Do central bankers have a quick fix for low inflation?

Conventional theories have proved utterly wrong

John H. Cochrane | May 21, 2016

Sections Economics

Collections Monetary Policy

Central bankers’ attempts to raise inflation are starting to make them look more and more like the legendary King Canute, commanding the tide to stop coming in. Despite massive quantitative easing (QE), ultralow (and even some negative) interest rates, and extensive “forward guidance” promises to keep rates low for a long time, inflation has remained chronically low in most of the developed world.

At the same time, conventional theories of inflation have proved utterly wrong. The Keynesian prediction that, once interest rates hit zero, economies would enter a deflation spiral failed. The monetarist prediction that massive QE would lead to hyperinflation failed.

Have central bankers lost control? Or perhaps they are suffering from pedal misapplication: Could it be that low interest rates have unwittingly pushed inflation downward? What will happen as the US Federal Reserve starts to raise rates? Putting aside whether more inflation is a good idea (I think not), if central banks want more inflation, what could they do to get it?

To answer these questions, we need to think through how interest rates might affect inflation. Here’s a stab at an answer, in four parts.

Part 1: The liquidity effect

The liquidity effect is a classic mechanism by which lower interest rates were thought to raise inflation. To lower interest rates, the central bank bought bonds, which put money in the economy. More money was thought to drive down interest rates, as the pressure to borrow money would be lower. More money in the economy, and more bank lending, was thought to increase aggregate demand for goods and services, which increased inflation. Conversely, the Fed raised rates by selling bonds, soaking up money, and thereby lowering inflation.

However, the United States is now in a classic liquidity trap. Interest rates have been essentially zero since 2008. Money and bonds are perfect substitutes, so buying or selling bonds has no effect on interest rates. The proof is in the pudding: the Fed massively increased excess reserves (accounts that banks hold at the Fed), from less than $50 billion to almost $3,000 billion, and inflation went nowhere.

The liquidity effect will remain absent as the Fed starts raising interest rates. The Fed plans to leave the $3,000 billion of excess reserves outstanding and to raise interest rates by raising the rate that it pays banks on these reserves. There will be no huge bond sales, no open-market operations, no monetary “tightening” associated with this interest-rate raise. Interest-paying reserves will remain perfect substitutes for short-term interest-paying government debt.

The liquidity effect will also remain absent if the Fed cuts rates or reduces rates below zero, as other central banks are doing. You can’t have more-than-perfect liquidity.

Part 2: The intertemporal substitution effect

The intertemporal substitution effect at the heart of today’s New-Keynesian models offers a different story for why lower interest rates might raise inflation and vice versa.

If real interest rates decline, people have an incentive to spend more today, and less in the future. If greater consumption demand means more output, and more output means more inflation, then when the Fed lowers interest rates, inflation will temporarily rise. This story does not rely on any scarcity of money, so it can continue to work when the liquidity effect vanishes.

The trouble is, this logic connects lower interest rates only with lower consumption growth rates. These models assume that consumption jumps up, so it can then grow at a lower rate. It is equally possible that consumption just starts to grow more slowly, and then pushes inflation down uniformly. Conversely, higher interest rates need not induce consumption to jump down so it can then start growing faster. Higher interest rates can increase consumption growth directly, resulting in steadily higher inflation. The fact that lower and lower interest rates have done nothing to stimulate consumption and inflation suggests more and more that the assumed upward jump in inflation and consumption doesn’t happen.

Part 3: The Fisher effect

The “expected inflation” effect, or Fisher effect, suggests that lower interest rates lower inflation, and vice versa.

 In the long run, higher inflation and higher interest rates must go together, as they did in the early 1980s, and lower interest rates must correspond to lower inflation.  Saving and investment ultimately respond to the real, after-inflation, interest rate. For saving and investment to balance, interest rates cannot be far from inflation.

After seven years of low interest rates in the US and 20 in Japan, perhaps we’re at that long run, and lower interest rates just lower inflation; the Fisher effect predominates and the liquidity and intertemporal-substitution effects have vanished. We got to low inflation because central banks have been unwittingly pushing on the brake.

