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More on Inflation Expectations and Stock Prices

Published June 6, 2012 expectations , inflation , Little Depression 11 Comments

It was three and a half weeks ago (May 14) that I wrote a post “Inflation Expectations Are Falling; Run for Cover” in which I called attention to the fact that inflation expectations, which had been rising since early in 2012, had begun to fall, and that the shift had coincided with falling stock prices. I included in that post the chart below showing the close correlation between inflation expectations (approximated by the breakeven TIPS spread on 10-year constant-maturity Treasuries and 10-year constant-maturity TIPS).

Then I noted in two posts (May 24 and May 30) that since early in May, I had detected an anomaly in the usual close correlation between short-term and long-term real interest rates, longer-term real interest rates having fallen more sharply than shorter-term real interest rates since the start of May. That was shown in the chart below.

I thought it would now be useful to look at my chart from May 14 with the additional observations from the past three weeks included. The new version of the May 14 chart is shown below.

What does it teach us? There still seems to be a correlation between inflation expectations and stock prices, but it is not as close as it was until three weeks ago. I confirmed this by computing the correlation coefficient between inflation expectations and the S&P 500 from January 3 to May 14. The correlation was .9. Since May 14, the correlation is only .4. That is a relatively weak correlation, but one should note that there are other three-week periods between January 3 and May 14 in which the correlation between inflation expectations and stock prices is even lower than .4. Still, one can’t exclude the possibility that the last three weeks involve some change in circumstances that has altered the relationship between inflation expectations and stock prices. The chart below plots the movement in inflation expectations and stock prices for just the last three weeks.

One other point bears mentioning: the sharp increase in stock prices yesterday was accompanied by increases in nominal and real interest rates, for all durations. That is not an anomalous result; it has been the typical relationship since the early stages of the Little Depression. Expected inflation implies increased nominal rates and increased borrowing costs. Moreover, expected inflation has generally been positively correlated with real interest rates, expectations of increased inflation being correlated with expectation of increased real returns on investment. So the conventional textbook theory that loose monetary policy increases stock prices and economic activity by reducing borrowing costs is simply not reflected in the data since the start of the Little Depression.

Do I See a Patch of Blue?

Published June 6, 2012 expectations , monetary policy 7 Comments

It’s June, and I’m in Washington DC; the sky is blue, and the temperature outside is in the low 70s. Oh, and stock markets around the world are soaring. This is as good as it gets.

With Europe on the brink of the abyss, and all the gloom and doom of the past month, is there really cause for optimism? I don’t know, but Scott Sumner got all excited yesterday about signs that people are finally starting to get it, especially this piece by Matthew O’Brien posted on the Atlantic website. Optimism seems to be catching, at least on the stock market.

There does seem to be a growing understanding that the conventional way of thinking about how monetary policy works – increasing the quantity of money causes interest rates to fall, inducing increased spending by business and households – is misleading, especially when interest rates are already close to zero. Instead, the way to think about the money supply is that the monetary authority ties its creation of money to a price or spending target. But for monetary policy to work in this way, the monetary authority has to announce, or at least make clear, that its policy is subordinate to the target it is aiming at, so that the public can revise its expectations accordingly. When the public’s expectations change in the appropriate direction, the battle is more than half won; the rest is a mopping up operation.

Also worthy of mention (a huge understatement BTW) are three recent posts by the precocious Evan Soltas (on monetary policy in Switzerland here and here and on monetary policy in Israel) which beautifully illustrate points that Scott and others have been making with little effect (on policy) since 2009. The voices crying out for a different approach to monetary policy are no longer lonely, and no longer in the wilderness. (And while handing out plaudits, I’ll just mention my own post about Switzerland back in September).

And here’s what one story (“Dow Surges on Stimulus Expectations”) says about the world-wide rise in stock markets today:

U.S. stocks were soaring Wednesday morning as investors rushed in from the sidelines on hopes the Federal Reserve could soon signal it’s open to additional stimulus measures.

The Dow Jones Industrial Average was rising 178 points, or 1.5%, at 12,306. The move puts the blue-chip index back in positive territory for the year.

