, the Fed has to raise rates, push inflation down, then quickly get on the other side. That's the historical pattern, and what it will likely do.  But it's only honest, and fun, to remember the prediction of the opposite possibility and to think about how it might work out. 

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Update. A second try, with more English. The government, Fed and Treasury, basically printed up about $5 trillion of new cash and treasury debt -- these are largely perfect substitutes so the composition doesn't really matter -- with no change at all in plans to repay debt. By simple FTPL, a 25% increase in debt with no increase in expected future surpluses generates a 25% rise in the price level, 25% cumulative inflation. It basically defaults on outstanding debt and transfers that value to the recipients of stimulus. 

But then it ends. If there is no more issue of nominal debt, without additional surpluses, then there is no more inflation. 

Additional issues of nominal debt can come from more unbacked fiscal expansion, or it can come from monetary policy. Monetary policy also puts extra government debt (same thing as interest-paying reserves) out there, with (of course) no change in fiscal policy. 

So there is the FTPL case for "transitory."In the long run, no change in interest rate puts no extra government debt in the system, and higher nominal interest rates must mean eventually higher inflation and hence more unbacked government debt in the system. 

 

Central bank expansionism

A keynote talk at the FGV EPGE (Brazilian School of Economics and Finance) 60th anniversary conference, program here. Direct link to my talk here (YouTube).  (I start at about 4:00 if you're impatient). I plan to turn these thoughts in to an essay at some point. All the conference videos here 

The theme: Central banks, and especially the US Fed, are spinning out of control. I trace the history of this expansion, and how little steps taken here and there mushroomed. The decision in 2008 to regulate assets rather than pursue equity-financed banking, and buying huge amounts of assets, are small steps that mushroomed. They are the moment that central banks became the proverbial two year old with a hammer. The end, the natural meaning of "whole of government" approaches, must be the end of central bank independence and their complete politicization. 

Supply

The Revenge of Supply, at Project Syndicate

Surging inflation, skyrocketing energy prices, production bottlenecks, shortages, plumbers who won’t return your calls – economic orthodoxy has just run smack into a wall of reality called “supply.” 

Demand matters too, of course. If people wanted to buy half as much as they do, today’s bottlenecks and shortages would not be happening. But the US Federal Reserve and Treasury have printed trillions of new dollars and sent checks to just about every American. Inflation should not have been terribly hard to foresee; and yet it has caught the Fed completely by surprise. 

The Fed’s excuse is that the supply shocks are transient symptoms of pent-up demand. But the Fed’s job is – or at least should be – to calibrate how much supply the economy can offer, and then adjust demand to that level and no more. Being surprised by a supply issue is like the Army being surprised by an invasion. 

The current crunch should change ideas. Renewed respect may come to the real-business-cycle school, which focuses precisely on supply constraints and warns against death by a thousand cuts from supply inefficiencies. Arthur Laffer, whose eponymous curve announced that lower marginal tax rates stimulate growth, ought to be chuckling at the record-breaking revenues that corporate taxes are bringing in this year. 

Equally, one hopes that we will hear no more from Modern Monetary Theory, whose proponents advocate that the government print money and send it to people. They proclaimed that inflation would not follow, because, as Stephanie Kelton puts it in The Deficit Myth, “there is always slack” in our economy. It is hard to ask for a clearer test. 

But the US shouldn’t be in a supply crunch. Real (inflation-adjusted) per capita US GDP just barely passed its pre-pandemic level this last quarter, and overall employment is still five million below its previous peak. Why is the supply capacity of the US economy so low? Evidently, there is a lot of sand in the gears. Consequently, the economic-policy task has been upended – or, rather, reoriented to where it should have been all along: focused on reducing supply-side inefficiencies. 

One underlying problem today is the intersection of labor shortages and Americans who are not even looking for jobs. Although there are more than ten million listed job openings – three million more than the pre-pandemic peak – only six million people are looking for work. All told, the number of people working or looking for work has fallen by three million, from a steady 63% of the working-age population to just 61.6%. 

We know two things about human behavior: First, if people have more money, they work less. Lottery winners tend to quit their jobs. Second, if the rewards of working are greater, people work more. Our current policies offer a double whammy: more money, but much of it will be taken away if one works. Last summer, it became clear to everyone that people receiving more benefits while unemployed than they would earn from working would not return to the labor market. That problem remains with us and is getting worse. 

Remember when commentators warned a few years ago that we would need to send basic-income checks to truck drivers whose jobs would soon be eliminated by artificial intelligence? Well, we started sending people checks, and now we are surprised to find that there is a truck driver shortage. 

Practically every policy on the current agenda compounds this disincentive, adding to the supply constraints. Consider childcare as one tiny example among thousands. Childcare costs have been proclaimed the latest “crisis,” and the “Build Back Better” bill proposes a new open-ended entitlement. Yes, entitlement: “every family who applies for assistance … shall be offered child care assistance” no matter the cost. 

The bill explodes costs and disincentives. It stipulates that childcare workers must be paid at least as much as elementary school teachers ($63,930), rather than the current average ($25,510). Providers must be licensed. Families pay a fixed and rising fraction of family income. If families earn more money, benefits are reduced. If a couple marries, they pay a higher rate, based on combined income. With payments proclaimed as a fraction of income and the government picking up the rest, either prices will explode or price controls must swiftly follow. Adding to the absurdity, the proposed legislation requires states to implement a “tiered system” of “quality,” but grants everyone the right to a top-tier placement. And this is just one tiny element of a huge bill. 

