10 reasons not to fear high inflation

I am a product of the 1970s, with a visceral distaste for inflation.  Yet despite the massive budget deficits and doubling of the monetary base, I am for some strange reason worried about excessively low inflation, rather than high inflation.  Why?

1.  The bond market shows very low inflation expectations.  Especially the TIPS spread.  As I have said many times, “good economists don’t make predictions, they infer market predictions.”  (It’s fun to create maxims that imply you are almost the only “good economist” in the world.)

2.  OK, but that’s just one market.  Well what market does show high inflation expectations?  Thirty year mortgage rates are very low; would house prices be plunging if people thought we’d have runaway inflation 10 years from now?  What about commodity prices?  Yes gold is relatively high, but that could be financial instability.  And even gold prices are far lower in real terms than 1980, the last high inflation period.

3.  OK, but those are just market forecasts, what about economists—I see lots of articles by people like Allan Meltzer warning about high inflation down the road.  This is a tough one.  All the consensus economic forecasts show very low inflation ahead.  But then again those consensus forecasts only go out a few years.

4.  What about the big increase in the money supply, doesn’t that presage high inflation?  No, the closest parallel to the current U.S. situation is Japan, which still hasn’t seen the “long run” inflation from the late 1990s base increase.  Another parallel is the big monetary base increase during 1931-33 and the devaluation of 1933.  The devaluation did cause inflation, but mostly during that very year, not later.  Prices were only 5% higher in mid-1940 than mid-1934.  Of course inflation did occur during and after WWII.

5.  Why won’t the bloated MB cause inflation in the long run?  Because the Fed is engaged in inflation targeting.  If inflation shows signs of rising above 2%, the Fed will tighten policy; they’ve learned their lesson from the 1970s.  (BTW, if they withdraw ANY monetary stimulus before withdrawing ALL fiscal stimulus, you will see me go ballistic.  You will see hate-filled posts you never thought I was capable of producing.)

6.  Won’t the Fed be afraid that withdrawing the monetary stimulus would push us back into a recession?  No, not if it is merely offsetting a drop in the real demand for base money.  Monetary shocks matter only to the extent to which they cause unexpected changes in inflation and NGDP growth.  If they don’t, they have no cyclical impact.  Otherwise the recent doubling of the base would have led to rapid growth.

7.  OK, maybe the Fed is technically able to prevent inflation in the future.  But what about the budget deficit?  Won’t they want to inflate to reduce the burden of the debt?  This is probably the best argument that high inflation is coming, but in the end I still don’t buy it.  Here are a few counterarguments:

8.  The national debt seems headed much higher, but is still likely to remain at a level that other industrial countries have been able to absorb for decades (say around 100% of GDP, or maybe even less.)  These countries include Japan and several European nations.)

9.  I expect very low nominal (and real) interest rates for a long time.  This means the cost of financing the debt will be much lower than if real rates were back at 1980s levels.  This is because I expect the mother of all credit bubbles to soon emerge out of East Asia.  If East Asia (especially China) continues to grow rapidly (which I expect) and continues to save at relatively high rates (which I also expect), then world real interest rates are likely to remain depressed for decades.  Don’t forget that China alone has nearly as many people as North and South America, Europe, and Australia.  And they save 40% of their incomes.  And they are growing extremely fast.  And as we saw with Japan, local investment opportunities will begin to dry up as they approach Western income levels.  (BTW, being a believer in the EMH, I don’t give investment advice.  However, let’s just say I don’t put my money where my mouth is regarding the EMH.  The EMH is for people who have no sense of adventure.)

10.  The conservative culture of central bankers is becoming increasingly obvious.  They are refusing to inflate right now, even though the world desperately needs a bit more inflation.  Why would they suddenly turn into a bunch of Arthur Burns, or G. William Millers?  I just don’t see that happening.

You might think this is merely naivete on my part; that I don’t understand that a price must be paid for all our current sins.  Oh I understand that we will have a price to pay.  I don’t like the current deficits at all (which is why I favor monetary stimulus.) But the price won’t be an inflation tax on (mostly) drug dealers and tax evaders holding Federal Reserve notes.  It will be higher income and consumption taxes on people who play by the rules.



44 Responses to “10 reasons not to fear high inflation”

  1. Gravatar of Thruth Thruth
    7. May 2009 at 05:49

    I want to hear more on #3, the Meltzer claim that QE poses a huge risk of future inflation (or a failed fed and huge fiscal defiicts) seems to be widespread. Is this a long and variable lags argument? The QE takes a long time to work, but when it does BOOM. It sounds sort of plausible in a “conventional wisdom” kind of sense, but is there an analytical framework for this view or is it just voodoo?

  2. Gravatar of Stephen Monrad Stephen Monrad
    7. May 2009 at 06:04

    One question. Can the central banks contract the money supply fast enough to prevent inflation when we start spending money again?

  3. Gravatar of Alex Golubev Alex Golubev
    7. May 2009 at 06:15

    I agree that we do end up turning Japanese in the best case scenario. However i can also see value in holding 10-15% of your portfolio in gold as “in case shit happens” allocation. Gold will go up if we have inflation or in the other extreme – further instability. if the governments of us, china, EU get everything right, gold will lose. My bet’s on further instability, not inflation. There’s no way we get out of this with just a couple of minor devaluations. party like it’s 1931

  4. Gravatar of david glasner david glasner
    7. May 2009 at 06:46

    Scott, you left out the best reason, which is that high inflation is exactly what we want. High inflation for a year or two would make us all better off, first, by making hoarding cash less attractive than buying real goods for consumption or for investment, which would be the impetus for production and employment, which would mean that we would start recovering from this recession. Second, it would stabilize nominal real estate values and would reduce the rate of foreclosures and enable households and businesses to restore their balance sheets. The Fed could certainly reverse course and drain reserves out of the system before the price level rose by 20 percent. A 20 percent increase in the price level would do much more good than harm. A commitment to long-term price stability, preferably along the lines that you have been advocating or that Earl Thompson developed and I wrote about in my book, would certainly prevent a temporary inflation from becoming embedded in long term expectations.

