Two Speed Inflation: Implications for policy around the globe (Summary)

Opening Remarks

URATA Shujiro (Chairman, RIETI)

This year's symposium, entitled "Two Speed Inflation: Implications for policy around the globe," will explore measures to address inflation. Inflation is a major issue worldwide. The consumer price Index temporarily exceeded 10% from the same month in the previous year in the Eurozone, 8% in the U.S. and 4% in Japan for the first time in 41 years. This directly affects the livelihoods of citizens in developing countries and threatens the stability of their governments. The World Economic Forum's Global Risk Report 2023 cited the cost-of-living crisis as the largest current risk. On the other hand, so-called “two-speed inflation,” in which rising costs on the producer side are not fully reflected in consumer prices, is also a major challenge. In Japan, more than 20 years of deflation have resulted in an entrenched structure in which consumers do not allow companies to raise prices even when their costs increase.

Today's symposium will be composed of three sessions. Session 1 will include a presentation by Prof. Tommaso Monacelli from Bocconi University and a Research Affiliate of CEPR, followed by a discussion on the topic by a RIETI Faculty Fellow, Ippei Fujiwara, professor at the Faculty of Economics at Keio University and Australian National University. Prof. Refet Gurkaynak from BilKent University and a research fellow on CEPR will chair this session.

Session 2 will include a presentation by Prof. Ester Faia from Goethe University and a fellow at CEPR, followed by a discussion led by Dr. Nao Sudo, Director and Head of the Economic and Financial Studies Division of the Institute for Monetary and Economic Studies at the Bank of Japan. This session will be chaired by Prof. Fujiwara.

A panel discussion will follow in which Prof. Faia, Dr. Sudo and Prof. Kosuke Aoki from the Faculty of Economics at the University of Tokyo will discuss the causes and consequences of diverging inflation rates. This discussion will be chaired by Prof. Gurkaynak.

Session 1: Monetary and Fiscal Policy with High Inflation

Tommaso MONACELLI (Professor of Economics, Bocconi University / Research Affiliate, CEPR)

The subject of my presentation is Monetary Fiscal Coordination in Periods of Surging Inflation. The traditional view is that conquering inflation should be a duty of monetary policy. Fiscal policy aside from that isn’t well understood. Should it complement or substitute for monetary policy? Should it be expansionary during periods of tightening monetary policy, risking a surge in unemployment and an economic slowdown? Should fiscal policy be tightening?

All over the world, the monetary policy response to rising inflation has been a rise in interest rates. The fiscal policy response has been largely expansionary to shield lower income families from the burden of rising energy prices. To summarize the position of the IMF’s World Economic Outlook on the monetary-fiscal policy relationship during periods of rising inflation, we should stay the course to restore price stability and fiscal policy should aim to alleviate the cost-of-living pressures while maintaining a sufficiently tight stance aligned with the monetary policy. However, different countries are employing different combinations of fiscal and monetary policy. Some countries are pairing monetary tightening with fiscal loosening while others are pairing it with fiscal tightening.

The modeling framework I will use is a minimal deviation from a standard representative agent New Keynesian model to allow for distribution. That means having two agents: one is an agent—a permanent income consumer—while the other is a hand-to-mouth consumer whose consumption is basically tied to current income. I will speak of fiscal policy in terms of transfers. Inequality in consumption is the difference in consumption between the saver and the hand-to-mouth agent. This inequality variable is a function of two main elements: transfers and aggregate economic activity.

If x is a parameter that signals the elasticity of consumption of the hand-to-mouth agents to aggregate economic activity during periods of recession, and x > 1 (i.e., the income and consumption of the hand-to-mouth agent react more than proportionately to aggregate income), the inequality equation says that during economic booms, aggregate consumption rises. This likewise has the effect of lowering inequality—when consumption rises, inequality falls. One monetary policy tradeoff in the context of this account is that increased transfers decrease inequality directly. In addition, there is a general equilibrium effect which causes transfers to affect aggregate demand. If x > 1, the income of hand-to-mouth agents over-reacts, and inequality falls further. The amplification of inequality requires central bank intervention to engineer a recession plus deflation to return it to a zero-inequality steady-state allocation.

There is a trade-off: it is impossible to stabilize inequality at zero and at the same time engineer aggregate demand stabilization. The monetary policy maker will feature a welfare objective to stabilize inequality.