Or consider climate policy, which is heading for a rude awakening this winter. This, too, was foreseeable. The current policy focus is on killing off fossil-fuel supply before reliable alternatives are ready at scale. Quiz: If you reduce supply, do prices go up or go down? Europeans facing surging energy prices this fall have just found out. 

In the United States, policymakers have devised a “whole-of-government” approach to strangle fossil fuels, while repeating the mantra that “climate risk” is threatening fossil-fuel companies with bankruptcy due to low prices. We shall see if the facts shame anyone here. Pleading for OPEC and Russia to open the spigots that we have closed will only go so far. 

Last week, the International Energy Agency declared that current climate pledges will “create” 13 million new jobs, and that this figure would double in a “Net-Zero Scenario.” But we’re in a labor shortage. If you can’t hire truckers to unload ships, where are these 13 million new workers going to come from, and who is going to do the jobs that they were previously doing? Sooner or later, we have to realize it’s not 1933 anymore, and using more workers to provide the same energy is a cost, not a benefit. 

It is time to unlock the supply shackles that our governments have created. Government policy prevents people from building more housing. Occupational licenses reduce supply. Labor legislation reduces supply and opportunity, for example, laws requiring that Uber drivers be categorized as employees rather than independent contractors. The infrastructure problem is not money, it is that law and regulation have made infrastructure absurdly expensive, if it can be built at all. Subways now cost more than a billion dollars per mile. Contracting rules, mandates to pay union wages, “buy American” provisions, and suits filed under environmental pretexts gum up the works and reduce supply. We bemoan a labor shortage, yet thousands of would-be immigrants are desperate to come to our shores to work, pay taxes, and get our economy going. 

A supply crunch with inflation is a great wake-up call. Supply, and efficiency, must now top our economic-policy priorities.

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Update: I am vaguely aware of many regulations causing port bottlenecks, including union work rules, rules against trucks parking and idling, overtime rules, and so on. But it turns out a crucial bottleneck in the port of LA is... Zoning laws! By zoning law you're not allowed to stack empty containers more than two high, so there is nowhere to leave them but on the truck, which then can't take a full container. The tweet thread is really interesting for suggesting the ports are at a standstill, bottled up FUBARed and SNAFUed, not running full steam but just can't handle the goods. 

Disclaimer: To my economist friends, yes, using the word "supply" here is not really accurate. "Aggregate supply" is different from the supply of an individual good. Supply of one good increases when its price rises relative to other prices. "Aggregate supply" is the supply of all goods when prices and wages rise together, a much trickier and different concept. What I mean, of course, is something like "the amount produced by the general equilibrium functioning of the economy, supply and demand, in the absence of whatever frictions we call low 'aggregate demand', but as reduced by taxes, regulations, and other market distortions." That being too much of a mouthful, and popular writing using the word "supply" and "supply-side" for this concept, I did not try to bend language towards something more accurate. 

Inflation, debt, politics, and insurance at Project Syndicate

An essay at Project Syndicate

Inflation in the Shadow of Debt

Today’s inflation is transitory, our central bankers assure us. It will go away on its own. But what if it does not? Central banks will have “the tools” to deal with inflation, they tell us. But just what are those tools? Do central banks have the will to use them, and will governments allow them to do so?

Should inflation continue to surge, central banks’ main tool is to raise interest rates sharply, and keep them high for several years, even if that causes a painful recession, as it did in the early 1980s. How much pain, and how deep of a dip, would it take? The well-respected Taylor rule (named after my Hoover Institution colleague John B. Taylor) recommends that interest rates rise one and a half times as much as inflation. So, if inflation rises from 2% to 5%, interest rates should rise by 4.5 percentage points. Add a baseline of 2% for the inflation target and 1% for the long-run real rate of interest, and the rule recommends a central-bank rate of 7.5%. If inflation accelerates further before central banks act, reining it in could require the 15% interest rates of the early 1980s.

Would central banks do that? If they did, would high interest rates control inflation in today’s economy? There are many reasons for worry.

The shadow of debt

Monetary policy lives in the shadow of debt. US federal debt held by the public was about 25% of GDP in 1980, when US Federal Reserve Board Chair Paul Volcker started raising rates to tame inflation. Now, it is 100% of GDP and rising quickly, with no end in sight. When the Fed raises interest rates one percentage point, it raises the interest costs on debt by one percentage point, and, at 100% debt-to-GDP, 1% of GDP is around $227 billion. A 7.5% interest rate therefore creates interest costs of 7.5% of GDP, or $1.7 trillion.

Where will those trillions of dollars come from? Congress could drastically cut spending or find ways to increase tax revenues. Alternatively, the US Treasury could try to borrow additional trillions. But for that option to work, bond buyers must be convinced that a future Congress will cut spending or raise tax revenues by the same trillions of dollars, plus interest. Even if investors seem confident at the moment, we cannot assume that they will remain so indefinitely, especially if additional borrowing serves only to pay higher interest on existing debt. Even for the United States, there is a point at which bond investors see the end coming, and demand even higher interest rates as a risk premium, thereby raising debt costs even more, in a spiral that leads to a debt crisis or to a sharp and uncontrollable surge of inflation. If the US government could borrow arbitrary amounts and never worry about repayment, it could send its citizens checks forever and nobody would have to work or pay taxes again. Alas, we do not live in that fanciful world.

In sum, for higher interest rates to reduce inflation, higher interest rates must be accompanied by credible and persistent fiscal tightening, now or later. If the fiscal tightening does not come, the monetary policy will eventually fail to contain inflation.

