Inflation Expectations for Beginners

For a complete list of Beginners articles, see Financial Crisis for Beginners.

Only a few years ago, the accepted remedy for a recession was for the Federal Reserve to lower interest rates – namely, the Federal funds rate. Now, however, the economy has been stuck in recession for over fifteen months and the Federal funds rate has spent the last several months at zero. (The Fed funds rate cannot ordinarily be negative, because one bank won’t lend $100 to another bank and accept less than $100 in return; it always has the option of just holding onto its $100.) As a result, the Fed has resorted to other policy tools, most notably large-scale purchases of agency and Treasury securities, funded by creating money. (Here’s James Hamilton’s analysis.)

As the Fed’s monetary policy plays a more prominent role in the response to the economic crisis, there will be more talk of inflation or, more accurately, inflation expectations. While inflation is what affects the purchasing power of the money in your wallet, inflation expectations are what affect people’s behavior in ways that have a long-term economic impact. Take the case of wage negotiations, for example: a union that believes inflation will average 5% over the life of a contract will demand higher wage increases than a union that believes inflation will average only 1%. Once those higher wages are built into the contract, the employer is forced to raise prices in order to cover those wage increases, and inflation begins to ripple through the economy.

One of the major objectives of modern monetary policy is to control inflation expectations, because controlling inflation expectations is the first step to controlling inflation. If there is a short-term burst of inflation – as we had a year ago, if you look at headline inflation numbers that include the prices of food and energy – the macroeconomic consequences can be limited if people believe that the Fed can and will bring inflation under control.

Unfortunately, it is impossible to know exactly what people’s inflation expectations are; in fact, it may not even be a sensible question, since different people have different understandings of what inflation is. However, there are three main approaches to estimating inflation expectations.

1. Inflation-indexed government bonds. (If you need a refresher on how a bond works, read the first part of this article.) A traditional bond is a stream of payments that is fixed in nominal terms: for example, $100 in 10 years, and 6% interest, paid semi-annually ($3 every 6 months). Such a bond is not inflation-indexed; if inflation goes up, the purchasing power of that $100 goes down, and it’s too bad for the bondholder.

An inflation-indexed bond, by contrast, pays an amount that is indexed to some measure of inflation. In the U.S., where these bonds are called Treasury Inflation Protected Securities (TIPS),  we use the Consumer Price Index. A TIPS bond may have a $100 face value and pay a 2% interest rate. However, every 6 months, that $100 face value is adjusted to reflect the change in the CPI, and the interest payment is calculated as a percentage of the adjusted value of the bond. Then, after 10 years, the bondholder gets back not $100, but $100 times the ratio between the CPI at the end of the period and the CPI at the beginning of the period. This way the bondholder is guaranteed a 2% real return (assuming he paid $100 for the bond), no matter what the rate of inflation is in the interim.

The implied inflation expectation, then, is the difference between the yield on an ordinary bond and the yield on an inflation-indexed bond with the same maturity. If the 5-year Treasury has a yield of 4% and the 5-year TIPS has a yield of 2%, then inflation expectations for the next five years are (about) 2% per year. The reasoning is that in order to buy the regular bond as opposed to the inflation-indexed bond, an investor has to be paid a higher yield to compensate him for the level of inflation that he expects.

Actually, in addition to expected inflation, the Treasury investor also has to be paid an inflation risk premium because, all things being equal, it is better not to have inflation risk than to have it. So the implied inflation expectation is actually slightly less than the spread between the regular and the inflation-indexed bonds. If you didn’t follow that, don’t worry, just remember that, roughly speaking, Treasury yield = TIPS yield + expected inflation.

2. Inflation swaps. These are a type of derivative contract, where the payments under the contract depend on the value of an inflation index, such as the CPI. The swap has a nominal value of, say, $100, but $100 never changes hands. Instead, at the end of some period of time, party A pays party B a fixed rate of interest on $100 – say 2.5% per year. At the end of the period, B pays A the cumulative percentage change in the inflation index over the period. Assuming A has $100 in his pocket, he has now hedged the inflation risk on that $100, because no matter what happens, at the end of the period he will get an amount that compensates him for the impact of inflation on his $100. The price of this hedge is $2.50 per year. (Because these are over-the-counter contracts, there many variations on this, including swaps with periodic coupon payments.)

For the same reasons described above, the implied inflation expectation is roughly 2.5% per year: party B thinks inflation will be less than 2.5% per year, and therefore is willing to take 2.5% and pay the amount of inflation; party A thinks inflation will be more than 2.5% per year, and therefore is willing to pay 2.5% per year to get the amount of inflation back. So the market clears at 2.5%. (Actually, for the exact same reasons as with bonds – party B has to be paid an inflation risk premium for absorbing the risk in this trade – the inflation expectation is slightly less than 2.5% per year. There are also some complications having to do with the lag in the publication of inflation indices, but let’s ignore that for now.)

One curiosity is that the inflation-indexed bond method and the inflation swap method can produce different estimates. Theoretically this should not happen, because if two products that will have the same price in the long term (since they are based on the same index) have different prices today, there should be an arbitrage opportunity. Why this happens in practice is discussed on pp. 5-6 of this Bank of England paper. (Thanks to Bond Girl for pointing out the paper.)

3. Surveys. You can also just ask people what they think inflation will be. Economists ordinarily prefer markets, under the principle that when people are paying money they are signaling what they really believe. But if you think there are sufficient problems with the markets you may want to go with surveys. Tim Duy has a post with a number of charts, including one of an inflation expectations survey.

So what do things look like today?

This is the historical graph for implied U.S. inflation over the next 5 years, based on TIPS. Remember, you are looking at 5-year inflation expectations as they changed over the last year.


In the dark days of October-December, inflation expectations were clearly negative: that is, the market was expecting deflation over a 5-year period. Things have picked up, but inflation expectations are still around 0.6% – far less than the 1.7-2.0% targeted by the Fed. And that 0.6% is before adjusting for the inflation risk premium, so inflation expectations are actually lower than the chart shows.

And these are current inflation expectations over various time horizons, again derived from inflation-indexed bonds. Note that they are sorted by value, not by time.


