Inflation, Deflation, and Debt

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1 Inflation, Deflation, and Debt John H. Cochrane University of Chicago Booth School of Business October 14, 2010

2 Fiscal theory # Shares Price = Expected discounted dividends Money + Gov t Debt Price level = Expected discounted surpluses

3 Fiscal theory # Shares Price = Expected discounted dividends Money + Gov t Debt Price level = Expected discounted surpluses (Money+Deposits) Velocity = Price Income

4 Classic doctrines Money + Gov t Debt Price level = Expected discounted surpluses Money vs. Debt? Inside vs. outside? Peg rates, provide liquidity. Deficits and inflation.

5 Interest rates Interest Rates 9 8 BAA FF 3 mo govt AAA 10 y govt 1 0 Jul06 Jan07 Jul07 Jan08 Jul08 Jan09 Jul09 Jan10 Jul10

6 Long rates, TIPS, inflation and expected inflation 6 5 Coreπ 10 year treas. 10 year indexed Mar05 Oct05 May06 Nov06 Jun07 Dec07 Jul08 Jan09 Aug09 Mar10

7 Fighting recessions and deflations Money+Gov t Debt Price level = Expected discounted surpluses Cause? Discounted. Tools? 1. Rates = 0? 2. Quantitative Easing I short bonds. 3. Quantitative Easing II long bonds. 4. Quantitative Easing III private/government debt. 5. Announcements: Desperation? 6. Helicopter drops?

8 $,Trillions $,Trillions Quantitative easing I II III, Debt Operations Federal Reserve Assets TALF, CP, Lending, etc. Mbs Agencies Treasuries 0 Jan08 Apr08 Jul08 Oct08 Jan09 Apr09 Jul09 Oct09 Jan10 Apr10 Jul10 Federal Reserve Liabilities Other Reserves 1 Treasury 0.5 Currency 0 Jan08 Apr08 Jul08 Oct08 Jan09 Apr09 Jul09 Oct09 Jan10 Apr10 Jul10

9 Announcements

10 Fighting inflation Money + Gov t Debt Price level = Expected discounted surpluses

11 Percent Real primary surplus / GDP Real Primary Surplus / GDP Date

12 Fighting inflation Money + Gov t Debt Price Level = Expected discounted surpluses Unsustainable long-run deficits Nominal credit guarantees (houses), government salaries, pensions, state/country bailouts. Present value Laffer curve: slow growth is the enemy. log PV log τ PV t = τy t r g = 1 + log Y log τ + 1 g r g log τ τ = 30 35% = 15% reduction in Y., τ = 30 35% = 0.3% reduction in g!

13 Yield Inflation scenario 12 Bond yield reaction 10 s shock Inflation Date

14 percent Inflation scenario New Keynesian+fiscal model 14 Response to delayed inflation i π 4 2 r 0 y time

15 Is the Fed Worried? Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time. (FOMC August ) Fed view Fed r other r "demand" "slack," "gaps" inflation Other shocks expectations, costs

16 Inflation Phillips curves don t work 6 Inflation and unemployment, Unemployment

17 Inflation Phillips curves don t work 70s 14 Inflation and unemployment, Unemployment Inflation can break out despite slack!

18 Better monetary/fiscal arrangements Money + Gov t Debt Price level = Expected discounted surpluses New tools? 1. Modern Commodity standard? 2. CPI futures/tips spread? 3. Long term debt 4. Government equity

19 More Fiscal theory of the price level 1. Understanding Policy 2. Money as Stock 3. Long Term Debt and Optimal Policy 4. Determinacy and Identification in New-Keynesian Models 5. A Frictionless view of US inflation 6. Etc., Etc., Etc.

20 SPARE GRAPHS FOLLOW

21 Greece and Euro Money + Gov t Debt Price Level = Expected discounted surpluses Debt vs. Equity; inflation vs. default Currency union and fiscal union Optimal currency area Commitment to pay ex-post lets you borrow more ex-ante Capital ratios long term debt Government equity?

