Tapering and the fiscal theory of the price level

Each week, Symposium Magazine invites an author to guest-blog. This week’s featured piece is Why Central Bank Transparency May Be Overrated by Brigitte Granville.

Alan Greenspan has recently described the exit from “Quantitative Easing” (QE) that the Federal Reserve must accomplish in the coming years as a “brutal” challenge. This is by now a commonplace assumption, and it has not been lost on thoughtful observers that the expected “brutality” is foreshadowed in this year’s false start to the “tapering” of QE (that is, the gradual reduction in the pace of the Fed’s purchases of US government bonds and other securities).

Most commentary on this episode has concentrated on the risks to growth from tapering, since the period between Chairman Ben Bernanke’s advertisement for tapering in May and the Fed’s September postponement of the expected start date for tapering saw mortgage rates increase by a full percentage point. But I would highlight the coming risk to inflation from tapering.

The annual interest expense of the US federal budget now stands at around $360 billion, close to 11 per cent of the federal government’s budget. Normalization of 10-year yields to closer to 6 percent from the current level of around 2.5 percent would increase this interest expense to more than 25 percent of the budget. In the last six months, the Fed has been responsible for 95 per cent of demand for net issuance of US Treasuries. When the Fed does begin to scale back its purchases, this will raise the government’s debt servicing expense by a non-negligible margin – assuming economic growth dynamics are not yet strong enough to ensure fiscal sustainability. That seems a fair assumption given the Fed’s stated plan that tapering will precede increases in actual interest rates, which will occur only once unemployment is falling decisively below 6.5 percent.

Since tapering is supposed to start before the economic recovery hits escape velocity, the result at this stage could be the appearance of unsustainable increases in the nominal debt outstanding (since in the absence of tax rises and/or spending cuts, more debt will have to be issued to finance the growing debt service burden). And this will give rise, in turn, to heightened expectations of inflation as the only way for the government to contain the public debt problem.

The formal framework for understanding this practical risk of QE tapering proving inflationary is known as the Fiscal Theory of the Price Level (FTPL). This theory defines the price level in any economy as the ratio of the total nominal bonds outstanding to the present discounted value of future real primary budget surpluses. Tighter monetary policy (that is, increases in policy interest rates or a reduction in central bank purchases of government bonds) raises the interest expense component of the budget, adding to the nominal debt stock. According to FTPL, the nominal rate of debt growth is the key determinant of the inflation rate. Monetary tightening can be inflationary as it raises the stock of debt that will eventually need to be eroded by inflation.

The optimal path through such quandaries involves encouraging just enough inflation to help stimulate growth but without inflation expectations getting out of control – and resulting in the worst of all worlds that is stagflation. In my next post, I will suggest the best way to navigate through these narrow and treacherous policy straits.



Share This