A paper in Project Syndicate

Inflation in the shadow of debt

Our central bank officials assured us that today’s inflation is temporary. It will disappear on its own. But what if not? They told us that the central bank will have the “tools” to deal with inflation. But what are those tools? Is the central bank willing to use them, and will the government allow them to do so?

If inflation continues to soar, the central bank’s main tool is to substantially increase interest rates and keep interest rates high for a few years, even if this leads to a painful recession, as it did in the early 1980s. How much pain does it take, how deep does it take to dive? The highly respected Taylor Rule (named after my Hoover Institution colleague John B. Taylor) recommends that interest rates rise by one and a half times the inflation rate. Therefore, if the inflation rate rises from 2% to 5%, interest rates should rise by 4.5 percentage points. Together with the 2% baseline inflation target and the 1% long-term real interest rate, the rule recommends a central bank interest rate of 7.5%. If inflation accelerates further before the central bank takes action, controlling it may require the 15% interest rate in the early 1980s.

Will the central bank do this? If they do, will 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 In 1980, US Federal Reserve Chairman Paul Volcker began to raise interest rates to curb inflation, which was about 25% of GDP. Now, it is 100% of GDP, and it is rising rapidly, and there is no end in sight. When the Fed raises interest rates by 1 percentage point, it will increase the interest cost of debt by 1 percentage point. When debt accounts for 100% of GDP, 1% of GDP is approximately $227 billion. Therefore, an interest rate of 7.5% will incur an interest cost of 7.5% of GDP or US$1.7 trillion.

Where do these trillion dollars come from? Congress can drastically cut spending or find ways to increase taxes. Or, the U.S. Treasury Department may try to borrow trillions of dollars. But for this choice to work, bond buyers must be confident that the future Congress will cut spending or increase the same trillions of dollars in taxes, plus interest. Even if investors seem to be confident at the moment, we cannot assume that they will remain so indefinitely, especially if additional borrowing will only pay higher interest on existing debt. Even for the United States, bond investors have seen the end of the day and demand higher interest rates as a risk premium, which will further increase the cost of debt, leading to a spiral of debt crises or sharp rises. And uncontrollable inflation. If the US government can borrow money at will and never worry about repayment, it can always send checks to its citizens, and no one needs to work or pay taxes again. Alas, we do not live in that fantasy world.

All in all, to raise interest rates to reduce inflation, higher interest rates must be accompanied by credible and sustained fiscal austerity, both now and in the future. If fiscal austerity does not come, monetary policy will ultimately fail to curb inflation.

This is a completely standard proposition, although it is often overlooked when discussing the United States and Europe. It is embodied in the model used by the Federal Reserve and other central banks. [Previous post here on just what that means.] For decades, this has been the standard recommendation of the International Monetary Fund.

Successful inflation and currency stability almost always include monetary and fiscal reforms, usually microeconomic reforms. The role of fiscal and microeconomic reforms is to generate sustainable higher taxes by promoting economic growth and expanding the tax base, rather than by substantially increasing and reducing the marginal tax rate for growth. Many attempts to stabilize the currency have failed due to the failure of fiscal or microeconomic reforms. The economic history of Latin America is full of such plots.

Even the experience of the United States in the 1980s fits this model. The high interest rates in the early 1980s increased the interest cost of U.S. Treasury bonds and caused most of the huge annual “Reagan deficit” at that time. Even after the decline in inflation, interest rates remain high. It can be said that the market is worried that inflation will soar again.

So why did the United States’ efforts to stabilize inflation succeeded in the 1980s, failed twice before the 1970s, and failed countless times in other countries? In addition to the Fed’s firmness and the support of the Reagan administration in the two severe recessions, the United States has also carried out a series of important tax and microeconomic reforms. Interest rates and market-oriented regulatory reforms began with the deregulation of trucking, air transportation, and finance in the Carter era.

The United States has experienced two years of economic prosperity. A larger GDP increases taxes, and despite high real interest rates, it can still pay off debts. By the late 1990s, although it sounded strange now, economists were actually worried about how the financial markets would work once all US Treasuries were paid off. Prosperity can be said to be the result of these monetary, fiscal, and microeconomic reforms, although we do not need to argue about the cause and effect of this period of history. Even if the economic boom that generated fiscal surpluses coincided with tax and regulatory reforms, the fact remains that the US government successfully paid off debts, including debts that were generated by high interest costs in the early 1980s. If this is not done, inflation will make a comeback.

Borrower duck

But will this kind of successful stabilization happen now. U.S. Treasuries are four times the controversial Reagan deficit and are rising, and the interest cost at a given interest rate level is four times the controversial Reagan deficit? Will Congress really abandon its ambitious spending plans or increase taxes by trillions of dollars to pay unexpected interest to mainly wealthy foreign bondholders?

It can be said that it will not. If the interest cost of debt spirals upwards, Congress may demand a reversal of the high interest rate policy. The last time the U.S. debt-to-GDP ratio was 100% was at the end of World War II when the Federal Reserve was clearly instructed to reduce the interest cost of U.S. debt until inflation broke out in the 1950s.

Unraveling can be slow or fast. As debt rolls over, higher interest rates will take time to raise interest costs. As long as people believe that there will be fiscal liquidation in the future, the government can borrow. But when people lose this belief, things fall apart quickly and unpredictably.

Will and politics

Fiscal policy restrictions are only the beginning of the Fed’s dilemma. Will the Fed act quickly before inflation gets out of control? Or will it continue to treat every rise in inflation as “temporary” and, as in the early 1970s, blame it on the price that rose the most during the month?

It is no easy task for the Fed to trigger a recession and stick to its policies in pain. It is not easy for the government to support the central bank through this long-term struggle. But in today’s political climate, it seems particularly difficult to tolerate the continued rise in unemployment – ??concentrated among disadvantaged groups as usual – and the Fed is vocally seeking to address inequality and inequality as it explains its mission of pursuing “maximum employment”. Methods.

In addition, the ensuing recession may become more severe. If people really believe that the policy will be seen through, inflation can stabilize with almost no recession. But if they think this is a fleeting attempt that may be reversed, then the associated downturn will be worse.

One might think that this debate can be postponed until we see whether inflation is really temporary. But now this question is very important. If inflation expectations do not rise, it will be much easier to fight inflation. Our central bank insists that inflation expectations are “anchored.” But by what mechanism? Well, I believe these central banks will reapply the harsh Volcker drugs of the 1980s to control inflation when necessary. How long can this confidence last? When did the anchor become a sail?

The military or foreign policy analogy is helpful. Fighting inflation is like deterring the enemy. If you just say that you have “tools”, it’s not terrible. If you tell the enemy what these tools are, show that they are all in a shiny working state, and show that you are willing to use them, no matter what kind of pain you bring to yourself, the possibility of deterrence is much greater.

However, the Fed has been silent about what “tools” are and how prepared they are to deploy them, no matter how painful it is. There was no material demonstration. The Fed continues to adopt the opposite strategy: by committing to any stimulus measures, it will unswervingly stimulate the economy and increase inflation and inflation expectations. The Fed is still working hard to curb deflation and has stated that it will reduce the unemployment rate by keeping inflation above the target for a period of time as it did in the 1970s. It also promised in advance not to raise interest rates for a fixed period of time, rather than raising interest rates when the required economic conditions remain the same, which is just as counterproductive as announcing the withdrawal of troops on a specific date. Like most members of the US government, the Fed is plagued by race, inequality, and climate change, so it cannot stop the deterrence of its traditional enemies.

Buy some insurance!

The perfect opportunity to avoid this problem is beckoning, but it will not beckoning forever. The US government is like a homeowner, walking out the door, smelling the smoke, and oncoming is a salesman who provides fire insurance. So far, the government has rejected this proposal because it does not want to pay a premium. There is still time to reconsider this choice.

Higher interest rates will increase interest costs, simply because the United States mainly finances its debt by extending short-term debt rather than issuing long-term bonds. The Fed has made this problem even more complicated by buying large amounts of long-term bonds and issuing overnight bonds (reserves) in return.

In this respect, the US government is like any homeowner. It can choose adjustable-rate mortgages, which provide a lower initial interest rate, but if the interest rate rises, it will lead to a substantial increase in the payment. Or, it can choose a 30-year (or longer) fixed-rate mortgage, which requires a higher initial interest rate, but provides 30-year interest rate hike protection.

At present, the one-year treasury bond interest rate is 0.07%, the ten-year period is 1.3%, and the 30-year period is 1.9%. As long as interest rates remain the same, each one-year bond can save the US government about two percentage points in interest costs. But in fact 2% is still negative. Two percentage points are insurance premiums that eliminate the possibility of a 30-year debt crisis and ensure that the Fed can fight inflation when needed. I’m not the only one who thinks this seems to be cheap insurance.Even the former U.S. Secretary of the Treasury Lawrence H. Summers has changed His previous views arrive debate The United States should quickly turn to long-term debt.

But this is a limited time opportunity. Countries that are beginning to experience debt problems usually face higher long-term interest rates, which forces them to borrow short-term and face the ensuing dangers. When a house on the street catches fire, the insurance salesman will disappear or charge excessive fees.

Bottom line

Is the current inflation spike temporary or will it continue? The answer depends on our central bank and government. If people believe that the fiscal and monetary authorities are ready to take measures to curb the inflation breakthrough, then inflation will remain subdued.

Doing whatever you want means combining monetary and fiscal stability, as well as growth-oriented microeconomic reforms. This means sticking to the policy amid inevitable political and economic pain. This means postponing or abandoning grand plans that rely on completely opposite policies.

If people and the market lose confidence that the government will respond to inflation with such policies in the future, then inflation will explode now. Under the shadow of debt and slow economic growth, the central bank cannot control inflation on its own.

*********

PS, I don’t know if the advertisements that appeared in Project Cindy Plus are common or tailor-made for me. In either case, if you fully understand me, you will find that the advertising options are quite humorous. PS let me write because they felt that some intellectual diversity was needed, I think this shows!