The Fiscal Theory Of The Price Level, John Cochrane and the Dallas Fed. The Fed’s QE Program Is Anti-Inflationary?

A Benjamin Cole post

Stanford luminary and economist John Cochrane is touting the fiscal theory of the price level (FTPL), in which the anticipated future of federal budget primary (operating) deficits is the key tell in present-day inflation. If the national budget looks re-inky, then inflation will result.

Cochrane contends FTPL is why the Fed’s QE program has been met with an inflationary yawn. The federal budget deficit outlook is unaffected by QE.

Set aside modern-day empirical observations to the contrary (isn’t the federal budget operating deficit slated to widen?), and let’s run with Cochrane—but also with a June, 2014 paper from the freshwater (okay, dry-gulch) Dallas Fed, “Inflation Is Not Always and Everywhere a Monetary Phenomenon” by Antonella Tutino and Carlos E.J.M. Zarazaga.

Though of dual peninsular heritage, Tutino and Zarazaga are devout FTPL’ers who cite the Teutonic success in bashing Weimar Republic hyperinflation through FTPL tactics—but those tactics included the central-bank buying of real estate assets, which looks really close to quantitative easing. The Rentenbank stifled inflation by backing currency with rents from property.

The authors aver:

“The fiscal theory of the price level argues that what’s true about hyperinflation is valid more generally: Fiscal policy can prevent inflation from rising or falling too much by backing all outstanding nominal government liabilities—interest bearing or not—with a stable level of expected future primary government surpluses.

By formally incorporating fiscal policy in the analysis of price-level dynamics, the fiscal theory of the price level is better equipped than the conventional monetarist approach to explain why the recent large expansion of the money supply in the U.S. has not caused higher inflation.
 The (FTPL) theory implies that the quantitative easing programs, which created money to purchase mortgage-backed securities from the public, preserved price stability because that money is backed by the returns from real estate investments. Similarly, Germany restored price stability after its interwar hyperinflation with its real-estate-backed currency.”

So when the Fed bought more than $1 trillion in mortgage-backed securities, that boosted bond- and dollar-holder confidence in the U.S. dollar.

By this version of FTPL, it appears that some monetizing of government debt (central bank purchases of Treasuries), counter-intuitively, is also anti-inflationary. The government is less indebted, more able to meet obligations.

Indeed the authors say, “Likewise, any money created to purchase government debt from the public at market prices is backed by the same primary surpluses that the public already expected would service that debt. As long as the expected primary surpluses backing existing government liabilities haven’t changed, there is no reason for the price level to change either.”


Like many observers, I may remain skeptical about FTPL. I suspect QE did not lead to inflation, or even to much more aggregate demand, as banks are not going to lend except to credible risks, no matter how large their reserves (IOER did not help).

My view is the QE stimulus stems from printing (digitizing) money and giving it to bondholders, who then must spend the new money, or place the digitized cash into bank accounts, or into securities or property (or convert into paper cash, which also happened). QE worked, it just should have been earlier, larger and more-sustained. The world is so swamped with over-capacity in everything that QE did not lead to inflation for obvious and old-fashioned supply and demand reasons. People selling automobiles don’t know that future federal deficits mean they should raise their prices. They only know there is chronic global over-capacity in the auto trade. Ditto oil, in spades.

Suppose global manufacturing platforms and incredible innovations in production (some not really measured) are a continuous series of positive supply shocks?

Still, the Dallas Fedsters offer an interesting avenue to explore. Should the Federal Reserve target further reductions of federal debt through QE, or the buying of more real-estate backed assets?

Should not QE be utilized to develop to structural improvement in federal revenues and cutting of taxes? What if the Fed bought enough global real estate assets that the stream of rents could negate the need for any federal borrowing?

Or, is such a concept the equivalent of macroeconomic pornography, that which we would do if we were not shamed out of it?