TIPS are not very liquid compared to regular Treasury bonds, and the implied inflation expectation numbers are sensitive to aberrations in both the Treasury and the TIPS markets (which have both been pretty aberrant recently). For example, if there is a shortage of TIPS of a given maturity, then the TIPS yields will be artificially low and the implied inflation expectation will be artificially high. Still, it seems like inflation expectations are on the low side, even when it comes to the 10- and 20-year time horizons. (I don’t know what’s going on with the 2-year number: when I look at the underlying bonds, it seems like it should be about -0.1%.)

For more on measuring inflation expectations, there is a short primer from the San Francisco Fed, as well as the Bank of England paper mentioned above.

By James Kwak

64 thoughts on “Inflation Expectations for Beginners

  1. Very good and didactic, with perhaps the exception of the following statement: “Once those higher wages are built into the contract, the employer is forced to raise prices in order to cover those wage increases, and inflation begins to ripple through the economy.” I didn’t think it was still fashionable for ‘progressive’ economists to subscribe to wage-push inflation theory. Could the employer perhaps raise productivity? Accept a lower profit? Doesn’t demand elasticity have anything to do with the issue? Oversimplification only causes confusion.

  2. Guilty as charged. It just seemed like the simplest way to explain the importance of expectations as opposed to actuals.

  3. Great article. Except the basic fact that short term increase of prices is not inflation. In free market all general price increasing stimuli like wages or crude are quickly balanced out. The only way CPI can rise for 100 years in row (like in the USA since 1913) is for the Fed to accomodate these stimuli by increasing supply of money.

    Inflation is purely monetary problem. Always and everywhere.

  4. Seems to me that mvoements in the inflation expectations index over this time frame correlate pretty closely with the changes in the price of oil (just eye-balling it, but would be interesting to run an analysis of this). If that is the case, then people essentially equate inflation with changes in energy prices, and not say – what the Fed is going to try to do.

    Since inflation has been low for so many years, there’s a built in bias assuming that the fed doesn’t cause inflation with their monetary prices. It’s just too murkey to think of in a pratical way (If I’m a union boss negotiating a labor contract today, how do I price in likely Fed mismanagement?) One day, the inflation expectations index is going to really jump when the connection becomes more obvious. And when that day happens, look out.

  5. I bought a small amount of 20-year TIPs at the January auction which yielded 2.5%. But not because of my expectation was that inflation WOULD be x%, but that high rates of inflation were a risk and a real return of 2.5% was acceptable on a very safe investment.

    I think a lot of money going into TIPs right now is along those lines. I can’t believe there are many people who feel they are capable of accurately predicting future inflation rates in this environment.

    Could part of the gap between TIP and swap derived expectations be that TIPs are far easier to invest in, and buyers therefor pay a higher inflation risk premium?

    Swaps aren’t available to someone like me, but I can buy TIPs in amounts as small as $1,000 nowadays.

  6. Great article.

    You have to be a little careful with TIPS, because the “index multiplier” never goes below 1. This matters if deflation is expected and you use on-the-run bonds to calculate the spread. At the end of November, the Treasury stopped incorporating data from off-the-run TIPS in their numbers.

    I do not know which bonds your Bloomberg chart is using. I also do not know if swaps have the same “feature”. (If we have deflation instead of inflation, does A pay B instead?) Although maybe it doesn’t matter, since people seem to be starting to believe that the Fed means business.

  7. Since inflation has been low for so many years

    Ex food, real housing and gasoline.

    If you included actual house prices in the CPI, inflation has been running 5%+ for the last decade. That’s why I think a deflationary collapse is inevitable, unless we go Zimbabwe, which we won’t. Instead, we’ll have a deflationary collapse (probably in slow motion, like japan) with the fed pumping money into the gaps, keeping banks relatively rich compared to the rest of the economy.

    Looking like a fun couple of decades to me…


  8. I agree. What a joke -> that inflation has been low – more manipulation of stats by the government.

  9. “Boo” & “hiss” for those drooling for inflation or inflationary expectations.

    I want a health dose of deflation. The quicker the better. That with a the breakup of big banks, new financial regs WITH enforcement, prosecutions of the crooks, a return to a focus on real wealth rather than phantom wealth and maybe, just maybe, we can start to reinvigorate ourselves and begin to grow healthfully.

    In the meantime, someone should be shoring up ways to make sure people have food and shelter. Cutting up the tents of people living in tent cities (such as was done in St. Petersburg, FL = is not a solution, but rather a heartless abomination.

  10. First, and I’ve always wanted an answer to this question, will the Austrian school zealots out there please explain to me how there was inflation in the 18th and 19th century if it is purely a monetary problem – and why did we have recessions and financial collapses during that wonderful time when there was no Federal Reserve bank, about once every seven years?

    With that said, as someone who works closely with the retired, I have seen how much the CPI has been low balled over the last decade. Anyone who spends a majority of their income on housing, health care and food as opposed to electronic equipment has seen a substantially higher inflation rate than what has been reported, which has been a tremendous weakness of TIPS, and the adjustments to SSI as well.

    As Dr. Kwak has observed from me before (as if he’s paying attention) I also don’t hold much faith in the market’s reading of future inflation or anything else. This recent crisis has reaffirmed to me that the markets are remarkably less efficient than economists would like to believe they are. I mean all markets whether measuring stock prices, currencies or inflation. Assuming the TIPS vs. Treasuries metric for example to determine even the expectations of inflation assumes that those who anticipate very low or very high inflation are in those markets. Those who are assuming runaway future inflation may very well be hording gold, etc.

    I certainly don’t see how inflation spikes anytime soon in this environment, but I also believe the economy recovers much faster than the sponsors of this blog expect, mainly for counter-intuitive rather than firm economic reasons.

  11. I don’t really understand why you think that everyone who finds some reason and economic sanity in the Austrian school is “zealot”, but anyway… Your question cannot be satisfactorily answered in a blog comment. I recommend Rothbard’s Mystery of Banking (, it can be quite an eye opener, if you don’t know how money is created and how banks work.

  12. Mr. Kwak,
    Keeping it simple for your fan-base? Were you surprised that Paris caught the mistake? Never underestimate the peanut gallery, James. Often, you know not to whom you speak :-)

  13. One thing that needs to be added here, perhaps, is that different sectors of the population may have different inflation (or deflation) expectations, and thus will act differently despite both seeing the exact same economic indicators (see: John Maynard Keynes’ concept of “propensity to spend”). For example, it is clear that right now the average consumer has deflationary expectations. He expects that his income in the future will be less than his income today, and thus he is taking actions to increase his savings rate because he feels that the money will be more valuable to him in the future than it is today. In essense, he is stuffing the dollars being printed by Bernanke under his mattress, since increasing his savings rate at the same time that banks are not increasing their lending rates leads to an effectively higher reserve ratio, and thus less money in the economy due to the multiplier effect of fractional reserve lending.

