INTEREST RATES, EXPECTED INFLATION, AND A POSSIBLE BENEFIT OF FISCAL POLICY OVER MONETARY POLICY

Given that United States inflation rates have risen from what may have been a briefly negative rate during at least part of the COVID-19-related economic collapse to positive rates that are now likely greater than rates during perhaps all of the Not-So-Great Recovery (based on implicit deflator data from the FRED website of the Saint Louis Federal Reserve Bank accessed December 6, 2021), it may not be surprising that at least some are calling for the Federal Open Market Committee of the Federal Reserve Bank to tighten monetary policy. Inflation expectations may be a factor, as market participants may expect an increase in the rate of inflation, in part due to very expansionary monetary policy in recent years. Perhaps an increase in expected inflation winds up being reflected in actual inflation rates, all other things equal. 

What do bond market participants expect inflation rates will be in the U.S. in coming years? In a textbook-style approach, thinking attributed to Irving Fisher states that the nominal interest rate paid by bonds equals the sum of a real interest rate that lenders (and perhaps also borrowers) try to maintain plus an inflation premium. The inflation premium varies with expected inflation. At least one complicating factor appears a few paragraphs below. 

But for now, consider an illustrative example. Let’s suppose that lenders attempt to keep a three per cent real return per year for lending their funds. A three per cent real interest rate (or real return) means that because lenders granted loans, they would be able to increase their buying power on average (as some goods would have prices rising but other goods would have no price increase and some could have a price decrease) by three per cent per year when they are repaid with principal and interest. If lenders expect that inflation will be two per cent per year over the life of a loan, then they could require a five per cent nominal interest rate. Subtracting an expected inflation rate of two per cent per year from the five per cent nominal interest rate would give lenders a three per cent real interest rate if the inflation expectation turned out to be accurate. 

Readers should note that nominal interest rates are measured in either U.S. dollars or units of other currencies that are not measured in constant buying power. Of course, the buying power of currency changes as prices change, and when most prices in the economy tend to rise, the buying power of each unit of currency tends to fall because each unit of currency on average can buy fewer goods and services than before the price increase. Real interest rates are measured in units of currencies that have constant buying power. 

If lenders expect that inflation rates will be higher than before, for example seven per cent, then to preserve the three per cent real interest rate, lenders could require a ten per cent nominal interest rate – the three per cent targeted real return plus a seven per cent inflation premium. If borrowers also think that inflation will be higher, then they are more likely to be willing to pay the higher nominal interest rate of ten per cent because they would be repaying the loan in dollars or other currencies that have less buying power. This reasoning helps to explain how an increase in inflation expectations can result in higher nominal interest rates on loans. 

Given that many if not most (or all) interest rates in the U.S. economy have risen, one explanation for these increases would be an increase in inflation expectations. However, in light of the facts that (1) interest rates on U.S. Treasury notes maturing in ten years and U.S. Treasury bonds maturing in thirty years are still relatively low (both less than two per cent as of this writing as shown on CNBC television on December 6, 2021) compared with interest rates at least over the past few decades if not longer, and (2) most if not all interest rates probably rose by much less than two percentage points (because the ten year and thirty years rates almost certainly did not go negative), have inflation expectations risen all that much? Additionally, some approaching the term structure of interest rates from the perspective of the segmented markets hypothesis might explain the increase in interest rates on longer term U.S. Treasuries based on a change in the supply of U.S. Treasuries or a change in the demand for U.S. Treasuries or changes in both the supply of and the demand for U.S. securities, perhaps with little or no change in expected inflation. Still, a change in expected inflation could help to explain changes in the demands for and supplies of debt instruments. 

The above analysis may possibly provide some insight for policymakers and financial market participants. The Federal Reserve may not need to reduce its debt purchases as quickly as some think is necessary. Given that U.S. Treasury interest rates are not rising very rapidly now, to the extent that the analysis of Irving Fisher explains the recent increase of nominal interest rates on U.S. Treasuries, financial market participants may believe that U.S. inflation pressure is largely if not completely contained at the present. 