PS Dallas Fed authors and FTPL’ers Tutino and Zarazaga also posit that capital gains taxes undercut inflation continuously, as even capital gains induced solely by inflation result in increased federal revenues. The public knows that if inflation budges up, tax collections rise even more quickly. By extension, the progressive tax code further cements market sentiments that the federal government is or is moving towards primary surpluses. I suspect John Cochrane will find this aspect of FTPL theory less noteworthy.

PPS The developed world is 30 years into declining inflation and interest rates, and now into slow growth and deflation in Europe and Japan.  Yet we have an entire generation of (now senior) economists and central bankers still framing every discussion in terms of inflation. Using monetary or fiscal policy to spur economic growth? Not a topic, so much.

Consider this preface to a recent conference at the University of Chicago:

“Macroeconomic policy—monetary and fiscal—has two primary goals to achieve: determining the aggregate price level and stabilizing government debt.”

Steve Williamson should change the name of his blog from “New Monetarist” to “New Fisherite”!

Noah Smith comments on John Cochrane. Noah updates to consider Steve´s comments:

Steve also has a post responding to mine. Particularly interesting is the argument that Volcker’s rate hikes in the early 1980s actually made the inflation situation worse, and that it was his subsequent rate cuts that actually whipped inflation. I’m probably more open to that story than most people, but I think there are a number of things about it that are very fishy, e.g. the fact that inflation started going down after the rate hikes instead of rising further.

A clear indication that interest rates do not define the stance of monetary policy! What really went on is described in the charts below.

In the top chart you, like Steve, see that inflation is going up while the FF rate is climbing and coming down when the FF rate is falling (“kudos” for “neo fischerism”).

The bottom chart shows that in fact monetary policy (NGDP growth) is guiding inflation. Rising interest rates do not mean monetary policy is tightening. Rising NGDP growth is telling us that monetary policy is “easy”! Then, the “inflation expectations-changing recession” came along, associated with the steep fall in NGDP growth. If you look at interest rates, you could believe monetary policy was getting “easier”!

Noah S-SW_1

Noah S-SW_2

The final charts show the behavior of ten-year inflation expectations (only available from January 1982). It tumbles when NGDP growth is forcefully restrained. Note how inflation expectations briefly (and mistakenly) rise when the Fed steps on the “spending pedal” to get the economy back up, as reflected in the drop in the unemployment rate! This sort of “spending spike” is what didn´t happen after the 2008 NGDP dive, leaving the real economy in a “depressed state”!

Noah S-SW_3

Thinking About Martin Feldstein Again

A Benjamin Cole post

Market Monetarists have already done a superb job explaining why NGDPLT is the best tool for a central bank, especially if measuring real GDP is guesswork—the latter point Martin Feldstein made recently in The Wall Street Journal.

Feldstein’s extraordinarily oblique point was that the CPI or other indexes overstate inflation, something he could not say out loud, so un-PC is such a sentiment. But his conclusion is much more palatable to certain classes, and that is that middle-class America is better off than ever, even if they don’t know it, as wage stagnation is a mirage.

University of Chicago scholar John Cochrane leaped on the Feldstein bandwagon to posit that maybe the CPI overstates inflation by 3%, essentially meaning Fat City for Mr. and Mrs. America. This is a reprise of Bush-era sentiments of economist and right-winger Don Boudreaux of George Mason University.

Is The Fed Suffocating The Economy?

That Cochrane likes the Fed now is not much of a surprise; he has argued that deflation is the economic cure-all, notwithstanding the 20-year long debacle with falling prices that is Japan.

Cochrane says that Feldstein’s premise today means in the United States “we really have 0% nominal interest rates, 1.5% deflation rather than 1.5% inflation; +1.5% real rates rather than -1.5% real rates. That is about the ideal monetary policy.”

Cochrane then exults, “We live the (Milton) Friedman optimal quantity of money.”

But others may wish to ponder if the Fed, by accomplishing less than 2.0% inflation as measured on the PCE, is actually obtaining minor deflation, and thus Japan-like results.