I will now engineer an inflationary shock by introducing a cost-push shock which drives inflation independent of the output gap. This generates a surge in inflation and a contraction in economic activity. It's a “stagflationary” shock: a supply-side shock that generates a divergence between rising inflation and the output gap. I’ll model a period of high inflation in which inflation is surging and economic activity is falling. The central bank is trying to tighten monetary policy and inflation is rising.

The cost-push shock generates rising inflation and a contraction in economic activity while also increasing inequality. Real activity falls because the shock is stagflationary. The policymaker now needs to engineer a transfer on the fiscal side to the constrained agents—the hand-to-mouth agents—to stabilize inequality. In a period of high supply-side inflation generated by a cost-push shock, fiscal policy should be expansionary. This is the main takeaway from the model. Monetary policy should be used to stabilize a cost-push shock. Government spending in the face of a cost-push shock should be counter-cyclical.

It's important to remember that short-term fiscal policy should be expansionary through transfers or government spending, but that in the long run, the government should be expected to engineer a fiscal contraction to stabilize government debt in the future. If monetary tightening is not supported by the expectation of appropriate fiscal adjustments in the future, fiscal and monetary policy will actually clash. Monetary policy would be tightening, raising interest rates, but this would generate a vicious circle of rising nominal interest rates, rising inflation, economic stagnation and increasing debt.

For the proponent of the fiscal theory of inflation, inflation is always and everywhere a fiscal phenomenon when it is persistent, meaning that when expectations that government debt will be stabilized in the future are lost, and go out of control, fiscal policy takes over. The independence of the central bank and the autonomous ability of monetary policy to control inflation is lost and we enter a regime of fiscal dominance.

The long-run expectation of debt stabilization remains key. Otherwise, monetary policy loses the ability to control inflation. This question is critical for the U.S. and the Eurozone today. It's not entirely clear that fiscal policy is cooperating with monetary policy in the U.S. or in Europe to keep inflation under control.

Refet S. GURKAYNAK (Professor of Economics, Bilkent University / Research Fellow and Director of the Monetary Economic and Fluctuations Program, CEPR)

Your presentation begs the question of how 30 years of very expansionary Japanese monetary fiscal policy resulting in a total debt-to-GDP ratio of 250% did not succeed in creating much higher inflation.

FUJIWARA Ippei (Faculty Fellow, RIETI / Research Fellow, CEPR / Professor, Faculty of Economics, Keio University / Professor, Australian National University)

According to the traditional view, monetary policy must actively respond to the inflation rate—the real interest rate—not the nominal interest rate—must be raised to reduce aggregate demand. In order for monetary policy to be successful in stabilizing prices, fiscal policy must be passive (Ricardian). When government debt increases, governments should increase taxes or reduce expenditures.

However, fiscal policy needs to take into account redistribution after the supply-side shock to address increasing inequality when the recession happens. This needs to be expansionary. While monetary policy is increasing interest rates to reduce aggregate demand, fiscal policy tries to increase aggregate demand. In this sense, monetary and fiscal policy are substitute in the short run, but in the long run they are complementary. In response to inflation, taxes must be increased and/or government expenditures reduced.

This paper offers some very important messages. One is that fiscal policy should be expansionary in periods of high supply-side inflation, which is in line with the IMF’s view. However, long-run expectations of debt stabilization are key because persistent high inflation is always a fiscal phenomenon.

The first point I would like to comment is the time inconsistency of the sustainable fiscal policy. After the Global Financial Crisis, there's a significant increase in debt. Although we can see some signs of debt consolidation in Germany, in many countries, debt is increasing. COVID-19 further increased debt massively. In recent decades, the world is repeatedly faced with unprecedented crises: the global financial crisis, COVID-19 and the Ukraine war. It’s very difficult to engineer short-run expansionary fiscal policy while allowing for long-run fiscal contraction in this environment. In Japan, which is entering the super-aging society, structural factors, such as aging, make fiscal consolidation even more challenging.

My last, minor point concerns the elasticity of income to aggregate income for the hand-to-mouth agent. This paper assumes that x > 1, leading to relatively smaller consumption for hands-to-mouth households – supposed to be poor househoulds in this paper. In contrast, several papers have pointed out that the consumption of the rich is more volatile and pro-cyclical, and that rich people's consumption declines more in recessions. I would therefore like to see some empirical evidence to support the assumption that x > 1.

