To me, the answer to this question seems obvious. The central bank. But lots of very smart people don’t agree.
MMT proponents believe that when inflation is lower than target it can be increased only with fiscal stimulus—monetary policy is ineffective. Similarly, they believe that high inflation can only be reduced with higher taxes or lower spending.
On the right, some economists advocate a fiscal theory of the price level, the view that Congress determines the inflation rate through its spending and tax decisions (including actions that change the future expected path of fiscal policy).
Nick Rowe links to a Stephen Gordon tweet showing how inflation averaged 2% after the Bank of Canada adopted a 2% inflation target in 1991:
For someone like me, this graph is completely uninteresting. But for the economists who believe the BOC is unable to control inflation, it calls for an explanation. Perhaps due to some weird coincidence, Canada’s parliament decided in the early 1990s to adjust its tax and spending policies in such a way as to keep inflation at roughly 2%, on average.
(Just kidding)
Nick Rowe is alluding to the fact that most central banks have some sort of dual mandate. Thus the volatility in inflation since 1991 is not necessarily a sign of the BOC’s inability to prevent short run fluctuations in inflation. However, in this case I suspect that the policy was indeed imperfect, as Nick suggested. For instance, the brief period of deflation in 2009 was not done to offset excessively high employment levels. Rather it represented a policy error by the BOC—policy was too tight to achieve either central bank policy goal.
PS. In another tweet, Nick says:
Any central bank that wants to maximise sustainable/average employment will need to:
1. Increase employment some times.
2. Reduce employment other times.
Grasping that 2nd bit is hard. Figuring out which is which is even harder. (It’s like catching fish, but different.)
If you want to see what happens when the second point is overlooked, look at Canadian inflation from 1953 to 1981.
PPS. Whenever I post on MMT, its proponents tell me that I’ve misrepresented their model.
READER COMMENTS
Market Fiscalist
Dec 29 2021 at 10:13am
Is it possible that the BoC was able to maintain an average of 2% inflation only because the Canadian government’s fiscal policy was consistent with it? If Canadian fiscal policy had been seen as unsustainable then would this at some point have undermined monetary policy ?
In other words: Is it the case that a CB can fine tune the money supply to hit an inflation target but only if the totality of government assets (money and bonds) is growing at a rate consistent with that target in the long run?
Scott Sumner
Dec 29 2021 at 11:48am
Sure, but fiscal policy in all developed economies is basically always consistent with 2% inflation. Only in places like Venezuela is the central bank forced to inflate.
Also, why is inflation not lower than 2% on average, as it was during the gold standard?
MarkLouis
Dec 29 2021 at 11:55am
Agree, good post.
However, I think it’s a very relevant question whether certain conditions lend themselves to creating a “fiscal dominance” situation. As you well know, rate increases impact the budget significantly more with a large debt load outstanding. It remains to be seen if central banks are willing to force the government to dramatically increase its debt service payments.
I can’t prove this, but I think we will ultimately come to understand a phenomenon resembling “asset price dominance.” At high valuations, assets become hyper-sensitive to changes in real interest rates and central banks risk a crisis with even slightly tighter conditions.
The mistake is allowing either of these conditions to take hold in the first place, but that ship may have sailed.
Matthias
Dec 30 2021 at 5:35am
For this kind of issue, the real interest rate would be what’s important. Not the nominal rate.
MarkLouis
Dec 30 2021 at 8:18am
Agree, and thus far I’d say the evidence would suggest that the Fed is very reluctant to push up real rates and we should be thinking harder about why. For all the Fed talk of tightening, the 10y real yield is essentially unchanged from six months ago.
My theory is they are essentially trapped by what I call “fiscal dominance” and/or “asset price dominance” because they lacked the ability to foresee these fairly obvious risks.
Scott Sumner
Dec 30 2021 at 10:45am
The Fed doesn’t control real interest rates over a period of time that is meaningful for public finance considerations.
MarkLouis
Dec 31 2021 at 12:05pm
That’s where you and I disagree. I know you wont agree but i see the mechanism as follows:
By reacting increasingly aggressively to any financial panic, the Fed has increasingly put a floor under financial asset values. This increases the relative value of saving relative to consumption. As a result you have a record low “velocity of wealth.” Wealth earning a positive real return with a central bank committed to providing a floor is more attractive to many than increased consumption. This pushes down real rates.
The true test would be if we had a financial panic with inflation expectations still >2%. My hunch is the Fed would find a reason to ignore its inflation target and support asset values. It’s perceived as a free lunch – and many take the offer.
Scott Sumner
Dec 31 2021 at 9:57pm
The Fed doesn’t have some sort of magic wand to control interest rates.
vince
Jan 1 2022 at 1:21pm
ssumner wrote: “The Fed doesn’t have some sort of magic wand to control interest rates.”
Are you referring to real interest rates? Volcker pushed the prime rate over 20 percent in 1981.
Scott Sumner
Jan 1 2022 at 2:25pm
Monetary policy influences both real and nominal rates in the very short run. But over any meaningful period of time, they only influence nominal rates (via their control of inflation.)
marcus nunes
Dec 30 2021 at 8:54pm
Which dog barks when needed?
https://thefaintofheart.wordpress.com/2013/09/05/three-dogs-two-didnt-bark/
David S
Dec 31 2021 at 10:36am
I had been meaning to ask your opinion about the “fiscal theory of the price level” in relation to some recent stuff that John Cochrane posted, so I appreciate this post. I don’t understand things completely, and I never will, but I think Fed actions over the next 18 months will demonstrate who has the best model.
With respect to timelines, I think Cochrane belongs to the “just you wait!” crowd when it comes to a fiscal and monetary doomsday for the United States. We would need about 10 years of an Erdogan-like president to completely wreck all credibility in our monetary system. Fortunately, there’s no one that crazy who could be elected….right?
Scott Sumner
Dec 31 2021 at 9:59pm
“I think Fed actions over the next 18 months will demonstrate who has the best model.”
It will certainly provide some information. But does the next 18 months matter more than the previous 100 years?
Nick Rowe
Jan 1 2022 at 5:16pm
Good post Scott!
The Canadian govt didn’t tighten fiscal policy in the early 90’s. Funny thing is though, it did tighten fiscal policy a lot, in the mid to late 90’s. After inflation had already come down to target.
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