What is the outlook for inflation and interest rates today? Consider four scenarios.
Low interest rates and low inflation.
Low interest rates and rising inflation.
High interest rates and high inflation.
High interest rates and falling inflation.
We went through these four scenarios in sequence in the period 1964 to 1984. In November of 1964, the interest rate on three-month Treasury bills was 3.64 percent. The Consumer Price Index that year rose 1.28 percent. This was the low interest rate, low inflation period.
By 1976, inflation was 5.74 percent. Although the interest rate in November, at 4.75 percent, was higher than in 1964, it was lower than the rate of inflation. In that sense, the interest rate was low, and we were in scenario (2).
In 1980, we were in scenario (3). The interest rate in November stood at 13.73 percent, and inflation for the year was 13.55 percent.
In November of 1984, the interest rate was 8.61 percent, and the inflation rate was 4.30 percent. We were in scenario (4).
In terms of a narrative, we started out in 1964 with a reasonably balanced economy. But then we increased government spending to pay for the Vietnam War and domestic Great Society programs, and much of this higher spending was financed by issuing paper, not by tax revenue. This created inflationary pressure.
As interest rates remained at or below the inflation rate in the early 1970s, households and businesses had incentives to borrow and spend. Upward pressure on inflation persisted. Finally in 1980 interest rates caught up with inflation, and the higher interest rates eventually caused inflation to subside. By 1984 the bond market was still wary of inflation (economist Edward Yardeni coined the phrase “bond market vigilantes”), so that interest rates were high even though inflation was trending down.
What about today? Since the late 1980s, we have been mostly in scenario (1), with low inflation and low interest rates. This is in spite of large Budget deficits, especially those of the past two years. Old-fashioned macroeconomics would have predicted that these deficits will cause higher interest rates, higher inflation, or both. In contrast, Modern Monetary Theory says that unless we are at full employment, deficits will cause neither higher interest rates nor inflation.
Today, financial markets expect inflation to subside and interest rates to remain low. Are we all Modern Monetary Theorists today? Not quite. Some of us still believe in old-fashioned macroeconomics.
At the moment, we are in scenario (2). The interest rate is close to zero, while the inflation rate is close to 10 percent (just annualizing the CPI increases of the most recent months). The markets and MMTers expect us to settle back comfortably into scenario (1). But I see history telling a different story.
Looking at 1968-1976, scenario (2) is one in which interest rates are too low to keep inflation from accelerating. It will be followed by scenario (3), in which inflation and interest rates are at high levels. Only when we suffer though scenario (4), with interest rates well above inflation, will inflation recede.
One important difference between today’s situation and that which prevailed from 1964-1984 is that the amount of government debt outstanding is much higher—100 percent of GDP today, compared to about 25 percent of GDP back then. That means that an increase in interest rates will require much more government spending just to pay back holders of government debt.
In other words, if we do experience scenario (3), in which inflation remains elevated and interest rates start to catch up, then we may be in a state of fiscal crisis. What that scenario might look like is a topic for another essay.
Meanwhile, let’s hope that the markets and the MMTers are correct, and that I am the one who is wrong.