The S&P 500 was up 20 points, or 1.6%, at 1305. The Nasdaq was surging 50 points, or 1.8%, at 2828.

All 30 Dow components were in positive territory, with Bank of America(BAC _), JPMorgan Chase(JPM _) and Hewlett-Packard(HPQ _) leading the gains.

Within the S&P 500, 95% of components were on the rise.

Gainers were outpacing decliners by a 7-to-1 ratio on the New York Stock Exchange and 4-to-1 on the Nasdaq. The leading sectors were basic materials, capital goods and energy.

The European Central Bank said Wednesday that it was keeping its benchmark interest rate at 1%. However, the markets continued to look for clues that the central bank would show an openness to lowering rates by July in the face of growing signs of recession on the continent and Spain’s troubled banking system.

“There is a necessity for them to show their cards when conditions turn urgent,” said Geoffrey Yu, analyst at UBS.

After the meeting, ECB President Mario Draghi indicated that short-term liquidity measures would continue but withheld clues on more aggressive plans to tackle the debt crisis.

“Today, we have decided to continue conducting our main refinancing operations as fixed rate tender procedures with full allotment for as long as necessary, and at least until … January,” Draghi said at a press briefing.

Federal Reserve Chairman Ben Bernanke testifies before Congress on Thursday, and it will be his first opportunity to comment on the weak jobs report last Friday. Given that the benchmark interest rate in the U.S. is already at a record low, the market will look for clues that the central bank could embark on a third round of quantitative easing.

The FTSE in London was rising 1.9% and the DAX in Germany was gaining 1.6%.

Maybe things really are darkest just before the dawn. We may be in for a long hot summer in Washington, but today I will enjoy the good weather and blue sky while it lasts. I sure hope Bernanke doesn’t spoil it all tomorrow.

Why Not Arbitrage TIPS and Treasuries?

Published June 4, 2012 expectations , monetary theory 27 Comments

Larry Summers has a really interesting piece in today’s Financial Times (“Look beyond interest rates to get out of the gloom”), advocating that safe-haven governments (like the US, Germany and the UK) which are now able to borrow at close to zero rates of interest, which adjusted for expected inflation, amount to negative rates. Given such low borrowing costs, Summers argues, governments should be borrowing like crazy to finance any investment that promises even a marginally positive real return, even apart from Keynesian stimulative effects. This is not a new idea, countercyclical public works spending has often been advocated even by orthodox anti-Keynesians as nothing more than sensible budgetary policy, borrowing when the cost of borrowing is cheap and hiring factors of production in excess supply at discounted prices, to finance long-term investment projects. If there is a Keynesian effect on top of that, so much the better, but the rationale for doing so doesn’t depend on the existence of a positive multiplier effect.

But Summers’s argument takes this argument a step further, because as he presents it, the case for doing so is almost akin to engaging in an arbitrage transaction.

As my fellow Harvard economist Martin Feldstein has pointed out, this principle applies to accelerating replacement cycles for military supplies. Similarly, government decisions to issue debt and then buy space that is currently being leased will improve the government’s financial position. That is, as long as the interest rate on debt is less than the ratio of rents to building values, a condition almost certain to be met in a world of government borrowing rates of less than 2 per cent.

These examples are the place to begin because they involve what is in effect an arbitrage, whereby the government uses its credit to deliver essentially the same bundle of services at a lower cost. It would be amazing if there were not many public investment projects with certain equivalent real returns well above zero. Consider a $1 project that yielded even a permanent 4 cents a year in real terms increment to GDP by expanding the economy’s capacity or its ability to innovate. Depending on where it was undertaken, this project would yield at least 1 cent a year in government revenue. At any real interest rate below 1 per cent, the project pays for itself even before taking into account any Keynesian effects.

Now one blogger (Tea With FT) commenting on Summers’s piece found grounds to quibble about whether the rates governments pay on their debt are “free market rates,” because banking regulations allow banks to reduce their capital requirements by holding government debt but must increase their capital requirements as they increase their holdings of private debt.