22 Index, 1983 = 100 Price levels Price levels May06 Nov06 Jun07 Dec07 Jul08 Jan09 Aug09 Mar10 All Core Housing Note food&energy, housing

23 Percent, ch. from a year ago Inflation Inflation All Core Housing May06 Nov06 Jun07 Dec07 Jul08 Jan09 Aug09 Mar10

24 Interest rates and inflation? Interest rates Interest Rates BAA C ris is 6 AAA y govt Crisis ends, inflation? FF 3 mo govt 1 Mo fin. C P 1 Mo N F C P 0 Aug08 Sep08 Oct08 Nov08 Dec08 Jan09 Feb09 Mar09 Apr09 May09 Jun09 Jul09 Crisis/credit risk premium! Inflation? Low rates = loose policy? Fed sets rates?

25 Interest rates Interest Rates 9 8 BAA FF 3 mo govt AAA 10 y govt 1 0 Jul06 Jan07 Jul07 Jan08 Jul08 Jan09 Jul09 Jan10 Jul10

26 Long rates, TIPS, inflation and expected inflation 6 5 Coreπ 10 year treas. 10 year indexed Mar05 Oct05 May06 Nov06 Jun07 Dec07 Jul08 Jan09 Aug09 Mar10

27 What do long rates tell us, really? year treas. 1 year treas Oct65 Apr71 Oct76 Mar82 Sep87 Mar93 Sep98 Feb04 Aug09 Usual cyclical pattern

28 Long rates do not forecast inflation! Core π 10 year treas Oct65 Apr71 Oct76 Mar82 Sep87 Mar93 Sep98 Feb04 Aug09 Do long rates today tell you where future inflation will be? Long rates did not warn of 70s inflation, 80s disinflation

29 5 year inflation Long rates do not forecast inflation! Year Yield x: 10 year treasury y: inflation in next 5 years

30 5 year change in inflation Long rates do not forecast inflation! Yield Spread Why not? 1) risk premium obscures inflation 2) inflation is not forecastable We have to think! Pundits?

31 Different opinions? Different theories! You choose! Fed view Fed r other r "demand" "slack," "gaps" inflation other shocks costs, expectations ("Credit constraints" vs. "Old-Keynesian") New-Keynesian view π t = i t = π t+1 Coordinate expectations on unique local equilibrium Monetarist view MV = PY Today s M tomorrow s P? Deficits more M? Fiscal theory Money + Gov t Debt Price level = Present value [Real primary surpluses ]

32 Laffer Money Get Ready for Inflation and Higher Interest Rates... The unprecedented expansion of the money supply could make the 70s look benign...we can expect rapidly rising prices and much, much higher interest rates over the next four or five years.....the panic demand for money has begun to and should continue to recede. The dramatic drop in output and employment in the U.S. economy will also reduce the demand for money. Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates...

33 Laffer Money

34 Feldstein Money, and deficits can tempt monetization Inflation is looming on America s horizon The unprecedented explosion of the US fiscal deficit raises the spectre of high future inflation...there is ample historic evidence of the link between fiscal profligacy and subsequent inflation....the large US fiscal deficits are being accompanied by rapid increases in the money supply...the excess reserves of the banking system have ballooned from less than $3bn a year ago to more than $700bn ( 536bn, 474bn) now. The money supply consists largely of government-insured bank deposits that households and businesses are holding because of a concern about the liquidity and safety of other forms of investment. But this could change when conditions improve, turning these money balances into sources of inflation.

