Two types of debt monetization (and one misconception)
By Scott Sumner
I see a lot of discussion of Fed “debt monetization”, and yet it’s not exactly clear what that term means. Here I’ll discuss two types of debt monetization, and a third policy that is often wrongly viewed as debt monetization.
The best example of debt monetization is a large, one-time increase in high-powered money, which the central bank uses to purchase interest-bearing government bonds. High-powered money is base money that pays no interest, such as currency and zero interest bank reserves.
This policy produces a one-time increase in the price level, but no persistent increase in the rate of inflation.
A second type of debt monetization involves a persistent increase in the rate of inflation, such as we saw during the 1960s and 1970s. This is only effective if a substantial amount of government debt is in the form of long-term bonds. The inflation reduces the value of these bonds in real terms. In contrast, if all government debt is in the form of short-term T-bills, then the interest cost on T-bills rises with the higher inflation, producing no real gain to the government.
This second type of “debt monetization” doesn’t actually involve very much conversion of debt into money. That’s because at high rates of inflation the real demand for high-powered money falls sharply. If the Fed switched to an 8% inflation target tomorrow, then the Fed would likely have to reduce the amount of high-powered money in circulation. (Interest-bearing bank reserves are not high-powered money, as there is no long run fiscal gain is swapping interest-bearing reserves for interest-bearing T-bills.)
Some people regard a “low interest rate policy” as another form of debt monetization. This is false. Indeed low interest rates are not even a policy; they are the outcome of various other monetary policies, plus other non-monetary factors. The Fed has only a very transitory effect on real interest rates, which are determined by underlying economic fundamentals. As a result, a policy of persistently low nominal interest rates requires persistently low inflation, i.e. a tight money policy. That does not provide a fiscal gain to the government, as one can see from the example of Japan.
David Beckworth recently retweeted a couple of Adams making a similar point:
PS. The recent surge in the CPI is not relevant to this post, as it’s likely just a transitory supply-side shock. While I follow convention in focusing on price inflation, NGDP growth is the more relevant variable for this sort of analysis.