In recent years, as the US economy has slowly recovered from the Great Recession, a puzzle has emerged: Where is the inflation? Despite a historically low unemployment rate, and interest rates that remain low by historical standards, inflation in the United States sits stubbornly below the Federal Reserve’s target rate of 2 percent. The Great Recession posed a similar puzzle: Where was the deflation? Inflation declined a bit, but the deflation spiral, widely predicted to break out once interest rates hit zero, did not happen.   

There’s an explanation for this that challenges conventional economics, according to John H. Cochrane, a senior fellow at the Hoover Institution and distinguished senior fellow at Chicago Booth. Standard economic theory has long held that inflation is entirely controlled by monetary policy, but outside extreme hyperinflations, has little to do with fiscal policy. This orthodoxy is wrong, according to Cochrane and other economists who’ve been developing the fiscal theory of the price level (FTPL) over the past 30 years. Under this theory, fiscal policy is also an important driver of inflation.

In research using data on inflation, monetary and fiscal policy, and economic conditions, Cochrane explores what drove US inflation between 1947 and 2018. His analysis links inflation to the real value of government debt, on the basis of the economic identity that the real value of government debt must be equal to the real present value of primary surpluses that the government is expected to run in the future to pay back the debt. (Primary surpluses are tax revenue less government spending, excluding interest payments.)

In conventional theories, the Federal Reserve’s interest-rate policy completely determines price levels and inflation. Congress and the Treasury are assumed to raise or lower taxes and spending as needed to pay off the debt, even if deflation drives up the value of that debt. But in the FTPL, the real value of government debt drives prices, much as the present value of future dividends determines a stock price. 

To understand inflation, Cochrane says, compare the amount of outstanding debt with the present value of future surpluses—and with the discount rate, or return that holders of government debt require. Unexpected inflation implies that investors think the government is not going to have the surpluses needed to repay debt, or that they require a higher return to hold debt. In either case, they try to sell government bonds, driving up the price of everything else.     

The data shed light on a historical correlation that has puzzled FTPL researchers: a reduced rate of inflation during recessions. In the Great Recession, for example, deficits in the US worsened dramatically because of falling tax receipts, and increased spending, including on the stimulus and bailouts. Expectations of future surpluses plunged as well. Inflation, however, dropped, as investors preferred to hold safe assets such as government bonds. Why? Because interest rates dropped as well. Investors were willing to hold government bonds, and actually bought less of everything else to get them, in the name of safety, despite very low returns. A low discount rate is a higher real value, which requires lower inflation. 

Just as research finds that the discount rate is the most important driver of stock prices, Cochrane finds that the discount rate has played an important role in US inflation as well. Historically, unexpected inflation has largely corresponded with rises in real interest rates that lower the value of debt, and vice versa—not to changes in expected surpluses. 

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Turning specifically to the effects of monetary and fiscal policy, Cochrane finds that a monetary-policy shock—in the form of an interest-rate increase unaccompanied by changes in the fiscal surplus or growth—led to an immediate and persistent increase in inflation. Meanwhile, a negative fiscal-policy shock, or a decline in surpluses, also resulted in persistent inflation, about half of which was offset by changes in the discount rate.

Cochrane’s research has meaningful policy implications, for both the Federal Reserve and fiscal-policy makers. It suggests that the models the Fed uses to describe how its actions affect inflation are wrong, and that the Fed by itself cannot stop inflation or deflation. Monetary and fiscal policy need to act together to keep the price level stable. 

The findings point to the danger of running consistent annual deficits, together with the short-term nature of US debt, Cochrane argues. The government rolls over about half the debt every two years. If there’s another global recession and “people lose faith in the US government to eventually start running surpluses, they refuse to roll over the debt, you get a spike in interest rates, a spike in inflation, and you can have an immense crisis.”

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