Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Sunday, May 3, 2015

Understanding Lowflation

Lowflation refers to an inflation rate persistently below an official target rate. Here's what the picture looks like for several countries as of January 2014 (source: Contessi): 

Here's what the time-series looks like for the United States (source: Duy):

The apparent inability of a central bank to raise inflation seems truly remarkable for those of who lived through the great "peace-time" inflation (see Romer and DeLong). What's going on here? Isn't high inflation supposed to be easy to get?  Didn't Zimbabwe give us a modern day lesson in creating inflation? Didn't former Fed Chair Paul Volker demonstrate how a sufficiently determined central bank can lower inflation? If so, then why does it appear so difficult to accomplish the reverse?

In this post I want to think out loud about how one might interpret this strange state of affairs. There are two broad themes running through my head these days. The first, and more important theme, is the old Sargent and Wallace idea of potential conflicts arising between independent monetary and fiscal authorities that are linked through a consolidated government budget constraint.

The second, and less important theme, revolves around the concept of a liquidity trap. Think of a liquidity trap as a situation where investors view central bank money and treasury debt as perfect substitutes. Such a condition likely never holds exactly in reality, but that's neither here nor there. Empirical relevance is possible even if liquidity trap conditions hold approximately. In any case, if money and bonds are close to perfect substitutes, then the composition of total government debt (between money and bonds) has little economic significance (in the same way that the composition of the money supply between $5 and $10 bills does not matter).

Let's start with the monetary-fiscal policy game. For those who are interested in a formal description of the model I have in mind, LOOK HERE. The fiscal authority is assumed to choose the time-path for government debt. The monetary authority takes the time-path of debt as given and simply chooses the composition of the debt between low-interest-money and high-interest-bonds. That is, the monetary authority can choose the money-to-debt ratio, but not the total amount of debt (money plus bonds).

If the central bank holds the money-to-debt ratio fixed, then inflation is determined by the growth rate of nominal government debt (minus the growth rate in the real demand for such debt). The two forces determining inflation in this case are (1) the fiscal authority, which chooses the growth rate of nominal debt and (2) the economic forces, domestic and foreign, influencing the rate of growth in the demand for government debt.

Now, suppose that the central bank thinks that the inflation is too high. The central bank could ask the fiscal authority to reign in its nominal deficits. Suppose the fiscal authority does not acquiesce. Suppose that the central bank is determined to lower inflation nevertheless. A permanent reduction in the inflation rate requires a monotonically decreasing money-to-debt ratio. That is, the central must threaten to monetize a progressively smaller fraction of the government's debt. The tighter and tighter monetary policy leads to a higher and higher real rate of interest. Because the inflation rate is pegged, the nominal interest rises as well. Investment collapses and the debt-service cost of the government's debt rises relentlessly. The fiscal authority capitulates, and lowers the growth rate of its nominal debt to accommodate the central bank's lower inflation target.

That is, by the way, one interpretation of the 1981-82 recession. If it is correct, it's rather unfortunate because the theory suggests that it could have been avoided had the conflict been resolved sooner rather than later. [Sargent (1986) has a nice discussion here of Wallace's "game of chicken" between decentralized branches of a government, with application toward interpreting the Reagan deficits.]

In any case, let's move forward to today where we see the opposite situation unfolding: inflation rates persistently below the central bank's target rate. What is the proximate cause of this? The notion of a diminished growth rate in the supply of debt is not tenable. I'm inclined to view countries like the U.S. as having an relatively stable fiscal anchor. Treasury-issuance in the U.S. did rise sharply during the financial crisis, but the growth rate has subsided to more sustainable levels. Here is the growth rate of nominal U.S. debt held by the public:

And here is the debt-GDP ratio for the U.S. 

Well then, if the supply of debt is not responsible for lowering inflation, what is? The demand side, of course. While one can't provide direct evidence pertaining to the demand for debt, we can make reasonable inferences based on its price behavior. Judging by the collapse of U.S. treasury yields since the crisis (see next diagram), I'd say that one can safely infer a robust demand for the product. (I would be curious to know what other conclusion one could come to, especially in light of how much the supply of U.S. treasury debt has increased.)

