Niall Ferguson has an excellent piece in Bloomberg. Here’s an excerpt:

Detente has a lousy reputation, as we have seen. Neoconservatives continue to argue that it was a misconceived strategy that mainly benefited the Soviet Union and that Reagan was right to ditch it in favor of a more confrontational strategy.

But this is misleading. First, Reagan ended up doing his own version of detente with Mikhail Gorbachev — involving more radical disarmament than Kissinger himself thought prudent! Second, detente in the 1970s made a good deal of sense at a time when the US was struggling with inflation, deep domestic division, and a war that grew steadily less popular the longer it lasted.

If that sounds familiar, then consider how detente might be helping Joe Biden today if, instead of talking tough on Taiwan in Tokyo, he had taken a trip to Beijing — fittingly, on the 50th anniversary of Nixon’s trip there in 1972. He could have:

1. Ended the trade war with China.

2. Begun the process of ending the war in Ukraine with a little Chinese pressure on Putin.

3. Applied joint US-China pressure on the Arab oil producers to step up production in a serious way (last week’s announcement was unserious), instead of letting them play Washington and Beijing off against one another.

Would Xi Jinping take detente if Biden offered it? Like Mao in 1972, the Chinese leader is in enough of a mess himself that he might well. Zero Covid has become Xi’s version of the Cultural Revolution, a policy that is ultimately destabilizing China, whatever the original intent was. As for China’s international position, the decision to back Putin has surely weakened it.

Read the whole thing.

PS. This hilarious 15-minute video on how Taiwan sorta claims sovereignty over Mongolia (but not really) is actually pretty educational.

[If you only read one post today, read my new Econlog post. I regard it as the most important post I’ll do this year.]

I am amused when I see people debating whether the current inflation is supply or demand driven, as if this is some sort of factual question.

To a hard-core inflation hawk that favors of policy of 2% inflation come hell or high water, all excessive inflation is demand driven, by definition.

In contrast, let’s say you favor 5.5% NGDP growth because you want an inflation rate high enough to keep us out of a liquidity trap. (Recall those economists who wanted to raise the inflation target to 4%.) If 5.5% NGDP growth is the baseline, then nominal spending growth since late 2019 has been roughly appropriate, and all of the current high inflation is supply driven.

When people debate whether inflation is caused by supply or demand factors they believe they are debating something about the nature of the universe, whereas they are actually debating what sort of monetary policy would have been appropriate over the past 2 years.

When I started blogging in early 2009, I assumed a trend rate of NGDP growth of roughly 5%, representing 2% inflation and 3% RGDP growth. But then the trend rate of RGDP growth began slowing, mostly due to slower population growth, but also slower productivity growth. Because the Fed insists on a 2% inflation target, I began suggesting a 4% NGDP growth figure as being roughly consistent with the Fed’s policy preferences.

But even 4% may now be too high. RGDP growth over the past 15 years has averaged only 1.63%, despite a falling unemployment rate. Even worse, population growth has plummeted during that period, so the next 15 years are likely to be even slower. If the Fed is serious about 2% inflation (and I’m having my doubts) then 3.5% NGDP growth is the baseline to evaluate monetary policy.

On the other hand, under their current asymmetric FAIT policy it seems like they are correcting inflation undershoots but not overshoots, implying more than 2% inflation on average. So let’s just stay with 4% NGDP growth as roughly representing the Fed’s dual mandate of 2% inflation (with occasional overshoots) and 1.5% RGDP growth.

Since the 4th quarter of 2019, NGDP growth has averaged about 5.26%, pushing the level roughly 3% above trend over the past 2 1/4 years (or even more if you use the 3.5% trend line benchmark.) So a significant portion of the inflation is demand driven.

The Fed’s preferred PCE price index has averaged 4% inflation since January 2020. So there’s a total of roughly 5% excess inflation over the past 2 1/4 years. From my perspective, it makes sense to view the recent higher than normal inflation as being roughly half supply driven and half demand driven, with the caveat that the overshooting (of both NGDP and PCE) will get even worse over the next 6 months.