  5. Gravatar of Jon Jon
    7. May 2009 at 06:48

    I’d like to argue that you’re wrong, but I think you are right.

    The interest-on-reserves program has the possibility of doing the work even if the Fed would otherwise have trouble redeeming the junk accumulating on its balance-sheet. The interest-rates that will be required do concern me a bit though. Its clear that at a minimum the Fed will need to drain liquidity proportionate to its net-interest payments to be policy neutral, but if its holdings default, trouble will mount.

    The doomsday scenario is defaults on the Fed’s balance sheet induce a rapid rise inflation expectations–a situation develops at which the target needs to be at a level above overall yield of the Fed’s portfolio. At this point the system will spiral out of control. Net interest payments will become negative and the open market value of the debt will decrease substantially which will create a spiraling feedback loop.

    The solution… scarily enough: tax and burn.

  6. Gravatar of Stevie b. Stevie b.
    7. May 2009 at 09:33

    @ David Glasner – “High inflation for a year or two would make us all better off”. Utterly wrong I’m afraid. For example, the mostly blameless on a fixed income would be screwed.

  7. Gravatar of Nick Rowe Nick Rowe
    7. May 2009 at 10:37


    A couple of minor points:

    The 40% savings in China is perhaps better thought of as government savings, rather than household savings. The government fiddles with prices (and the central bank with exchange rates), rather than explicit taxes, to capture a large part of GDP. (This is what I gather via Brad Setser). Doesn’t affect your argument though.

    Some (e.g. Willem Buiter) argue that the Fed’s net worth on its balance sheet is deteriorating (if its assets aren’t worth what it paid for them), and that it may be unable to withdraw enough money without getting help from the fiscal authorities. Negative seigniorage, if you like to think of it that way, will be needed to keep inflation on target. Take the extreme case: it has only toxic waste on the asset side of its balance sheet, and all that toxic waste becomes worthless. So it can’t reduce the monetary base. But of course, as long as the present value of the Fed’s seigniorage is still worth more than the reduction in monetary base it wants to achieve, it can still do it. This is where interest on reserves comes into play. It is equivalent to the Fed issuing its own bonds, backed by future seigniorage streams.

  8. Gravatar of Nick Rowe Nick Rowe
    7. May 2009 at 10:39

    Sorry Jon. I just realised you had already made the same point.

  9. Gravatar of Marcus Jones Marcus Jones
    7. May 2009 at 11:08

    (BTW, if they withdraw ANY monetary stimulus before withdrawing ALL fiscal stimulus, you will see me go ballistic. You will see hate-filled posts you never thought I was capable of producing.)

    Is it really possible for the government to withdraw fiscal stimulus? Can we really expect the government to decrease overall spending year over year?

  10. Gravatar of Joe Calhoun Joe Calhoun
    7. May 2009 at 11:29

    What will the effect of “the mother of all credit bubbles” in East Asia have on the US?

  11. Gravatar of Alex Golubev Alex Golubev
    7. May 2009 at 13:14

    Scott, it would be great to get some comments on the “difficulties” in the 30 year auction today. Can we call this (dollar) inflation? Are these “difficulties” positive in your framework? A rush from the dollar is a good thing, right? I mean of course it’s bad FOR the government, that the gov’t can’t raise money for the Newer Deal, but these are signs that QE is working. unless of course it’s a sign of another liquidity crisis. but for the Treasury. can we call that inflation as well?

  12. Gravatar of Alex Golubev Alex Golubev
    7. May 2009 at 13:14

    here’s the story:

  13. Gravatar of ssumner ssumner
    7. May 2009 at 13:47

    Thruth, I don’t believe in “long and variable lags”, which I consider voodoo monetarism. Much of my Depression manuscript is devoted to refuting that idea. Monetary policy impacts auction-style markets right away. If there is no impact in auction-style markets right away, then don’t bother waiting around for the long and variable lags. Like the Japanese, you’ll be waiting a long time. Of course if auction-style markets are impacted, then sticky wages and prices will respond with a lag–nothing voodoo about that. It’s the “invisible” monetary stimulus stuff that drives me nuts.

    Stephen, The problem isn’t inflation, it is inflation expectations. As long as those don’t increase, any temporary burst of inflation can be ended with no effect on employment. And inflation expectations are clearly visible in real time. Only gross incompetence by the Fed would allow TIPS spreads to rise to 4%.

    Alex, I wouldn’t call Japan a “best case” as their NGDP is now returning to 1993 levels, but I see your point.

    David, I’m going to halfway defend your argument in response to Steve, but let me say why I prefer 5% NGDP growth. This policy idea is something that I see as a long term policy regime, not a quick fix. Thus I am trying to educate people to the fact that if we have such a policy regime, we don’t need any special counter-cyclical policies in recession (like fiscal stimulus.) It’s not inflation to bail us out now, it will not be a contractionary policy when the economy gets overheated. A policy not an expedient. If you take the stance St. Augustine took regarding sin, it will just confuse the debate. Obviously if the Fed ever adopted my policy, for the first year they might consider where we are relative to trend–so I understand your point.

    Jon, If the Fed did succeed in reflating, wouldn’t this dramatically raise the market value of this “junk” I.e. reverse the effects that deflation has had on the junk. If so, isn’t it unlikely that we would have the worst of both worlds—high inflation and the Fed holding lots of junk? Not that even one of those problems wouldn’t be bad enough.

