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Inflation in the shadow of debt

The effect of monetary policy on inflation depends crucially on fiscal policy. In standard new-Keynesian models, of the type used throughout the Fed,…

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This article was originally published by The Grumpy Economist

The effect of monetary policy on inflation depends crucially on fiscal policy.

In standard new-Keynesian models, of the type used throughout the Fed, ECB, and similar institutions, for the central bank to reduce inflation by raising interest rates, there must be a contemporaneous fiscal tightening. If fiscal policy does not tighten, the Fed will not lower inflation by raising interest rates.

The warning for today is obvious: Fiscal policy is on a tear, and not about to tighten any time soon no matter what central banks do. An interest rate rise might not, then, provoke the expected decline in inflation.

Here is a very stripped down model to show the point. begin{align*} x_t & = E_t x_{t+1} - sigma(i_t - E_t pi_{t+1}) \ pi_t & = beta E_t pi_{t+1} - kappa x_t \ i_t &= phi pi_t + u_t \ Delta E_{t+1}pi_{t+1} & = - sum_{j=0}^infty rho^j Delta E_{t+1} tilde{s}_{t+1+j} + sum_{j=1}^infty rho^j Delta E_{t+1}(i_{t+j}-pi_{t+1+j}) end{align*} The first two equations are the IS and Phillips curves of a standard new-Keynesian model. The third equation is the monetary policy rule.

The fourth equation stems from the condition that the value of debt equals the present value of surpluses. This condition is also a part of the standard new-Keynesian model. We're not doing fiscal theory here. Fiscal policy is assumed to be "passive:" Surpluses adjust to whatever inflation results from monetary policy. For example, if monetary policy induces a big deflation, that raises the real value of nominal debt, so real primary surpluses must raise to pay the now larger value of the debt. Since it just determines surpluses given everything else, this equation is often omitted, or relegated to a footnote, but it is there. Today, we just look at the surpluses. Without them, the Fed's monetary policy cannot produce the inflation path it desires.

Notation: (Delta E_{t+1} equiv E_{t+1}-E_t), (rho) is a constant of approximation slightly less than or equal to one, (tilde{s}) is the real primary surplus relative to debt. For example, (tilde{s}=0.01) means the surplus is 1% of the value of debt, or 1% of GDP at current 100% debt to GDP. The last term captures a discount rate effect. If real interest rates are higher, that lowers the present value of surpluses. Equivalently, higher real interest rates raise the interest costs in the deficit, requiring still higher primary surpluses to pay off debt. (Reference: Equation (4.23) of Fiscal Theory of the Price Level.)

Now, suppose the Fed raises interest rates ({i_t}) following a standard AR(1). with coefficient (eta = 0.6). However, there are multiple ({u_t}) which produce the same path for ({i_t}), each of which produces a different inflation path ({pi_t}). Each of them also produces a different fiscal response ({s_t}). So, let's look for given (AR(1)) interest rate ({i_t}) path at the different possible inflation ({pi_t}) paths, their associated monetary policy disturbance ({u_t}) and their associated fiscal underpinnings.

The top left panel shows a standard result. The interest rate in blue rises, and then returns following an AR(1). Here, the 1% interest rate rise causes a 1% inflation decline, shown in red. I use (eta=0.6, sigma = 1, kappa = 0.25, beta = 0.95, phi = 1.2 ) The monetary policy disturbance (u_t), dashed magenta.  is even larger than the actual inflation rise, but ( i_t = phi pi_t + u_t) and  the disinflation in (pi_t) bring the interest rate to a lower value. 

Now, let's calculate the implied "passive" surplus response. I use (rho=1). With a 1% disinflation, the present value of surpluses must rise by 1%. However, the real interest rate rises substantially and persistently. From a present value point of view, that higher discount rate devalues government debt, an inflationary force.  From an ex-post point of view the higher real rates lead to years of higher debt service costs. Viewed either way, the constant-discounted sum of surpluses must rise by even more than one percent. In this case, the sum of surpluses must rise by 3.55, meaning 3.55 percent of debt or 3.55 percent of GDP at 100% debt to GDP ratio, or about $700 billion dollars. 

What if Congress looks at that and just laughs? Well, the Fed must do something else. The top right panel has a different disturbance process ({u_t}). This disturbance produces exactly the same path of interest rates, shown in blue. But it produces half as much initial deflation, -0.5%. The disinflation also turns to slight inflation after 3 years. With less disinflation, there is less need to produce a larger value of government debt, so the sum of surpluses must only rise by 2.23%. 

The bottom left shows a case that inflation does not decline at all, though again the path of interest rates is exactly the same. This occurs with a different disturbance ({u_t}) as shown. Finally, in the bottom right, it is possible that this interest rate rise produces 0.5% inflation. In this case, fiscal policy produces a slight deficit. The case of no change in surplus or deficit occurs between 0% and 0.5% inflation. 

