We analyze the effect of structural change in the payment sector and of monetary policy on prices. Means of payment are obtained through portfolio choices and commodity sales and “liquified” through velocity choices. Interest rates, intermediation margins, and costs of payment instrument use affect portfolios, velocities, liquidity, relative prices, and the aggregate price level. Money is neutral, interest rate policy is not. Scarcer liquidity need not drive up velocity. Payment instruments and velocities generate positive externalities. Commodity price aggregates mis-measure consumer price inflation, distinctly so over the business cycle.
In an NBER working paper, Laurence Ball and Sandeep Mazumder question the puzzles of first, missing disinflation and subsequently, missing inflation in the Euro area. From the abstract:
… we measure core inflation with the weighted median of industry inflation rates, which is less volatile than the common measure of inflation excluding food and energy prices. We find that fluctuations in core inflation since the creation of the euro are well explained by three factors: expected inflation (as measured by surveys of forecasters); the output gap (as measured by the OECD); and the pass-through of movements in headline inflation. Our specification resolves the puzzle of a “missing disinflation” after the Great Recession, and it diminishes the puzzle of a “missing inflation” during the recent economic recovery.
See also the paper by James Stock and Mark Watson.
NZZ, April 25, 2019. PDF.
- Modern monetary theory (MMT) is neither a theory, nor modern, nor exclusively monetary.
- I discuss fallacies related to MMT.
- Dynamic inefficiency requires permanent, not transitory, r<g.
- For now, policy makers should rely on common sense rather than MMT.
On VoxEU, Myrvin Anthony, Narcissa Balta, Tom Best, Sanaa Nadeem, and Eriko Togo discuss the history of government debt with state contingent coupons and offer some lessons.
- In the mid-19th century, the Confederate states issued cotton-linked bonds
- In the late 1970s, Mexico issued oil-linked bonds
- In the 2000s, Turkey issued revenue-indexed bonds
- Since 2014, Uruguay issues nominal wage-issued bonds
- Some other examples (figure taken from the column):
- Obviously, confidence in data quality and thus, quality of institutions is important for the success of such issues.
State contingent securities also have been used in debt restructurings:
The first use of state contingent bonds in debt restructurings occurred in the Brady deals from 1989-97, which allowed commercial banks’ claims on debtor countries to be exchanged for tradable instruments, allowing the banks to clean up their balance sheets. Many of these instruments included ‘value recovery rights’, which envisaged additional debt payments in circumstances where the debtor country’s economic or terms of trade conditions improved substantially … Oil exporters generally linked the payments to oil prices, while other countries linked either to GDP or measures of the terms of trade. Many of the Brady instruments subsequently made significant ongoing upside payments (e.g. Bosnia and Venezuela), while in some cases sovereigns chose to repurchase the instruments as it became clear that upside payments would be triggered (e.g. Mexico, and Bulgaria in the mid-2000s).
More recently, ‘upside’ GDP-warrants have featured as part of the package of bonds issued to creditors in each of the three major restructurings of the past decade: Argentina (2005 and 2010), Greece (2012), and Ukraine (2015). In the case of Grenada (2015), the restructuring deal included instruments with both upside and downside features (Table 2).
Inflation linked bonds have been successful:
Inflation-linked bonds have a long history, dating back to a 1780 issuance by the State of Massachusetts … More recently, they emerged in Latin America in the 1950s and 1960s, in an environment of very high domestic inflation, and the UK became the first advanced economy to issue inflation-linked bonds in 1981. … the global stock of government inflation-linked bonds had grown to around USD 3 trillion by 2015 … Despite this recent growth, inflation-linked debt still accounts for a relatively small share of sovereign debt portfolios in most countries …
Related VoxEU column on policy implications.
In the Journal of Economic Literature, William Roberds reviews Christine Desan’s “Making Money: Coin, Currency, and the Coming of Capitalism” and he provides his own perspective on European monetary history.
… the transition of the Bank of England’s notes from the status of experimental debt securities (in 1694) to “as good as gold” (1833) required more than a century of legal accommodation and business comfort with their use.
Desan emphasizes England’s traditions of nominalism (as opposed to metallism) and monetary restraint as well as early experiments in monetary substitution in laying the foundations for the Bank of England’s success. Lobbying played its role, too.
Roberds discusses the experience of note issuing institutions in other countries.