John Cochrane has an excellent (and fairly long) post on monetary policy. He starts by discussing the pessimistic view of current Fed policy. Taylor Rule models suggest that we need much higher interest rates to get on top of the inflation problem—to get high enough real interest rates to drive inflation down. Then he discusses a more optimistic view of the Fed:

But what if expectations are rational? Here’s a little modification of the model with the arrows pointing to the changes. What if, the real interest rate and the Phillips curve are centered at expected future inflation rather than lagged inflation? Same simulation: Put in the federal funds rate path, anchor inflation at last year’s inflation. Turn off all shocks. What happens? I obtain almost exactly what the Federal Reserve is projecting. 

Intuitively, the rational expectations Phillips curve looks at inflation relative to future inflation. Unemployment is low, as it is today, when inflation is high relative to future inflation. Inflation high relative to future inflation means that inflation is declining. And that’s exactly what this projection says. Rational expectations means you solve models from future to present. If people thought inflation was really going to be high in the future, inflation would already be high today. The fact that it was only five percent tells us that it’s going to decline and go away. 

To be clear I don’t think the Fed thinks this way procedurally. They have a gut instinct about inflation dynamics, informed by lots of VAR forecasts and model simulations. But this theory gives a pretty good as-if description, a slightly more micro founded model that makes sense of those intuitive beliefs. 

So the Federal Reserve’s projections are not nuts! Inflation might just go away on its own! There is a model that describes the projections. And this is a perfectly standard model: it’s the new-Keynesian model that has been in the equations if not the prose of every academic and central bank research paper for 30 years. So, it is not completely nuts. Our job is to think about these two models and think about which one is right about the world. 

Cochrane points out that financial markets also believe that inflation will subside:

The markets, by the way, seem to agree with the Fed. Until the Fed started saying it’s going to move, markets also seemed to think inflation would go away all on its own. 

I am a big fan of the rational expectations/efficient markets approach to macro, so I find that argument to be quite appealing. Of course there is no guarantee that the markets will be correct. Market inflation forecasts a year ago turned out to be incorrect as the Fed unexpectedly abandoned average inflation targeting. But Cochrane is right that controlling inflation doesn’t necessarily require high interest rates. A credible anti-inflation policy pushes inflation expectations much lower than current inflation, making the necessary adjustment in rates much less painful.

This is the central paradox of monetary policy. The most effective policies often (not always) look to average people like the least effective policies.

I slightly part company with Cochrane when he veers close to NeoFisherism:

Another, more uncomfortable way of putting the question, 

• Is the economy stable or unstable with an interest rate that reacts less than one for one to past inflation? 

The Fed’s projections say, stable. If we just leave interest rates alone, eventually, inflation will settle down. There may be a lot of short-run dynamics on the way, which these models don’t capture. But it settles down in the end. This answers Larry’s [Summers] last question. It’s not necessarily a mistake. This is a model of the world in which nominal things do control nominal things, and the nominal interest rate eventually drags inflation along with it. A k percent interest rate rule is possible. Not necessarily optimal, but possible. 

I was with Cochrane until he used the NeoFisherian term “drags”, instead of “follows”. The “nominal things” the Fed does to drag inflation down is controlling the nominal supply of base money and the real demand for base money. Turkey tried to drag inflation down with low interest rates. It didn’t work. Never reason from a price change.

Again, policies that lead to low interest rates are often contractionary (as Cochrane suggests). But lowering interest rates is not in itself contractionary.

Cochrane then applies the fiscal theory of the price level to the US, but it’s not a good fit. There’s no doubt that fiscal deficits drive inflation in places like Venezuela. But the Fed did not create the Great Inflation of 1966-81 because it was trying to finance fiscal deficits (which were quite small at the time.) It printed money in a misguided attempt to create jobs. The Fed is the dog and fiscal policymakers are the tail.

David Beckworth has a great podcast with Bill Nelson. At one point Nelson discussed recent Fed losses due to rising interest rates (which depress the market value of bonds held by the Fed.)

Nelson: Sure. Yeah. So as you know, I send out these periodic emails on monetary policy to anybody who wants to receive them. And if they’ve your listeners who want to receive those emails, should just email me, they’re free. And I’m happy to add you. But I sent one out a couple weeks ago, pointing out that the Fed probably lost about $500 billion in the first quarter. And that we’ll know in a month or so when the Fed releases its quarterly update of its balance sheet, or maybe even sooner when the New York Fed releases its annual projection of Fed income and balance sheet. But in any case, the logic was fairly simple. The Fed’s interest rates rose very sharply in the first quarter. On average the yield curve rose about one and a quarter percentage points.