Alright, so let's imagine, not unreasonably I think, that there's been an uptick in the worldwide demand for high-grade debt. On the first instance, the effect of this growing appetite is to pull yields down. On the second instance, with yields bounded below by zero, the effect is deflationary (a lower price-level is the market's mechanism for increasing the real supply of nominal debt when it is in short supply).

Most central bankers are likely hoping that this demand-driven disinflationary pressure is transitory. But suppose it is not and suppose the central bank wants to act to raise inflation back to target. Again, one way to do this is to ask the fiscal authority to consider raising its nominal deficits (insert laughter here). Alright, we weren't seriously thinking that was going to work, did we?

So our steadfast central bank embarks on the reverse-Volker path, steadily increasing the money-to-debt ratio over time. With larger and larger fractions of the public debt being monetized, real and nominal interest rates decline (I'm assuming that the inflation peg is being held). Will the fiscal authority "blink" this time around in face of the central bank's resolve?

But why should the fiscal authority "chicken out" here? In this case, the government's debt-service costs are declining instead of rising. Moreover, the lower real interest rate is stimulating investment. Why should the fiscal authority capitulate to this sort of "pain?"

Alright then, well suppose the central bank nevertheless carries on with its program of monetary stimulus. What is the end game (assuming that the elevated growth rate in the demand for government debt continues unabated)?

The answer to this question depends on what limits govern the growth and size of a central bank's balance sheet. Let impose a relatively weak condition.

[A1] The central bank cannot forever monetize debt at a rate faster than it is being issued. 

Assumption [A1] is relatively weak because it does permit a central bank to grow the money-to-debt ratio temporarily. It just can't do so forever.

If [A1] holds, then the endgame is clear. Eventually the growth in the money-to-debt ratio must cease. At this point, inflation must decline back to the rate implied by the fiscal anchor. The cards are stacked against the central bank in this game. Sumimasen, Nippon Ginko.

So where does the liquidity trap relate to this discussion? I don't think it's necessary for understanding the logic above, but it does add a bit of contemporary color. In a liquidity trap, even very rapid increases in the money-to-debt ratio will be inconsequential, apart from leading to a correspondingly rapid increase in the level of excess reserves in the banking system. The BOJ is presently trying very hard to prove this prediction incorrect, but so far, with mixed success. And already, cracks are beginning to appear in the resolve of some top Japanese policy advisers.

The seminal modern treatment of the liquidity trap was presented in Krugman (1998).  In that piece, he states (pg. 139):
The traditional view that monetary policy is ineffective in a liquidity trap, and that fiscal expansion is the only way out, must therefore be qualified: monetary policy will in fact be effective if the central bank can credibly promise to be irresponsible, to seek a higher future price level.
I think that this statement is true but that the conditioning factor "if the central bank can credibly promise" does not presently apply to central banks of countries with high-grade sovereign debt. The rapidly growing appetite for high-grade debt depresses yields and inflation. To overcome these deflationary pressures, central banks must threaten to expand their balance sheets far beyond what anyone can sensibly believe is possible. In such circumstances, it really can be more difficult to raise the inflation rate than lower it. Such is the "price" of responsibility.

PS. Lest there be any misunderstanding, this post is not about why raising inflation back to a central bank's target is inherently a good thing for the economy. I appeal to no theory here of what constitutes an optimal inflation target. The purpose is simply to explain why in some circumstances it might be harder to raise inflation rather than to lower it. 


  1. It seems to me that the "credible promise" is critical here. Isn't this promise completely undermined by an insufficiently high inflation target? A target that doesn't allow a path for real rates to go bellow the natural rate to push up inflation will never be credible. It is probably actually easier to reach a 4% inflation target than a 2% target because the former creates a credible path to get there and stay there whereas the later does not.

    That is the market might believe that even if a 2% target is briefly attained through fiscal help or natural fluctuations, that inflation is soon going to go right back down. The expectation of this makes it a self fulfilling prophecy where inflation simply never rises.

    1. Benoit,

      I'm not sure why real interest rates have fall below the "natural" rate to make inflation rise. I know of several models where that does not happen. Indeed, the model I linked to in my post is one of them.

      Self-fulfilling prophecies are possible, but it seems to me that at some level, the fiscal authority has to accommodate private sector expectations to make that possible.