This is a perfectly standard proposition, though it is often overlooked when discussing the US and Europe. It is embodied in the models used by the Fed and other central banks. [Previous post here on just what that means.] It was standard IMF advice for decades.

Successful inflation and currency stabilization almost always includes monetary and fiscal reform, and usually microeconomic reform. The role of fiscal and microeconomic reform is to generate sustainably higher tax revenues by boosting economic growth and broadening the tax base, rather than with sharply higher and growth-reducing marginal tax rates. Many attempts at monetary stabilization have fallen apart because the fiscal or microeconomic reforms failed. Latin-American economic history is full of such episodes.

Even the US experience in the 1980s conforms to this pattern. The high interest rates of the early 1980s raised interest costs on the US national debt, contributing to most of the then-large annual “Reagan deficits.” Even after inflation declined, interest rates remained high, arguably because markets were worried that inflation would come surging back.

So, why did the US inflation-stabilization effort succeed in the1980s, after failing twice before in the 1970s, and countless times in other countries? In addition to the Fed remaining steadfast and the Reagan administration supporting it through two bruising recessions, the US undertook a series of important tax and microeconomic reforms, most notably the 1982 and 1986 tax reforms, which sharply lowered marginal rates, and market-oriented regulatory reforms starting with the Carter-era deregulation of trucking, air transport, and finance.

The US experienced a two-decade economic boom. A larger GDP boosted tax revenues, enabling debt repayment despite high real-interest rates. By the late 1990s, strange as it sounds now, economists were actually worrying about how financial markets would work once all US Treasury debt had been paid off. The boom was arguably a result of these monetary, fiscal, and microeconomic reforms, though we do not need to argue the cause and effect of this history. Even if the economic boom that produced fiscal surpluses was coincidental with tax and regulatory reform, the fact remains that the US government successfully paid off its debt, including debt incurred from the high interest costs of the early 1980s. Had it not done so, inflation would have returned.

The Borrower Ducks

But would that kind of successful stabilization happen now, with the US national debt four times larger and still rising, and with interest costs for a given level of interest rates four times larger than the contentious Reagan deficits? Would Congress really abandon its ambitious spending plans, or raise tax revenues by trillions, all to pay a windfall of interest payments to largely wealthy and foreign bondholders?

Arguably, it would not. If interest costs on the debt were to spiral upward, Congress would likely demand a reversal of the high interest-rate policy. The last time the US debt-to-GDP ratio was 100%, at the end of World War II, the Fed was explicitly instructed to hold down interest costs on US debt, until inflation erupted in the 1950s.

The unraveling can be slow or fast. It takes time for higher interest rates to raise interest costs, as debt is rolled over. The government can borrow as long as people believe that the fiscal reckoning will come in the future. But when people lose that faith, things can unravel quickly and unpredictably.

Will and Politics

Fiscal policy constraints are only the beginning of the Fed’s difficulties. Will the Fed act promptly, before inflation gets out of control? Or will it continue to treat every increase of inflation as “transitory,” to be blamed on whichever price is going up most that month, as it did in the early 1970s?

It is never easy for the Fed to cause a recession, and to stick with its policy through the pain. Nor is it easy for an administration to support the central bank through that kind of long fight. But tolerating a lasting rise in unemployment – concentrated as usual among the disadvantaged – seems especially difficult in today’s political climate, with the Fed loudly pursuing solutions to inequality and inequity in its interpretation of its mandate to pursue “maximum employment.”

Moreover, the ensuing recession would likely be more severe. Inflation can be stabilized with little recession if people really believe the policy will be seen through. But if they think it is a fleeting attempt that may be reversed, the associated downturn will be worse.

One might think this debate can be postponed until we see if inflation really is transitory or not. But the issue matters now. Fighting inflation is much easier if inflation expectations do not rise. Our central banks insist that inflation expectations are “anchored.” But by what mechanism? Well, by the faith that those same central banks would, if necessary, reapply the harsh Volcker medicine of the 1980s to contain inflation. How long will that faith last? When does the anchor become a sail?

A military or foreign-policy analogy is helpful. Fighting inflation is like deterring an enemy. If you just say you have “the tools,” that’s not very scary. If you tell the enemy what the tools are, show that they all are in shiny working order, and demonstrate that you have the will to use them no matter the pain inflicted on yourself, deterrence is much more likely.

Yet the Fed has been remarkably silent on just what the “tools” are, and just how ready it is to deploy those tools, no matter how painful doing so may be. There has been no parading of materiel. The Fed continues to follow the opposite strategy: a determined effort to stimulate the economy and to raise inflation and inflation expectations, by promising no-matter-what stimulus. The Fed is still trying to deter deflation, and says it will let inflation run above target for a while in an attempt to reduce unemployment, as it did in the 1970s. It has also precommitted not to raise interest rates for a fixed period of time, rather than for as long as required economic conditions remain, which has the same counterproductive result as announcing military withdrawals on specific dates. Like much of the US government, the Fed is consumed with race, inequality, and climate change, and thus is distracted from deterring its traditional enemies.

Buy some insurance! 

An amazing opportunity to avoid this conundrum beckons, but it won’t beckon forever. The US government is like a homeowner who steps outside, smells smoke, and is greeted by a salesman offering fire insurance. So far, the government has declined the offer because it doesn’t want to pay the premium. There is still time to reconsider that choice.

Higher interest rates raise interest costs only because the US has financed its debts largely by rolling over short-term debt, rather than by issuing long-term bonds. The Fed has compounded this problem by buying up large quantities of long-term debt and issuing overnight debt – reserves – in return.