At the time of the Bank’s founding, there were about twenty-five publicly owned or sponsored banks operating in Europe. These institutions are largely forgotten today; most were dissolved by the early nineteenth century and only one continues in existence, Sweden’s Riksbank. …
These banks were run by and for the merchant communities in their respective cities [Amsterdam, Genoa, Hamburg, and Venice] … The existence of the early municipal banks depended on a form of nominalism more extreme than what prevailed in contemporary England. Merchants in these “banking cities” were required by law and by custom to settle all bills of exchange (the dominant form of commercial credit) with transfers of money on the ledgers of the local public bank. The practical advantage of such a restriction was that it reduced or eliminated the possibility of settlement in the debased coins … the municipal banks’ ledger money was often seen as more reliable than the typical coin in circulation …
Most of these banks failed after getting involved in speculative episodes, hyperinflation, or political turmoil. The Bank of England was lucky.
Between November 8 and 9, medium and long-term US Treasury Yield Curve rates increased substantially:
Source: US Treasury.
At the recent Karl Brunner Centenary event, Ernst Baltensperger characterized Monetarism as a set of five convictions:
- Money matters (as accepted in the neoclassical synthesis)
- Rules are preferred over discretion (in contrast to the views of Modigliani, Samuelson or Klein), but some flexibility is accepted
- Inflation and inflation expectations are key (in contrast to traditional Keynesian views)—adaptive expectation formation, parallels to Phelps
- Money growth targeting is useful—Brunner and Meltzer favored the monetary base, Friedman M1
- Money, credit and the “details” of financial markets matter for the monetary transmission mechanism—Brunner and Meltzer pushed the credit view, parallels to Tobin
Baltensperger concluded that the macroeconomic mainstream has absorbed many of these convictions, as it has absorbed many pillars of Keynesian thought.
In the JEEA 14(4) (August 2016) Klaus Adam and Junyi Zhu argue that
unexpected price-level movements generate sizable wealth redistribution in the Euro Area (EA) … The EA as a whole is a net loser of unexpected price-level decreases, with Italy, Greece, Portugal, and Spain losing most in per capita terms, and Belgium and Malta being net winners. Governments are net losers of deflation, while the household (HH) sector is a net winner … HHs in Belgium, Ireland, Malta, and Germany experience the biggest per capita gains, while HHs in Finland and Spain turn out to be net losers. … relatively young middle class HHs are net losers of deflation, while older and richer HHs are winners. … wealth inequality in the EA increases with unexpected deflation, although in some countries (Austria, Germany, and Malta) inequality decreases due to the presence of relatively few young borrowing HHs. … HHs in high-inflation EA countries hold… systematically lower nominal exposures.
The table reports the estimated effects of a one-time unexpected change in the general price level by 10% (expressed either in thousand EUR per capita, or as a share of GDP); a positive sign indicates a gain from deflation.
(1000 EUR p.c.)
(1000 EUR p.c.)
(1000 EUR p.c.)
(share of GDP)
(share of GDP)
(share of GDP)
The Economist speculates that central bank independence might be on its way out. The article suggests that motives for independence (i.e., Sargent/Wallace or Barro/Gordon type arguments) might be less relevant given the environment of low inflation and interest rates.
See also my earlier, related blog post.
The winners and losers of the current monetary environment are not that easy to identify. Investors holding long-term, non-indexed debt gain as unexpectedly low inflation shifts wealth from borrowers to lenders. Governments suffer from increased real debt burdens and reduced revenue due to effectively lower capital income tax rates. Policies that succeed in affecting the real exchange rate entail redistribution.
On his blog, John Cochrane offers a stripped down model and some intuition for why inflation would rise after an increase in the interest rate. The model features the usual Euler (IS) equation and a Mickey Mouse Phillips curve—inflation is proportional to consumption (or output). The intuition:
During the time of high real interest rates — when the nominal rate has risen, but inflation has not yet caught up — consumption must grow faster [the Euler equation, DN]. … Since more consumption pushes up prices, giving more inflation, inflation must also rise during the period of high consumption growth.
I really like that the Phillips curve here is so completely old fashioned. This is Phillips’ Phillips curve, with a permanent inflation-output tradeoff. That fact shows squarely where the neo-Fisherian result comes from. The forward-looking intertemporal-substitution IS equation is the central ingredient.