    But ah, those banks… and yes, *they* appear to have deflationary expectations too, viewing the money in their vaults as more valuable in the future than it is today, and thus holding on to their money rather than lending it out, but also may be acting based on long-term unstable inflationary expectations where they do not know how to properly assign nominal interest rates to their loans in order to obtain a predictable future actual rate of return. As a result, Ben Bernanke, in a recent speech before the NY Federal Reserve, basically admitted that the $4 trillion he’d lent to the banks were still sitting on his books at the Federal Reserve as deposits on account.

    In short, deflationary expectations appear to be defeating attempts at inflationary pressures by disappearing the freshly-printed money under (virtual) mattresses, where it contributes nothing to current economic activity, while long-term inflationary expectations by banks appear to be interfering with their lending activities by causing them to stockpile money until the long-term inflation rate becomes more transparent.

    So, how do these facts tie in to TIPS, inflation swaps, and surveys? Well. Not a whole lot when it comes to TIPS, actually. As others in this thread have noticed, the CPI is not a reliable indicator of overall inflation anymore due to the way it has been mangled and watered down over the years in order to prevent the necessity of paying full premiums for Social Security , TIPS, and other inflation-indexed government responsibilities. Inflation swaps… yes, the market is just *so* reliable in the short term, why, really *was* worth $1.2B despite never making money and never having any chance of making money. Over the long term inflation swaps might approach accuracy, but in the long term we are dead and there’s no easy way to know their accuracy in the short term, so dismiss them. Surveys? Well. I suggest that the most accurate survey here is a behavioral survey, not a “do you expect inflation in the future?” survey. If you examine people’s actual financial behavior regarding savings, borrowing, lending, and spending, you can attain an actual useful statistic for predicting economic activity in the near term.

    So: Do we face inflation in the near term? Bernanke is confident that he can un-print money just as fast as he printed it if the banks start actually lending out that freshly-printed money that they’re busily stuffing under (virtual) mattresses right now. Personally, I’m not so sure. Raising the federal funds rate isn’t going to unprint all that money printed via open market operations, and then we run up into the fiscal implications of open market operations, i.e., if Bernanke starts flooding the market with U.S. Treasuries and other debt securities in exchange for the dollars he’s been flooding the market with in order to un-print those dollars, not only will he be forced to undervalue them in order to sell them (and thus will end up un-printing fewer dollars than he printed to buy them), but he will also drive up the interest rates for those securities dramatically — which will have serious fiscal implications for the U.S. Treasury and its ability to sell debt at auction and overall debt costs, since the Treasury will have to pay a higher interest rate to get people to buy at Treasury auctions rather than buying these Treasuries that Bernanke is flooding the market with. In short, I don’t personally see any way we’re going to avoid inflation in the future, and if the stars align in the wrong alignment, we’ll end up with 1970’s-style stagflation again — i.e., not only inflation, but inflation in an era of high unemployment and declining economic activity.

    So the next question is: Is this bad? Well, maybe, maybe not. Inflation evenly distributed throughout the economy on both the consumer and producer sides of the economy will certainly help with the fundamental solvency issues confronting consumers, since inflation will decrease the actual (as vs. nominal) value of outstanding loans. On the other hand, unpredictable inflation interferes with the ability of banks to lend, since they have no idea what nominal interest rate will produce an acceptable actual rate of return, and that puts us into stagflation because that interferes with the ability of companies to leverage current income into future production.

    I guess the best way to put it is that capitalism works best when the fundamental token (currency) representing goods and services in the economy has a predictable future value, and leave it at that. Either deflationary or (more than mildly) inflationary expectations seem to have economic effects that are, well, not nice (to put it mildly).

  14. Middle,
    Inflation? Low? Don’t believe the hype. Have you noticed that the middle class in your country don’t seem to have the same purchasing power they had even 15-years ago? It is my understanding that years ago, a middle class wage earner could buy a modest home outside of a metropolitan city and raise a family on one income. I am not from America, but I understand that is pretty much no longer possible. So, in reality, isn’t that a very good measure of REAL inflation? A long-term look?.
    My 2 cents.

  15. MK,
    I do know EXACTLY what inflation is going to do. Are ya ready? It’s going to do one of these three things, ya ready? Here goes:
    1. Go up
    2. Go down
    3. Or, stay the same.
    I’m pretty certain this is what interest rates are going to do too. :-)
    Can I have my PHD now? LOL, too funny.

  16. Certainly his question can be answered in a blog posting. All fractional reserve lending produces money. Period. This is whether you are on a gold standard, silver standard, or fiat money standard, as long as the majority of financial activity flows through banks so that the money supply is a closed loop. Thus as banks lend out their reserves, money is created as the money flows in a loop back to the bank, so that $10 of gold turns into $100 of money in the money supply after it makes a few circles around (assuming a 10% reserve ratio). Thus inflation.

    When banks collapsed during this pre-FDIC era, on the other hand, all that virtual money on their books disappeared and only the 10% on reserve was left. 90% of the money they’d had on their books goes poof, up in smoke. Thus deflation.

    Again, this happens whether in a fiat money, gold standard, or silver standard environment. The only real difference, and the one that the “gold bugs” refuse to look at, is that if the Federal Reserve simply prints more fiat money to replace the money that disappeared to avoid deflation, or un-prints fiat money when strong bank-lending creates more money than can be absorbed via increased economic activity in order to avoid inflation, then you can avoid deflation *and* inflation. For this to happen requires a strong central bank whose sole purpose for existing is to maintain a stable value for the currency. If you have this, then you can maintain a stable currency in a way that you could *never* accomplish with the gold or silver standard, which are subject only to the whims of bank boom / collapse cycles with no possibility of printing or unprinting money to maintain stable valuation of money.