To reiterate the point, the observable path of interest rates is exactly the same in all four cases. In a new-Keynesian model, the difference is the dynamic path of the monetary policy disturbance. Different underlying disturbances then produce the different inflation outcomes, and the different requirements for the "passive" fiscal policy authorities. Of course (I can't help myself here) to a fiscal theorist the ({u_t}) business is meaningless. Congress' choice to match the Fed's tightening with its own tightening produces the deflationary path, and if Congress does not do so, we get an inflationary path. 

Looked at either way, in a totally standard new-Keynesian model, the effects of an interest rate rise depend crucially on fiscal policy. If fiscal policy does not agree to tighten along with an interest rate rise, the interest rate rise will not produce lower inflation. 

Hat tip: This point emerged out of discussions with Eric Leeper on his 2021 Jackson Hole paper on fiscal-monetary interactions.  

**********

Calculations. To produce the plots I write the monetary policy rule in a different form [ i_t = i^ast_t + phi ( pi_t - pi^ast_t) ] [ i^ast_t = eta i^ast_{t-1} + varepsilon_t ] Then I can specify directly the interest rate AR(1) in (i^ast_t), and the initial inflation in (pi^ast_t).  These forms are equivalent. Indeed, I construct ( u_t = i^ast_t - phi pi^ast_t ) in order to plot it. 

I use the analytical solutions for inflation given an interest rate path derived 26.4 of Fiscal Theory, [ pi_{t+1}=frac{sigmakappa}{lambda_{1}-lambda_{2}}left[ i_{t}+sum _{j=1}^{infty}lambda_{1}^{-j}i_{t-j}+sum_{j=1}^{infty}lambda_{2}% ^{j}E_{t+1}i_{t+j}right] +sum_{j=0}^{infty}lambda_{1}^{-j}delta_{t+1-j}. ] [ lambda_{1, 2}=frac{left( 1+beta+sigmakapparight) pmsqrt{left( 1+beta+sigmakapparight) ^{2}-4beta}}{2}, ]

Matlab code: T = 50;
sig = 1;
kap = 0.25;
eta = 0.6;
bet = 0.95;
phi = 1.2;
pi1 = [-1 -0.5 0 0.5];

lam1 = ((1+bet+sig*kap)+ ((1+bet+sig*kap)^2-4*bet)^0.5)/2;
lam2 = ((1+bet+sig*kap)- ((1+bet+sig*kap)^2-4*bet)^0.5)/2;
lam1i = lam1^(-1);

delt = pi1 - sig*kap/(lam1-lam2)*lam2/(1-lam2*eta);

tim = (0:1:T-1)';

pit = zeros(T,1);
pit(2) = sig*kap/(lam1-lam2)*lam2/(1-lam2*eta) ; % t=1
pit(3) = sig*kap/(lam1-lam2)*(1/(1-lam2*eta)) ;
for indx = 4:T;
pit(indx) = sig*kap/(lam1-lam2)*...
(eta^(indx-3)/(1-lam2*eta) + lam1i*(eta^(indx-3)-lam1i^(indx-3))/(eta-lam1i) );
end;

pim = [pit*(1+0*pi1) + [0*delt;(lam1i.^((0:T-2)')).*delt]];
it = [0; eta.^(0:1:T-2)'];
um = it*(1+0*pi1) - phi*pim;
rterm = sum(it(2:end-1,:)-pim(3:end,:));
sterm = rterm-pim(2,:);
disp('r');
disp(rterm);
disp('s');
disp(sterm);

if 0; % all together
figure;
C = colororder;
hold on
plot(tim,pim,'-r','linewidth',2);
plot(tim,um,'--m','linewidth',2);
plot(tim,it,'-b','linewidth',2);
plot(tim,0*tim,'-k')
axis([ 0 6 -inf inf])
end;

figure; % 4 panel plot
for indx = 1:4;
subplot(2,2,indx);
hold on;
plot(tim,pim(:,indx),'-r','linewidth',2);
if indx == 1;
text(1.8,-0.7,'pi','color','r','fontsize',18)
text(1,0.7,'i','color','b','fontsize',18);
text(2.4,1,'u','color','m','fontsize',18)
end
plot(tim,um(:,indx),'--m','linewidth',2);
plot(tim,it,'-b','linewidth',2);
plot(tim,0*tim,'-k')
title(['Sigma s = ' num2str(sterm(indx),'%4.2f')],'fontsize',16)
axis([ 0 6 -1 1.5])
end
if eta == 0.6
print -dpng nk_fiscal_1.png
end

Economics

UK Gas Crisis Stuns Poultry Slaughterhouses, May Trigger Higher Chicken Prices

UK Gas Crisis Stuns Poultry Slaughterhouses, May Trigger Higher Chicken Prices

Soaring natural gas prices across the UK have disrupted companies…

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UK Gas Crisis Stuns Poultry Slaughterhouses, May Trigger Higher Chicken Prices

Soaring natural gas prices across the UK have disrupted companies from operating. The latest is slaughterhouses that use carbon dioxide, a byproduct of fertilizer derived from natural gas. 

