In the summer of 2021, the chair of the Federal Reserve (the Fed), Jerome Powell, publicly stated, “We now understand better how little we understand about inflation” (Ashworth 2022). Flash forward more than one year and not only has the Fed aggressively tightened interest rates, but economists like Olivier Blanchard are suggesting a need to tighten more (Blanchard 2023). How did we get here?

Inflation is far from a new phenomenon. Neither are the debates about fiscal and monetary policy in determining inflation. From Keynes’ emphasis on government expenditures to Milton Friedman’s stress on the money supply, ways to understand the relationship between the roles of government spending and central banks have long been debated. Despite this, economists generally agree that central banks, such as the Fed, are responsible for raising interest rates to curb inflation. However, in John Cochrane’s new book The Fiscal Theory of the Price Level, Cochrane presents an argument convincing enough that he believes even “Milton Friedman might change his mind with new facts and experience at hand” (The Economist 2023). In this 600-page tome, Cochrane challenges the conventional wisdom of fiscal policy and its impact on the price level, suggesting that the Fed is not to blame for America’s current spell of inflation, but rather massive fiscal deficits are (Cochrane 2023). 

Cochrane’s Theory

Before analyzing Cochrane’s work, we must understand what makes money valuable in his model. Simply put, Cochrane argues that money is valuable because the government must accept it for tax payments. Conceptually, his position is analogous to the gold standard, except rather than gold backing money, taxes do. But how does this work? These tax payments are crucial in this model because they are used to pay off government debt. Cochrane’s fiscal theory maintains that “inflation adjusts so that the real value of government debt equals the present value of (future) primary surpluses” (Cochrane 2022, 126). In other words, a current budgetary deficit must be offset by future surpluses; inflation occurring when people are not confident that the government will be able to do this (Cochrane, Zingales and Mclean 2022). In an interview with the former Chief Economist of the White House’s Office of Management and Budget, Vance Ginn, Cochrane compared this theory to valuing an equity. When determining the price of a stock, he says, “there’s how many shares and how many dividends you think the company is going to pay for those shares. You divide it; you get the stock prices” (Ginn and Cochrane 2023). Investors who believe that a company’s stock will appreciate have no issue holding onto their shares. Similarly, if the government runs enormous deficits, but people have confidence that there will be future surpluses to repay these deficits, people will hold onto their extra cash, and price levels will remain unchanged. Just as investors sell shares when they lose faith in a company, people begin spending money when they believe the government will not be able to repay the deficit, inflation ensuing. 

The Role of Monetary Policy

It is important to note Cochrane’s emphasis on fiscal policy does not diminish the significance of monetary policy. He exclaims that, “Central banks remain powerful!” (Cochrane 2022, 127). By targeting nominal interest rates, central banks can still fight against expected inflation. But in Cochrane’s model, sufficiently large fiscal shocks can give rise to unexpected inflation because the price level must increase enough to reduce the real value of the deficit to the present value of future surpluses. While monetary policy can delay or target levels of expected inflation in the long run, in the event of a fiscal shock, it is a temporary solution that will only postpone and worsen inflation later on. Central banks can no longer be seen as the institution that bears primary responsibility for reducing excessive inflation. Rather they must work together with fiscal policy to ensure price stability and vice-versa. The zero lower bound––when short-term nominal interest rates are zero—offers a clear lens to this argument. A traditional monetarist would predict that when Japan’s interest rates were essentially zero, an inflationary spiral was inevitable. Yet, inflation has been remarkably stable since 1995, hovering between -2% and 2% (FRED 2023). Similarly, when U.S. short-term interest rates neared zero percent in 2008, inflation did not spiral out of control (Woods, Wong, and Cochrane 2022). Traditional monetarists are perfectly rational to predict a high rate of inflation, but if their forecasts are wrong, another variable must be at play. Cochrane’s model suggests large, unexpected fiscal deficits take on this role. In other words, when interest rates are low and stable and there are no fiscal shocks, people can rationally expect the government will repay the current debt. The same logic can be seen in Germany after World War I. Hyperinflation was resolved without any monetary tightening; instead, interest rates were stable and fiscal reforms proved pivotal in lowering inflation (Cochrane 2022, 143). Thus, central banks are still crucial, but everyone must understand their limitations. While they can target expected inflation, they cannot control unexpected inflation, making fiscal policy equally important. The lesson is clear: monetary and fiscal policy must work together to create expectations that are necessary for price stability.

Applying The Fiscal Theory of Price Level to the Modern Day

Using Cochrane’s framework, we can better understand America’s current spell of inflation. Over the course of the pandemic, the government has supplied over $5 trillion in Covid stimulus checks (Ginn and Cochrane 2023). This is a significant fiscal shock. But if Cochrane’s theory holds, why did the public hold different expectations in 2020 than in 2008, when fiscal policy was expansionary but inflation was not a problem? There are several reasons that we can point to. First, and perhaps the most notable, is the difference in the magnitude of the packages. Whereas the stimulus checks in 2008 totaled roughly $100 billion, in 2020 they amounted to $5 trillion, meaning deficits were significantly larger in 2020 (Parker et al. 2010, 2530). Furthermore, when policymakers and officials proposed the package, they did not outline how this would impact future surpluses or how they planned on repaying the associated debt (Cochrane 2022). Remember, when people do not expect the government to pay back deficits, they spend and increase the price level, which is exactly what happened. None of this is to say that COVID stimulus checks should not have been handed out. While they proved crucial for some Americans to survive the pandemic, $5 trillion of government spending is the very definition of a fiscal blowout (Ginn and Cochrane 2023). Nevertheless, when inflation surged, people immediately pointed fingers at the Fed for not raising interest rates early enough. Although the Fed should have been more responsive, which they openly admitted, monetary policy cannot be the culprit for fiscal-induced inflation, as it is outside the scope of a central bank’s responsibilities. We should not characterize current inflation to be the result of the Fed being too passive or the government as being too active, but recognize that the dissonance between the two intensified the fire. And as the public frantically runs around, demanding the Fed put it out, they lose sight that the best way to extinguish a fire is to not light one in the first place.