Lawrence Summers is just another economist fooled by looking only at the nominal low interest rates for government debt of some “infallible” sovereigns, “Look beyond the interest rates to get out of the gloom“. Those interest rates do not reflect real free market rates, but the rates after the subsidies given to much government borrowing implicit in requiring the banks to have much less capital for that than for other type of lending.

If the capital requirements for banks when lending to a small business or an entrepreneurs was the same as when lending to the government… then we could talk about market rates. As is, to the cost of government debt, we need to add all the opportunity cost of all bank lending that does not occur because of the subsidy… and those could be immense.

I’m not going to get in that discussion here, but the point seems well-taken. But leaving that aside, I want to ask the following question: As long as the interest rate on TIPS is negative, why is the US government not selling massive amount of TIPS, using the proceeds to retire conventional Treasuries while earning a profit on each exchange of a TIPS for a Treasury? That would be true arbitrage whatever the merits of Tea With FT’s argument. Are there statutory limits on the amount of TIPS that can be sold?

The issue also seems to bear on the discussion that Steve Williamson and Miles Kimball have been having (here, here, and here, and also see Noah Smith’s take) about whether the Modigliani-Miller theorem applies to the Fed’s balance sheet. If there are arbitrage profits available exchanging conventional Treasuries for TIPS, what does that say about whether the Modigliani-Miller theorem holds for the Fed?

My next question is: if there are arbitrage profits to be made from such an exchange of assets, what is the mechanism by which the arbitrage profits would be eliminated? Why would exchanging Treasuries for TIPS alter real interest rates or inflation expectations in such a way as to eliminate the discrepancy in yields? Maybe there is something obvious going on that I’m not getting. What is it? And if the reason is not obvious, I’ld like to know it, too.

UPDATE: Thanks to Cantillonblog and Foosion for explaining the obvious to me. In my haste, I wasn’t thinking clearly. Given the expectation of inflation, the negative yield on TIPS will have to be supplemented by a further payment to compensate for the loss of principle due to inflation, so the cash flows associated with either a conventional Treasury or a TIPS are equal if inflation matches the implicit expectation of inflation corresponding to the TIPS spread. But suppose the Treasury did issue more TIPS relative to conventional Treasuries, wouldn’t the additional Treasuries be sold to people who had slightly higher expectations of inflation than those who were already holding them? Or alternatively, wouldn’t the very fact that the government was trying to sell more TIPS and fewer conventional Treasuries cause the public to revise their expectations of inflation upwards? That’s not exactly the conventional channel by which either monetary policy or fiscal policy affects inflation expectations, but it does suggest that the policy authorities have some traction in trying to affect inflation expectations. In addition, since interest rates fell close to zero after the financial panic of 2008, inflation expectations have responded in the expected direction to changes in the stance of monetary policy, rising after the announcment of QE1 and QE2 and falling when they were terminated.

UPDATE 2: I am posting too fast today. If the Treasury increased the quantity of TIPS being offered, it would drive down the price of the TIPS, increasing the real inflation adjusted yield. An increased real yield, at a given nominal rate, would imply a reduced break even TIPS spread, or reduced inflation expectations. Thus, increasing the proportion of TIPS relative to conventional Treasuries would induce savers with relatively lower inflation expectations than those previously holding them to begin holding them as well. Alternatively, increasing the proportion of TIPS outstanding would encourage individuals to revise their expectations of inflation downward because the Treasury would be increasing its exposure to inflation. But the point about the applicability of the MM theorem still applies with the appropriate adjustments. At least until further notice.

