Inflation and Policy


Inflation and Fiscal Policy

I was asked: Whatever Happened to Inflation after all this Money-Printing?


Raising inflation was not something that worried economists.

“Yet, today, even as central banks lower policy rates close to zero (or below) and expand their balance sheets beyond what anyone previously imagined possible, inflation remains stubbornly below target in most of the advanced world.”


The problem is most profound in Japan, where inflation doomed even with  BOJ’s 1/3 GDP balance sheet and NIRP.


“Aggressive monetary policies have worked even in periods when riskless interest rates were close to zero, private risk premia were elevated, banks were fragile, and burdensome debt overhangs were pervasive.” – the Great Depression


The stunning shift in the U.S. monetary and prudential regime that included the combination ofabandoning the Gold Standard and buttressing the fragile banking system triggered this sudden reversal.

-> it sharply altered expectations virtually overnight, changing the behavior of households, firms and banks in short order.

It looks like the most important thing is expectation.

(although the role of fiscal policy since 1933 is still arguable [1])

Back to Japan’s case,

Commonly-held view is that policy stimulus in the advanced economies ought to include a substantial expansionary fiscal component that has generally been lacking.

<- Abe has overseen a large fiscal tightening:

1. current IMF estimates show Japan’s structural fiscal deficit shrinking by 3.7% of potential GDP over the past three years
2. Cashin and Unayama estimate that, upon announcement of Abe’s tax plans in October 2013, households reduced consumption by 5.2%.
3. restoring debt sustainability will require a large fiscal tightening (Hoshi and Ito (2012)).


Why a fiscal policy is so important?

Christopher Sims argues that monetary expansion will not succeed in driving up inflation if “low interest rates fail to generate substantial fiscal expansion.”

<- According to this fiscal theory of the price level (FTPL), at low interest rates, stabilizing inflation requires a modicum of fiscal-monetary cooperation: the fiscal policymaker must be seen as willing to run an easier future policy that is consistent with higher inflation.

<- “If in the face of low inflation the central bank lowers interest rates, demand increases and inflation rises only if the reduced interest expense component of the budget is expected eventually to flow through to a reduced primary surplus.… There is no automatic stabilizing mechanism to bring the economy back to target inflation and stay there, unless the commitment to true fiscal expansion at very low interest rates is widely understood.”

So it seems Abe’s policy failed because he did not offer expectation.

“Put differently, today’s price level is jointly determined by monetary and fiscal policy. And, it is not just today’s policies that matters, but the entire path into the distant future.”


But, wait! We once read articles that told us Japan’s Fiscal Stimulus Won’t Work.

The economy is already at full employment!

<- Fiscal stimulus relies crucially on having those unemployed and unused real resources sitting around.

But maybe fiscal policy can do something with the high cash holding of Japan’s firms.


Wolf Richter has some different idea about why all this central-bank “money-printing” along with 0/NIRP haven’t caused a big bout of inflation, which actually supports the fiscal policy idea.


Yes central banks have heaped on their balance sheets, but the inflation caused by QE is not consumer price inflation, but rampant asset price inflation.

And the reason is because the money never went to consumers – in form of wages.

“Because the money has been channeled to big financial and corporate entities, and they plowed it into financial and other assets (including share buybacks and other forms of “financial engineering”), thus pushing up asset prices.These already wealthy people didn’t need to spend their gains (what Bernanke called the “wealth effect”) because they already were spending all they wanted to spend. So the asset price boom had little impact on consumption and thus didn’t create inflationary pressures from consumers.”

QE and ZIRP put a priority on capital rather than labor.

-> So inflation-adjusted wages for the lower 80% of households have declined, a trend that started after the real-wage peak in 2000, and accelerated with the Financial Crisis.



And QE and 0/NIRP also “search for yield”, which floods entire and very risky sectors with huge amounts of money -> “malinvestment”

-> which causes overproduction and gluts, such as in ocean container shipping, US oil & gas, mining & metals, other commodities, even ghost cities in China

-> which cause prices to collapse, filtering into consumer prices and pushes down consumer price inflation



Economic historians argue that fiscal policy played only a secondary role in lifting the U.S. economy during the 1930s (see, for example, DeLong and Romer). Importantly, this assessment is notbecause fiscal policy doesn’t matter, but because discretionary fiscal stimulus was so limited and desultory until World War II. Eggertsson contends that fiscal expansion in 1933 gave credibility to the stated objective of raising prices. But, as was the case in 1937 with the first round of Social Security contributions. at times, fiscal policy turned quite contractionary.


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