    In short, if you have fractional reserve lending, you have the boom/bust cycles that typified the world economy prior to the fiat money era. If you *don’t* have fractional reserve lending, you don’t have a modern economy, because you can no longer leverage current income to produce future economic output. Let us not forget that Britain built an empire upon which the sun never set via money borrowed via fractional reserve lending — and paid it back using the income derived from the thus-purchased empire. The British Empire happened because the British were the first to develop a fully realized fractional reserve banking system and thus out-competed all other nations that were grasping for empire. That is the sort of power that fractional reserve lending gives an economy, and economies which lack fractional reserve lending are simply incapable of competing against economics which have it. So if you are going to have a modern economy not subject to the whims of rampant inflationary/deflationary cycles caused by banking boom/bust cycles, fiat money is the only way you’re going to have it.

  17. The problem with deflation is that it raises the real (as vs. nominal) interest rate of existing debts, and thus serves to transfer wealth from the debtor class (i.e. most Americans) to the creditor class (i.e., the wealthiest Americans). If you are amongst the wealthiest Americans and have no debt and have significant cash on hand, I can see why you would want deflation. If you are anybody else, I am astounded as to why you might want deflation.

    As I’ve stated elsewhere, capitalism works best with a very mild but predictable inflation rate, just enough to encourage banks to lend rather than hoard cash and encourage people to spend rather than hoard cash but not enough to quickly render their capital reserves worthless. Wishing for deflation *or* for high/unpredictable inflation is a recipe for economic disaster.

  18. AA, you are confusing two different issues, income inequality and inflation. The middle class in the USA indeed does not have the purchasing power that they had 15 years ago, but that is largely because their income as a percentage of the national income has declined. On the inflation front, indeed there were significant sectors of the economy — housing, in particular — whose inflation rate far surpassed the inflation rate as a whole, due to relaxed lending standards allowing people to buy more expensive housing with the same income and down payment. Over time that drives up the price of housing until it reaches a point where people are no longer capable of meeting the debt obligations on the housing, at which point the price of housing collapses back to sustainable levels. (I.e., 2002-2006 bo2007-2009). But that has nothing to do with declining real income of the middle class, which is an income distribution issue rather than a case of unrecorded inflation.

  19. One morning a frog woke up from a long nights sleep on his lilly pad, only to find that he had outgrown his “Pad”. So, he swam over to the side of the pond and hopped down to the local bank. Mr. Frog decided he was going to go see his Banker, Mr. Paddywack, about a home improvement loan, to expand his “pad”.
    Mr. Frog went into the bank, and hopped into Mr. Paddywacks office, and sat down in a chair in front of Mr. Paddywacks desk. Upon seeing Mr. Frog, Mr. Paddywack said “Mr. Frog! How are you? What can I do for you?” Mr. Frog said, “well, Mr. Paddywack, I have been a customer of your bank for many years now, and I need a loan to fix up my pad, I need a pad-improvement loan.” Mr. Paddywack, being a good Basnker said “well Mr. Frog, what do you have to offer as collateral for this loan?” At that point, Mr. Frog reached into a bag he had carried with him, and pulled out the finest collection of small statues and Hummels that Mr. Paddywack had ever laid eyes on. Paddywack picked up the trinkets, examined them, and decided to get the advice of their Chief Credit officer and Lead Underwriter, Mr. Harrelson. Mr. Paddywack went to Mr. Harrelson’s office and laid the trinkets on the table and said “Mr. Frog is in my office, he wants a loan to fix up his pad, and he’s offering this junk as collateral, what shall we do?” He asked. Chief Credit Officer Harrelson took a fleeting look at the items laid out on his desk and said “These are nick-nacks Paddywack, give the frog a loan”.

  20. This post makes a point of noting that the discussion is of inflation expectations.

    Are inflation expectations a good predictor of actual inflation historically?

  21. Great post. I hope you will do more posts explaining inflation.

    During the housing bubble, I deferred purchasing a house because I was certain prices were inflated. At the time, I thought “when house prices turn, I will really be happy.”

    However, now that they have turned, my best course of action is less clear. If we are entering a period of deflation, then I should continue waiting. If we are entering a period of high inflation (wage inflation, particularly) then I should buy now. Worst of all, inflation may, or may not, be controlled by the fed, or the Chinese, or no one, and few sources seem to agree on whether we will have inflation or deflation.

    My point is that inflation is an area which is critical to my financial decision making, but also an area where there seems to be a lack of ‘actionable intelligence.’

  22. excellent post james. makes alot of sense. thank you. i have always said “don’t screw with MIT”. i mean that. very insightful writing.

  23. PLEASE GO TO THE 1:05 POINT OR THEREABOUT AND SEE THE REST OF THE MOVIE….zeitgeist the full movie on youtube.

    “ I believer that banking institutions are more dangerous than standing armies…if the American people ever allow private banks to control the issue or currency…the banks and corporations that will grow up around them will deprive the people of their property until their children will wake up homeless on the continent their father’s conquered.”

    Thomas Jefferson 1743-1826

    “ If you want to remain slaves of the bankers and pay for the costs of your own slavery, let them continue to create money, and control the nations credit.”

    Sir Josiah Stamp 1880-1941

    How much money has been loaned to the US Government (with interest) by the Fed (private banks) for the US Government to ‘bailout” the banks….imagine how much money the member banks are making on the interest to ‘allegedly” protect all of us from the world coming to an end as hank/ben cartel figure heads wanted to make us believe last fall?

    When we still get a DOW, lower than the last low, and there has been 20 trillion LOANED to OUR government at interest TO PERFORM THE BIG BAILOUT, then will anyone question the consider repealing the Federal Reserve Act?


  24. i stress this is a econ think tank. misc talking is not welcome. adios amigos if you have something to say besides a fable,,,go ahead. if not, read and follow. america is and will always be leading the way. we, believe or not, do respect each other. simon,, james good work. i will be in from time to time. let’s move forward.

  25. the problem i have is seperation of church and state. jefferson was adament about keeping it clean. the founding fathers did not want the religous part of society to intervene. it’s like they beieved in God but did not want to say. these pepole were brilliant. listen to our ghosts. after all,,,it’s really thier country.

  26. Dear Billy,

    Do you really think it is healthy to try to keep someone (even if it is adios ) from speaking? Is that a healthy way to advance ideas?

    Since James’ BE NICE post, he hasn’t attacked anyone here, so why do you think it is OK to attack him? I really don’t want an answer to that, it was said with hope that you would see that you were not ‘being nice”

  27. Bill,
    i stress that this is an economic think tank blog, not a discussion regarding the seperation of church and state. Bill, if you have something to say besides a religion/government debate….go ahead. if not, read and follow. simon, james….this is Adios Amigo…over and out.

