Arnold Kling on the Fiscal Theory of the Price Level
By Scott Sumner
Arnold Kling recently responded to a point I made about the Fed not determining the path of interest rates:
Unfortunately, the Fed doesn’t get to decide the path of interest rates. It looks like they do, but that’s a cognitive illusion. The bond market determines the path of interest rates, reflecting factors such as global credit markets, as well as NGDP growth and the level of NGDP in the US.
I am fond of Winston Churchill’s remark about someone who “stumbles across the truth, but then picks himself up as if nothing happened.”
That is what I feel took place here. I think that the implication of the quoted sentences is that it is the bond market, not the Fed, that is in control. As I write in the Book of Arnold, the Fed is just another bank. It has no more ability to “target” macroeconomic variables than does Citibank.
He’s wrong, but it’s partly my fault as I was using a bit of poetic license. Of course the Fed does have some control over the path of interest rates. My point was that if the Fed wants a reasonably stable economy, then it pretty much has to follow the bond market. And that insight has no implications at all for the Fed’s ability to steer the macroeconomy, because it doesn’t steer the macroeconomy by controlling interest rates, it steers it by controlling the supply and demand for base money. More importantly, I was discussing the case where the Fed wanted 2% inflation, which limits its discretion over the path of interest rates, and Arnold is concluding that my claim has implications for whether the Fed could hit a different inflation target.
I’m much more concerned about this claim by Arnold in the comment section:
2. Central banks by themselves do not cause high inflation. High inflation is a fiscal phenomenon. When the government runs out of cheap credit but still runs a deficit, it starts printing money in great quantities, and that leads to high inflation.
That’s true for Zimbabwe, but the US? The budget deficits were not particularly big during the Great Inflation of 1965-81. But monetary policy was very expansionary. LBJ’s tax increase of 1968 failed to slow inflation, but Volcker’s tight money of 1981 succeeded—despite Reagan running massive fiscal deficits. Around 1990, the Fed decided to target inflation at about 2%. Since 1990 it’s averaged 2%. And how did this miracle happen? The Fiscal Theory of the Price Level proponents would presumably say it had nothing to do with the Fed, nothing to do with the Taylor Rule. Instead, Newt Gingrich and the other geniuses in the House of Representatives got together and masterfully produced an inflation rate of 2% through the budget process. And not just in the US. Other countries with very different fiscal policies also got inflation under control in the 1990s.
Or maybe Milton Friedman and Ben Bernanke and Paul Krugman and John Taylor and Janet Yellen and Friedrich Hayek and Michael Woodford and lots of other economists (including me) are right, and the central bank determines the trend rate of inflation. Maybe the financial markets have good reason to react strongly to hints of Fed policy shifts. Maybe because prices are measured in money terms, not apple terms or copper terms, the supply and demand for base money might actually have an important impact on the value of base money.
As Arnold said in a more recent post:
Supply and demand is an example of an interpretive framework that is very strong. That is, it seems to explain a lot, one rarely encounters anomalies, and it is consistent with other beliefs that we tend to hold.
I couldn’t put it better myself.
PS. Take a look at the fiscal situation in Europe and Japan, and then the inflation rates in Europe and Japan, if you are still skeptical that monetary policy drives inflation.