As widely noted, economic growth in the United States since the Fed ostensibly set its 2% PCE IT (which many suspect works out to 1.5% in practice) has been…well, Japan-like.

In 2015, the first half GDP may exhibit some real economic growth, but may not with any bad luck. Industrial production has been falling through most of the year. And the previous seven years have been anemic. If this is the Friedman optimum….*


If after seven years in the United States, and 20 years in Japan, the Friedman optimum does not work in real life, then we can dispense with deflation as reasonable monetary goal. It just does not work in the here and now.

On the contrary, I wonder how long the United States could be in boom times before we saw old-fashioned demand-pull inflation. The 1990s was pretty boomy, and inflation remained moderate. Maybe there is another lesson there, too.

As I always say, the Fed should print more money.


*Friedman may have opined about a theoretical optimum. But in practice he advised Japan to pursue QE hard and heavy, and three times criticized the Fed for being too tight; in the Great Depression; in 1957; and in 1992. Did Friedman ever advocate a real-world policy of deflation?

Surprise! Martin Feldstein, unwittingly, makes the case for nominal stability

In the WSJ, MF writes “The U.S. Underestimates Growth”:

…This is why we shouldn’t place much weight on the official measures of real GDP growth. It is relatively easy to add up the total dollars that are spent in the economy—the amount labeled nominal GDP. Calculating the growth of real GDP requires comparing the increase of nominal GDP to the increase in the price level. That is impossibly difficult.

But John Cochrane gives a “convenient” interpretation of MF in “Feldstein on Inflation“:

The basic idea is that inflation may be overstated, because it doesn’t do a good job of handling new products. As a result, real output growth may be a bit stronger than measured.  Marty runs through a lot of sensible conclusions.

He doesn’t talk about monetary policy, but that’s interesting too. So what if inflation really is (say) 3% lower than we think it is, and therefore real output growth is 3% larger than it really is?
That would mean we are a lot closer to “normal” of course.

It´s not Friedman´s Chicago any longer!

Note: Nominal Stability a.k.a. NGDP Level Targeting

Monetary Policy Creates Financial Instability?

A Benjamin Cole post

Paul Krugman may be persona non grata in my house, but I must begrudgingly admit when the NYT blogger makes a good point:

“Let me also add that if it’s really that easy for monetary errors to endanger financial stability—if a deviation from perfection so small that it leaves no mark on the inflation rate is nonetheless enough to produce the second-worst financial crisis in history—this is an overwhelming argument for draconian bank regulation. Modest monetary mistakes will happen, so if you believe that these mistakes caused the global financial crisis you must surely believe that we need to do whatever it takes to make the system less fragile. Strange to say, however, I don’t seem to be hearing that from (John) Taylor or anyone else in that camp.”—Paul Krugman.

Krugman plays a little fast and loose here, and also ignores University of Chicago scholar John Cochrane, who has in fact called for major reforms, such as bank lending 100% backed by equity. No more 30-to-one leverage.

And inflation did sag after 2008, indicating monetary policy was too tight, as Market Monetarists have said. There was a “mark on the inflation rate,” such as Western economies sinking into deflation. I noticed that mark.

Still, Krugman has a point. We keep hearing monetary policy is too loose, and have heard that for 30 years. Yet the developed world is in deflation or close, led by Japan. Then we had a global financial collapse.

So, the record suggests the inflation-hysterics have it exactly backwards. If monetary policy has threatened financial stability, it has been because it has been too tight. We are in ZLB now—that is not a sign of decades of easy money.

Krugman has a point about banks, too. How is it in the U.S. we have such a feeble financial system? Why has the right-wing no interest in measures that would create strong banks? Being “against Dodd-Frank” is not a policy. If Dodd-Frank is no good, then embrace John Cochrane, or please devise a policy that would make for strong banks.

And, as I always say, print more money.

Because, not printing more money will have unintended and unforeseeable but catastrophic consequences on financial stability. Well, you can take out the word not, but the insanity level remains unchanged.