    Steve, I agree that a one-time 20% price level increase is excessive. I think David is referring to the difference between “inflation” and “reflation.” When prices fell more that 25% in the early 1930s, even some people who were opposed to inflation argued that a certain amount of “reflation” could be justified on both efficiency and equity grounds. Thus it would boost RGDP growth, and it would unwind an unfair redistribution toward lenders. So I understand the argument. But in my view the price level is at most 5% below trend, and hence I would oppose any once and for all increases larger than 5%. I am sticking to 5% NGDP targets, not because I don’t think there is merit to David’s argument, but rather because I want to focus on what we need to do in the long run.

    Nick, I agree about China. But I think even their private savings rate is pretty high. Many urban Chinese families have incomes that would put them at our poverty line, even in PPP terms, and yet save half their income. I personally know people like that. I don’t know if it is culture, a lack of a safety net, or what, but the saving propensity is amazing. And I expect it to continue even if China becomes capitalist.

    I’ll take your other comment after dinner.

  14. Gravatar of ssumner ssumner
    7. May 2009 at 15:13

    Nick, I agree with your argument, but I was under the impression that most experts thought the Fed’s losses would be modest. Have those forecasts changed recently?

    In another post, I argued that the Fed had “inside information” (their own future policy intentions.) But also that they were not skilled enough to take advantage of that information. They ought to buy assets that would do well if they carry out their plans, but are they doing that? Do they even know their own plans?

    Marcus, I don’t expect the government to withdraw the fiscal stimulus. And when they don’t I will argue that it shows what a fraud the argument was from the beginning. We were told we needed fiscal stimulus (despite the massive deficits), because monetary policy was ineffective at the zero bound. If they withdraw any monetary stimulus before unwinding all fiscal stimulus (obviously excluding the small portion going to major projects already underway) then the real reason for fiscal stimulus will be apparent for everyone to see.

    Joe, I don’t really believe in “bubbles” I was just using the term most people use. My thought was that if people thought low interest rates inflated the 2006 housing bubble, wait until they see how low real, long term rates go when Asian saving goes up 4-fold.

    Alex, I guess this is a bad day to be arguing that low interest rates are coming. People who know more about business cycles than me (like James Hamilton) think the employment numbers show we are just weeks from the bottom, if we haven’t reached it already. So real rates and inflation are both rising on signs that a recovery may occur soon.

    And yes, higher long term nominal rates are very good news. Anyone notice how stocks have been rising in the past month along with nominal yields?

  15. Gravatar of Jim Glass Jim Glass
    7. May 2009 at 17:22

    You’re right, fear not, Hayek showed how to get a grip on Inflation.

  16. Gravatar of azmyth azmyth
    7. May 2009 at 18:42

    Just as unconventional monetary policy has room to work at 0% interest rates, unconventional monetary policy can reduce inflation if the central bank is truly committed to doing so. While I like the sound of “tax and burn”, the Fed could also alter reserve ratios. They showed how powerful a tool required reserves can be in ’37, and the disaster it caused probably convinced them never to try that trick again. In a high inflation environment however, it could be a useful tool. And there’s certainly one other contractionary policy they could use: interest on reserves!

  17. Gravatar of Joe Calhoun Joe Calhoun
    7. May 2009 at 19:05


    I don’t really believe in bubbles either. I think people make the most rational choice they can given the price signals given off by the market. On the other hand, living in Miami, I had a front row seat to the housing speculation and camping overnight with the mosquitos to buy a pre-construction condo is, in my humble opinion, a tad irrational. So, I suppose it depends on how you define “bubble”.

    My question then only needs rewording: What will be the effect on the US of a 4 fold rise in Asian savings? If I read your post correctly, you believe this savings (or at least some portion of it) will be recycled into the US as it has in the past and that will depress real long term rates. Or have I got that wrong?

    I find the Greenspan savings glut period interesting. We had all that excess Asian savings coming to the US, but at the same time we had a dollar that was falling like a rock (against gold, the euro, aussie dollar, etc.). If there was so much of the world’s savings coming to the US, why did the dollar fall? If so many dollars were being bought to purchase Treasuries that it depressed yields, why did the dollar fall? It would seem that, despite heavy demand for dollars from Asia, we managed to print so many of the things that they still lost value. That’s a lot of printing.

    It seems to me that the effect on the US from all that future savings you envision will depend as much on how many dollars we print as how many they save (which are obviously related). If we do the same thing we did from 2002 to 2007 and print too many, I suspect we’ll get inflation in some form just as we did last time. Real estate prices is where it was manifested last time, but maybe it’ll be commodity prices this time and $150 oil was just a test. Or something else; I don’t know. On the other hand, if we are able to maintain the value of the dollar or even somehow get it to appreciate in the face of massive fiscal deficits, we might get a quite happy economic outcome. That also seems a mighty big if.

    It is amazing to me that inflation expectations remained anchored during that period of dollar devaluation. The public and apparently a large portion of the economic profession has been convinced that CPI is inflation and if it behaves well then by golly we don’t have inflation. I wonder how long we can maintain that illusion?

  18. Gravatar of Jon Jon
    7. May 2009 at 19:41


    How junky is the junk and at what price was it acquired? My understanding is that the Maiden Lane vehicles did not acquire their assets at fire-sale prices. ML I liquidated Bear Sterns in March 2008 and JP Morgan drove a costly deal, the venture has lost about 4 Billion at current prices and is arguably actually junk.

    Maiden Lane III bought CDOs on which AIG had written derivatives contracts so as terminate those arrangements. ML III paid top-dollar to hold-outs who knew that the government was behind AIG, but the underlying CDOs are super-senior tranches. Losses if held to maturity were never likely.

