What Anchors Inflation?

Conventional wisdom is that a central bank can anchor the long-run rate of inflation to a target of its own choosing. This belief is evident where ever a government has charged its central bank with a “price stability” mandate (commonly interpreted nowadays as keeping a consumer price index growing on average at around 2% per annum over long periods of time).

What exactly is the mechanism by which a central bank is supposed to control the long-run rate of inflation (the growth rate of the price-level)? And is it really the case that a central bank can defend its preferred inflation target without any degree of fiscal support?

Asking these questions reminds me of the old joke of an economist as someone who sees something work in practice and then asks whether it might also work in theory. In the present context one might point to the success that central banks have experienced with inflation-targeting. It works! And remember how the Fed under Paul Volcker (Chair from 1979-87) slew the 1970s inflation dragon with its Draconian anti-inflation policy? What else do we need to know?

Well, how did Volcker do it exactly? The conventional view is that Volcker tightened monetary policy sharply by contracting the rate of growth of the monetary base (which paid zero interest at the time). The unexpected shortfall in bank reserves led to a sharp increase in short-term interest rates and a severe recession (1981.2-1982.4). As is typically the case in a recession, the rate of inflation fell, a phenomenon commonly attributed to the decline in aggregate demand for goods and services as unemployment rises and as incomes fall.

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But what kept the inflation low after the recession ended? Why did the inflation rate continue to decline as the economy grew (and as the unemployment rate fell)?

It’s hard to argue that inflation expectations were declining. While inflation expectations fell with inflation from 1980-82, the median one-year-ahead inflation forecast from the University of Michigan survey remained flat at around 3% for the rest of Volcker’s tenure. Although we have no direct market measure of long-term inflation expectations for that period, the 10-year treasury yield is probably not a bad proxy. And while the 10-year yield does decline in the 1981-82 recession, it remains elevated relative to historical (low inflation) norms and begins to rise in 1983 from just over 10% to 13.5% in 1984.

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One could argue, I suppose, that the Volcker Fed kept inflation in check by raising its policy rate aggressively against signs of rising inflation expectations (the Fed had by this time abandoned targeting monetary aggregates). Thus, despite a growing economy, the Fed’s interest rate policy kept realized inflation in check, even as expected inflation remained elevated.

Then, in the second half of 1984, long-term yields (long-term inflation expectations) began to decline. Shortly after, the Fed’s policy rate declined as well. Inflation continued to decline modestly. All the while, the economy continued to grow (the unemployment rate continued to decline). Why did inflation remain low and why did inflation expectations decline?

One could argue, I suppose, that the aggressive action taken by the Fed in the first half of 1984 (not to mention the even more aggressive actions taken earlier in Volcker’s tenure) finally convinced markets that the Fed was committed to keeping inflation low. This had the effect of keeping short-term inflation expectations low, which motivated wage and price setters to factor in lower cost increases. And it had the effect of lowering long-term inflation expectations, driving long-bond yields lower (as bondholders require less compensation against the loss of purchasing power of money due far in the future). The decline in longer-term inflation expectations c. 1984-85 also evident in the median 5-10 year forecast of inflation from the University of Michigan survey.

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So that’s the basic story. A central bank that credibly promises to snuff out any hint of rising inflation (and inflation expectations) can keep inflation anchored at a preferred long-run target of its choosing. Ironically, the threat of raising the short-term interest rate against inflationary pressure is what keeps nominal interest rates low. Moreover, if a central bank can credibly commit to a long-run inflation target, the effect is to keep longer-term bond yields low as well. The fact that things didn’t work out so smoothly for Volcker early in his regime was because the Fed lost credibility in the 1970s and this credibility took time to rebuild.

I think there’s a lot of merit to this view. But I still have a nagging doubt that U.S. fiscal policy had little or anything to do with Volcker’s success at keeping inflation low. What exactly am I talking about–didn’t Volcker accomplish his goal despite the Reagan deficits?