Refet S. GURKAYNAK:
Activist fiscal policymaker minding fiscal policy and through that, minding the hand-to-mouth consumers. This doesn’t make fiscal policy overall expansionary. It may be possible to maintain neutral fiscal policy and redistribute the taxes of savers to hand-to-mouth consumers. Why isn’t letting aggregate stabilization be the responsibility of monetary policy and redistribution be the responsibility of fiscal policy part of the optimal policy regime?

Tommaso MONACELLI:
This is a simple model. In principle, fiscal policy can be neutral, but it definitely should not move in the direction of tightening. If taxation is progressive to ensure that transfers from savers to hand-to-mouth consumers is maintained, the model shows that government spending should be expansionary. Fiscal policy can be neutral in relation to government debt, but it shouldn’t be tightening while monetary policy is tightening. The model supports this view provided that the longer-run view of debt stabilization is not lost.

Refet S. GURKAYNAK:
I think a natural corollary of your point is that you want to let monetary policy focus on the aggregates and let fiscal policy pick up the pieces on the distributive side, making sure that sustainability is not sacrificed.

Session 2: Firms' Inflation Expectations: Implications for U.S. and Euro area

Ester FAIA (Professor, Goethe University Frankfurt / Fellow, CEPR)

Ester Faia discussed the role of information experiments on firm for policy making. Monetary policy makers increasingly rely on survey responses to gain an assessment of the agents' expectations. Most surveys are done with households or professional forecasters. Surveys on firms maybe of more informative as firms are also price setters. There is an increasing literature building randomised control information experiments on firm expectations, particularly inflation expectations. Those may provide useful insights on the the developments of firms inflation expectations, their response to shocks and their implications for monetary policy. Beyond that randomised control experiments proved a full causal setting.

SUDO Nao (Director and Head of Economic and Financial Studies Division, Institute for Monetary and Economic Studies, Bank of Japan)

(Please note that usual disclaimers apply and the comments are of myself and not of the BOJ or the IMES.)

My first comment is about the interpretation of the results. The authors regress the prior-posterior gap on the cross term of the perception gap, and also on the prior of an aggregate variable, such as CPI. The interpretation of the first is quite straightforward, but that of the second is difficult to understand. Does the explanatory variables, if significant, say that the respondents’ updated expectations systemically correlate not only with the size of the shocks but also to the level of the prior?

I have two more comments. A good number of recent works on household inflation expectations has revealed that there are observations that are difficult to understand. For example, in one survey, Japanese households’ perceived inflation and inflation expectations are reported to be both 4% when CPI in Japan was about 1%. I am curious if firms are the same or they are different from households.

My last comment is about firms' heterogeneity in terms of information processing. The paper argues that firms treat information homogeneously. However, in your survey data, apparently there are firms that report substantially different numbers from the rest of the firms regarding the macroeconomic variables. That suggests that some firms may be very inattentive while others are very attentive and knowledgeable about the macroeconomic environment.

Session 3: Panel Discussion "Causes and Consequences of Diverging Inflation Rates"

AOKI Kosuke (Professor, Faculty of Economics, University of Tokyo)

I would like to discuss implications of much higher long-term interest rates in the United States for the yield curve control in Japan, and differential inflation expectations across countries.

Comparing the Japanese yield curve with those of the U.S. and Germany, there are several interesting differences. The Japanese interest rate is extremely low compared with that of the U.S. The 30-year yield is only about 1-2%. The high interest rates in the U.S. make it more difficult for the Bank of Japan to implement the yield curve control. When the U.S. interest rate increases, we could anticipate either an increase in the Japanese long rate or a depreciation of the Japanese yen, which creates inflationary pressure through the pass-through effect to inflation.

When the U.S. rate increases, then either through UIP or through exchange rate depreciation and the BOJ's response to inflation, people tend to expect an increase in the future interest rate. Given that the Japanese short rate is already at a lower bound, it's not so easy for the BOJ to control long-term interest rates.

Turning to inflation expectations, a survey conducted in August 2021 and April 2022 by Professor Tsutomu Watanabe at the University of Tokyo in five countries revealed interesting results. The Japanese responses differed greatly from those of the other countries. In 2021, not many Japanese answered that prices would increase significantly, but by 2022, more and more respondents believed that prices would increase.

