John Cochrane provides perspective at Project Syndicate.
The outlook is not good.
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Inflation in the Shadow of DebtToday’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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