  28. While TJ was a brilliant political thinker, he was no economist. While he could see a problem — that fractional reserve lending creates and destroys money and and thus can be used to create cycles of inflation and deflation that function to transfer the wealth of the masses to a small elite — he had no answer to that problem other than “ban fractional reserve lending” which is no answer at all since a modern economy requires the leverage of lending in order to decouple inputs and outputs and thereby create greater wealth.

    An example of the decoupling that I mention: For example, my company builds servers. If we get an order for 500 servers, we do not have the finances to buy the parts to build 500 servers and carry those parts on inventory for a month while building the servers and then waiting another a month for MegaCorporation to pay us. Instead, we get a loan with the parts inventory purchased with the loan as backing, then another loan to pay off the first loan with the accounts receivables from MegaCorporation as backing, and then pay off the receivables loan when MegaCorporation pays. Thus we manage to make $200K of net income when we needed $1M of cash to fulfill MegaCorporation’s order yet only had $500K of cash in the bank. Having access to a modern banking system allowed us to add much more to the economy — those 500 servers — than if a modern banking system did not exist.

    That’s just an example of the sort of leveraging allowed by a modern banking system. If you want a modern economy, you need that kind of power. The problem is, as mentioned above, the cycles of inflation and deflation that happen if the base money supply is a fixed amount of gold which is arbitrarily leveraged and de-leveraged via the operations of banking to create / destroy money. It took another set of great thinkers to finally figure out the problem, the problem being the gold standard that placed all creation and destruction of money outside of government control, and transition to a fiat system where a stable money supply could be maintained. As economist Paul Krugman has noted, those countries which abandoned the gold standard most swiftly during the Great Depression had the quickest recovery… but TJ wouldn’t have even been able to consider it, because he knew what money was — money was *gold*.

  29. Thank you for the courage and conviction James and Simon!

    Could you please give your opinion about where we are now, and how much more money our country can print before our currency collapses?

  30. The flip side is also true though. If wages don’t increase during an inflationary period people can’t pay their bills since the prices around them are going up while their debt remains the same.

  31. I’m not James or Simon, but here’s my answer to that. Our country can print basically an infinite amount of money, if the current situation continues where any freshly-printed money gets shoved under mattresses or locked away in bank vaults rather than actually circulated into the economy. Money which is locked up and never circulated is doing nothing to create economic activity, and you can have dump truck loads of such money and until spent it has no (zero) effect upon prices or economic activity.

    And the “until spent” is the problem here. If deflationary expectations turn into inflationary expectations, then the Federal Reserve ceases to be pushing on a string trying to get money actually circulating into the economy since people will then want to get rid of this money before inflation renders it worthless. The Fed then must bail, bail, bail as fast as it can to *un*-print the money that it printed or else you’re correct, the currency *will* collapse. Bernanke has announced that he has plans to handle this scenario, via open market operations, increases in the Federal funds rate, and increasing bank reserve requirements to destroy money faster than it can be shoveled into the system from under mattresses, i.e., pretty much all the tools the Fed has used in reverse to create the money in the first place. The problem is, these take *time*, and if people start shoveling money from those dump trucks into the marketplace to buy stuff because they think inflation is on the way, inflation *will* be on the way.

    In short, it’s not so much the amount of money being printed, as the time it’ll take to *un* print the money, that is the problem here. Given Bernanke’s plans, I seriously doubt that the currency will collapse. I do suspect, however, that once expectations turn from deflation to inflation that Bernanke is going to have to bail with every tool at his disposal, and my suspicion is that despite all his frantic bailing to un-print that money, we’ll still end up with a nasty case of Jimmy Carter style stagflation in the end because it will be as if all that money he’s been printing for the past six months all magically appeared in the money supply at once. No matter how fast you bail, you aren’t going to destroy money that took six months to print in much less than six months…

  32. Why do you have to have fractional reserve banking to do such a thing? You can have lending banks w/o fractional reserve banking.

  33. Thank you Badtux! You confirmed my fears, i was so hoping someone would say something to make me believe that the situation was different…wishful thinking is never a good policy….so thank you again Badtux! With this on the horizon, the housing realestate market should soon take off since people will try to avoid the Carter mortgages of 20plus percent!

  34. Agrotera, note that my guess is *just* a guess. An informed guess, but a guess no less. I’ve been wrong as often as I’ve been right, for example, at the start of this crisis I thought we were in a simple liquidity crisis and thus Bernanke’s attempts to inject liquidity into the market would be sufficient. Except that doesn’t work if the problem is actually a solvency crisis, as we have found out, because you’re pushing on a string at that point. So while I believe I am correct about what happens once deflationary pressures turn into inflationary pressures, maybe Bernanke has more tricks up his sleeve that I haven’t considered. We are literally in uncharted territory here — what Bernanke is doing has never been done before, though I’d of course read Bernanke’s papers and knew he’d talked about doing these sorts of things as his response to a new Great Depression if one happened to come around on his watch — so what will actually happen? I think I have a good guess, based on the data available to me, but I could be wrong this time too. Maybe Bernanke has some clever plan I haven’t considered. Maybe the economy turns up so slowly that inflationary expectations never build. Heck, maybe the horse will even learn to speak.

  35. Anon, you can have finance companies w/o fractional reserve banking, but having fractional reserve banking allows use of all the current assets of the people with money on deposit for leveraging current assets into future assets. That is, it is a magnitude of order difference in leveraging capability compared to economies that do not have fractional reserve banking, and any economy with fractional reserve banking will thus out-compete those economies which lack it. I do not think it is coincidence that the development of fractional reserve banking and the rise of the British Empire coincided in the same geographical location during the same period of time.

    The problem is how to tame fractional reserve lending so that it doesn’t result in the boom-bust cycles that TJ noted. FDR handled that one by de-coupling the money supply from the gold standard and thus allowing fiat currency to be created and destroyed in inverse ratio to the money created and destroyed via the action of fractional reserve banking. Fractional reserve banking is like corporations — nastiness which, alas, has proven necessary in order to achieve the necessary scale for a modern economy.