People tend to remember the famous Reagan tax cut (the Economic Recovery Act of 1981). The deficit grew very rapidly soon after because of the tax cut, but also because of the severe recession and also to some extent because of the Fed’s high interest rate policy (which increased the interest expense of government debt). But as Justin Fox points out here, people frequently forget about the tax increases that came steadily throughout the Reagan administration (and into the Clinton years.)

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As the diagram above shows, the year-over-year growth rate of nominal debt in April 1983 hit a peak of about 22%. The growth rate of debt turned around sharply after that, dropping to 14% in July 1984. After popping briefly to 17.5% in October of 1984, it started to decline, slowly at first, and then more sharply in 1986.

The ups and downs in the picture probably do not matter as much as the underlying trends. What matters is whether people generally believe fiscal policy to be anchored in the sense of keeping the long-run rate of nominal debt growth low. (Note: another notion of “anchored” fiscal policy corresponds to keeping the debt-to-GDP ratio stable, even though stability of this ratio is consistent with any inflation rate). If the claim is that the Volcker Fed could have lowered inflation permanently without fiscal accommodation, then it could have done so with debt continuing to grow indefinitely at (say) 20% per annum. There would have been no reason to reverse the Reagan tax cuts!

So, the thought experiment is this: suppose that the political pressure to reduce the Reagan deficits was absent. Could Volcker have kept inflation low?

Who knows what would have happened to economic growth. It may have gone up, down, or roughly followed the path it took. Let’s take the middle ground and assume that growth would have remained unaffected. Let us further assume that the U.S. government is never going to default on its debt. (There is, of course, no reason for why a sovereign government issuing debt constituting claims against the currency it issues need ever default. If default does occur, it is a political decision and not an economic one.)

Alright, so now we have nominal debt growing at 20%. Suppose inflation does not change and suppose inflation expectations remain anchored. Then the Fed will have no reason to raise its short-term interest rate. And bondholders will have no reason to demand higher long-term yields. But lo, then there’s a free lunch at hand. The government can simply use its paper to finance its expenditures without resorting to taxes. At best this might hold for a highly depressed economy, but it seems unlikely to hold for the case we are considering (robust economic growth and low average unemployment).

Something has to give. But what? If inflation and interest rates don’t budge, then the public is being asked to hold an ever-increasing quantity of debt at the same real (inflation-adjusted) rate of interest. Assuming that the foreign sector doesn’t fully absorb it, the increasing level of debt must crowd out domestic investment at some point. The private sector will attempt, at this point, to attract funding by offering higher returns on its debt-offerings. How does the real yield on government bonds rise if the nominal interest rate and inflation remain fixed? Is the Fed supposed to increase its policy rate in the face of declining investment (crowding out)?

One thing to keep in mind is that the permanent tax cuts will have made the private sector wealthier. It seems likely that at some point, they will want to spend this wealth. Of course, in aggregate, the public cannot dispose of the government bonds it holds–the bonds can only pass hand-to-hand. But this smells like a classic “hot potato” effect — people will try to spend their wealth, driving the price-level higher (reducing the real value of the outstanding government debt).

So, suppose that inflation starts to rise (along with expectations of inflation). In response, the Volcker Fed increases its policy rate sharply and restates its commitment to keeping inflation anchored. The effect of the rate increase might be to slow economic growth and keep inflation in check for a while. But remember, the fiscal authority doesn’t care in this thought experiment–it just keeps printing debt as rapidly as ever. The inflationary pressure has to return. So the Volcker Fed raises its policy rate again. And again. And again. And again. This is not going to work.

It is of some interest to note that Volcker himself did not appear to believe that the Fed could unilaterally keep inflation low. At least, I say this judging by the way he often criticized the Reagan administration for its loose fiscal policies. According to Volcker 1982 (see here), huge government deficits were responsible for high interest rates (the Fed’s high-interest policy). In other words, fiscal policy was responsible for the price-level pressure that necessitated the Fed’s high-interest rate policy.

The clash between the Fed and the administration at that time makes for some interesting reading (see also here). In light of the recent shift in fiscal policy, one wonders whether a similar conflict might be in the works in the not too-distant future.

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