And the duration of the Fed’s securities portfolio, it indicates is about five years. And so if you just do the math, that’s a 6% loss. And a 6% loss on eight and a half trillion dollars in securities is about $500 billion. So, that’s a loss on their books. Some might argue that that doesn’t matter because they’ll never realize that loss. But I, really as any good economist, would completely disagree with that. And one way to think about it is really the same view that you were just describing that Seth articulated, which is that the present discounted value of remittances are lower by $500 billion. And you can think about that either as the loss on the securities or the rise in the IORB rate. But basically they’re going to be remitting to Treasury and therefore you and I, and everyone else are going to be paying higher taxes with a present value today of $500 billion. That’s just what the math tells you.

And the losses of course could be considerably higher as interest rates keep going up. And I agree that primarily the problem here is political. But it is a real loss. If you think about the consolidated balance sheet of the Federal Government, the Fed’s QE actions shortened up that balance sheet. They replaced long-term debt with short-term debt. They’re borrowing through the Overnight RRP Facility and through reserve balances, that’s the new debt. And they retired as it were long-term debt that they bought. So the consolidated balance sheet of the U.S. Government now has a shorter duration. Which means that the government is now more exposed to the rising short-term interest rates then they would’ve been if the Fed had not taken these actions. And that’s a real effect.

Now a hasten to add that a comprehensive view of this needs to take into account the benefits that accrued from the Fed’s actions. So, insofar as the Fed’s QE stimulated the economy, and that boosts tax revenues, and that’s something that needs to be considered as well. Now, I think you could probably make a pretty good case that the Fed’s three trillion or so of purchases around in the spring of 2020 to sort of save the financial system were extraordinarily beneficial. In terms of the long flow-based QE program that they then launched into, I am less convinced that that actually added a lot of value. But many would disagree. And so it’s that whole picture that needs to be considered.

For simplicity, I’m going to focus on the Fed’s holdings of T-bonds. They also hold some MBSs, but nothing important hinges on that distinction, at least for the purposes of this post.

How should we think about these losses being absorbed by the Fed? Let’s start with the fact that in a fiscal sense the Fed is part of the federal government. So when the value of T-bonds declines, that’s a gain for the Treasury and an equal loss for the Fed. For the consolidated federal government balance sheet it’s a wash.

Nelson suggests that the loss from rising interest rates is real. Does that contradict what I’ve been saying? Not really, it depends how one frames the question.

Image a world with a Treasury that borrows long-term, but there is no Fed. In that case, rising interest rates would benefit the Treasury in the sense that the market value of their debt would be smaller than if they had faced rising rates with nothing but short-term debt. Their previous decision to borrow long would have been wise, in retrospect.

Now imagine the Fed is created and starts buying up some of that long-term Treasury debt, and replaces it with interest bearing reserves (a short-term liability.) The Fed has effectively shifted the consolidated federal balance sheet toward shorter maturities. So the federal government gains less than otherwise from a period of rising interest rates. In that sense the Fed has imposed a loss (as Nelson suggests). The Fed’s $500 billion loss reduces the Treasury’s even larger gain that results from having the market value of its previously issued long-term debt fall by much more than $500 billion.

Given that the Treasury is a huge borrower, it might seem odd for me to claim that the Treasury gains from higher interest rates. Consider this statement by Nelson, which seems to suggest the opposite:

Which means that the government is now more exposed to the rising short-term interest rates then they would’ve been if the Fed had not taken these actions.

Once again, there is no contradiction once you understand what’s going on. Rising interest rates affect the Treasury in two distinct ways. First, the Treasury benefits from a decline in the market value of its existing liabilities. But only longer-term liabilities; T-bill prices are barely affected at all. Second, the Treasury is hurt because it has to pay higher rates on future borrowing.

Now let’s consider a scenario where the higher interest rates reflect higher inflation (the Fisher effect). In that case, the Treasury is an unambiguous winner. The real value of its existing debt declines, and the real interest rate paid on new debt does not increase. This is one way the government benefits from the inflation tax. (Others include seignorage and increased capital gains tax revenue.)

In the past year, real interest rates have risen somewhat, but remain very low. (Near zero on 5 and 10-year bonds, and negative on shorter maturities.) So I suspect that the high inflation of 2021-22 has been a net plus for the federal government, despite somewhat higher real interest rates for new borrowing.