More on the Recent Anomaly in the Real Term Structure of Interest Rates

Published May 30, 2012 expectations 11 Comments

In a post last week, I pointed out that there was a highly unusual inverse correlation between the 5- and 10-year real interest rates as approximately reflected in constant maturity 5- and 10-year TIPS. (On the meaning of the term “constant maturity” see the very valuable and informative post in J.P. Koning’s excellent blog summarizing discussions in the many blogs that he follows and comments on) about the various blogs Since early May the correlation coefficient between the yields on constant maturity 5- and 10-year TIPS was about -.72 (as of today it’s -.77), while the correlation coefficient between the two yields since the start of 2012 was .86. It occurred to me after writing the post (I added an update to make the point) that one reason for the inverse correlation might be an increased in the expected likelihood of a financial crisis, in which case real short-term interest rates would rise during the crisis as people expecting to be short of cash bid up real rates trying to get their hands on cash ahead of the crisis, while also selling off assets (either fixed capital or inventories).

This week, I was able to do a little further work, looking at data since 2003, on the correlation between interest rates at the 5- and 10-year time horizons. Since 2003, the correlation between real 5- and 10-year interest rates is about .96. I computed monthly correlations, which are usually over .8 and regularly over .9. Only very rarely was there a (barely) negative monthly correlation, certainly nothing close to the -.77 correlation during the first 30 days of this month. However, as I computed the correlations, I found that a more meaningful measure of the relationship between the 5- and 10-year yields on TIPS is the absolute difference between them. The graph below plots the yields on 5- and 10-year constant maturity TIPS since 2003. The most striking period is clearly in October and November of 2008, when the yield on 5-year TIPS soared above the yield on 10-year TIPS, because of the desperate scramble for liquidity at the height of the financial crisis. A few other periods of financial stress, associated I think with the first signs of the bursting of the housing bubble, were also associated with yields on the 5-year TIPS slightly exceeding the yield on the 10-year TIPS.

A second graph displaying the difference between the yields on the 10-year and the 5-year TIPS is also useful, clearly showing the effect of the spike in short-term real interest rates at the height of the financial crisis.

In this context what is striking about the recent anomaly in the real term structure of interest rates is the steepness with which the difference between the yields on the 10- and the 5-year TIPS has been falling. The drop seems steeper than any but the one that started around October 6, 2008, three weeks after the failure of Lehman Brothers, but the day on which the Fed announced that it would begin paying interest on reserves. By the end of October, the difference between the yields on the 10-year and 5-year TIPS had fallen by over a percentage point. Since May 3, the difference between the yields on the 10-year and 5-year TIPS have fallen 37 basis points, so we are clearly not in a panic. But the signs are disturbing.

A Recent Anomaly in the Real Term Structure of Interest Rates

Published May 24, 2012 expectations , inflation 21 Comments

Regular readers of this blog know that I track the break-even TIPS spread to follow changes in inflation expectations. Doing so also provides an implicit (and imperfect) estimate of changes in the real interest rate. (For an explanation of why the break-even TIPS spread is an imperfect estimate of inflation expectations and the real interest rate, see the Cleveland Federal Reserve Bank website.) Since early in May, the data show a fairly striking anomaly in real interest rates: real interest rates over a 5-year time horizon have been rising (though still negative) while real interest rates over a 10-year horizon have been falling.

Why is this anomalous? Because real interest rates at the 5-year and 10-year time horizons are generally closely correlated. The chart below shows fluctuations in real interest rates at constant 5- and 10-year maturities since the beginning of 2012. The two lines track each other closely until the beginning of May when the 5-year real interest rate begins to rise while the 10-year real interest rate continues to fall. The coefficient between the 5-year and 10-year real interest rates from January 3 to May 24 is slightly over .8. From January 3 to May 3, the correlation coefficient is almost .86; the correlation coefficient since May 3 is -.72.

I have no explanation for this anomaly. Anybody out there like to take a crack at it?

UPDATE: It just occurred to me that the increase in short term real rates is reflecting a liquidity premium associated with an increasing perceived likelihood of a financial crisis associated with a breakdown of the euro. Not a very happy thought as I prepare to call it a night.

Expected Inflation and the S&P 500 Redux

Published May 17, 2012 expectations , inflation , Little Depression , monetary policy 4 Comments

On Monday I wrote a post with the chart below showing the close correlation since January of this year between the S&P 500 and expected inflation as (approximately) reflected in the spread between the constant maturity 10-year Treasury note and the constant maturity 10-year TIPS. A number of other bloggers noticed the post and the chart. One of those was Matthew Yglesias who coupled my chart with a somewhat similar one posted by Marcus Nunes on his blog on the same day as mine.