A slightly more plausible model with an accelerationist Phillips curve and very slowly adjusting adaptive expectations yields the following responses to an increase in the nominal interest rate:
As you can see, we still have a completely positive response. Inflation ends up moving one for one with the rate change. Consumption booms and then slowly reverts to zero. …
The positive consumption response does not survive with more realistic or better grounded Phillips curves. With the standard forward looking new Keynesian Phillips curve inflation looks about the same, but output goes down throughout the episode: you get stagflation.
A November 2015 paper on the topic by James Bullard.
A critique by Mariana García-Schmidt and Michael Woodford in an NBER working paper. Abstract:
We illustrate a pitfall that can result from the common practice of assessing alternative monetary policies purely by considering the perfect foresight equilibria (PFE) consistent with the proposed rule. In a standard New Keynesian model, such analysis may seem to support the “Neo-Fisherian” proposition according to which low nominal interest rates can cause inflation to be lower. We propose instead an explicit cognitive process by which agents may form their expectations of future endogenous variables. Under some circumstances, a PFE can arise as a limiting case of our more general concept of reflective equilibrium, when the process of reflection is pursued sufficiently far. But we show that an announced intention to fix the nominal interest rate for a long enough period of time creates a situation in which reflective equilibrium need not resemble any PFE. In our view, this makes PFE predictions not plausible outcomes in the case of such policies. Our alternative approach implies that a commitment to keep interest rates low should raise inflation and output, though by less than some PFE analyses apply.
On his blog, Stephen Williamson addresses “Neo-Fisherian Denial.” Williamson starts with the model analyzed by Cochrane (see above) featuring a Mickey Mouse Phillips curve. He argues:
[This] NK model actually doesn’t conform to conventional central banking beliefs about how monetary policy works. What’s going on? … an increase in the current nominal interest rate will increase the real interest rate, everything else held constant. This implies that future consumption (output) must be higher than current consumption, for consumers to be happy with their consumption profile given the higher nominal interest rate. But, it turns out that this is achieved not through a reduction in current output and consumption, but through an increase in future output and consumption. This serves, through the Phillips curve mechanism, to increase future inflation relative to current inflation. Then, along the path to the new steady state, output and inflation increase.
Williamson recalls the “perils” of Taylor rules. And he addresses the critique by Garcia-Schmidt and Woodford:
Some people (e.g. Garcia-Schmidt and Woodford) have argued that Neo-Fisherian results go out the window in NK models under learning rules. As was shown above, these models are always fundamentally Fisherian in that any monetary policy rule has to somehow adhere to Fisherian logic on average – basically the long-run nominal interest rate is the inflation anchor. But there can also be learning rules that give very Fisherian results. …
Williamson also argues that other (non-Keynesian) monetary models give neo-Fisherian results as well.
A few years ago, also on his blog, Stephen Williamson argued that lowering the interest rate (by engaging in QE) might also affect the real interest rate:
… short-run liquidity effects are short-lived. Further, my work shows that there is another liquidity effect, associated with the interest bearing liquid assets, that causes the long run real rate to increase as a result of QE. … which implies lower inflation.
Further, there are other forces in play … The destruction of private sources of collateral and the shaky state of sovereign governments in parts of the world gave U.S. government debt a large liquidity premium – i.e. those things reduced real interest rates. As those effects go away over time, real rates of return will rise, shifting up the long-run Fisher relation, and reducing inflation if the Fed keeps the nominal interest rate at the zero lower bound.
In a paper, Peter Rupert and Roman Sustek dig deeper. In the abstract they write:
The monetary transmission mechanism in New-Keynesian models is put to scrutiny, focusing on the role of capital. We demonstrate that, contrary to a widely held view, the transmission mechanism does not operate through a real interest rate channel. Instead, as a first pass, inflation is determined by Fisherian principles, through current and expected future monetary policy shocks, while output is then pinned down by the New-Keynesian Phillips curve. The real rate largely only reflects consumption smoothing. In fact, declines in output and inflation are consistent with a decline, increase, or no change in the ex-ante real rate.