    Maiden Lane II bought MBS directly from AIG. The purpose of this was to give AIG access to capital. I suspect that the government paid full-value for these shares. I’m not sure of the quality of these securities.

    More significantly though are the 300B+ in MBS that the Fed owns directly as a consequence of Open Markets trading. In theory these are “high grade” aka insured by Freddie Mac (grrr.) It paid top dollar for these too.

    If inflation swings up, the yield on all these instruments is going to be judged low and their value will drop accordingly.

  19. Gravatar of Bill Woolsey Bill Woolsey
    8. May 2009 at 03:35


    It is possible that the Fed may require a taxpayer bailout. It is possible (maybe likely) that FDIC will require the same.

    If Federal Resrerve (or FDIC) policy is aimed at avoiding bureaucratic embarrassment from asking for money from Congress to cover losses, then the leadship needs to be changed. There is no excuse.

  20. Gravatar of Bill Stepp Bill Stepp
    8. May 2009 at 03:57

    Jeff Christian, a gold analyst who owns a metals and commodities research firm, once told me that gold is better at predicting monetary instability (and I would say by implication bad monetary policy, except that this might imply there’s such a thing as good monetary policy) than predicting inflation.

    And, yeah, there will be “good” monetary policy the day there is “good” socialismo.

  21. Gravatar of ssumner ssumner
    8. May 2009 at 04:34

    Joe, One puzzle is why the condos sold so cheaply that lines formed–that seems to violate the laws of supply and demand. I believe that one answer that has been offered is that lines are a way of whipping up enthusiasm for your product, making it seem “hot.”

    I don’t think the low real, long term interest rates will cause any serious problems for the U.S., just as I don’t think they did in 2002-07. I think that what caused problems back then was some really foolish bank lending practices, that thank God are unlikely to be repeated in the near future. But I do expect more asset movements that other people (not you or I) will cause bubbles.

    Let me also say that I am not fond of the idea of inflation being “manifested” in certain areas. Inflation pushes up the prices of all goods and services. If it is unexpected it can have cyclical effects, which can also affect relative prices. But what happened in 2002 is that business investment fell very, very sharply. To prevent a severe recession Greenspan appropriately allowed rates to fall sharply (I don’t say cut, because it was the free market that cut rates) as the demand for credit shrank dramatically. Because tech was so overbuilt, even at low interest rates there wasn’t much tech investment for a while. Just like the laws of classical economics predict, if we stay near the PPF, and there is much less business investment, there will be more of some other kind of investment–in this case residential. Greenspan had the bad luck to preside over this eminently sensible policy at a time when commercial bankers were making some bad decisions. Greenspan did make one error however, just as in 1999-2000 he focused too much on inflation, and not enough on NGDP. Hence in the 2004-07 period monetary policy became too expansionary. Normally that would have merely led to the sort of small recession that we have all the time. But because of the subprime disaster, and much more importantly then the Fed’s mishandling of zero rates, the recession was much worse than it needed to be.
    House prices rose for microeconomic reasons, that wasn’t “inflation”. Ditto for oil prices, which rose because of the Asian boom. House prices and commodities rise and fall. I lived through the 1970s and I can tell you that when we get real inflation, there will be no doubt. The normal pay increase back then was often 10%, not the 3-4% norm in recent years. I view wage inflation as the best measure of macro instability (although it probably lags NGDP a bit.)

    Jon, Are you saying that when inflation drops sharply and nominal rates plunge (like last year), the value of these assets will fall, and when inflation rises and nominal rates rise, the value of these assets also falls. How can that be? Should it not be symmetrical? I knew about the Bear Steans problem, but as you indicate the numbers are insignificant. Fannie and Freddie won’t be allowed to fail, the taxpayers would bail them out. I guess I still don’t see where the big Fed losses would be. By “big losses” I mean much more than just $100 or $200 billion. But I haven’t studied this issue, so I am completely open to having my mind changed. As you know, I think my proposed policy would make the banking crisis much less severe, as much of it is caused by the Fed’s deflationary policies.

    Bill W. I also look at things that way.

    Bill S. If gold can only say something bad will happen, but can’t distinguish between deflation and high inflation, then it may not be a useful inflation forecaster, but it might help vis a vis stocks (which are hurt by both.) Unfortunately both gold and stocks respond instantly to news, so neither would “Granger cause” changes in the other.

  22. Gravatar of Dilip Dilip
    8. May 2009 at 06:52

    Free exchange has picked up your post:

  23. Gravatar of Scott Sumner Scott Sumner
    8. May 2009 at 08:59

    azmyth, yes, I agree they would easily be alble to keep inflation in check, if they wish to do so. Once central banks figured out what they did wrong in the 1970s, they were able to prevent a repeat. Not just one central banks, but all developed economy central banks.

    dilip, Thanks, that was a nice link by The Economist (my favorite magazine.)

  24. Gravatar of David Pearson David Pearson
    8. May 2009 at 12:06

    Just as an aside, I don’t understand this issue of gold responding to “instability”, or “monetary instability”. Can you be more precise? What do the gold holders actually hope to achieve?

    In virtually every instance where “instability” is a risk, actors are better off holding currency than gold. It is more liquid; more easily transported, stored, etc.

    Fear of a bank holiday? Currency is better. War? Currency. Government confiscation? Currency is way better.

    The above seems obvious, yet analysts continue to believe actors prefer to hold gold in the face of “instability”. What’s really going on?

    There is only one instance where actors should prefer gold over currency, and that is when “instability” carries with it an implied threat of inflation. War, banking crises, currency volatility, social unrest — these are all events that, given a plausible government response, can lead to inflation. The “safe haven” is from that threat, and that threat only.