One commenter (“Fact Checker”) on Matthew’s blog criticized my chart accusing me of cherry picking.

The second graph is meaningless, as it does not work through time.

Here it is from 1990: http://research.stlouisfed.org/fredgraph.png?g=7gX
Again from 2000: http://research.stlouisfed.org/fredgraph.png?g=7gY
From 2005: http://research.stlouisfed.org/fredgraph.png?g=7gZ
From 2009: http://research.stlouisfed.org/fredgraph.png?g=7h0

And in another comment:

The S&P + inflation chart is reproduced below, with longer windows. And as you suggest there is no correlation in any time frame but the very short window cherry picked by MY.

Two points to make about his comment. First, if Fact Checker had read Yglesias’s post carefully, or, better yet, actually read my post (let alone the original paper on which the post was based), he would have realized that my whole point is that the close correlation between expected inflation and stock prices is generally not observed, and that one would expect to observe the correlation only when deflation exceeds the real rate of interest (as it does now when slightly positive expected inflation exceeds the negative real real rate of interest). So the fact that the correlation doesn’t work through time was precisely the point of my post. Second, the graphs to which Fact Checker links use survey data by the University of Michigan of the inflation expectations of households. I do not totally discount such data, but I regard survey estimates of expected inflation as much less reliable than the implicit market expectations of inflation reflected in the TIPS spread.

To show that the correlation I have found is reflected in the data since approximately the beginning of the downturn at the very end of 2007, but not before, here is a graph similar to the one I posted on Monday covering the entire period since 2003 for which I have data on the 10-year TIPS spread.

Before the beginning of 2008, there is plainly no correlation at all between inflation expectations and stock prices. It is only at some point early in 2008 that the correlation begins to be observed, and it has persisted ever since. We will know that we are out of this Little Depression when the correlation vanishes.

John Kay on Central Bank Credibility

Published May 16, 2012 expectations , Little Depression , monetary policy 13 Comments

Few, if any, newspaper columnists are as consistently insightful and challenging as John Kay of the Financial Times. In his column today (“The dogma of ‘credibility’ now endangers stability”), Kay brilliantly demolishes the modern obsession with central-bank credibility, the notion that failing to meet an arbitrary inflation target will cause inflation expectations to become “unanchored,” thereby setting us on the road to hyper-inflation of Zimbabwean dimensions. (Talk about a slippery slope! If only central bankers and Austrians Business Cycle Theorists realized how much they had in common, they would become best friends.)

Here’s Kay:

The elevation of credibility into a central economic has turned a sensible point — that policy stability is good for both business and households — into a dogma that endangers economic stability. The credibility the models describe is impossible in a democracy. Worse, the attempt to achieve it threatens democracy. Pasok, the established party of the Greek left, lost votes to the moderate Democratic Left and more extreme Syriza party because it committed to seeing austerity measures through. Now the Democratic Left cannot commit to that package because it would lose to Syriza if it did. The UK’s Liberal Democrats, by making such a deal, have suffered electoral disaster. The more comprehensive the coalition supporting unpalatable policies, the more votes will go to extremists who reject them.

We got into this mess in 2008, because the FOMC, focused almost exclusively on rising oil and food prices that were driving up the CPI in the spring and summer of 2008, ignored signs of a badly weakening economy, fearing that rises in the CPI would cause inflation expectations to become “unanchored.” The result was an effective tightening of monetary policy DURING a recession, which led to an unanchoring of inflation expectations all right, but in precisely the other direction!

Now, the ECB, having similarly focused on CPI inflation in Europe for the last two years, is in the process of causing inflation expectations to become unanchored in precisely the other direction. Why is it that central bankers, like the Bourbons, seem to learn nothing and forget nothing? Don’t they see that central bank credibility cannot be achieved by mindlessly following a single rule? That sort of credibility is a will o the wisp.