Richard Griffiths, chief executive officer of the British Poultry Council, told Bloomberg surging natural gas prices is a massive blow for poultry companies, which frequently use a byproduct of fertilizer production -- carbon dioxide -- to incapacitate birds at slaughterhouses.

CO2 supplies are incredibly tight, Griffiths said, adding that any further shortages could create massive headwinds for the industry and hinder chicken production. Already, weekly chicken output has dropped 5-10%, and Christmas turkey production could drop by a fifth. 

The unintended consequences of natural gas shortages are the effects on the food industry and how it may result in rising meat prices if slaughterhouse output continues to decline. 

On Thursday, we outlined how CF Industries Holdings' fertilizer plants, one in Billingham and another in Ince, suspended operations "due to high natural gas prices." 

"I would expect it to be having impacts very quickly," Griffiths said by phone. "At the moment, we've got all the Brexit effects, including labor shortages, all the Covid add-ons. And now, we're seeing these supply-chain problems emerge at a time when we really don't need it." 

Energy inflation could be a company's worse nightmare in the UK -- prices for the fuel have already doubled this year, while power costs are on a record-breaking run thanks to the lack of renewable energy output

More companies could be impacted by soaring natural gas prices and elevated electricity prices. This problem isn't likely to fade anytime soon as gas inventories remain low ahead of the winter season. 

All of this is feeding into inflation across the continent. European Central Bank President Christine Lagarde recently said energy markets are a significant driver in higher inflation. To solve this, Germany has to certify Russia's Nord Stream 2 to begin receiving shipments - but as we recently noted, that could take months and may suggest European inventories won't be resupplied in time for winter. 

    Tyler Durden Sat, 09/18/2021 - 07:35
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    Economics

    US stocks close in a sea of red as tax hike fears grow

    US stocks closed the week in a sea of red on Friday September 17 after technology shares led the broad losses across segments and tax hike fears dragged…

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    US stocks closed the week in a sea of red on Friday, September 17, after technology shares led the broad losses across segments and tax hike fears dragged the benchmark indices down.

    The S&P 500 fell 0.91% to 4,432.99. The Dow Jones fell 0.48% to 34,584.88. The NASDAQ Composite Index declined 0.91% to 15,043.97, and the small-cap Russell 2000 was up 0.18% to 2,236.87.

    Markets have been volatile this week amid mixed global cues. Loses in the Asian markets over worries of slow economic recovery and recent geopolitical developments weighed on investors’ minds. The tech-savvy Nasdaq declined the most.

    In addition, the recent retail sales and unemployment data offered mixed signals about the US economy. While retails sales were up in August, jobless benefits claims rose noticeably last week.

    Meanwhile, lawmakers were considering a proposal to hike corporate tax. The news could be worrisome for some investors as a tax hike may eat into the companies’ profits. Democrats are seeking to increase the corporate tax from the current 21% to 26.5%.

    Investors will now eagerly wait for the Fed’s monthly meeting next week. The central bank officials are expected to discuss the latest economic data as they continue with the stimulus tapering talks.

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    Invesco Ltd. (IVZ) stock rose 5.71% after reports that it is in talks to merge with the asset management unit of State Street Corporation (STT). STT stock declined 2.47% in intraday trading.

    SmileDirectClub, Inc. (SDC) shares surged 12.92% after the stock was discussed on social media.

    AbCellera Biologics Inc. (ABCL) stock rose 2.53%, a day after the US Food and Drug Administration extended the emergency use authorization for its covid drug Bamlanivimab.

    In technology stocks, Apple Inc. (AAPL) fell 1.94%, Microsoft Corporation (MSFT) fell 1.65%, and ASML Holdings N.V. (ASML) declined 3.18%. Adobe Inc. (ADBE) and Cisco Systems, Inc. (CSCO) fell 1.75% and 1.19%, respectively.

    In communication stocks, Alphabet Inc. (GOOG) fell 2.08%, Facebook, Inc. (FB) declined 2.96%, and T-Mobile US, Inc. (TMUS) declined 1.19%. In addition, Sea Limited (SE) dropped 1.23%, and Snap Inc. (SNAP) advanced 3.08%.