  36. Badtux, couldnt you have fractional reserve banking that isn’t directed by the grand master fed reserve chair? I know that it sounds radical, but when you consider that some are estimating that 20 trillion dollars is out now, thanks to monitary policy–and what fraction of that 20 T will be lost in an effort to keep the current system strong? It still seems that when a financial organization fails, it shouldn’t be kept alive with furure taxes paid by US citizens….and with the current power that the Fed has, combined with the support of the treasury, i think that is what just happened in the fall of 2008.

  37. James:

    I can see how managing inflation expectations can help control wage inflation as long as the “management” is credible and realistic. However, I don’t understand how this could be used to directly control price inflation. Were you specifically referring to wage inflation and any resulting effects on prices in your post when you say that the first step in managing inflation is managing expectations?
    Also, it seems to me that managing inflation expectations would also be important in how a currency is valued in forex markets. I would be interested in hearing your thoughts.

  38. The basic problem is one of decoupling the money supply from the operation of banks. You basically need a central banker under loose government control with a mandate to maintain a stable money supply, or you simply aren’t going to maintain a stable money supply. Winston Churchill supposedly said that democracy is the worst of all possible governments, with the exception of all others that have been tried. Various nations have tried all sorts of different methods for regulating the money supply and the current U.S. mechanism, while not perfect, is better than everything else that has thus far been tried, including the gold standard, which utterly failed because it decoupled the supply of tokens representing goods and services in the economy (i.e., money) from the supply of goods and services in the economy, and therefore led to boom/bust cycles of inflation/deflation that were not conducive to maintaining sustained economic activity.

  39. James:

    One more question. If the Fed buys Treasuries with an implied purpose of keeping yields low, aren’t they in danger of driving away other potential buyers who have inflation expectations above what the yield would provide? If so, it seems that they would be motivated to manage expectations as low as possible so they would not become the only buyer. A tricky proposition.

  40. James,

    Very good primer. One thing which would be interesting as a follow up (I have got pretty good at explaining it to friends and family now, but it took me a long time to get my head around – not being an economist) is why we care about inflation. Why some small amount of inflation is good, why, if hyperinflation is bad, the opposite – deflation – is not good etc etc.


  41. hyperinflation destroys purchasing power…deflation destroys asset values…like alter egos…the worst of both worlds….a one two punch in the face that we are in the process of enduring.

  42. As usual, an insightful analysis. I looked for some way to contact you or Mr. Johnson directly but have found none. I think your readers should know about the protests against the latest iteration of the bank bailout being planned around the country:

    It would be great if you could re-post the link as I believe many of your readers would gladly join us in the streets to prevent the american oligarchs from winning yet another round.

  43. I’m not James, but… one of the reasons to maintain your central banker as ostensibly independent from the government is that theoretically they will be making monetary decisions based on what’s necessary to properly regulate the money supply without regard for their fiscal impact upon the government. That is, your core assumption — that the Fed is buying Treasuries to keep yields low, rather than to print money during an era of deflationary expectations — appears dubious. At present there is no danger of the Fed driving away potential buyers of Treasuries because even though yields are effectively 0% right now, buying Treasuries is quite preferable to stuffing bales of $100 bills into your mattress (makes for difficulty sleeping due to the lumpiness of all those bales of money). As long as deflationary expectations hold true, this will continue to be the case.

    Once inflationary expectations take hold, you are correct, the U.S. Treasury would be forced to raise yields in order to attract sufficient buyers, with consequent dire effect upon the fiscal situation. Furthermore, assuming the Federal Reserve is performing its chartered role, the Federal Reserve will cease open market operations at that point, so will not serve as buyer of last resort for Treasuries. Assuming that the Federal Reserve is as quasi-independent as is purported by both its supporters and its detractors, this is what in fact should take place, and you are correct, yields on Treasuries *will* go up at that point, with subsequent dire effects on the federal budget.

    The thought that instead the Federal Reserve would continue printing money by becoming the buyer of last resort for the federal government leads to a scenario where one needs a wheelbarrow to carry sufficient cash to the store to buy a loaf of bread. I seriously doubt that anybody currently in the leadership of the Federal Reserve has given even a single thought to the notion of doing something so ridiculous. In particular, the notion that Ben Bernanke could somehow be forced into doing something so counterproductive is along the lines of the notion of President Obama as a covert lizard man from Mars sent to destroy America — it simply doesn’t pass the laugh and giggle test.

  44. Badtux – somehow I can’t find “Reply” button under your some of your comments, so I’ll answer here.

    Your explanation of fractional reserve banking is correct, although it contains a few “remarkable” statements.

    1. First is the age old argument that central bank is somehow more “competent” to keep the stable value of currency than gold standard (which those pesky gold bugs don’t realize). There are two major problems with this claim, empirical and theoretical. As for the empirical one, in 1813 the American consumer could buy the same amount of goods for 1 dollar asi in 1913, that means zero long-term inflation. Since the Fed, the great protector of our money, was established, the dollar was debased by approx. 95 %. That means that today the American consumer can buy for 1 dollar the same amount of goods he could buy in 1913 for 4 cents. So much for the competence of the Fed.
    And as for the theoretical one, you are making the same mistake as the people who favor big government. Sure, it would be great to have big government, only if the politicians were not people but angels, all knowing, unconditionally altruistic and pure of heart. Then we could rely on them to act only in the interest of their constituents. But since they are just people like us, they act mainly in their own interest and the more power we give them the more they will abuse it. And the same goes for central bankers. The central bank is not independent (remember famous Arthur Burns’ slip of the tongue “If we don’t give the politicians the monetary policy they want, we could lose our independence”?) and the central bankers are just fallible humans and they make mistakes. And the more power we give them the more serious their mistakes will be.
    So no, the central bank is not “competent” at all, central bankers are central planners that act on limited information and succumb to political pressures. The “gold bugs” favour the gold standard precisely because gold is impartial, neutral cannot be bribed, extorted or printed ad nauseam.

    2. “If you *don’t* have fractional reserve lending, you don’t have a modern economy” – in the words of late Rudy Giulliani, that is a truly extraordinary statement. It’s like saying if you don’t have doping, you don’t have modern sport industry. And when you’re saying “a modern economy requires the leverage of lending in order to decouple inputs and outputs and thereby create greater wealth”, it’s like saying athletes need the steroids in order to deliver better performance, which is somewhat dubious logic. Sure, FRB gives the economy the artificial inflationary boost, but it’s always followed by bust. We can discuss if it’s really worth it, if it wouldn’t be better to have much slower but also much stable growth, but that would be a matter of preferences and personal feelings and those usually lead nowhere. But I acknowledge there’s is a serious doubt if a call for banning FRB is a realistic one. That would be a debate I’d be really interested in.