Part 4: The fiscal theory of the price level

Interest rates near zero have coincided with slowly declining inflation. That observation, together with my quick review of current theory, suggests that if the Fed continues to raise interest rates, it will produce more inflation. But the data also suggest that any rise in inflation will be a slow affair, just as the decline in inflation at zero rates has been slow.

Again, I don’t think more inflation is a good idea. But as an intellectual exercise, if we want more inflation, is there anything central banks can do to produce it in the short run? What about helicopter drops, fiscal stimulus, and other creative ideas?

The fiscal theory of the price level is a new perspective on just where inflation comes from. (Well, it’s sort of new. I’ve been working on it for 20 years, and others for longer.) This theory says, fundamentally, that money has value because the government accepts that money for taxes, and inflation is a fiscal phenomenon over which central banks’ conventional tools—open-market operations trading money for government bonds—have limited power unless coordinated with that fiscal policy.

In theory, then, central bankers could mingle fiscal policy with monetary policy to spur inflation. The late Milton Friedman’s famous proposal to drop money from helicopters to spur inflation is actually fiscal policy. In the US economy, a helicopter drop is accomplished by the Treasury borrowing money and writing checks to people, and then the Fed buying the Treasury bonds. The Economist (“Unfamiliar ways forward,” February 20, 2016) describes this scenario in some detail:


. . . a central bank and its finance ministry . . . collude in printing money to pay for public spending (or tax cuts). . . . The government announces a tax rebate and issues bonds to finance it, but instead of selling them to private investors swaps them for a deposit with the central bank. The central bank proceeds to cancel the bonds, and the government withdraws the money it has on deposit and gives it to citizens. “Helicopter money” of this sort—named in honour of a parable told by Milton Friedman, a famous economist—is as close as you can get to raining cash from a clear blue sky like manna from heaven, untouched by banks and financial markets.

Such largesse is, in effect, fiscal policy financed by money instead of bonds. . . . But the unaccustomed drama—indeed, the apparent recklessness—of helicopter money could increase the expected inflation rate, encouraging taxpayers to spend rather
than save.


Will it work? Alas, “recklessness” is crucial. Normally, when a government sells a lot of bonds, people think that it is sooner or later going to soak up these bonds with taxes. That’s the only reason people are willing to buy the bonds, and the only reason the government can raise revenue by selling the bonds. But if the government drops $100 in every voter’s pocket and simultaneously announces that taxes are going up $100 tomorrow, even helicopter drops have no effect. In the Economist’s proposal, canceling the bonds says, “We are really going to be reckless. We’re not going to soak up this money, so you’d better spend it before it loses value.”

Our governments have spent centuries building up a reputation for paying their debts so they can sell bonds at good prices. That reputation is now hard to break. It’s especially hard to break just a little bit; we know how to create Zimbabwe, but creating 2 percent inflation is as hard as smoking just one cigarette a week.

As you can see, though, central banks cannot accomplish a helicopter drop alone. Many of them are legally forbidden from doing so. Central banks must always buy something—usually government bonds—in return for creating money. They can’t send checks to people.

Why? The people who set up our monetary systems understood all this very well. Their memories were full of disastrous inflations, and they knew that printing money without promises that taxes would eventually soak up that money would lead quickly to inflation. So, yes, central banks are prohibited from doing the one thing that would most quickly produce inflation, for about the same reason that wise parents don’t keep the car keys in the liquor cabinet. There are also all sorts of good political economy reasons that an independent central bank should not lend to specific businesses or send checks to voters.

One can get more creative. The central trick is finding a way to promise that we’re going to pay back only 98 percent of the debt next year. If we were on a gold standard, a schedule of 2-percent-per-year devaluations would work. We’re not, and we shouldn’t be.

But I’m not going to go further than that. Why? Shh. Zero inflation is great! I see little argument that raising inflation will be good for the economy, and plenty of argument that permanently killing inflation will be good for the economy and for financial markets. If central banks have the wrong pedal, but we’re driving the right speed anyway, why wake them up? 

John H. Cochrane is distinguished senior fellow at Chicago Booth and a senior fellow of the Hoover Institution at Stanford University.

This essay is adapted from two posts on The Grumpy Economist blog.