A possible complicating factor is that expansionary monetary policy may have a different effect on interest rates over different time horizons. Given the recent experience in the United States, expansionary monetary policy may cause interest rates to decrease, at least initially. The thinking is that as the money supply rises, at least part of the increase in the money supply winds up contributing to bank reserves, so that the federal funds rate decreases, all other things equal, because banks seeking short term loans will not need to offer to pay as much in interest to borrow the funds with more reserves in the system. Longer term rates could possibly also fall due to a greater money supply and due to potential substitutability between debt with differing maturity lengths. However, over time, continued expansionary monetary policy could cause interest rates to rise, as lenders expect higher inflation in the future. This suggests that the role of monetary policy could dominate inflation expectations in the short term regarding nominal interest rates on debt instruments. In turn, it may be essential to conduct surveys to determine expected inflation in an economy because market participants may not be able to override the impact of monetary policy on interest rates, particularly in the short term. 

Related to the above about the possible difference between the short term impact versus the long term impact of monetary policy on interest rates, the current situation in the U.S. regarding monetary policy, inflation rates, and nominal interest rates on U.S. Treasury debt provides evidence that it may take quite a while for expansionary policy to result in a roughly proportional increase in the price level, the percentage increase in the latter being a measure of the inflation rate. Large percentage increases in the money supply at least some times have been accompanied by decreases in the velocity of money so that total spending on the items in gross domestic product (GDP) measured in nominal terms has not increased by a percentage as large as the increase in the money supply. My book It’s Velocity, Stupid! (short title) has more information on the plunge in the velocity of the M1 measure of the money supply in the U.S. that started in the first quarter of the year 2008. 

Readers may realize that the Fed in the U.S. has a dual mandate to pursue policies that (1) contain inflation and (2) increase employment. A potential problem for the Fed is that policies that reduce inflation such as raising interest rate targets and reducing the money supply growth rate could result in reducing real GDP growth (possibly to the point of economic recession or negative growth) and reducing employment. Despite this, the Fed may need to implement tighter monetary policy to prevent inflation from surging to levels that many would find unacceptable. 

However, could interest rates in the U.S. Treasury debt market indicate that the Fed does not need to tighten by much in the short term? Could it be that the market for U.S. Treasuries indicates that additional expansionary monetary policy for a bit longer than the Fed’s current plans would not increase inflation rates by much? If the Fed pursues more contractionary policy, then expansionary fiscal policy (reductions in taxes, increases in government spending) could help to continue to stimulate economic growth. Further, strategic expansionary fiscal policy may spark less inflation pressure than additional expansionary monetary policy. I may have more about this and at least some of the other topics in this blog entry in my upcoming book (hint hint 😉). It could be interesting and informative reading. 

Of course, all other things equal, expansionary fiscal policy means budget deficits.  But, from a modern money theory perspective such as in Stephanie Kelton’s The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy (2020 [first release], Public Affairs), my understanding of the concern of additional expansionary fiscal policy would be how to find and assign resources into the production of goods and services. By contrast, from a non-modern money theory perspective, the interest cost of the debt used to finance the federal deficit spending is still quite low. 

Readers may want to note a difference between tapering and tightening in monetary policy. Tapering in this context refers to the Fed buying fewer longer-term assets. For example, the Fed used tapering to phase out its quantitative easing measures implemented in response to the Great Recession. By contrast, tightening by the Fed would imply the Fed increasing its target for the federal funds rate, the bank-to-bank overnight interest rate. The Fed would cut back on buying short-term Treasury debt from depository institutions such as banks so that fewer reserves would be in the banking system, in turn creating pressure for the federal funds rate to rise. At this point, we may not need to emphasize the difference between tapering by the Fed and tightening by the Fed, except to note that the Fed may be more likely at this point to taper than to tighten.