35 Krugman Deflation! Deflation, not inflation, is the clear and present danger....why the inflation worries? Some claim that the Federal Reserve is printing lots of money, which must be inflationary, while others claim that budget deficits will eventually force the U.S. government to inflate away its debt. The first story is just wrong. The second could be right, but isn t....banks aren t lending out their extra reserves. They re just sitting on them in effect, they re sending the money right back to the Fed. So the Fed isn t really printing money after all

36 Krugman Deflation and the usual insults...is there a risk that we ll have inflation after the economy recovers? That s the claim of those who look at projections that federal debt may rise to more than 100 percent of G.D.P. and say that America will eventually have to inflate away that debt.. Such things have happened in the past. For example, France ultimately inflated away much of the debt it incurred while fighting World War I. But more modern examples are lacking. If inflation isn t a real risk, why all the claims that it is?.. it s hard to escape the sense that the current inflation fear-mongering is partly political..

37 Bernanke/Fed Credit channel; Phillips curve; cost-push BB June 2009: Even after a recovery gets under way, the rate of growth of real economic activity is likely to remain below its longer-run potential for a while, implying that the current slack in resource utilization will increase further....in this environment, we anticipate that inflation will remain low... cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in That said, improving economic conditions and stable inflation expectations should limit further declines in inflation. FOMC March : With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

38 Bernanke/Fed Credit channel; Phillips curve; cost-push FOMC August : Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time BB Aug 27: Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee s objectives. At this juncture, the risk of either an undesirable rise in inflation or of significant further disinflation seems low. Internal: Big debate on how to stop deflation.

39 Low rates do not cause inflation month TB Core π Oct65 Apr71 Oct76 Mar82 Sep87 Mar93 Sep98 Feb04 Aug09

40 Inflation Phillips curves don t work 6 Inflation and unemployment, Unemployment

41 Inflation Phillips curves don t work 70s 14 Inflation and unemployment, Unemployment Inflation can break out despite slack!

42 $ Billion Percent Money expands a lot! Dollar increase in money from Jan 07 Percent increase in money from Jan M1 Currency 60 M1 Currency Deposits Deposits 350 GDP Jan08 Apr08 Jul08 Oct08 Jan09Apr09 Jul09 Oct09 Jan10Apr10 Jul10 Jan08 Apr08 Jul08 Oct08 Jan09 Apr09 Jul09 Oct09 Jan10Apr10 Jul10 Large increase

43 $,Trillions $,Trillions Balance sheet Reserves expand more! Federal Reserve Assets TALF, CP, Lending, etc. Mbs Agencies Treasuries 0 Jan08 Apr08 Jul08 Oct08 Jan09 Apr09 Jul09 Oct09 Jan10 Apr10 Jul10 Federal Reserve Liabilities Other Reserves 1 Treasury 0.5 Currency 0 Jan08 Apr08 Jul08 Oct08 Jan09 Apr09 Jul09 Oct09 Jan10 Apr10 Jul10

44 But...Money has little actual correlation with inflation! M1 PY M1 and GDP Jun90 Mar93 Dec95 Sep98 May01 Feb04 Nov06 Aug09 May12 And if it did, will smoking a cigar make you rich?

45 M 1/PY, Percent Money demand 17 M1 Demand month T bill rate At 0 rates, money demand is huge!

46 Does monetary expansion mean more inflation? Fed does not print money; open market operations ; M&Ms Easy to reverse: As Md declines (panic, r), it s easy for the Fed to soak it up Conversely, at 0 rates Fed is powerless to stop deflation! When interest rates are zero, buying and selling debt of different maturities has no effect.

47 $ Billion Fiscal: inflation? M+B is rising a lot! Money + Gov t Debt Price level = Present value [Real primary surpluses ] Pension, soc. sec., health,..?? Including Fed Treasury held by by public US debt Jun07 Dec07 Jul08 Jan09 Aug09 Mar10

48 Bottom line Why so much confusion/debate? Wildly different theories, few of which work. 1. Fed view Fed r other r "demand" "slack," "gaps" inflation 2. New-Keynesian view 3. Announcements Coordinate expectations on unique local equilibrium 4. Monetarist view MV = PY 5. Fiscal theory Money + Gov t Debt Price level = Present value [Real primary surpluses ] To make a good forecast, understand mechanism! You don t know, but nobody else does either!

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