  2. The Fed's ceiling on core cpi is 2%, and its floor appears to be 1%. Is it a surprise that inflation has gravitated towards the narrow corridor between? Since this squashes rate volatility, it is no wonder the bond term premium has declined along with the inflation premium. Krugman's argument implies the Fed should (pretend to?) abandon its target. Until it does, it stands to reason the Fed won't get the result they wish for.

    The question is, in market participants' minds, what would possibly force the Fed to abandon the 2% ceiling? One scenario is a self-reinforcing inflation exp./rates/deficits/money creation feedback loop, one made possible by the extreme short-term duration of government liabilities (i.e. all those ER's that force the Fed into issuing reserves to pay the IOR). I my experience in emerging markets, no one ever pays attention to the duration of government obligations...until they do.

    1. I agree that the decline in inflation rate volatility could be putting downward pressure on inflation. But still, the question addressed here is what tools the Fed has at its disposal to raise inflation, especially in a liquidity trap. Krugman's argument has nothing to do with abandoning an inflation target. It has to do with the credibility of expanding the central bank's balance sheet as much as would be needed to actually engineer a higher inflation. My argument is that to do so, the central bank needs cooperation on the part of the fiscal authority.

    2. I think Krugman has defined "irresponsible" as a higher target in the past, rather than as more QE. However, I'm no expert on Krugman.

      My point is the deficit used to improve with inflation because tax brackets adjusted faster than interest expense. That is no longer the case because of QE, the IOR, and the low rate and healthy Fed remittances built into the CBO's baseline forecast.

      In other words, if inflation expectations increase, the Fed will have, automatically, the cooperation of the fiscal authority in the form of expanding deficits.

  3. You rabid lefty keynesian! What the heck happened to Western after us old monetarists left?

    "[A1] The central bank cannot forever monetize debt at a rate faster than it is being issued. "

    Why can't it monetise something else?

    Assume the stock of government bonds is zero, and stays at zero forever. There's lots of other assets the central bank could buy: foreign government bonds; provincial and municipal bonds; corporate bonds; commercial bank liabilities; stocks; land, houses.

    Only when the central bank runs out of things to buy, and nobody wants a loan from the central bank, would the central bank need to resort to giving money away.

    1. I am not rabid! lol

      I appreciate what you are saying, Nick, but you did not read [A1] correctly. [A1] does in fact permit the central bank to monetize assets other than government securities. It merely states that in the long-run, the money-to-government debt ratio is bounded from above. An alternative specification for [A1] is to state that the central bank's balance sheet has an upper bound of some sort. IF such a bound exists, THEN my conclusions hold true.

      The upper bound I have in mind is determined by political factors. If these real-world limitations were removed, then of course what you say is true. But of course, if you want to live in imaginary worlds, then why not imagine the Fed having the power to engage in direct helicopter drops? In reality, the Fed is not permitted to. And in reality, I think people know that there are bounds to how large a central bank balance sheet can grow. It is the knowledge of this bound that makes raising inflation in a liquidity trap very difficult.

    2. "And in reality, I think people know that there are bounds to how large a central bank balance sheet can grow" - expectations are hand-waving fudge factors. The central bank balance sheet has already grown much more than people could have imaged in 2008. The Fed has been irresponsible, going from 1T to 4.5T in balance sheet since 2008, yet nothing has happened to demand. The only logical conclusion to draw is money is neutral or super-neutral, and monetarism is impotent, not important.

    3. Ray, how do you know "nothing has happened to demand." Do you have a direct measure of "demand" that economists have missed?

  4. David,

    In reading your article, I am aware of the real life limitations on what the U. S. central bank can / cannot purchase outlined here:

    But what stops a central bank from paying more for a government bond than it's interest and principle are worth?

    It seems to me that even with the legal constraints in place, a central bank only needs one bond that it can repeatedly buy / sell to add liquidity into a market.

    Buy $100 bond for $500, sell same bond for $25, rinse and repeat.

    1. Frank,

      When I visiting the FRB NY trading desk, it was interesting to observe how they are obsessed with buying/selling securities at the best rates possible. I'm not 100% sure, but I'm guessing that the FRA does not permit the trading desk to operate in a manner that guarantees certain losses.