Implications

The implications of Cochrane’s work are still unclear. If The Fiscal Theory of the Price Level holds true, it will invariably redefine the roles and dynamics of governments and their central banks. Specifically, fiscal and monetary policy must work closely together to control the price level and set price expectations. In the early 1990s, central banks worldwide began engaging in “inflation-targeting”—a monetary strategy in which central banks announce their inflation targets. In doing so, central banks communicated with the public in order to anchor expectations (Bernanke and Mishkin 1997). If Cochrane’s theory is true, governments may well begin to openly announce fiscal plans and, importantly, how they affect future fiscal and monetary policy to build credible expectations. However, with the current inflation still at the forefront of economic concerns, the U.S. may undergo similar economic reforms to the 1980s: high interest rates alone proved futile, but when combined with government fiscal surpluses, inflation fell (Cochrane 2022, 133). 

Cochrane’s model is potentially one of the most important contributions to our understanding of the inflationary process. However, for that to happen some theoretical issues need to be addressed. On a technical level, some macro-economists have questioned if the model is over-determined, implying there are multiple solutions (Farmer and Zabczyk 2019). The model is incredibly complex and because of this it will require some time to resolve. In addition to this, there is the issue of empirical verification. Are there statistical tests of the data that tend to support the model? This may be harder with the Cochrane model than was the case with earlier macro models because of the inordinate emphasis placed on expectations. While accounting for expectations–such as expected inflation rates–is indispensable, they are very difficult to measure, and once again take time to prove. Cochrane himself openly acknowledges that his model is hard to test. But if the model emerges intact, there is probably a place for it on the bookshelf next to Milton Friedman and Anna Schwartz’s A Monetary History of the United States and John Maynard Keynes’ A General Theory of Employment, Interest Rates, and Prices.

References

Ashworth, Marcus. "Jackson Hole Should Be a Mea Culpa for Central Bankers." The Washington Post (Washington D.C., District of Columbia), August 25, 2022. https://www.washingtonpost.com/business/jackson-hole-should-be-a-mea-culpa-for-central-bankers/2022/08/25/97578676-2433-11ed-a72f-1e7149072fbc_story.html.

Bernanke, Ben S., and Frederic S. Mishkin. "Inflation Targeting: A New Framework for Monetary Policy?" The Journal of Economic Perspectives 11, no. 2 (1997): 97–116. http://www.jstor.org/stable/2138238.

Blanchard, Olivier. "'1. Avoiding Charybdis and Scylla: After today's numbers, the Fed is going to hear two siren songs: Inflation is dramatically lower. Last month, CPI decreased. Time to stop tightening. The economy is not slowing down. Unemployment keeps decreasing. Need to tighten more.'" Twitter. Last modified February 3, 2023. https://twitter.com/ojblanchard1/status/1621558676136804353?cxt=HHwWgoCymcnB94AtAAAA.

Cochrane, John, Luigi Zingales, and Bethany McLean. "A Different Story Of Inflation With John Cochrane." October 27, 2022. On Capital Isn't. Podcast, video, 40:15. https://www.capitalisnt.com/episodes/a-different-story-of-inflation-with-john-cochrane/transcript.

The Economist. "Have economists misunderstood inflation?" The Economist, January 23, 2023. https://www.economist.com/finance-and-economics/2023/01/26/have-economists-misunderstood-inflation?giftId=e87f2695-5495-4caf-ba94-f5021c3bbdb8.

Farmer, Roger, and Pawel Zabczyk. "A Requiem for the Fiscal Theory of the Price Level." Working paper, October 11, 2019. https://www.imf.org/en/Publications/WP/Issues/2019/10/11/A-Requiem-for-the-Fiscal-Theory-of-the-Price-Level-48715.

Federal Reserve of St. Louis. "Inflation, GDP deflator (annual %) - Japan." Chart. Federal Reserve Bank of St. Louis. Accessed February 19, 2023. https://data.worldbank.org/indicator/NY.GDP.DEFL.KD.ZG?locations=JP.

Ginn, Vance, and John Cochrane. Season 1, episode 27, "Explaining Inflation & Economy with Fiscal Theory of the Price Level & More w John Cochrane." January 17, 2023. On Let People Prosper Show. Podcast, video, 42:06. https://www.youtube.com/watch?v=VbZ4EOTYq78.

John H. Cochrane. Fiscal Theory of the Price Level. N.p.: Princeton University Press, 2023.

Parker, Jonathan A., Nicholas S. Souleles, David S. Johnson, and Robert Mcclelland. "Consumer Spending and the Economic Stimulus Payments of 2008." The American Economic Review 103, no. 6 (2013): 2530-53. http://www.jstor.org/stable/42920659.

Woods, Darian, Wailin Wong, and John Cochrane. "A macroeconomist walks into a bar fight." June 10, 2022. On NPR. Podcast, video, 9:06. https://www.npr.org/transcripts/1104293317.