The US government is like any homeowner in this regard. It can choose the adjustable-rate mortgage, which offers a low initial rate, but will lead to sharply higher payments if interest rates rise. Or it can choose the 30-year (or longer) fixed-rate mortgage, which requires a larger initial rate but offers 30 years of protection against interest-rate increases.

Right now, the one-year Treasury rate is 0.07%, the ten-year rate is 1.3%, and the 30-year rate is 1.9%. Each one-year bond saves the US government about two percentage points of interest cost as long as rates stay where they are. But 2% is still negative in real terms. Two percentage points is the insurance premium for eliminating the chance of a debt crisis for 30 years, and for making sure the Fed can fight inflation if it needs to do so. I am not alone in thinking that this seems like inexpensive insurance. Even former US Secretary of the Treasury Lawrence H. Summers has changed his previous view to argue that the US should move swiftly to long-term debt.

But it’s a limited-time opportunity. Countries that start to encounter debt problems generally face higher long-term interest rates, which forces them to borrow short-term and expose themselves to the attendant dangers. When the house down the street is on fire, the insurance salesman disappears, or charges an exorbitant rate.

Bottom line

Will the current inflation surge turn out to be transitory, or will it continue? The answer depends on our central banks and our governments. If people believe that fiscal and monetary authorities are ready to do what it takes to contain breakout inflation, inflation will remain subdued.

Doing what it takes means joint monetary and fiscal stabilization, with growth-oriented microeconomic reforms. It means sticking to that policy through the inevitable political and economic pain. And it means postponing or abandoning grand plans that depend on the exact opposite policies.

If people and markets lose faith that governments will respond to inflation with such policies in the future, inflation will erupt now. And in the shadow of debt and slow economic growth, central banks cannot control inflation on their own.

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PS, I don't know if the ads that come up on project syndicate are common or are tailored to me. In either case, if you know me at all, you will find the ad choice rather humorous. PS asked me to write because they felt the need for some intellectual diversity, and I guess it shows!

Inflation in the shadow of debt

(Note: This post uses mathjax equations. If you see garbled latex code, come to the original source.) 

The effect of monetary policy on inflation depends crucially on fiscal policy.

In standard new-Keynesian models, of the type used throughout the Fed, ECB, and similar institutions, for the central bank to reduce inflation by raising interest rates, there must be a contemporaneous fiscal tightening. If fiscal policy does not tighten, the Fed will not lower inflation by raising interest rates.

The warning for today is obvious: Fiscal policy is on a tear, and not about to tighten any time soon no matter what central banks do. An interest rate rise might not, then, provoke the expected decline in inflation.

Here is a very stripped down model to show the point. \begin{align*} x_t & = E_t x_{t+1} - \sigma(i_t - E_t \pi_{t+1}) \\ \pi_t & = \beta E_t \pi_{t+1} + \kappa x_t \\ i_t &= \phi \pi_t + u_t \\ \Delta E_{t+1}\pi_{t+1} & = - \sum_{j=0}^\infty \rho^j \Delta E_{t+1} \tilde{s}_{t+1+j} + \sum_{j=1}^\infty \rho^j \Delta E_{t+1}(i_{t+j}-\pi_{t+1+j}) \end{align*} The first two equations are the IS and Phillips curves of a standard new-Keynesian model. The third equation is the monetary policy rule.

The fourth equation stems from the condition that the value of debt equals the present value of surpluses. This condition is also a part of the standard new-Keynesian model. We're not doing fiscal theory here. Fiscal policy is assumed to be "passive:" Surpluses adjust to whatever inflation results from monetary policy. For example, if monetary policy induces a big deflation, that raises the real value of nominal debt, so real primary surpluses must raise to pay the now larger value of the debt. Since it just determines surpluses given everything else, this equation is often omitted, or relegated to a footnote, but it is there. Today, we just look at the surpluses. Without them, the Fed's monetary policy cannot produce the inflation path it desires.

Notation: \(\Delta E_{t+1} \equiv E_{t+1}-E_t\), \(\rho\) is a constant of approximation slightly less than or equal to one, \(\tilde{s}\) is the real primary surplus relative to debt. For example, \(\tilde{s}=0.01\) means the surplus is 1% of the value of debt, or 1% of GDP at current 100% debt to GDP. The last term captures a discount rate effect. If real interest rates are higher, that lowers the present value of surpluses. Equivalently, higher real interest rates raise the interest costs in the deficit, requiring still higher primary surpluses to pay off debt. (Reference: Equation (4.23) of Fiscal Theory of the Price Level.) \(x\) is the output gap, \(\pi\) is inflation, \(s\) is the real primary surplus, \(i\) is the interest rate, and the Greek letters are parameters. 

Now, suppose the Fed raises interest rates \(\{i_t\}\) following a standard AR(1). with coefficient \(\eta = 0.6\). However, there are multiple \(\{u_t\}\) which produce the same path for \(\{i_t\}\), each of which produces a different inflation path \(\{\pi_t\}\). Each of them also produces a different fiscal response \(\{s_t\}\). So, let's look for given (AR(1)) interest rate \(\{i_t\}\) path at the different possible inflation \(\{\pi_t\}\) paths, their associated monetary policy disturbance \(\{u_t\}\) and their associated fiscal underpinnings.

The top left panel shows a standard result. The interest rate in blue rises, and then returns following an AR(1). Here, the 1% interest rate rise causes a 1% inflation decline, shown in red. I use \(\eta=0.6, \sigma = 1, \kappa = 0.25, \beta = 0.95, \phi = 1.2 \) The monetary policy disturbance \(u_t\), dashed magenta.  is even larger than the actual inflation rise, but \( i_t = \phi \pi_t + u_t\) and  the disinflation in \(\pi_t\) bring the interest rate to a lower value. 