    2. David,

      What you are basically saying is that the FRB NY trading desk operates to turn a profit on all purchases / sales? It tries to buy at a discount and sell at a premium?

      Or is the FRB NY trading only concerned with the best current market price, not whether or not it turns a net profit on a buy / sell trade over a significant time frame?

      Why would anyone take the other side of that trade recognizing that the central bank basically prints the money it uses to buy bonds with when every other private bank is constrained by profitability requirements?

      It would make sense to me if the central bank always bought and sold bonds at par acting a pure provider of liquidity, but a central bank as a profit center seems counterintuitive.

    3. Frank, yes, this is what I'm telling you. They count on the announcement effects of policy to dictate equilibrium prices, but when the desk engages in actual purchases, it tries to get the best deal possible.

  5. Also,

    It was my impression that the central bank is a price setter, not a price taker. So why should the FRB NY trading desk be obsessed with buying / selling securities at the best rates possible?

    Or does the FRB NY look at your economic back ground and then send you down different corridors:

    Monetarists to the left where they tell you we are quantity setters
    All others to the right where they tell you we are price setters


  6. David Andalfatto says, “Didn't Zimbabwe give us a modern day lesson in creating inflation?” Indeed. Two years ago I published a blog post arguing that Robert Mugabe should be in charge of economics at Harvard because he seems to know more about the subject than many Western economists:

    1. Ralph,

      Nice post.

      One way to effect the Mugabe solution is to consolidate the power of the central bank, the treasury, and the legislative+executive branches of the government. Then there'd be no question that our dictator could (and likely would) produce an inflation.

      But I rather view the fiscal anchor provided by the checks and balances of American politics as a positive on net. The world is not a perfect place and I'll take the U.S. model over Zimbawe's any day.

  7. I am an armchair economist and I very much enjoyed this post.

    My take away is that other things equal if a CB wants to hit an inflation target that is greater than than the % rate of increase in the govt deficit (plus the increase in demand to hold money and govt-bonds), then it will have to expand the money-to-debt ratio , which eventually will be unsustainable and may be politically unacceptable.

    In a liquidity trap potential solutions would be to increase the govt deficit (which would induce inflation without the need for an increase in the money-to-debt ratio) or simply allow the CB balance sheet to expand beyond the generally accepted norms.

    Is that a (more-or-less) correct reading ?

    1. Thanks David.

      I took a look at the related paper and have a comment/question.

      It easy to imagine that in the 1970s deficits were running higher than the CB's desire for inflation , leading to the kind of conflict you describe , and that finally got resolved in the early 1980s.

      However Its harder to imagine that currently the deficit is lower than the inflation target so you have to bring in increased demand to hold debt to make the model work.

      A one-off increase in demand to hold debt would lead to a one-off blip in inflation (if the CB kept its bond-buying ratio fixed) or a one-off variance in its bond-buying ratio if it varied it to hit the IT. Then things would return to normal.

      Therefore (if I have understood correctly) to see something like your lowflation scenario we need demand for debt to be increasing overtime at a rate greater than the Inflation target/deficit equilibrium level.

      Is there any evidence that that is indeed the scenario we are in ?

  8. Hi David,

    I looked at this a while ago....

    I like S&W, but it's a child of its time. No-one in 1983 would have considered that a fiscal authority could irresponsibly reduce deficit spending.

    I reached similar conclusions to you. Whereas the ultimate brake on fiscal profligacy is the bond market, there is no such market brake on fiscal austerity. Fiscal authorities like low yields on their debt, and bondholders like fiscal authorities to run tight budgets.

    The only brake on fiscal austerity is the central bank's willingness to buy assets. But this is subject to real political limits because the fiscal authority is responsible for the central bank's solvency. I know there is a huge debate among economists about whether this really matters, but as long as fiscal authorities believe it does, they will set limits on both the size and the composition of the central bank's balance sheet.

    So what we have is fiscal dominance, though not as S&W envisaged. Central banks are only as independent as politicians allow them to be.

    1. Frances,

      What a pleasure it was to read your piece. It's always nice to find a like-minded person...helps persuade me that I'm not the only lunatic in the asylum. :)

      In terms of your concluding thoughts, about whether we should be concerned about deflation in this reversed circumstance, I'm not so sure. I don't think so. And I do have some maths that considers this opposite situation, available here:

      It's very much in the spirit of the S&W literature (I use OLG model...very simple). Cheers.