  25. Gravatar of 123 123
    8. May 2009 at 12:20

    “Greenspan did make one error however, just as in 1999-2000 he focused too much on inflation, and not enough on NGDP. Hence in the 2004-07 period monetary policy became too expansionary.”

    In 2004-07 period NGDP returned to the 5% growth trendline.

  26. Gravatar of Rafael Rafael
    8. May 2009 at 15:23

    Is the money supply exogenous or endogenous? I just can´t figure out whether it is more or less endogenous. If it is endogenous, BY HOW MUCH, and how does its “endogeneity” changes over time, if so?

  27. Gravatar of ssumner ssumner
    8. May 2009 at 18:00

    David, You may well be right.

    123, I guess a better way to make my point was that if we judge policy relative to the 5% NGDP growth benchmark, then growth was too fast in the late 1990s and 2004-07, when NGDP growth exceeded 5%, and was too slow in 2001-03 and 2008-09.

    I gather you are referring to some arbitrary trendline, which the economy was below in 2001-03. That is a reasonable way of looking at it, but until the Fed actually adopts such a trendline, and starts engaging in level targating, I prefer to simply argue that policy is too tight during recessions and too loose during booms. Most estimates of the trendline probably show the economy usually below that line (otherwise you would have had 2007 as an above trendline year.) But in that case the policy implications would be likely to lead to higher inflation, as you’d be adopting expansionary policies much more often than contractionary policies.

    Or perhaps I totally misunderstood your point.

    Rafael, The whole endogenous money question has endless interpretations. Just off he top of my head I’d say the money supply is endogenous if the central bank targets something other than money, and exogenous if they target money. However it may be more complicated than that.

  28. Gravatar of Jon Jon
    8. May 2009 at 21:33


    Jon, Are you saying that when inflation drops sharply and nominal rates plunge (like last year), the value of these assets will fall, and when inflation rises and nominal rates rise, the value of these assets also falls. How can that be?

    Wait, wait. Bond prices move for different reasons at different times, but in general: if the prevailing nominal rate at constant-maturity is above the coupon the market price of the a bond declines below par such that yield to a new buyer is equivalent to the market price and vice-versa.

    I argued very specifically that the Fed has either bought unconventional debt under one of two scenarios:
    1) It paid at or near par (well above the trading price) as a form of bailout.
    2) It bought insured securities whose price is presently now well above par because the Treasury is backing and has an equity stake in the Freddie/Fannie.

    Thus I do not argue that the Fed owns assets that were acquired on the cheap.

    Regardless (and as a point to the side) MBS etc plunged in value despite the lessening of inflation both because the duration of the deflation is assumed minor and the risk premia component demanded rose dramatically countervailing the monetary risks.

    I don’t think the Fed has acquired assets at prices that would be conducive to profit taking following a recovery of confidence. At best the Fed can hope to break-even which means that its vulnerable to a shift upwards of inflation expectations beyond those prevalent when the securities were issued.

  29. Gravatar of Nick Rowe Nick Rowe
    9. May 2009 at 02:10

    Scott: “Rafael, The whole endogenous money question has endless interpretations. Just off he top of my head I’d say the money supply is endogenous if the central bank targets something other than money, and exogenous if they target money. However it may be more complicated than that.”

    Yep. If I am driving my car along a hilly road, what’s endogenous and what’s exogenous?

    If I decide to hold the gas pedal constant, and let the car speed up or slow down when I’m driving down or up hill, then the speed is endogenous and the gas pedal exogenous. If instead I decide to drive the speed limit regardless (or engage cruise control, then the speed is exogenous and the position of the gas pedal endogenous. Exactly the same car and same mechanics in both cases.

    It would be hard to imagine two auto mechanics getting into a big debate about what’s really exogenous or endogenous: the gas pedal or the speed (or the flow of gas and air into the engine). It’s a debate about how to model the driver, not the car.

    (But we may agree that the time period matters, if the driver cannot adjust speed instantly in response to changing conditions.)

  30. Gravatar of ssumner ssumner
    9. May 2009 at 04:29

    Jon, Thanks for clarifying. My only big concern would be how much the Fed bought at below market prices. The rest is a fair gamble. I don’t know why the Fed bought assets at below market price (or perhaps I should say I think I do know, but I don’t think it was a good reason.)

    Nick, You are correct, and I certainly don’t draw the implications from “endogenous money” that someone like a Post-Keynesian might. If you target interest rates then money is endogenous in one sense. But this will cause the price level to be indeterminate unless you have something like a Taylor Rule. Of course a Taylor Rule is just a formula for adjusting interest rate targets in such a way that the money supply moves in such a way as to stabilize the price level. Is that also your view?

  31. Gravatar of Joe Calhoun Joe Calhoun
    9. May 2009 at 08:19


    Sorry but those people in the pre construction condo buying lines were real buyers. They weren’t planted there by the condo builders. I personally know of scores of real buyers (well, at least real buyers in the sense that they had enough money to pay the deposit) who were in those lines. These people believed that by buying pre construction, they were buying below what the market price would be on completion. They had visions of rising prices in their heads.

    I agree that bad lending practices were the root of the problem, but I also wonder if the bad lending practices weren’t a function of excessive money creation. If money were a bit more scarce during that period, maybe the banks would have been more prudent about how they lent it out. As to whether those practices will be repeated, well I repeat my assertion from my earlier post that that will depend, at least to some degree, on what happens to the value of the dollar. I also think one could argue that the bad lending practices still haven’t stopped but are being facilitated now through fannie mae and freddie mac.