    In the material sector, BHP Group (BHP) fell 4.46%, Rio Tinto Group (RIO) fell 3.02%, and Vale S.A. (VALE) fell 2.21%. Ecolab Inc. (ECL) and Freeport-McMoRan Inc. declined 2.01% and 4.10%.

    Also Read: Check these 5 oil and gas stocks with high price-to-earnings ratio

     

    Copyright ©Kalkine Media 2021

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    Gold futures were down 0.22% to US$1,752.85 per ounce. Silver decreased by 1.87% to US$22.367 per ounce, while copper fell 1.15% to US$4.2322.

    Brent oil futures decreased by 0.45% to US$75.33 per barrel and WTI crude was down 0.81% to US$71.97.

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    US Dollar Futures Index increased by 0.33% to US$93.227.

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    Economics

    Victor Davis Hanson: The Death Of Science

    Victor Davis Hanson: The Death Of Science

    Authored by Victor Davis Hanson,

    The scientific method used to govern much of popular American…

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    Victor Davis Hanson: The Death Of Science

    Authored by Victor Davis Hanson,

    The scientific method used to govern much of popular American thinking.

    In empirical fashion, scientists advised us to examine evidence and data, and then by induction come to rational hypotheses. The enemies of "science" were politics, superstition, bias and deduction.

    Yet we are now returning to our version of medieval alchemy and astrology in rejecting a millennium of the scientific method.

    Take the superstitions that now surround COVID-19.

    We now know from data that a prior case of COVID-19 offers immunity as robust as vaccination. Why, then, are Joe Biden's proposed vaccination mandates ignoring that scientific fact? Dr. Anthony Fauci, when asked, seemed at a loss for words.

    Is this yet another of the scientific community's Platonic "noble lies," as when Fauci assured the public last year that there was no need for masks?

    He later claimed he had lied so that medical professionals would not run out of needed supplies.

    Fauci also threw out mythical percentages needed for herd immunity, apparently in an attempt to convince the public that it will never be safe until every American is protected from COVID-19 by vaccination only.

    And why was it that hard for the scientific community to postulate a likely origin of COVID-19 Some of the very scientists engaged in gain-of-function research oversaw an investigation with Chinese authorities. They confirmed the predetermined conclusion that the virus likely had little to do with gain-of-function engineering. And they saw little proof it was birthed in a Wuhan virology lab. Yet scientific opinion, emerging evidence and basic logic have suggested the opposite.

    How can the government hector citizens that they have a moral duty -- and soon a legal obligation -- to be vaccinated when it does not mandate vaccinations for unvetted refugees flying in from Afghanistan?

    How can the government medical community remain largely silent when an anticipated 2 million foreign nationals will cross into the United States in the current fiscal year -- almost none of whom are vaccinated or tested for COVID-19?

    Why do the media and government blame particular races for the delta variant outbreak on grounds that they were insufficiently vaccinated?

    Why wouldn't officials simply urge the Latino and Black communities to be vaccinated as quickly as possible?

    Data shows that both groups have lower vaccination rates than white and Asian populations.

    Are woke political agendas discrediting science and losing public health?

    We saw just that in June 2020, when more than 1,200 "health care professionals" signed a petition demanding exemptions from lockdowns and quarantines for Black Lives Matter protesters marching en masse. And they concocted medical excuses such as "vital to the national public health" to insist that violating quarantines was less unhealthy than not pouring into the streets.

    Why did presidential candidate Joe Biden and his running mate, Kamala Harris, warn the American people on the eve of vaccination rollouts that an inoculation under the Trump administration could be unsafe, thereby undermining confidence in vaccines?

    Why was the medical community largely silent about such dangerous sabotaging of new vaccines, but months later became vociferous in warning the public that any doubts about the safety of these Operation Warp Speed vaccinations were scientifically misplaced? Was there a medical breakthrough on Jan. 20, 2020, to alter their consensus?

    From rewarding wokeness in medical school admissions to the peer reviewing of scientific papers, the anti-scientific mania has polluted scientific endeavors.

    "Critical race theory" would preposterously tell us that we need racism to fight racism.

    "Critical legal theory" ludicrously claims that laws have no rational basis but simply reflect power inequities.

    "Modern monetary theory" defies millennia of evidence and basic logic in stating that governments can simply print money without worrying about balancing expenditures with revenues or inflating the currency to ruination.

    Corporations are now asked to substitute a new woke agenda theory -- "Environmental, Social and Corporate Governance (ESG)" -- in lieu of market realities, rules of investment and economic data.

    Science is dying; superstition disguised as morality is returning. And we'll all soon become poorer, angrier and more divided.

    Tyler Durden Fri, 09/17/2021 - 22:20
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