Now, let's calculate the implied "passive" surplus response. I use \(\rho=1\). With a 1% disinflation, the present value of surpluses must rise by 1%. However, the real interest rate rises substantially and persistently. From a present value point of view, that higher discount rate devalues government debt, an inflationary force.  From an ex-post point of view the higher real rates lead to years of higher debt service costs. Viewed either way, the constant-discounted sum of surpluses must rise by even more than one percent. In this case, the sum of surpluses must rise by 3.55, meaning 3.55 percent of debt or 3.55 percent of GDP at 100% debt to GDP ratio, or about $700 billion dollars. 

What if Congress looks at that and just laughs? Well, the Fed must do something else. The top right panel has a different disturbance process \(\{u_t\}\). This disturbance produces exactly the same path of interest rates, shown in blue. But it produces half as much initial deflation, -0.5%. The disinflation also turns to slight inflation after 3 years. With less disinflation, there is less need to produce a larger value of government debt, so the sum of surpluses must only rise by 2.23%. 

The bottom left shows a case that inflation does not decline at all, though again the path of interest rates is exactly the same. This occurs with a different disturbance \(\{u_t\}\) as shown. Finally, in the bottom right, it is possible that this interest rate rise produces 0.5% inflation. In this case, fiscal policy produces a slight deficit. The case of no change in surplus or deficit occurs between 0% and 0.5% inflation. 

To reiterate the point, the observable path of interest rates is exactly the same in all four cases. In a new-Keynesian model, the difference is the dynamic path of the monetary policy disturbance. Different underlying disturbances then produce the different inflation outcomes, and the different requirements for the "passive" fiscal policy authorities. Of course (I can't help myself here) to a fiscal theorist the \(\{u_t\}\) business is meaningless. Congress' choice to match the Fed's tightening with its own tightening produces the deflationary path, and if Congress does not do so, we get an inflationary path. 

Looked at either way, in a totally standard new-Keynesian model, the effects of an interest rate rise depend crucially on fiscal policy. If fiscal policy does not agree to tighten along with an interest rate rise, the interest rate rise will not produce lower inflation. 

Hat tip: This point emerged out of discussions with Eric Leeper on his 2021 Jackson Hole paper on fiscal-monetary interactions.  

The next post, an essay at Project Syndicate, provides larger context. 

**********

Update: Nicolas Caramp and  Dejanir Silva have a very nice paper "Fiscal Policy and the Monetary Transmission Mechanism" that makes this point in a very well worked out model, including quantitative calibration and HANK models. 

**********

Calculations. To produce the plots I write the monetary policy rule in a different form \[ i_t = i^\ast_t + \phi ( \pi_t - \pi^\ast_t) \] \[ i^\ast_t = \eta i^\ast_{t-1} + \varepsilon_t \] Then I can specify directly the interest rate AR(1) in \(i^\ast_t\), and the initial inflation in \(\pi^\ast_t\).  These forms are equivalent. Indeed, I construct \( u_t = i^\ast_t - \phi \pi^\ast_t \) in order to plot it. 

I use the analytical solutions for inflation given an interest rate path derived 26.4 of Fiscal Theory, \[ \pi_{t+1}=\frac{\sigma\kappa}{\lambda_{1}-\lambda_{2}}\left[ i_{t}+\sum _{j=1}^{\infty}\lambda_{1}^{-j}i_{t-j}+\sum_{j=1}^{\infty}\lambda_{2}% ^{j}E_{t+1}i_{t+j}\right] +\sum_{j=0}^{\infty}\lambda_{1}^{-j}\delta_{t+1-j}. \] \[ \lambda_{1,\ 2}=\frac{\left( 1+\beta+\sigma\kappa\right) \pm\sqrt{\left( 1+\beta+\sigma\kappa\right) ^{2}-4\beta}}{2}, \]

Matlab code: T = 50;
sig = 1;
kap = 0.25;
eta = 0.6;
bet = 0.95;
phi = 1.2;
pi1 = [-1 -0.5 0 0.5];

lam1 = ((1+bet+sig*kap)+ ((1+bet+sig*kap)^2-4*bet)^0.5)/2;
lam2 = ((1+bet+sig*kap)- ((1+bet+sig*kap)^2-4*bet)^0.5)/2;
lam1i = lam1^(-1);

delt = pi1 - sig*kap/(lam1-lam2)*lam2/(1-lam2*eta);

tim = (0:1:T-1)';

pit = zeros(T,1);
pit(2) = sig*kap/(lam1-lam2)*lam2/(1-lam2*eta) ; % t=1
pit(3) = sig*kap/(lam1-lam2)*(1/(1-lam2*eta)) ;
for indx = 4:T;
pit(indx) = sig*kap/(lam1-lam2)*...
(eta^(indx-3)/(1-lam2*eta) + lam1i*(eta^(indx-3)-lam1i^(indx-3))/(eta-lam1i) );
end;

pim = [pit*(1+0*pi1) + [0*delt;(lam1i.^((0:T-2)')).*delt]];
it = [0; eta.^(0:1:T-2)'];
um = it*(1+0*pi1) - phi*pim;
rterm = sum(it(2:end-1,:)-pim(3:end,:));
sterm = rterm-pim(2,:);
disp('r');
disp(rterm);
disp('s');
disp(sterm);

