The final nail for fiscal dominance?
One of my biggest frustrations over the past 15 years has been the economics profession’s drift away from certain well established propositions, such as the fact that the Fed controls the price level. But there are signs of light. David Beckworth has a twitter thread discussing how inflation has recently fallen sharply despite absurdly large budget deficits as far as the eye can see:
Ironically, our biggest inflation episode (1966-81) occurred during a period of relatively small budget deficits. The gross federal debt ratio fell from 40% of GDP in 1966 to 31% of GDP in 1981. Today, it’s over 120% of GDP and likely to rise much higher.
Read Beckworth’s entire thread.
Tags:
27. August 2024 at 15:35
I agree, but I wonder if the Federal Reserve should now emulate the Bank of Japan in building a balance sheet.
Doing so might not impact inflation by much, but it would sure help taxpayers and alleviate concerns that the debt can be honored.
28. August 2024 at 02:20
Scott,
I think the fact that Inflation has fallen amid large fiscal deficits doesn’t necessessarily disprove fiscal dominance.
“fiscal dominance” is about incentives, i.e. fiscal deficits will force the Fed to “easy monetary policy” once the goverment runs into funding problems by either lowering the IR or QE.
This has not happened yet (QT is on auto pilot and interest decreasees have yet to occur) as there have been no funding problems (to everyone’s surprise?)
As far as I know, nobody says that fiscal deficits WITHOUT accompaniying central bank action can produce spiraling inflaion…
You will be able to call victory once the government has difficulties issuing bonds and the Fed refuses to step in. until then we can only speculate…
28. August 2024 at 05:28
Who exactly are the people saying that we had fiscal dominance? Beckworth’s x/twitter thread doesn’t make a reference.
I wonder if this is meant as a critique of people like John Cochrane who believe in the fiscal theory of the price level. If that is the case, I’m not sure the critique hits the mark as strongly as intended.
My recollection is that Cochrane has argued that the inflation was the result of the big fiscal impulse that wasn’t expected to be paid back. I recall a post where he said the implications would be that inflation would be high and then fade away, even if the Fed didn’t do anything. Of course we did have the Fed raise rates, so I’m not entirely sure how that fits in with his thinking (he has also argued that the higher rates can make the deficit worse and cause issues that way).
I think that comes to one thing that makes things slippery about FTPL. Note that Cochrane adds that thing about the deficit not being expected to be paid back. How do you even measure that? My recollection is that it comes back to interest rates. Rising interest rates ipso facto becomes evidence that people don’t expect the government to repay their debts.
28. August 2024 at 05:46
A nail, yes. The final nail? Powell and Beckworth address only half the latest inflation story. Why did the Fed let things get so out of hand in the first place? If a significant component of inflation is expectations then expectations about fiscal policy and debt ought to matter too. It’s true that the 70’s inflation happened with modest federal debt and deficits compared to today. But, the trend at the time was for deficits to get larger and reach new record amounts with each downturn. Plus, Federal government was showing increased tolerance for aggressive (for the time) deficit spending to fight unemployment with continued to trend upward. John Cochrane takes a pry-bar to some of the nails here:
https://www.grumpy-economist.com/p/fiscal-narratives-for-us-inflation
See fig 7 for discussion of 60s/70s inflation.
28. August 2024 at 07:31
That’s true, of course, only if politicians aren’t able to undermine the Fed’s independence. I expect a lot of demagoguing against the Fed, especially if Trump wins, as our debt increases.
28. August 2024 at 07:45
–“Why did the Fed let things get so out of hand in the first place?”–
Inadequate monetary policy framework.
Rather than targeting market expectations of NGDP (which I’m sure were quite high in mid ’21), the Fed had to make a judgment as to whether the several months of high inflation experienced thus far was transitory/supply driven or demand driven, it had to take into account the guidance it had already given the market along, and it also had to consider the dual mandate (unemployment was still in the 5-6% context). The FOMC probably also didn’t want to be seen as largely neutralizing Biden’s freshly signed stimulus bill from March 2021.
The Russia/Ukraine war likely was a short-term exacerbating factor for 2022’s inflation.
28. August 2024 at 08:19
Viennacapitalist, I think you are mistaken, FD does claim that fiscal excess causes inflation regardless of what the Fed does in the short run.
JD, FD suggests that high inflation should last for as long as the reckless fiscal policy lasts.
Jerry, That sort of theory is impossible to refute. If we have no objective way of measuring the fiscal stance, then it becomes impossible to test.
In fact, America’s fiscal policy only became unsustainable under Trump.
28. August 2024 at 12:40
Hey Scott,
One idea maybe before you shut down and head for greener pastures as a full retiree in So Cal is maybe try to rank countries by their monetary policy guidelines and adherence. We often talk about other macro indicators to determine how rich a country is: human capital, economic freedom, etc. But it seems like monetary policy is pretty important. Lot of countries seem to fail from having unstable monetary policy which leads to bad and reactionary datapoint. Could help evaulate why certain countries are doing bad where other indicators show that they should be doing good.
28. August 2024 at 13:36
Amritius, I have cited a few examples. Argentina abandoned neoliberal reforms in 2002 because bad monetary policy led them to wrongly conclude that free markets are bad.
Australia has generally had pretty good public policies, partly because a good monetary policy allowed them to tame the business cycle.
Things got worse in the US and EU after 2008. Etc.
28. August 2024 at 16:14
John Cochrane recently had a series of posts in which he stated the Japan’s monetary policy has been perfect.
I can’t get him to answer the question of whether that includes the Bank of Japan’s large QE program.
The Federal Reserve of Saint Louis once released a report that quantitative easing has little effect on inflation.
So… The Fed should build a balance sheet?
28. August 2024 at 21:55
One good thing coming out of the recent bout of heightened inflation is that I’m seeing less Modern Monetary Theory nonsense these days.
28. August 2024 at 23:07
Scott,
it seems there are various definitions floating around.
I have used the understanding as expressed in this CATO institute article:
https://www.cato.org/blog/fiscal-dominance-fed-complacency
“…Fiscal dominance occurs when central banks use their monetary powers to support the prices of government securities and to peg interest rates at low levels to reduce the costs of servicing sovereign debt…”
or Mrs. Schnabel from the ECB:
https://www.ecb.europa.eu/press/key/date/2024/html/ecb.sp240607~c6ae070dc0.en.html
“…The question therefore arises of whether monetary policy’s ability to act – and therefore its independence – is being constrained by fiscal policy. This is called fiscal dominance…”
I have seen authors using it the way you do..
29. August 2024 at 13:42
Kind of off topic, but revised data again show that monetary policy is not tight or restrictive. Great work, Fed…
29. August 2024 at 14:43
Sumner, I think I called the economic impact of the Z War for Russia pretty much correct:
https://eharding.substack.com/p/no-a-sanctioned-russia-is-not-a-large?utm_source=publication-search
https://eharding.substack.com/p/the-case-for-russia-invading-ukraine?utm_source=publication-search