News Flash: Cleveland Fed Reports that Inflation Expectations Fell in April

Published May 15, 2012 expectations , inflation , monetary policy 10 Comments

From a news release issued by the Federal Reserve Bank of Cleveland after the BLS reported that the CPI was unchanged in April.

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.38 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

The Cleveland Fed’s estimate of inflation expectations is based on a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the “break-even” rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates. The Cleveland Fed model can produce estimates for many time horizons, and it isolates not only inflation expectations, but several other interesting variables, such as the real interest rate and the inflation risk premium.

The Cleveland Fed’s estimate of expected inflation was 1.47 percent, so expected inflation dropped by .09 basis point in April. It undoubtedly has continued falling in May. The lowest monthly estimate of expected inflation over a 10-year time horizon ever made by the Cleveland Fed was 1.34% in February of this year, so we may now already be stuck with the lowest inflation expectations ever. Is anyone at the FOMC paying attention?

Inflation Expectations Are Falling; Run for Cover

Published May 14, 2012 Eurozone crisis , expectations , Fisher equation , inflation , Little Depression , monetary policy , monetary theory 16 Comments

The S&P 500 fell today by more than 1 percent, continuing the downward trend began last month when the euro crisis, thought by some commentators to have been surmounted last November thanks to the consummate statesmanship of Mrs. Merkel, resurfaced once again, even more acute than in previous episodes. The S&P 500, having reached a post-crisis high of 1419.04 on April 2, a 10% increase since the end of 2011, closed today at 1338.35, almost 8% below its April 2^nd peak.

What accounts for the drop in the stock market since April 2? Well, as I have explained previously on this blog (here, here, here) and in my paper “The Fisher Effect under Deflationary Expectations,” when expected yield on holding cash is greater or even close to the expected yield on real capital, there is insufficient incentive for business to invest in real capital and for households to purchase consumer durables. Real interest rates have been consistently negative since early 2008, except in periods of acute financial distress (e.g., October 2008 to March 2009) when real interest rates, reflecting not the yield on capital, but a dearth of liquidity, were abnormally high. Thus, unless expected inflation is high enough to discourage hoarding, holding money becomes more attractive than investing in real capital. That is why ever since 2008, movements in stock prices have been positively correlated with expected inflation, a correlation neither implied by conventional models of stock-market valuation nor evident in the data under normal conditions.

As the euro crisis has worsened, the dollar has been appreciating relative to the euro, dampening expectations for US inflation, which have anyway been receding after last year’s temporary supply-driven uptick, and after the ambiguous signals about monetary policy emanating from Chairman Bernanke and the FOMC. The correspondence between inflation expectations, as reflected in the breakeven spread between the 10-year fixed maturity Treasury note and 10-year fixed maturity TIPS, and the S&P 500 is strikingly evident in the chart below showing the relative movements in inflation expectations and the S&P 500 (both normalized to 1.0 at the start of 2012.

With the euro crisis showing no signs of movement toward a satisfactory resolution, with news from China also indicating a deteriorating economy and possible deflation, the Fed’s current ineffectual monetary policy will not prevent a further slowing of inflation and a further perpetuation of our national agony. If inflation and expected inflation keep falling, the hopeful signs of recovery that we saw during the winter and early spring will, once again, turn out to have been nothing more than a mirage

Why NGDP Targeting?

Published April 29, 2012 expectations , inflation , monetary policy , monetary theory 12 Comments

Last week, David Andolfatto challenged proponents of NGDP targeting to provide the reasons for their belief that targeting NGDP, or to be more precise the time path of NGDP, as opposed to just a particular rate of growth of NGDP, is superior to any alternative nominal target. I am probably the wrong person to offer an explanation (and anyway Scott Sumner and Nick Rowe have already responded, probably more ably than I can), because I am on record (here and here) advocating targeting the average wage level. Moreover, at this stage of my life, I am skeptical that we know enough about the consequence of any particular rule to commit ourselves irrevocably to it come what may. Following rules is a good thing; we all know that. Ask any five-year old. But no rule is perfect, and even though one of the purposes of a rule is to make life more predictable, sometimes following a rule designed for, or relevant to, very different circumstances from those in which we may eventually find ourselves can produce really bad results, making our lives and our interactions with others less, not more, predictable.