Addendum (May 11–12, 2016): In the abstract of their NBER working paper, Julio Garín, Robert Lester and Eric Sims write:
Increasing the inflation target in a textbook New Keynesian (NK) model may require increasing, rather than decreasing, the nominal interest rate in the short run. We refer to this positive short run co-movement between the nominal interest rate and inflation conditional on a nominal shock as Neo-Fisherianism. We show that the NK model is more likely to be Neo-Fisherian the more persistent is the change in the inflation target and the more flexible are prices. Neo-Fisherianism is driven by the forward-looking nature of the model. Modifications which make the framework less forward-looking make it less likely for the model to exhibit Neo-Fisherianism. As an example, we show that a modest and empirically realistic fraction of “rule of thumb” price-setters may altogether eliminate Neo-Fisherianism in the textbook model.
In his 2008 textbook, Jordi Gali discusses the role of the persistence of monetary policy shocks (page 51). If it is sufficiently persistent, a contractionary monetary policy shock raises the real rate (and lowers output) but decreases the nominal rate, due to the
decline in inflation and the output gap more than offsetting the direct effect [of the shock].
In his blog, John Cochrane registers disagreement with Larry Summers and reiterates his own argument that in a liquidity trap, interest rate policy does not have a liquidity effect and thus, only a long-run “expected inflation” or “Fisher” effect:
When the liquidity effect is absent, the expected inflation effect is all that remains. Inflation must follow interest rates.
In an Atlanta Fed blog post, Nikolay Gospodinov, Paula Tkac, and Bin We explain research suggesting that inflation expectations are stable, in spite of the rather dramatic drop in five-year/five-year forward TIPS breakeven inflation. They conclude:
To summarize, our analysis suggests that (1) long-run inflation expectations remain stable and anchored, (2) the seemingly large correlation of market-implied inflation compensation with oil prices arises mainly from the dynamics of the TIPS liquidity premium, and (3) long-run market- and survey-based inflation expectations are remarkably close in terms of level and dynamics over time.
In his blog, John Cochrane critically reviews arguments in favor of higher inflation in Japan.
He approves of the view that a conventional stimulus argument does not make much sense—given that Japanese growth is around potential and unemployment is low.
He does not approve of the view that inflation would be helpful by lowering (public and private) debt burdens. He doubts that an inflation induced default on outstanding debt would significantly lower taxes (rather than lead to more government spending) and that even if it did, such a default would increase the optimism of young households.
He also questions whether inflation could significantly reduce the real value of Japanese public debt (because debt maturity is short) and whether the debt burden is actually large (given near zero interest rates).
A graph from the Wall Street Journal as reported by John Cochrane.
A report by the White House Council of Economic Advisors surveys long-term interest rates. The “key takeaways” include:
Real and nominal interest rates in the United States have been on a steady decline since the mid-1980s. Declining interest rates are a global phenomenon. … [F]orecasters largely missed the secular decline of the last three decades.
The Ramsey growth model implies a link between labor productivity growth, per capita consumption growth and the real (inflation-adjusted) interest rate. Historically, periods of low real long-term interest rates have tended to coincide with low labor productivity growth. Projections of labor productivity growth, while imprecise, suggest 10-year real interest rates in the range of 1.5 to 3.5 per cent.
Asset-pricing models that incorporate risk suggest that the long-run nominal interest rate is the sum of expected future short-term real rates, expected future inflation rates, and a term premium. The 10-year rate in ten years that forward transactions in nominal Treasuries imply is currently 3.1 percent. Forward transactions in the market for TIPS suggest a long-term real rate just above 1.00 percent in ten years. Adding the CPI inflation rate implied by the Federal Reserve’s PCE inflation target would imply a forward nominal interest rate of 3.25 percent. The term premium in nominal Treasuries is currently estimated to be near zero, with a 2005-2014 mean of 1 percent. These components together suggest a 10-year nominal interest rate in the range of 3.1 (forward Treasuries) to 4.6 percent (based on FOMC forecasts of the long-run federal funds rate).
In a world with financially integrated national capital markets, the general level of world interest rates is determined by the equality of the global supply of saving and global investment demand. Capital markets of advanced economies are now tightly integrated while emerging market economies are becoming increasingly integrated into the global financial system. Low-income economies remain partially segmented from the global capital market. As a consequence of increasing international market integration, long-term real and nominal interest rates are increasingly moving in tandem and have declined along with U.S. rates. Nominal interest rates also tend to be correlated across countries though differences in inflation expectations can produce differences in nominal rates. In a world with uncertainty, global long-term real and nominal interest rates will include risk premiums that can reflect country-specific risk factors. Strong economic linkages, however, reinforce substantial correlation in countries’ long-term bond risk premiums.