The survey also asked what people would do if the price of a product that they usually buy at the supermarket increased by 10%. In 2021, many Japanese respondents said that they would switch to a different supermarket. This may explain why Japanese firms were so reluctant to raise prices for fear of losing customers. This response was more pronounced in Japan than in the other countries surveyed. However, the April 2022 survey indicated a shift in attitudes. Fewer respondents said that they would switch supermarkets in the face of a price increase. This change may encourage Japanese supermarkets to increase their prices because they feel more secure in doing so.

Ester FAIA:
First of all, in terms of inflation development, we see both demand and supply shocks, in contrast to the seventies in which oil price shocks were dominant. Firms’ inflation expectations and prices are also more linked to strategic complementarities given the increasing market concentration and the rise of the mark-ups.

On the other side wage inflation spiral may be overlooked. It is believed that nowadays the wage indexation is less widespread than in the seventies, but this is not always true. In many European countries inflation indexation is still widespread.

Furthermore, it shall be noted that convenience yields may explain many of the differences in inflation development across countries. Safe currencies such as the U.S. Dollar or the euro and the Swiss franc have larger convenience yields than others. This may feed into the expectations of agents and eventually affect inflation.

To project the term structure of the interest rate it may be useful also to examine household investment decisions. Those may provide some information on their expectations for future developments of interest rates.

SUDO Nao:

(Again, please note that usual disclaimers apply and the comments are of myself and not of the BOJ or the IMES).

To respond to the third question about differential inflation expectations, the BOJ has conducted assessments regarding monetary easing policy in 2016 and in 2021. This slide uses the results of the assessments that compare how inflation expectations respond differently to changes in actual inflation in the U.S., Japan, Europe and the UK.

θ is the coefficient attached to the observed lag in inflation and it is large for Japan relative to other countries, indicating that the pass-through from the actual inflation to inflation expectations is more sluggish in our country. It is possible that θ is not really a fixed structural parameter and changes over time. However, the BOJ’s two assessments point out that θ is fairly unchanged.

These results do not imply inflation expectation does not change for good. This slide here shows changes in household inflation expectations based on a survey conducted in 2019 when inflation was very low and those conducted in 2022, respectively. It is seen inflation expectations actually increased from 4% to 8% in the current years.

The fifth question can be decomposed into two parts.
What is new this time and what is it that we don't know?

To respond to the first part of the question, I think there are two important differences between the 1970s and today which make the re-emergence of very serious inflation potentially less likely. The first is that we have learned from the experience of the 1970s. There are various aspects to learn from the experience such as a potential cause of the inflation and the needed policy reaction.

The second observation we have is about R-star, or the long-run real interest rate. Before the pandemic, we had a period of low interest rates for a prolonged period of time. Several works address the linkages between the low prolonged real interest rate (R-star) and demographics. The panel here shows the average life expectancy for the U.S. and Japan and the impact of longevity on the real interest rate computed from an overlapping generational model. Life expectancy increased from around 70 during the 1970s in both countries to around 75 in the U.S. and 85 in Japan. People live longer today, meaning that they accumulate more savings, resulting in a lower real interest rate. If this is the case going forward, we should expect low interest rates to persist going forward as well.

Now for the second part of the question: what is it that we don't understand? I think we should continue learning how inflation expectations are formed by households, firms and possibly by participants in financial markets. For example, quantitatively, inflation expectations constituted a very important part of the actual inflation during the 1970s.

AOKI Kosuke:
I would like to respond to the question about what’s different about inflation this time. In my opinion, the difference between the current situation and the inflation of the 1970s is the level of government debt. This is especially true for the Japanese economy. Monetary tightening often means a transfer from the public to private agents in the form of interest payments. Such payments can have an expansionary effect. To counterbalance this, the government has to increase negative transfers via taxes. However, since Japan has a huge amount of debt compared with its GDP, even a small increase in the interest rate can result in a massive increase interest payments. This presents a challenge to the standard policy prescriptions, such as raising the interest rate.

Ester FAIA:
On the role of monetary policy, currently policy makers make larger use of communication as a policy tool contrary to the seventies. This is also since the interest rate was kept at zero for long and policymakers had to rely on alternative policy instruments.

Regarding fiscal policy, one has to consider also its additional distributional consequences. Under non Ricardian equivalence (this is true for instance in models featuring hand to mouth consumers) expansionary policy reduces the extent of agents precautionary savings and may have unintended consequences for debt sustainability.