PS. It’s possible the Fed might need a bailout (although I doubt it.) But if it does, it’s mostly a symbolic issue, sort of like the symbolic Social Security “trust fund”. Of course symbolic issues can become political, and I’d expect a Fed bankruptcy to be highly controversial.

PPS. My argument might not seem to apply to Fed holdings of MBSs, but keep in mind that those are close substitutes for T-bonds. From the perspective of the consolidated federal balance sheet, the distinction between the Fed buying T-bonds and MBSs is not that important. It has some importance for capital allocation, but even there I believe the big problem lies elsewhere (the Treasury guarantee of MBSs, for instance.)

The Guardian has a piece discussing the sort of people involved in the Putin-Trump-Orban alliance:

A notorious Hungarian racist who has called Jews “stinking excrement”, referred to Roma as “animals” and used racial epithets to describe Black people, was a featured speaker at a major gathering of US Republicans in Budapest.

Zsolt Bayer took the stage at the second day of the Conservative Political Action Conference (CPAC) Hungary, a convention that also featured speeches from Donald Trump, Fox News host Tucker Carlson, and Trump’s former White House chief of staff, Mark Meadows. . . .

When he was awarded the Hungarian order of merit in 2016 by the country’s nationalist prime minister, Viktor Orbán, the star speaker on the first day of CPAC Hungary on Thursday, the US Holocaust Memorial Museum protested, saying it “reflects the longstanding refusal of the leadership of Hungary’s ruling Fidesz party to distance itself from Bayer, in spite of Bayer’s repeated pattern of racist, xenophobic, antisemitic, and anti-Roma incitement”.

The leader of America’s Republican party sees Orban as a model:

The last featured speaker of the conference was Jack Posobiec, a far-right US blogger who has used antisemitic symbols and promoted the fabricated “Pizzagate” conspiracy theory smearing prominent Democrats as pedophiles. . . .

Addressing the conference by video shortly before Bayer’s appearance, Trump poured compliments on Orbán, who was recently elected for a fourth term as prime minister.

“He is a great leader, a great gentleman, and he just had a very big election result. I was very honored to endorse him,” Trump said.

Republicans are also addressing the issue of what to do about 13-year old girls raped by their father.

Georgia Senate candidate and former football star Herschel Walker said Wednesday he supports abortion bans without any exceptions for rape, incest or the health of the mother. 

“There’s no exception in my mind,” Walker told reporters after a campaign speech. “Like I say, I believe in life. I believe in life.”

And every time you think the GOP has hit rock bottom, we find there’s another level.

PS. You might wonder where all this “pedophilia” stuff is coming from. The NYT has a good piece on how the evangelical churches are being affected by this new culture war:

FORT SMITH, Ark. — In the fall of 2020, Kevin Thompson delivered a sermon about the gentleness of God. At one point, he drew a quick contrast between a loving, accessible God and remote, inaccessible celebrities. Speaking without notes, his Bible in his hand, he reached for a few easy examples: Oprah, Jay-Z, Tom Hanks.

Mr. Thompson could not tell how his sermon was received. The church he led had only recently returned to meeting in person. Attendance was sparse, and it was hard to appreciate if his jokes were landing, or if his congregation — with family groups spaced three seats apart, and others watching online — remained engaged.

So he was caught off guard when two church members expressed alarm about the passing reference to Mr. Hanks. A young woman texted him, concerned; another member suggested the reference to Mr. Hanks proved Mr. Thompson did not care about the issue of sex trafficking. Mr. Thompson soon realized that their worries sprung from the sprawling QAnon conspiracy theory, which claims that the movie star is part of a ring of Hollywood pedophiles.

So it’s not just Democrats; Hollywood people are also pedophiles. (And some commenters claim that I’m one too.)

Apparently, this nonsense is splitting the evangelical movement:

Across the country, theologically conservative white evangelical churches that were once comfortably united have found themselves at odds over many of the same issues dividing the Republican Party and other institutions. The disruption, fear and physical separation of the pandemic have exacerbated every rift.

Many churches are fragile, with attendance far below prepandemic levels; denominations are shrinking, and so is the percentage of Americans who identify as Christian.

The Democrats have certainly picked an inopportune time to commit suicide.

Predictions:

Trump elected in 2024

Newsom elected in 2028

In 2029, pot made legal and tobacco made illegal.

But of course all my political predictions end up being wrong. All I know is that the 21st century is turning out really bad (after a great 1980s and 1990s.)