if 0; % all together
figure;
C = colororder;
hold on
plot(tim,pim,'-r','linewidth',2);
plot(tim,um,'--m','linewidth',2);
plot(tim,it,'-b','linewidth',2);
plot(tim,0*tim,'-k')
axis([ 0 6 -inf inf])
end;

figure; % 4 panel plot
for indx = 1:4;
subplot(2,2,indx);
hold on;
plot(tim,pim(:,indx),'-r','linewidth',2);
if indx == 1;
text(1.8,-0.7,'\pi','color','r','fontsize',18)
text(1,0.7,'i','color','b','fontsize',18);
text(2.4,1,'u','color','m','fontsize',18)
end
plot(tim,um(:,indx),'--m','linewidth',2);
plot(tim,it,'-b','linewidth',2);
plot(tim,0*tim,'-k')
title(['\Sigma s = ' num2str(sterm(indx),'%4.2f')],'fontsize',16)
axis([ 0 6 -1 1.5])
end
if eta == 0.6
print -dpng nk_fiscal_1.png
end

Whither the Fed

I gave the UCSD economic roundtable lecture Friday June 11 on inflation and the future of the Fed. It summarizes quickly a number of themes from previous Grumpy writings, and if you enjoy videos you might find it fun. Youtube link in case the above embed does not work. 

I happened on the New York Fed website, proclaiming on its landing page that it is now

"...dedicated to understanding and finding solutions to the numerous forms of inequality that communities of color experience and working with communities in our District to address deep-seated inequities," 

in case you want documentation that the Federal Reserve is taking on inequality and racial issues. 

Slides available here. 

The end of "the end of inflation"

This spring's spurt of inflation clearly already means one thing: The end of "the end of inflation." 

For 25 years inflation has seemed stuck on a downward trend. Those of us who worry about it seemed like end-of-the-world sign-holders that couldn't leave the 1970s behind. It's hard to buck the trend. A famous economist advised me to give up studying inflation -- inflation is 2%, he said, that's all you need to know. Apparently a new constant of nature. 

Well, apparently not. Inflation can happen, and there is an economics of inflation. Right now it's pretty obvious -- supply constraints both natural and artificial, coupled with rampant demand. 

Nobody is really sure where it will go. See the IGM survey for a good indication of how wide sensible consensus is on the issue. Maybe these are just temporary shocks, supply bottlenecks, a one-time price level rise from stimulus. Maybe it is the beginning of the 1970s, when exactly the same excuses were offered. 

I'll summarize my bottom line in thinking about this issue. 

1) The dynamics of inflation are roughly     

    inflation = expected inflation + inflation pressure   (*)

If people expect higher inflation next year, then sellers will be quicker to raise prices, and buyers quicker to pay higher prices.  The right measure of inflation pressure is more contentious. The unemployment rate or GDP gap (you will recognize a Phillips curve here) has been a pretty terrible measure. Take your pick of too-low interest rates set by the Fed, too much money, or too much debt and deficit. Whichever it is, if expected inflation remains "anchored," inflation comes back quickly once the pressure is off. If not, we're  in trouble as we have to bottle the expected inflation genie. 

The Fed seems to think that "anchoring" expectations comes from soothing speeches about how anchored expectations are. At worst they may say they have "the tools" to contain inflation should it break out, but they seldom say just what those tools are. I believe that expectations come from expected actions, not speeches, and better from robust institutional rules and commitments that force necessary but unpleasant actions when needed. At least, people must believe that the Fed is willing to repeat 1980 if it comes to that.  And raising interest rates will be much harder now, with a) 100% debt / GDP not 25%, so higher interest rates immediately hurt the budget b) huge reserves so the Fed will be seen to pay a windfall to big banks not to lend out money c) the too-big-to-fail banks will all lose a bundle if interest rates rise d) the current emphasis on inequality, as a recession will hurt the most vulnerable the most. 

2) In today's economy, in the end, inflation comes when people do not believe the government will repay debt. Beyond interest rates, the Fed changes the composition of government debt -- reserves vs. treasurys -- but not the amount of debt. Whether we hold treasurys via the world's largest money market fund (that's what the Fed is) or directly really does not matter. 

Inflation does not come from debt alone, but from debt relative to a credible plan and expectation that debt will be repaid. Expected inflation is anchored by the belief that  if inflation gets out of control our government will promptly put its fiscal as well as monetary house in order. Moreover, since our government has tragically borrowed short term, inflation comes when people believe that other people will lose this faith. Putting the fiscal house in order is not hard as a matter of economics -- a straightforward pro-growth reform of the tax code and entitlements. But our government has kicked that can down the road for nearly 40 years, and absolutely nobody wants to do it. It may have to come after the crisis, which will be much harder. 

None of this is very useful as a short-term forecast, which I do not offer. Both fiscal and monetary policy expectations, in this "regime-switching" moment, are volatile, not well anchored by decades of experience with a "regime," in the rational expectations tradition. I can offer then a summary of the forces at work, but those forces only emphasize how hard forecasting will be. If anyone could tell you for sure we would have inflation next year, we would already have inflation today. The logic of (*) is like the logic of a bank run or a stock market crash. That nobody can predict inflation well is proof of the theory. 

This spurt may pass, and expected inflation, reflecting faith in the ultimate sanity of US fiscal and monetary policy, remain anchored. This spurt may lead to a quick undermining of that faith. 

But at least the question is alive again, and a matter of useful economic analysis and debate. This for sure: The end of "the end of inflation" is at hand. 