Long-term interest rates are lower now than they were thirty years ago, reflecting an outward shift in the global supply curve of saving relative to global investment demand. It remains an open question whether the underlying factors producing current low rates are transitory, or imply long-run equilibrium long-term interest rates lower than before the financial crisis. Factors that are likely to dissipate over time—and therefore could lead to higher rates in the future—include current fiscal, monetary, and exchange rate policies; low-inflation risk as reflected in the term premium; and private-sector deleveraging in the aftermath of the global financial crisis. Factors that are more likely to persist—suggesting that low interest rates could be a long-run phenomenon—include lower forecasts of global output and productivity growth, demographic shifts, global demand for safe assets outstripping supply, and the impact of tail risks and fundamental uncertainty.
In a Project Syndicate post, Axel Weber argues that inflation targeting needs to be rethought.
Within a complex and constantly evolving economy, a simplistic inflation-targeting framework will not stabilize the value of money. Only an equally complex and highly adaptable monetary-policy approach – one that emphasizes risk management and reliance on policymakers’ judgment, rather than a clear-cut formula – can do that. Such an approach would be less predictable and eliminate forward guidance, thereby discouraging excessive risk-taking and reducing moral hazard. … intermediate targets … could potentially be applied to credit, interest rates, exchange rates, asset and commodity prices, risk premiums, and/or intermediate-goods prices. … Short-term consumer-price stability does not guarantee economic, financial, or monetary stability.
Ben Bernanke argues in his blog that it is not clear whether monetary policy fosters inequality. And if it did, other policy instruments should be used to address the resulting problems.
The concluding statement of the IMF mission to Switzerland (consultations under Article IV) includes the following top 5 recommendations:
- Ease monetary policy further to help limit an expected slowdown in growth and reduce risks related to very low inflation.
- To further support growth, allow fiscal automatic stabilizers to operate freely. If the downturn is more severe than expected, consider discretionary fiscal easing.
- Adopt pension reform to ensure the sustainability of the safety net for future generations.
- Raise banks’ minimum leverage ratio requirements to more ambitious levels to ensure banks have adequate capital to weather future shocks without recourse to public support.
- Pay bank auditors from a FINMA-managed, bank-financed fund rather than by the bank that is being audited to avoid conflicts of interest.
The IMF also calls for an overhaul of the deposit insurance scheme. It sees three risks to its central scenario:
- Risks related to low inflation.
- Uncertainty about EU relations and immigration.
- Global economic environment.
James Hamilton, Ethan Harris, Jan Hatzius and Kenneth West have computed historical time series for real interest rates in several countries (paper, blog post). The authors argue that there is significant uncertainty surrounding the equilibrium real rate—but no strong evidence for “secular stagnation.” They also argue that the uncertainty calls for inertial monetary policy. The paper includes many figures, for instance on this page a figure about US and UK real rates.
The Economist argues that negative interest rates appear not to spur inflation or growth but to weaken exchange rates. And they put pressure on banks.
In an FT oped, Thomas Mayer summarized a rather typical “German” perspective on European monetary policy. In his view, a sound euro needs either full political union or just stringent rules that are enforced. Helmut Kohl promised the former. When it didn’t happen, ECB independence and the Maastricht treaty should substitute. Ex post, Germany should have asked for more, in particular resolution and exit procedures (and, one may add, it should have played by the rules itself). The crises in the Eurozone illustrated governance problems. Merkel feared Grexit and tried to reestablish the rules. She
built a pan-European “shadow state” — a web of pacts to ensure that countries followed policies consistent with sound money.
It has not worked. From Greece to France, countries resist any infringement on their sovereignty and refuse to act in a way that is consistent with a hard currency policy. The ECB is forced to loosen its stance. Worse, it has allowed monetary policy to become a back channel for transfering economic resources between eurozone members, which politicians have refused to allow through fiscal mechanisms they control. This is Germany’s worst nightmare.
How will the situation be resolved? A century ago, Eugen Böhm-Bawerk, the Austrian economist and finance minister, proclaimed laws of economics to be a higher authority than political power. Some Germans say that a hard currency is an essential part of their economic value system. If both are right, politicians will be powerless to prevent Germany’s departure from a monetary union that is at odds with the country’s economic convictions.