    3. You’re claiming that what Fed is doing with the money supply now is not a problem, because it can always “unprint” the money and raise the rates. Sure, they have the right and the power to do so, but as I already said, the Fed is not really independent in their decisions. If they start to tighten, they will bring about serious economic problems, maybe a sharp recession, which is exactly what happened after Paul Volcker did the only sensible and necessary thing in the 1980s. Will Bernanke have the will and courage to deprive the addict of their drug? And if so, will he be lucky enough to do it neither too soon, nor too late? Let’s only hope.

  45. Badtux and Agrotera:

    What if you kept your money in the bank, while everyone else rushed to spend there’s? Interest rates skyrocket, so your CDs get paid 15% per annum.

    The high interest rates slam the housing market, as an example, and housing prices plummet as a result (as taxes rise, housing prices decline as a result).

    In a high inflation environment, the conventional wisdom is to buy hard assets because they will increase in value. Or take out loans because you will be able to pay off the loans with debased dollars.

    But as a contrarian, you play the “other side” of this coin–the cash side. A period of high inflation results in increased cash flow needs because of high interest rates, which in a relatively short time results in a corresponding decrease in the value of assets.

    As an example. If Bernanke today pushed interest rates to 15%, what would happen to asset prices, including home prices? They would plummet. He won’t do that, of course. But he will eventually.

    It’s the conventional wisdom paradox. If everyone’s doing it, it will be wrong.

  46. Regarding CPI, and in response to some comments above:

    This is a slightly complicated issue, and there are many who argue that the govt. intentionally understates inflation for political/economic reasons. However, there’s a strong case for lack of significant inflation in the cost of _basic_ food supplies and gasoline until about 4-5 years ago.

    So, through about 2004, the cost of _staples_ like bread, pasta, paper, etc. remained steadily low. Many consumer package goods companies saw their margins deteriorate as their products were increasingly commoditized, and they shifted toward value-added products to compensate (innovative packaging, new benefits, added ingredients). These new products are not necessarily comparable to old products in terms of ‘quality’ and so the impact of this trend of “upgrading” on the CPI is not immediate.

    Yet starting in 2003-2004, even the trend of decreasing prices in consumer _staples_ reversed. Commodity price increases drove price pressure, and gave consumer goods companies their first chance in several years to take substantial price increases across the board. Furthermore, improvements in consumer tracking technology have allowed retailers to become much more savvy about extracting money from consumers. (read about companies like Dunnhumby…

    On the other hand, companies like Walmart have streamlined supply chains of imported goods, allowing consumers to benefit more directly from the strong dollar (when it was strong). This helped keep the household average expenditure down – but with the deterioration of the dollar, we’ve hit the end of that road.

    In the case of fuel (oil), persistent low prices were largely driven by an extremely strong dollar that persisted through the 1990s, and then still remained somewhat strong through 2004. After 2004, however, it looks a little ugly.

    Meanwhile, nominal wages have remained relatively stagnant, leading to a real decline…


    And finally, CPI does not fully and immediately account for health insurance, college education, daycare, housing, or the requirement to have certain new technologies (cell phone, internet connectivity) to participate in today’s economy.

    So, CPI isn’t “lying” per se, but there are serious questions as to whether it has reflected the real increases in the cost of remaining a part of the “middle class”. And note that core CPI removes “highly volatile” items, like fuel.

    CPI is, perhaps, a better measure of the minimum cost of _surviving_ than the actual level of prices in a country.

  47. This myth that we had no inflation in the 19th century needs to be dispelled. The entire century was marked by 7-12 year, severe business cylces were we would get rampant inflation followed by rapid deflation. The fact that over the course of the century those cycles evened themselves out is not evidence of a better system. Look at Mark Twain, or U.S. Grant to see how well the boom and bust cycles worked during that era – and these were the smart and well connected.

    The problem with the Austrian school is not gold vs. fiat systems, it’s essentially a problem with govenment of any kind. I appreciate that government, that fallable people, should stay out of the money system – but that’s absolutely never going to happen. Going back to the gold standard would simply mean the Fed desingates the ratio of dollars to gold rather than the interest rates, same problem. The fiat money system works because it takes into account the reality of human systems and tries to make the best of them by having a combination of government officials and independent bankers. Much like our governmental system is not perfect, but tries to make the best of human nature by having co-equal branches of government, bi-cameral legislatures etc. It’s not the best system of government, but it’s the best we can come up with.

  48. Someone should point out that TIPs can never sell below their original par value. Therefore, a newly issued TIP is deflation protected. If you go back to say November or October of last year, when the author’s chart suggests deflation, the yields on newly issued TIPs were roughly 15 basis points lower than older TIPs, which lacked deflation protection. Some of that difference could be a liquidity premium. At any rate, even adjusting for the full 15 basis points, we should be reluctant to conclude that TIPs were predicting deflation.

    Another thing to consider is the extreme volatility of TIPS. How can the long-term TIPS go up and down by as much as 4% in a day? The value of a TIP should depend upon one thing: the expected real growth in the economy over the life of the bond. (They should depend upon inflation only to the extent that inflation could affect real growth) What are the growth prospects in the economy over the next 10 years? In October, TIPs predicted a real growth around 3.2%. Several weeks ago they were predicting growth of around 1.80. Currently, they are predicting growth of around 2.2%. Is the expected growth in the economy really one percent less today than it was in October? Should growth expectations, as predicted by TIPs, fluctuate so much?

  49. I suppose people make a distinction between say their medical bills that always seem to cost more and a more general basket of goods like staples. What I was trying to point out was people assume an inherent monetary stability due to recent experience.

    Let me give you a personal example from my time spent here in Ecuador. Ecuador is interesting becuase it has been dollarized for about 9 years. That was preceded by a local currency collapse in the late 90’s. The local currency (the Sucre) had a built in inflation bias that got out of control towards the end. People would not save their money in local currency, rather they would immediately switch to dollars. People equated inflation with monetary mismanagement. Now that it is dollarized, there is still inflation but local people here do not connect it with what the fed is doing.