Update: There is a slightly condensed and cleaned up version of this post at the Chicago Booth Review

Three inflations

 The latest inflation numbers are out, up 0.64% from April to May (7.7% annualized), on top of 0.77% (9.2% annualized) from March to April. . To get around the base controversy, I like to plot the level of the CPI: 

The graph suggests that  "reflation" from the pandemic recession was over last year, we had been back to the usual growth, and now we're embarked on something new. 

Inflation is not the same everywhere. For another purpose I broke inflation down to durable goods and services. 

Until about 1985, the three categories moved together. After that we saw a sharp divergence. Inflation depends on what you buy. Services got much more expensive, while durable goods actually saw deflation. The forces are familiar. The rise in skill premium has meant that people got more expensive, and some of that reflects also the rise in cost of businesses such as health care and universities which may have more to do with government payment. Durable goods got cheaper, thank you China, but also they got a lot better and the CPI decline reflects quality adjustments rather than lower sticker prices. (Nondurables and housing behave a lot like the average, so I don't show them.) 

Not all inflation is the same, and what you experience depends on what you buy and where you buy it. 

Now to the point: Where is the current surge in inflation coming from? I rebased the CPIs to 2018, and here they are. No surprise, the current surge of inflation is concentrated in durables.  Durables went up 3% April to May, a 36% annualized rate, on top of 3.52% March to April!  The others are rising too, interestingly, but not as spectacularly. It's also interesting that the big decline in the pandemic was among nondurables. This is all common sense. Bar and restaurant prices went down in the pandemic, less so TVs and gym equipment, and "stuff" is now really getting hard to find and to produce. 

As Tyler Goodspeed points out, this inflation has wiped out the real value of recent nominal wage gains.

(For analysis, the "inflation" tag has several recent posts on the topic.) 

 

Inflation options

From the lovely Minneapolis Fed website that computes probabilities from option prices.  

What about Japan?

What about Japan? It's a question I often hear from advocates of fiscal expansion. Japan has huge debts and no crisis or inflation (so far). Doesn't that prove the US can borrow a ton more money painlessly? 

I offer two new points today: 1) Not every high debt country is so happy. 2) Just what did Japan get for all its fiscal stimulus? Indeed, I will start asking "What about Japan?" Japan seems a tough case for those who advocate that fiscal stimulus will save us from secular stagnation, or that huge spending programs bring prosperity in other dimensions.   

1. Picking and choosing

Here, fresh from the April IMF Fiscal Monitor  is the list of top 30 countries sorted by debt to GDP ratios. I boldfaced larger countries. 

Yes, Japan is up there at 256% of GDP. The champion is Venezuela however. Sudan and Eritrea are not particularly known for economic prosperity. Greece and Italy are not held up as examples to follow either. Serial defaulter Argentina is behind the US already. 

If Japan is sustainable, that doesn't mean all large debts are sustainable. It means there's something different about Japan than the other countries on the list -- or ones now lower down on the list because they already defaulted or had crises. 

2. So what did Japan get for all that debt anyway? 

It was not always thus. Japan started borrowing heavily in the 1990s from a debt/GDP ratio of 63%. (For some reason the IMF does not have US data before 2002.) 

Those debts come from deficits, of 5-10% of GDP every year. Since 2006, the US has been behaving a lot like Japan, or more so. We only have less debt because the US ran surpluses through the 1990s. 

Japan has had perpetually low GDP growth, low inflation and zero interest rates since the 1990s. I view it as low "supply" growth, but it ought to be the poster child for "secular stagnation" fans. 

So I turn the question around: If massive deficits, including lots of "infrastructure"  are going to boost the US economy, why did they not do so for Japan? 

Update

In response to tweets about why is Japan different from the US,  

I did not want to repeat old points. Japan's debt is long-term, held by domestic people, pensions and central bank. US debt is short-term, held by foreign central banks and financial institutions. Our debt is much more prone to run, and a rise in interest rates will feed quickly into the budget. Japan also has accumulated assets from trade surpluses; we have the opposite. Japan's debt is held by old people and subject to estate tax. A lot of Japanese hold bank accounts, as mutual funds and similar investment vehicles familiar in the US are less prevalent. Bank accounts flow in to reserves, backed by Treasury debt. 

More importantly, Japan  does not have looming unfunded Social Security and Medicare, underfunded pensions, contingent liabilities (Fannie and Freddy guarantee most home mortgages, who is going to pay student loans?) bailout guarantees and more.

 Sustainability is about debt vs. ability to repay; about future deficits;  not debt alone.

Japan's slow growth for three decades comes from microeconomics, taxes, regulations, demographics, slow productivity, not money, stimulus, "aggregate demand." 

Brazilian Inflation

This marvelous plot comes from an interesting article, The Monetary and Fiscal History of Brazil, 1960-2016 by Joao Ayres, Marcio Garcia, Diogo A. Guillén, and Patrick J. Kehoe. The article is part of the Becker-Friedman Institute Project, complete with a big and now easily available data collection effort, and forthcoming book. 

If you want a deep historical and economic analysis of fiscal and monetary interactions, this is an amazing resource. And it summarizes historical episodes that North Americans just might want to know more about soon! 

(HT Ricardo Reis who pointed it out in a great discussion last week, that I will post as soon as it's available.) 

NBER monetary economics is up to date

I just got the program for the upcoming NBER summer institute monetary economics conference program.  Who says academics aren't up to the minute on policy issues? This will be interesting. 

 

Inflation and expectations at NRO

Essay at National Review Online. 

Inflation: The Ingredients Are in the Pot, and the Fire Is On. (But will it boil?) 