    I take a more classical view of inflation and don’t see the general rise in prices as inflation but rather the result or consequence of inflation. Inflation to me is a fall in the purchasing power of money and I don’t think anyone would disagree with the fact that the dollar fell in value during the relevant period. I see the Fed’s job as balancing the supply of and demand for dollars, a job they have failed at miserably for a very long time. They failed in the 90s when they failed to supply enough and they failed in the 00s when they supplied too many. And they continue to fail, as you’ve pointed out, now. There were consequences for all those failures. Can inflation (as I define it) cause relative price changes that don’t show up in the CPI? Obviously, I think so; the Fed can create excess money (causing its value to fall) but they can’t control how it is spent. I would also point out that the CPI back in the 70s used actual house prices whereas the more recent episode used imputed rent. If we had been calculating CPI as we did in the 70s, inflation (as you define it) would have been a great deal higher than what was reported.

    In your reponse you say:

    “But what happened in 2002 is that business investment fell very, very sharply. To prevent a severe recession Greenspan appropriately allowed rates to fall sharply (I don’t say cut, because it was the free market that cut rates) as the demand for credit shrank dramatically. Because tech was so overbuilt, even at low interest rates there wasn’t much tech investment for a while. Just like the laws of classical economics predict, if we stay near the PPF, and there is much less business investment, there will be more of some other kind of investment-in this case residential.”

    And then:

    “House prices rose for microeconomic reasons, that wasn’t “inflation”. Ditto for oil prices, which rose because of the Asian boom.”

    Didn’t Fed policy create those microeconomic conditions that caused home prices and commodity prices to rise? If the Fed had conducted monetary policy to maintain a constant purchasing power for the dollar, interest rates wouldn’t have been as low and while we would have had a recession, we wouldn’t have gotten all that residential “investment” that we obviouisly didn’t need. And we wouldn’t now be trying to correct that over-investment.

    I don’t think there is much, if any, difference in what we both believe the Fed should be doing. You want them to maintain a target NGDP and I want them to maintain a stable value for the currency. It seems to me that if they targeted the correct NGDP and complied with your wishes, they would likely comply with mine as well. The problem for both of us is in determining the correct value for our variables. What is the appropriate NGDP growth to target? How do we define the value of the dollar?

    In my opinion, the Fed has been able to keep inflation expectations anchored by manipulating the public perception of inflation. If we had continued to calculate CPI as we did in the 70s and it had risen at the higher rates that implies (and the headlines that implies), would inflation expectations have stayed anchored? Would interest rates have been as well behaved? I don’t think so and if the Fed returns to a policy that causes the value of the dollar to fall at the rate it did from 2002-2007, I don’t think they will be able to maintain that illusion for long.

    Should we fear high inflation? I watch the value of the dollar (in a variety of ways; gold, commodity indices, versus various currencies) to make that determination. You watch NGDP. To-may-to. To-mah-to.

  32. Gravatar of Scott Lawton Scott Lawton
    9. May 2009 at 08:54

    Housing: it’s very difficult to establish primary & secondary causes. Here’s an argument (from a source that I generally find sensible) that Fannie Mae drove the politics in order to increase their profits. “Easy money” (if true) may have helped, but may not have been a primary cause.

    Let’s see if I can include a real link:
    Fannie Mae’s Golden Goose: A Lesson In Moral Hazard

  33. Gravatar of Rafael Rafael
    9. May 2009 at 09:16

    Scott and Nick,

    I agree with your views. I wanted to provoke a sort of post-keynesian-heterodox economics debate.

    Regarding the time-changing aspect of “endogeneity”, I refer to current events. The Fed raised monetary base tremendously recently and yet banks in general are not making the money flow. There´s something going with money multiplier (may I say it´s a measure of endogenous money supply?).

  34. Gravatar of Nick Rowe Nick Rowe
    9. May 2009 at 10:08


    “If you target interest rates then money is endogenous in one sense. But this will cause the price level to be indeterminate unless you have something like a Taylor Rule. Of course a Taylor Rule is just a formula for adjusting interest rate targets in such a way that the money supply moves in such a way as to stabilize the price level. Is that also your view?”

    Roughly. I think so.

    Rafael: Agreed. There does seem to be something especially wrong with the traditional money multiplier story of the transmission mechanism. But it’s the same thing that’s equally wrong with the linkage between the Fed funds rate and bank lending story of the transmission mechanism too (where money is endogenous). Broken throttle cables are an auto mechanic problem in the linkage between policy levers and targets. Distinguishing between endogenous and exogenous doesn’t seem to help much. Here’s my (tentative) view on the broken linkage: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/quantitative-easing-circumvents-banks-capital-constraints-to-increase-m1.html

  35. Gravatar of David Beckworth David Beckworth
    9. May 2009 at 16:39

    Scott, you write the following:

    6. Won’t the Fed be afraid that withdrawing the monetary stimulus would push us back into a recession? No, not if it is merely offsetting a drop in the real demand for base money…

    Do you really think the Fed has the ability to precisely offset a change in real money demand? Since when has the Fed been able to perfectly estimate real money demand and offset it a timely fashion? I am dubious they have the technical ability to be so precise–and precision will be important here since everyone knows the stakes are high–and whether they have the political will. Yes, they may have learned a lesson about inflation in the 1970s, but unlike Paul Volker who did not 24-7 news coverage the current Fed faces more scrutiny and is more easily influenced by political pressures. (I wonder if Paul Volker would have been able to do what did in the early 1980s had faced the same media coverage Ben Bernanke gets today.)


    You raise an interesting point that as long as the net present value of the Fed’s future seiginorage streams exceeds the needed reduction of the monetary base all will be well (even if all the Fed’s assets are junk). Understand though, that this means that less seigniorage will be returned to the U.S. Treasury and thus, less ability to finance government spending. That makes it an implicit fiscal cost that U.S. taxpayers will have to bear. So either the government lends the Fed securities to mop up the excess monetary base (Buiter’s scenario) or the Fed turns less seigniorage over to the Treasury. Either way monetary policy will come at a cost.