So with that disclaimer, here is my response to Andolfatto’s challenge by way of comparing NGDP level targeting with inflation targeting. My point is that if we want the monetary authority to be committed to a specific nominal target, the level of NGDP seems to be a much better choice than the inflation rate.

As I mentioned, Scott Sumner and Nick Rowe have already provided a bunch of good reasons for preferring targeting the time path of NGDP to targeting either the level (or time path) of the price level or the inflation rate. The point that I want to discuss may have been touched on in their discussions, but I don’t think its implications were fully worked out.

Let me start by noting that there is a curious gap in contemporary discussions of inflation targeting; which is that despite the apparent rigor of contemporary macro models of the RBC or DSGE variety, supposedly derived from deep microfoundations, the models don’t seem to have much to say about what the optimal inflation target ought to be. The inflation target, so far as I can tell – and I admit that I am not really up to date on these models – is generally left up to the free choice of the monetary authority. That strikes me as curious, because there is a literature dating back to the late 1960s on the optimal rate of inflation. That literature, whose most notable contribution was Friedman’s 1969 essay “The Optimal Quantity of Money,” came to the conclusion that the optimal quantity of money corresponded to a rate of inflation equal to the negative of the equilibrium (or natural) real rate of interest in an economy operating at full employment.

So, Friedman’s result implies that the optimal rate of inflation ought to fluctuate as the real equilibrium (natural) rate of interest fluctuates, fluctuations to which Friedman devoted little, if any, attention in his essay. But from our perspective there is an even more serious shortcoming with Friedman’s discussion, namely, his assumption of perpetual full employment, so that the real interest rate could be identified with the equilibrium (or natural) rate of interest. Nevertheless, although Friedman seemed content with a steady-state analysis in which a unique equilibrium (natural) real interest rate defined a unique optimal rate of deflation (given a positive equilibrium real interest rate) over time, thereby allowing Friedman to achieve a partial reconciliation between the optimal-inflation analysis and his x-percent rule for steady growth in the money supply (despite the mismatch between his theoretical analysis of the rate of inflation in terms of the monetary base and his x-percent rule in terms of M1 or M2), Friedman’s analysis provided only a starting point for a discussion of optimal inflation targeting over time. But the discussion, to my knowledge, has never taken place. A Taylor rule takes into account some of these considerations, but only in an ad hoc fashion, certainly not in the spirit of the deep microfoundations on which modern macrotheory is supposedly based.

In my paper “The Fisher Effect under Deflationary Expectations,” I tried to explain and illustrate why the optimal rate of inflation is very sensitive to the real rate of interest, providing empirical evidence that the financial crisis of 2008 was a manifestation of a pathological situation in which the expected rate of deflation was greater than the real rate of interest, a disequilibrium phenomenon triggering a collapse of asset prices. I showed that, even before asset prices collapsed in the last quarter of 2008, there was an unusual positive correlation between changes in expected inflation and changes in the S&P 500, a correlation that has continued ever since as a result of the persistently negative real interest rates very close to, if not exceeding, expected inflation. In such circumstances, expected rates of inflation (consistently less than 2% even since the start of the “recovery”) have clearly been too low.

Targeting nominal GDP, at least in qualitative terms, would adjust the rate of inflation and expected inflation in a manner consistent with the implications of Friedman’s analysis and with my discussion of the Fisher effect. If the monetary authority kept nominal GDP increasing at a 5% annual rate, the rate of inflation would automatically rise in recessions, just when the real interest rate would be falling and the optimal inflation rate rising. And in a recovery, with nominal GDP increasing at a 5% annual rate, the rate of inflation would automatically fall, just when the real rate of interest would be rising and the optimal inflation rate falling. Viewed from this perspective, the presumption now governing contemporary central banking that the rate of inflation should be held forever constant, regardless of underlying economic conditions, seems, well, almost absurd.

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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