    Once the inflation cat is out of the bag, it’s really hard to put back in check. Once the general public realizes that the Fed doesn’t know what they’re doing, its going to be a tremendous shock to the system. Inflation is no longer about permanent energy price increases or other external factors. It’s about the system itself. I’m not saying its going to look like Zimbawe, but we may be looking at something a whole lot more serious than the late 70’s and it could unfold at a frightening pace.

  50. Badtux:

    I was thinking that the Fed might be interested in keeping long term interest rates low as ONE of their goals to maybe help the housing market stabilize. Seems plausible to me. Let’s see if they ramp up their purchases if yields start to rise.
    I am not suggesting that the Fed will actually become the buyer of last resort, just that they may be motivated to be not completely forthright in their efforts to “manage” inflation expectations so they can continue to buy treasuries.
    I haven’t heard the lizard man from Mars theory before. I mean, doesn’t EVERYBODY know that scientists are still trying to determine if even unicellular organisms exist on MARS? That’s almost as funny as the image of Bernanke flying around in a helicopter dropping bales of $100 bills for people to use as mattress stuffing.
    Didn’t Bernanke make the claim in 2007 that the subprime mortgage problem was contained? I bet he wishes he had not said that now that he has to manage all these inflation expectations.

  51. “Someone should point out that TIPs can never sell below their original par value.”

    Actually I did point that out in my own comment above…

    “The value of a TIP should depend upon one thing: the expected real growth in the economy over the life of the bond.”

    Could you elaborate on this point? TIPS are priced in nominal dollars but they offer a real return, so shouldn’t their price fluctuate with the real value of the dollar?

  52. James Kwak…”Take the case of wage negotiations, for example: a union that believes inflation will average 5% over the life of a contract will demand higher wage increases than a union that believes inflation will average only 1%. Once those higher wages are built into the contract, the employer is forced to raise prices in order to cover those wage increases, and inflation begins to ripple through the economy.”

    This is not the whole story. Back in the high inflation 70s, many union contracts simply asked for a COLA indexed to the CPI. If wages merely keep up with the CPI, this should not generate a wage/price spiral under current theory.

    However, automatic COLA provisions did trigger a wage/price spiral. What current theory does not take into account is that workers cannot consume the same goods that recipients of newly created money have already consumed. For recipients of newly created money to be able to buy goods with the newly created money, workers must consume less.

    That is what has been happening for the last few decades. Workers get fewer goods per hour worked, and recients of newly created money consume the difference. Retirees were pushed to the edge of subsistence.

  53. The alleged myth of zero to low inflation of the 19th century may need to be dispelled…but you’re clearly not the one to be able to do it…better hire a hit man…your handle on economics is sophmoric at best and your ability to present an argument rather than your conjectural statements, like, “Going back to the gold standard would simply mean the Fed desingates(sic)the ratio of dollars to gold rather than the interest rates, same problem.”, clearly shows your amateur status. My question…from whence comes this confidence in your misinformed point of view?

    Bertrand Russell said, “The problem is, the stupid are cocksure and the intelligent full of doubt…”

    Why don’t you add a little doubt to your rhetorical style…you would gain some insight.

    res ipsa loquitor

  54. is it really an economic think tank blog? or a circus? you know see the animals do tricks.

  55. Why are the lags so hard to predict?
    So far, we’ve described a complex chain of events that links a change in the funds rate with subsequent changes in output and inflation. Developments anywhere along this chain can alter how much a policy action will affect the economy and when.

    For example, one link in the chain is long-term interest rates, and they can respond differently to a policy action, depending on the market’s expectations about future Fed policy. If markets expect a change in the funds rate to be the beginning of a series of moves in the same direction, they’ll factor in those future changes right away, and long-term rates will react by more than if markets had expected the Fed to take no further action. In contrast, if markets had anticipated the policy action, long-term rates may not move much at all because they would have factored it into the rates already. As a result, the same policy move can appear to have different effects on financial markets and, through them, on output and inflation.

    Similarly, the effect of a policy action on the economy also depends on what people and firms outside the financial sector think the Fed action means for inflation in the future. If people believe that a tightening of policy means the Fed is determined to keep inflation under control, they’ll immediately expect low inflation in the future, so they’re likely to ask for smaller wage and price increases, and this will help achieve low inflation. But if people aren’t convinced that the Fed is going to contain inflation, they’re likely to ask for bigger wage and price increases, and that means that inflation is likely to rise. In this case, the only way to bring inflation down is to tighten so much and for so long that there are significant losses in employment and output

    i disagree with the above. workers aren’t thinking about future inflation when negotiating contracts. but i do agree that it is a confidence issue that the fed is doing its job. it’s a delicate dance with interest rate manipulation. right now, we have a lot of room with future interest rate hikes. i really don’t want to hear that we have been keeping the middle class wages below normal to curb inflation. any takers?

  56. Badtux you seem to have much faith in Helicopter Ben. I hope you are right that this Master of the Universe can just perfectly play with the money supply to avoid inflation.

    I, however, do no subscribe to blind faith in a central planner. Given the FEDs past record I highly doubt they’ll be able to control inflation/deflation or the economy.

    You state:”For this to happen requires a strong central bank whose sole purpose for existing is to maintain a stable value for the currency. If you have this, then you can maintain a stable currency in a way that you could *never* accomplish with the gold or silver standard, which are subject only to the whims of bank boom / collapse cycles with no possibility of printing or unprinting money to maintain stable valuation of money.”

    Has the FED really maintained a stable value for the currency? Has the FED really been able to prevent bank boom / collapse cycles? These are important questions, and questioning the necessity of the FED is totally legitimate.

  57. How can it be legitimate when the fed member banks stand to gain so much with the “monitary policy” that is mandated as part of the fed’s job? And every crisis that “requires” money to be printed and sent into the system, is money made by these private entities. Additionally, the primary dealers who trade treasuries are always at an advantage as if frontrunning because they know what is moving the market because they are doing it!

    What about the essay Common Sense…doesn’t that have any applicability to what is going on today?

    If all of the systems were about to fail when the fed and treasury got together to ask for TARP 1, they could have used their effort to ask for money to protect the money in the banks like the FDIC insurance does, instead of dropping it into the black hole for the fed banks to skim their benefit from and for the people on the other side of the black hole to catch ( i won’t name names)

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