  9. Interesting piece to get some thinking going. I have some thoughts on the matter myself.

    First off is that the inflation that the FED is trying to create is in fact a monetary inflation by money devaluation trough money printing so not an economic inflation in which the money velocity goes up. The money velocity only has been going down:

    The argument used by the FED is that if there’s inflation people will spend there money rather than save it because prices will be higher in the future than they are today. But this is a false argument for several reasons. The real reason the FED wants inflation is to try to inflate away the debts by making the money less worth in the future than it is today. They use the false first mentioned reason to persuade people to go along with these crazy policies because exactly the opposite is happening regarding people spending their money.

    People are not spending because they have too much debts and since the FED is devaluing their money can not spend more but less on top of peoples salaries being frozen or even lowered.

    As a consequence of that companies are not using their money to expand but to do massive stock buybacks while drastically shrinking their workforce.

    That results in even more people who can’t spend and thus the consumer economy is completely finished off in this stagflationary debt spiral meaning that while the FED is devaluating the currency which they call inflation the economy is going down.

    Some say that merely money printing is inflation which is complete bullshit since in even the most simplistic economic theory Money Velocity has it’s place and that is doing nothing like said.

    An other myth is that FED’s money printing somehow has to be called ‘Keynesian’ which it is not because this money is only used to prop up the banks and it’s gambling game in which JP Morgan for instance lost billions. And this money is not entering the real economy or only very little of it.

    It would be Keynesian if FED’s money printing was used to finance big government projects which would benefit the real economy like building roads and doing other big infrastructural projects in which the money would flow back in more taxes because more people would be at work and receive descent salaries but non of that is happening. More money was dealt to the military industrial complex which doesn’t make anything but only destroys things and lives.

    So the U.S. trough the FED and the expanding military complex has painted itself perfectly into a corner in which it can’t raise rates and debts are ever growing.

    Come to think of it this maybe the reason why instead of the U.S. luring Russia into a war in the Ukraine the opposite has happened and the U.S. is spending more and more money in the Ukraine while sending more military so in fact stepping into their own trap but I digress.

    The synthetic (caused by money printing) stagflationary situation mentioned before is a temporary one followed up by what has to happen in a new natural equilibrium deflation. Because you can’t have rising prices while people salaries are frozen and expect an economy to grow. People simply haven’t got the money for that also because people are still deleveraging from their private debts. Meanwhile health costs and home rents are still going up which is also the reason why lower oil prices didn’t have any positive effect on the consumer economy at all. In fact it only had negative effects on the consumer economy trough more layoffs in the only growing sector the US had left in the oil industry.

    To me this all sounds very logical but the FED doesn’t seem to understand any of this or is deliberately pursuing a destructive policy to bring in the NWO later as has been suggested by conspiracy theorists for a good reason. Because you begin to wonder am I that smart or are they that stupid?

  10. It's no coincidence that the flood of savings looking for low risk cash flows comes right alongside the collapse of US real estate in both real and nominal terms.

  11. The concluding para of the above article says, “To overcome these deflationary pressures, central banks must threaten to expand their balance sheets far beyond what anyone can sensibly believe is possible.”

    Well certainly balance sheet expansion MIGHT solve the problem. But given that central banks have done just that in recent years, and hyperinflation has not appeared in consequence, it looks like given a bit more demand for safe assets in the future, that even balance sheet expansion might not work. In that case, fiscal expansion would definitely be “the only way out” to quote Krugman.

    But I suggest there are more fundamental problems with artificial interest rate cuts, QE, etc. One is that there is no obvious reason why, given a recession, the cause is inadequate borrowing and investment, rather than a deficiency in some other constituent of aggregate demand, like consumer spending or exports. Second, there is no obvious reason why, to the extent that interest rate reductions are the free market’s cure for recessions, interest rates will not fall of their own accord: after all, interest rates have fallen substantially, and of their own accord over the last 25 years.

    Third, interest rate cuts do not work all that quickly: there’s a Bank of England article which says they take a full year to have their full effect.

    I considered the deficiencies in interest rate cuts in more detail in Part III (sections 10 & 11) of this paper: