The Adults are Talking: Are you listening?

While any mistakes in this piece are my own, I am indebted to Rob Dugger for pointing out some of the underlying trends and historical analogues. Consider this a hat-tip.

We don’t really have a definitive theory of inflation. It’s a mystery, like morning wood or … comic timing. It’s not that we don’t have any idea what drives inflation, but rather that we have multiple competing theories, some of which are mutually inconsistent, and none of which are very good at giving us any tradeable predictions. These theories have value, but they are certainly not universal, meaning they work sometimes but not at other times. It’s almost as if we are missing bits of the puzzle. What this means is that, as is true with most economics, the theories we have are of greater use in politics than in forecasting. Cos, if policies like excessive social spending are causing inflation, then our inflation theories (too much money/government spending/rates are too low/not enough workers) can be valuable rhetorical devices to push through a policy that might not otherwise make it.

The fiscal theory of the price level?

(From Aleksander Berentsen & Christopher Waller 2018 “Liquidity premiums on government debt and the fiscal theory of the price level”)

“The fiscal theory of the price (FTPL) is a controversial idea that states that fiscal policy, not monetary policy, pins down the aggregate price level. The argument for this follows from the intertemporal government budget constraint which states that the real value of the outstanding stock of government debt is pinned down by the discounted stream of real future surpluses. Since the initial stock of nominal debt is given, for any fixed stream of surpluses, this theory argues that the price level must adjust to make the real value of the government debt satisfy the intertemporal government budget constraint. Furthermore, dynamic movements of the price level are driven by expected changes in future fiscal policy.”

Which I would suggest can be expressed more succinctly (but less rigorously) as the greater the degree of imbalance between the PV of the cost of servicing the debt and the future fiscal flows that could pay it back, the higher inflation will be. Even more succinctly: inflation is inversely proportional to the capacity to service public debt internally.

Neo-Ricardian equivalence

I couldn’t help but notice the “controversial”. Controversial to who? In what sense? I will come back to this question. The other observation I would make is that the Fiscal Theory of the Price Level is part of a very old tradition in economics referencing something called Ricardian equivalence, after David Ricardo. The argument is that the timing of taxes doesn’t affect consumer(agent) behavior because rational agents would see through any short-term shenanigans to the underlying trends in government finances and therefore the prospect of higher future taxes (or inflation) because of government decisions today.

Anyone can see that the question of fiscal sustainability has become more prominent in recent years. The CBO’s projections are hair-raising. The grand old men of the hedge fund world have argued that fiscal conditions strongly favor steepeners and have had the trade on since last year (probably longer since they don’t usually tell us before placing their full bet).

It’s not that very high levels of debt (say, over 100% of GDP) are necessarily unsustainable. That would depend on global global circumstances. Policy choices are wider when you have most of the surplus countries keen to accumulate your IOUs, rather than use those surpluses themselves. Does anyone else remember Ben Bernanke’s “Global Savings Glut”? Just me? Well, back in 2005, Ben explained that the capital flows into the US were not because Americans were borrowing too much but rather because Asians were saving too much and needed some place to put those savings. But recent events have made it clear that accumulating claims on hostile powers is probably not a sensible idea. Who says the claims are worth anything?

With the world in a “less cooperative” mood, every major block has an interest in either attracting foreign capital or at least reducing capital flight. Most countries now have an interest in rebuilding their militaries to take account of the lessons learned in the Ukraine. Most countries want to win the big strategic tech races; AI (a critical military application), semi-conductors (see AI), Quantum Computing (which can turbo charge AI). Clean energy tech (including fusion). The point isn’t to be exhaustive about strategic investment priorities of different competitor states but rather simply to note that pretty much everyone has a lot of spending to do.

And that’s without considering the need to harden and adapt infrastructure to climate change. Events in Florida and California are examples of the costs of climate change and the failure to adapt to it. We will need to spend copious amounts of cash on this too. Not just rebuilding the damage (which while a big number, isn’t a massive shift in itself) but rather hardening our infrastructure. Power lines in California might need to go underground. Brush clearance prioritized. And property values will be lower because of these costs – through the mechanisms of insurance costs and property taxes. A big subject and one I am planning to tackle soon. Issues around Californian municipal finance are big enough to impact Federal finances.

The bottom line is that we are running out of fiscal headroom, and higher real yields, at higher sticky levels of inflation are telling us something about sovereign solvency. If anything, the only surprise in any of this is that US inflation risk premium are not higher too. Maybe that reflects other factors, or perhaps the market can smell a policy response to fiscal problems on the horizon. Either way, current debt trends do not seem sustainable. Remember what Stein’s law says about things which are not sustainable? They must end. The only question is how?

What might this mean for monetary policy?

The fiscal theory of the price level would suggest that the inflation problem we have faced was caused by overly aggressive use of fiscal policy. That was a political choice. Covid happened and we chose to cushion the impact on the private sector by increasing the indebtedness of the public sector. There was definitely a case for it. Some might think they noticed some evidence of unscrupulous looting in the use of the PPP and SBA forgivable loans, but I think whenever the government sets up an emergency funding scheme, some looting is inevitable. People are smart, and they will always take advantage of a big pile of money just begging to be grabbed. The more important point is that if the inflation problem is primarily fiscal, then the solution should also be primarily fiscal.

In effect we have been running the same combination of monetary and fiscal policy as Reagan: tight money, and loose fiscal, the net effect of which was to suck in capital from all over the world. Sadly, even the enormous pools of capital which have entered US capital markets were not enough to prevent long yields from rising. Perhaps foreigners can also see that the solvency position of the US government is challenged and prefer the risk of US companies. Look at what the Mag 7 paid for their debt! And bear in mind the heavy use of short end financing by the outgoing UST Sec. Was that a form a gerrymandering (boosting the economy by restricting the supply of duration as Miran and Roubini suggest? Maybe. Or you could argue she didn’t like the yields the buyers were prepared to accept and rejected them. Potato – potahto.

What are the “adults” saying?

When I think about Trumps policy agenda, it suggests that while we might not have crossed the fiscal dominance event horizon (maybe!), fiscal issues have become so prominent that appropriate monetary may be very different from the 1980s/90s consensus. And the people who think about these issues have noticed and have been discussing it. Of course, most people have not noticed because they don’t prioritize reading research notes issued by the Federal Reserve system. I can see their point. But none of this is either particularly weird, or particularly hidden. It’s just too boring to hide.

I can point to papers from as far back as Woodford in 2000, that make these points. But recently we have seen this discussion get increasingly direct and pointed.

All these papers make either the same point or related points about the need for consistency and coordination between monetary and fiscal policy.

Unsurprisingly the BIS did a good job of summarizing these developments. Also unsurprisingly, no one noticed.

That BIS paper

Taken as a whole, these papers suggest that some big intellectual shifts are taking place within the Federal Reserve system. For example R* may not be domestically determined but might perhaps be viewed as set by the global market for capital. Right now the Fed computes it exclusively from domestic variable. We might not have noticed this when the global supply of capital was seemly limitless because of Japanese and then Chinese savings, but once that changed, we notice the problem in increasing bond long bond yields and intensifying competition for internal capital flows.

And if the Fed is not able to independently address inflation, isn’t Fed independence itself problematic? Consider the case where Congress sets a deficit which implies higher inflation than the Fed’s target? So, Fed independence means higher rates? Which implies a stronger dollar, and potentially, financial sector instability – another Fed responsibility. Worse interest rates might be a very weak tool to address these problems. So, were the Fed trying to control inflation with only rates, it might require extremely high rates with all that means for leveraged balance sheets.

Volker

We often think of Arthur Burns and William McChesney Martin as the Central Bankers whose mistakes required Paul Volker to be brought in to fix things. It’s both overly simplistic view of the events leading up to Volker becoming Fed Chair and pretty unfair. I’m told by someone who had a ringside seat, that it was Paul Volker (who was the UST undersecretary for international monetary affairs from 1969 to 1974) who made the suggestion to come off the peg (Aug 15th 1971), and Volker who flew around the world announcing the shift to the US’s trade partners. If only there was a picture of de Gaulle’s face when he was told!

This decision, often referred to as the "Nixon Shock," effectively dismantled Bretton Woods. Prior to it, the dollar was pegged to gold at a rate of $35 per ounce, meaning that foreign governments could exchange their dollars for gold at that fixed rate. However, as the US experienced economic challenges and increased its money supply, maintaining this peg became increasingly difficult. Either the Vietnam war, the domestic economy (with domestic political consequences) or convertibility had to go. And Nixon chose convertibility.

I mention these choices, because I think US policymakers today are faced with a very similar dilemma. Bill Martin once said that the Fed is “independent within the government, not independent of the government” and I think he has a point. Who sets US economic policy? The unelected members of the FOMC, or the US President. Because in effect, that’s the stark choice the fiction of Fed independence suggests. And this fiction is useful because at the margin it might soothe the nerves of international UST buyers. But ultimately, if its fiscal policy that determines US inflation, should the Fed intervene against the electorate’s representatives at the cost of failed banks and lost homes?

The benefit of the doubt

We had a Fed meeting yesterday and a Q&A with Chair Powell. What I took away was that they thought rates broadly restrictive, which was consistent with the idea that inflation is too high. However, they seem fine to wait till inflation comes down before loosening policy further. Makes sense given you really don’t know how much deficit reduction Congress will come up with or precisely how much inflation one should pencil in from tariffs. I have been told that Speaker Johnson thinks the deficit reduction targets that would be in the budget reconciliation instructions might be less than some hope, but that he considered $2.5Tr the minimum required. And that there is a good chance that Mexican and Canadian tariffs will be tabled soon. So, the FOMC can afford to wait, in case the situation changes and appropriate monetary policy changes.

But I think the real takeaway is Bill Martin’s observation about Fed independence. If the Fed insists on proof of Congressional willingness to cut spending, then it will also hamstring the Administrations efforts to implement its economic agenda? And stopping your boss from doing what he wants is often bad for a career. Bill Martin was selected precisely because he would do roughly what the WH of the day wanted. Powell might be able to slow the WH, but doing so might conflict with other Fed objectives and damage the Fed itself as an institution.

Senator Daines makes the obvious connection

Chris Waller has followed the debate. We know this because he contributed to the literature on the Fiscal Theory of the Price Level. David Andolfatto tells us that Waller has been doing much of the heavylifting for the FOMC. People I speak to confirm this. Waller has been particularly influential with Powell over the last 4 years.

I take the view that anyone deadlifting over 300lbs is probably not thinking about retirement. Waller will want the top job, and much as the Fed gave the Biden administration the benefit of the doubt, he will know that the Trump policy mix will need accommodative monetary policy to offset the pressure from slower growth. At the margin, giving the Congress the benefit of the doubt on rate cuts will help offset the pressure on the long end of the curve from lower global savings. A Trump policy mix of tariffs, reduced government spending a shifting priorities of government spending will have very limited room for maneuver without lower short rates.

Of course, if lower short rates result in higher inflation, the room for maneuver will disappear and the Fed will eventually have to act. But the Fed will have to find an accommodation with the WH and Congress, and giving a little now will prevent a more damaging pissing contest which would damage everybody’s legacies. Waller can exert gentle pressure from within, which I am sure would be noticed by a grateful WH. So Powell will need to incorporate these arguments into his thinking.

Which brings us to Mr. Mosler’s observation: if Congress brings the deficit down by $2.5 trillion or more, we will be looking at sizable deflationary impetus. Ironically, cuts to interest rates would actually increase the fiscal deflationary impulse (albeit with a lag), even while it transferred income from creditors to debtors. Preemptive cuts of the curve would help ensure the solvency of leveraged balance sheets and they might even goose asset prices, but they probably wouldn’t offset the effect of the fiscal tightening on overall growth.

People like Bessent know all this. They also know that this is a good time to take pain because you have two years before the next Presidential election. So careful betting against bigger rate cuts than you think are appropriate given inflation.