  36. Gravatar of ssumner ssumner
    10. May 2009 at 05:03

    Joe, You misunderstood my point about waiting lines. I know they were real buyers, rather I said some people claim the sellers set prices below equilibrium to create lines of real buyers. So we agree there.

    Money and credit are two very different things. The Fed has little impact on real interest rates, it is believed that a worldwide savings glut depressed real rates after 2001. That’s not to say that monetary policy can’t pump up housing, but rather it is only to the extent that it pumps up overall AD. I would argue that even by your criterion, money was not too easy in 2003 when they cut rates to 1%. Both inflation and NGDP growth had been below trend. The housing boom had microeconomic causes as long as macro policy was on course. A drop in business investment pushed us along the PPF toward more housing investment. The only problem showed up in later years (say 2004-07) when NGDP growth rose a bit above the ideal 5%. At that time the Fed should have tightened more aggressively. Note that the housing market by itself tells us nothing about monetary policy. Some housing booms reflect sound macro policies, other reflect NGDP rising to fast.

    The value of money is defined as one over the price level. They are two sides of the same coin. So my definition of inflation is the same as yours. I also agree that the government errs in the way it measures housing inflation, and also thought they understated inflation in 2005-06. But I don’t worry about that issue, because I think inflation is a pretty meaningless concept, which is actually impossible to define. None of the definitions that I or you use come close to the theoretically appropriate definition–the change in income required to maintain a fixed utility level. BTW, even if they erred in 2005-06, the average inflation rate for the decade was not distorted all that much by housing, which has come down significantly, and thus inflation this decade was nothing like the 1970s.

    Too little money in the 1990s? I’ve never heard that one before. Care to explain which nominal aggregate grew too slowly.

    I don’t think the Fed can manipulate perceptions of inflation. Most people pay no attention to what Bernanke thinks the true inflation rate is. Most people don’t even believe the BLS numbers.

    Scott, Thanks. I warned years ago that Fannie and Freddie were potential time bombs. (Although I should add I totally failed to predict this specific crisis.) Obviously it was a mistake to abolish the 20% down payment regulation. What are the chances that the “pro-regulation” people in Congress like Barney Frank will re-instate that 20% rule? That is, will put into place regulations that actually might help? This whole debate over regulation vs deregulation has been a farce from day one.

    Rafael, The falling multiplier is easy to explain, they pay interest on reserves at a rate higher than banks can earn other other safe assets.

    Nick, I agree with your response to Rafael

    David, If they have a forward-looking monetary policy they can offset shifts in money demand, at least well enough to keep inflation in check. Indeed that was the policy they had in 1982–2007. They only abandoned it late last year, when they admitted that they were no longer targeting the forecast. All they need to do is ease when inflation expectations fall below 1.5%, and tighten when inflation expectations rise above 2.5% in the TIPS market. because these expectations are embedded in auction-style market prices, they can be controlled in real time through aggressive monetary policy. Actually, I don’t think inflation targeting is a good idea, but NGDP targeting will also keep inflation well-behaved. I think they can do this even without the futures targeting scheme discussed in my new post, but that scheme would definitely allow them to do this.

    Regarding your response to Nick–I agree that fiscal and monetary policy are inextricably linked. But the likely costs to the Fed from QE are tiny compared to the fiscal bills we are running up. And this is the key point–our fiscal bills are almost entirely due to a very tight money policy that has sharply reduced NGDP growth. Easy money would massively improve the fiscal situation, and only modestly increase risk to the Fed.

  37. Gravatar of Joe Calhoun Joe Calhoun
    10. May 2009 at 07:37


    I’m not an economist (as my posts probably reveal) but an investment advisor. I use market information and when I say the Fed didn’t supply enough dollars in the 90s, I get that from observing the value of the dollar and the actions of my clients. All I mean is the Fed didn’t supply enough dollars to balance the demand. I deal with quite a few foreign clients and they were sending money here in great quantities in the late 90s. Strangely enough it wasn’t because they were anxious to buy tech stocks. When I asked them why, they all said, “because the dollar is rising”. Most of them didn’t even buy stocks, but just wanted to park the money in CDs. If the Fed had met the demand for dollars earlier in the decade and kept the value of the dollar stable, those clients (and a lot of other people)would not have been buying dollars later in the decade. Now, I do think the dollar should have risen some in the late 90s because the internet/tech boom was inherently deflationary (increased productivity should be deflationary shouldn’t it?), but the Fed let it go too far.

    I agree with you that policy was not too easy earlier in the 00s. The dollar started to fall in 2002 and if they had stabilized it when it got back to about 1995 levels (or maybe a little higher to account for the productivity increase), we would have been okay. But in 2006, the dollar broke below that broad band and that is when policy went off the rails (in my opinion). Up until then, they were just correcting their errors from the late 90s.

    I also agree that defining inflation is impossible if you are using a price index as your criterion. It is impossible to get the basket of goods right and in fact the basket of goods would seem to be different for different people in my opinion. To me the only appropriate way is to observe the value of the dollar against a variety of other currencies and a commodity index. I long ago decided that for me that was the relevant metric because it was the only one that was market based. I’ve been doing this a long time and for me there have been four major cycles in the dollar since I started investing. A rising dollar from about 81-85 (deflation), a falling dollar from 85-88 (inflation), a transition period from 88-95 during which the dollar was fairly stable, a rising dollar from 95-02 (deflation) and lastly a falling dollar from 02-08 (inflation). Each of those periods required different approaches to investing. I would also point out that it is during the periods when the dollar is falling that we seem to build up the excesses. The real estate boom and bust in the mid to late 80s (which got us the S&L crisis) and the crash of 87 were during a period when the dollar was falling rapidly. And of course the most recent episode was during a period of a rapidly falling dollar. It’s my belief that if the Fed concentrated on keeping the value of the dollar stable, we would get much smoother economic performance.