John H. Cochrane and Kevin A. Hassett

The end of the COVID-19 recession is in sight. If the Atlanta Fed’s real-time estimate of 8.3 percent Q1 growth proves accurate, real GDP is only four-tenths of a percent below the all-time high from Fall 2019. And the vaccinated, post-COVID boom is on the way. Most people have money, and are ready to spend it. Yet unprecedented fiscal and monetary “stimulus” continues.

Is persistent inflation around the corner? Inflation and commodity prices are up sharply. The latest Michigan survey shows people expect 3.7 percent inflation next year. Shortages of everything from lumber to semiconductors have raised input prices for businesses, while the percentage of small businesses reporting that they cannot find qualified workers is at a record high. The ingredients are in the pot, and the fire is on.

But will the pot boil? Since 2008, observers have warned of imminent inflation, yet inflation has barely budged.

Inflation is hard to foresee, because inflation today depends in large part on what people expect of inflation in the future. If businesses expect higher prices and wages next year, they raise prices now. If workers expect higher prices and wages next year, they demand higher wages now.

Inflation has been so low for so long that most Americans understandably see persistent inflation as ancient history, and that any blip up today will quickly be reversed.

Yet faith that our government will take prompt action to reverse inflation seems increasingly unfounded.

The Federal Reserve’s new policy framework and its officials’ speeches are eerily reminiscent of the early 1970s, and repudiate the standard lessons of that experience. One may rightly worry that should inflation emerge, the Fed could repeat mistakes of the 1970s.

Inflation expectations

This post follow's last week's post on inflation levels prompted by the big March increases in CPI and PPI, and the CEA tweetstorm response. (Also a longer post on the chance of inflation.)

WIN button from the Ford Administration

Is inflation coming?   The CEA goes on to 

Over the longer-term, a key determinant of lasting price pressures is inflation expectations. 

And takes comfort that survey expectations don't see a large increase in inflation. But when did survey expectations ever predict inflation?  In fact most research on surveys, especially in finance,  is used to claim people are dumb and terrible at predicting the stock market and other variables. 

The CEA goes on to 

An increase in inflation expectations from an abnormally low level is a welcome development.  But inflation expectations must be carefully monitored to distinguish between the hotter but sustainable scenario versus true overheating. 

But  if after "carefully monitoring," when it becomes impossible to make excuses, it looks like inflation is breaking out, what do you do then? 

Inflation levels

 March inflation is up. The CEA delivered a historic tweetstorm. It starts with 

temporary factors: base effects, supply chain disruptions, and pent-up demand, especially for services

I'm glad for once to have nailed a forecast: That Fed and Administration's first response to inflation would be to invoke "temporary" factors, just as in the 1970s.  We'll see how that pans out. 

The CEA goes on to "base effects,"

In the near-term, we and other analysts expect to see “base-effects” in annual inflation measures. Such effects occur when the base, or initial month, of a growth rate is unusually low or high..

This unusually large price decrease early in the pandemic made April 2020 a low base. 

Since this is about the past, we can say something more definite. Yes, if you start from a low base, you can see a lot of growth. To get around the arbitrariness, let's look at price levels. Here is the recent CPI (blue) and CPI less food and energy (red). These are the levels of the CPI -- conceptually how many dollars it takes today ($271) to buy what $100 bought in 1983.  

The last few months uptick is clearly visible. You can find your own "base month" by drawing a line. Yes, a line from last April to today shows an unusually higher slope, because last April was unusually low. 

But to the extent that we're just seeing "reflation," a return of prices to normal after a steep covid-induced recession, the graph suggests that was over last summer. "Reflation" was over by September. Draw your own trends -- that's why I left some history in. 

Inflation options?

 

From Torsten Slok at Apollo. Torsten explains

Current pricing for caps and floors shows that the market sees a 30% probability that inflation will be above 3% for the next five years, and a 5% probability that inflation will be below 1%, see chart below. A similar worry about high inflation can be seen in 5-year breakevens, currently trading at 2.5%, the highest level since 2008.

A perpetual inflation worrier, I habitually confront the fact that bond prices don't signal inflation. I am forced to point out that they never do -- interest rates did not forecast the inflations of the 1970s, nor the disinflation of the 1980s. And I say inflation is unforecastable, a risk like a California Earthquake. 

But for once there does seem some inflation risk in asset prices.  

These are option prices. The main forecast remains subdued inflation. But these option prices are pointing to a larger chance that inflation does break out. More risk, not so much a sure thing. Also, it's not really screaming -- after all, we're about at the prices of July 2018.

In Torsten's view, despite these prices, 

Five years of CPI inflation above 2.5% or 3% is in my view extremely unlikely. 

Paper, silver, deficits and inflation -- Chinese history version

A history of paper money and inflation in China, from Edward Chancellor's Wall Street Journal review of Jin Xu's Empire of Silver.  In these sparse paragraphs is most of monetary (and fiscal!) theory, along with a history I was not aware of.

Paper money, Ms. Xu tells us, dates back to the Tang dynasty in the ninth century, when the authorities allowed merchants to exchange bronze coins for promissory notes, known as “flying cash.” Two centuries later, in the time of the Song dynasty, merchants in Sichuan were using private exchange notes in place of the cumbersome iron coinage. The Song emperor issued his own paper money against deposits of coin. The jiaozi, as these notes were called, proved so popular that they traded at a premium to cash.

The convenience of paper money proved its undoing, however. The first temptation was for the Song authorities to make the jiaozi inconvertible, severing the connection with metal reserves. The next step was to increase the issue of paper money, both to feed the people and, more pressingly, to fund the fight against the Mongol invaders. The inevitable outcome was inflation, followed by the collapse of the currency.