    By the way, I’m not in the “worried about inflation” camp – at least not yet. But the dollar will tell us what is happening with monetary policy. Take a look at a chart of the dollar from last year and you can see quite easily when the Fed fell behind the curve. The dollar changed trend in July/August which also happens to be the time commodities peaked. If they had balanced supply/demand and stabilized the dollar during that period rather than allowing it to rise so rapidly, I think we would have avoided what happened later in the year. If I’ve been reading your blog accurately, I think that is very similar to what you believe.

  38. Gravatar of ssumner ssumner
    10. May 2009 at 14:05

    Joe, Your last point is something I have emphasized, and discussed in my “some graphs” post a month back–which looked at five indicators of tight money after July 2008, including the exchange rate. I think we have broadly similar perspectives, except you are more real world finance-oriented, and I am more macro-oriented. As I said in another post, a stable dollar doesn’t always provide macro stability. Now if you add on stable commodity prices, then we are getting much closer to the ideal. I still prefer an NGDP target, but your dollar plus commodity price approach also would have prevented the big crash in late 2008, so I think your instincts there are pretty good. My suggestion is to always keep an open mind and keep looking a more indicators. There might be an occasional (rare) event where both the exchange rate and commodity prices simultaneously give misleading indications. I have never seen NGDP give the wrong signal.

  39. Gravatar of M. Simon M. Simon
    10. May 2009 at 23:23

    I live in farm country. As far as I can tell we have real inflation here. How do we gauge it? The price of milk at the supermarket.

    It has gone from $1 a gallon to near $2 a gallon in the last 8 years. Dollar a loaf bread is now two dollar a loaf bread – $1.59 for date code specials.

    I am most fortunate to have been a high earner who lost all of my assets through a series of misfortunes. I have gone from the top 1/5th to the bottom 1/5th. I no longer deal in abstractions like inflation numbers and expected GDP growth. I worry about being able to have enough food for the month.

    And I have to say – from the bottom of the pile the economy is not looking good. There are positives. My landlord is upside down on his mortgage so I expect rent will stay constant for some time to come. But I don’t see price stability (or even reductions) at the grocery store.

    What else do I see? Government crowding out private investment. And it is not just the money supply. It is also very much policy. Investments that made sense at one tax rate no longer make sense at the higher rates coming. OK. That is not too bad if policies are stable so you can assign some kind of number to future expectations. Not the case. And then you get things like cap ‘n trade which threatens to throttle energy supplies (the actual root of prosperity) before too long.

    You guys worry too much about dollars. You should pay more attention to Joules. And the policy of the current administration is to jack up the price of Joules and make the supply intermittent. The Chinese get it. They are building power plants at a furious rate and are making very serious efforts to collect access to future liquid fuels.

    What are we doing? Every thing possible to strangle current and future access to Joules.

    And if the climate is heading to a long term cooling period food is going to get a lot harder to come by. Couple that with the strangulation of energy supplies and we are looking at some very serious problems. Absolutely none of which are amenable to solution in the current political climate. NIMBY and Green Genocide (too many people) rules. In short the Californication of America.

  40. Gravatar of M. Simon M. Simon
    11. May 2009 at 00:16

    As to global warming. Pay no attention to the headlines. What you want to look at is orange groves. The more northerly ones are being shut down. In other words the climate is cooling.

    And then there is that other supplier of Joules. The sun. We have just passed a 100 year (and maybe a 11,000 year) peak in solar output. And more than a few solar scientists are predicting a Dalton type minimum. The more extreme are predicting a Maunder type minimum. You might want to look up the effect on the world economy of the Little Ice Age.

    What is the effect on food supplies of having to plant winter wheat in the summer? Now we can mitigate this to some extent with our better understanding of genetics.

    Did I mention that with a cooling world the oceans will be able to hold more CO2 decreasing the supply of CO2 in the atmosphere further depressing plant growth. The optimum CO2 atmospheric concentration for plant growth is .5% – 5,000 ppm. At less than 400 ppm we are a long way from that. In fact at 200 ppm some plants will no longer grow. At 90 ppm no plants will grow. Shorter growing seasons and slower plant growth. Which means that investments in the various segments of agriculture (including things like tree farming) will be less productive.

    Macroeconomics is quite far from explaining everything about economics. What happens when our most northerly farms go underwater because they can’t grow food profitably? Will the Goths and Vandals come south because their northern regions can no longer support them?

  41. Gravatar of Vangel Vangel
    11. May 2009 at 14:41

    I think that the USD is doomed as massive deficits will have to be financed by money printing and as current creditors try to hedge their concentrated positions in USTs. I would say that gold has a good chance of going over $2,000 an ounce in the next 18 months so I would rather be in that market than in positions that bet on low to no inflation.

  42. Gravatar of ssumner ssumner
    11. May 2009 at 17:11

    M. Simon, I can’t deal with all the world’s problems. I deal in “abstractions like NGDP,” to try to help (in a small way) those people on the “bottom of the pile.” BTW, one point I have not emphasized on this blog is that the biggest victims of our monetary malfunction (by far) has been poor workers in third world countries.

    Vangel, Good luck with your gold investments, but you should be aware that big public debts aren’t necessarily a precursor to high inflation (i.e. Japan.)

  43. Gravatar of The “Have No Fear” Inflation Update The “Have No Fear” Inflation Update
    19. June 2009 at 16:08

    […] A list of reasons why high inflation is unlikely was given by Scott Sumner in a post earlier this month. […]

  44. Gravatar of Forexfires Forexfires
    21. August 2009 at 07:13

    Great resource thanks for writing

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