Sep 5, 2022

Hanno Lustig on Fiscal Dominance, Inflation, and the Effects of Long-term Interest Rate Decline

The specter of fiscal dominance looms large over monetary policymaking, and this could have serious economic consequences for the US and Eurozone in the future.
David Beckworth Senior Research Fellow , Hanno Lustig

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Hanno Lustig is a professor of finance at Stanford University and a senior fellow at the Stanford Institute for Economic Policy Research. Hanno is also a former guest on Macro Musings and rejoins the podcast to talk about fiscal dominance, global inflation, interest rates, wealth and equality, and Eurozone challenges. David and Hanno also discuss how to reconcile Treasury yield movements with impending fiscal dominance, why we’re seeing a long-term decline in real interest rates, the early trends in post-pandemic inflation, and more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Hanno welcome back to the show.

Hanno Lustig: Thanks, David. Thanks for inviting me back on. I'm really happy to be here.

Beckworth: Well, it's great to have you on. We had a great time the last time you were on this show just over a year ago, and I understand you've been a busy man since then. You've been traveling around Europe, giving seminars, thinking about the Eurozone crisis. So, give us an update.

Lustig: That's right. I spent the past year in Europe on a sabbatical. I spent most of my time in Switzerland in Lausanne at EPFL. That's an engineering school, but it has a terrific finance group and they were gracious enough to host me for the year. And I took advantage of the opportunity to travel around Europe. As you know, Europe is experiencing some challenges on the macroeconomic front right now within the Eurozone. And so it was a really interesting, fascinating time to be in Europe and to learn about how the Eurozone is dealing with all these challenges.

Beckworth: Yes. And I hope we have time to get to the Eurozone. It's our last topic. We may not, but I do want to mention, as we set out that you've been very busy along with Ben Moll and a few others discussing the economic implications of the Russia Ukraine war. You've been very thoughtful and it's been interesting to see that commentary coming from folks inside Europe, with the European perspective who are also economists. So, it's been great to follow you on that conversation.

Lustig: Well thank you. Yes. So, as you know, Europe is heavily dependent in terms of its energy supply on Russia. And so in the past a couple of months after the invasion of Ukraine, Europe has continued to import gas and oil from Russia. And some people have argued that this really didn't matter because the Russians couldn't use it for currency. They earned from these export revenues because basically nobody wanted to trade with the Russians. But Ben Moll, Luis Garicano, and myself, and many others have been trying to argue that's really not a very plausible way to look at the world and that we have to recognize that. As long as we keep importing gas and oil from Russia, that we're directly funding Putin's invasion and we're contributing to a longer war in the Ukraine. And I think we have to, as Europeans recognize our responsibility there. So, I was happy to do my bit in trying to get that message across.

As long as we keep importing gas and oil from Russia, that we're directly funding Putin's invasion and we're contributing to a longer war in the Ukraine. And I think we have to, as Europeans recognize our responsibility there.

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Beckworth: Are you hopeful that this war will end soon? I mean, will the Russians eventually have to quit just through attrition and running out of resources, or do you think this is a prolonged struggle?

Lustig: This is obviously way outside my area of expertise.

Beckworth: Sure.

Lustig: But I am concerned that the Europeans will eventually grow tired of the indirect effects of the war on Europe's economy and will start to alleviate some of the sanctions that have been imposed on Russia. And so I'm worried that these efforts at isolating Russia economically will eventually fail. That is my big concern. I hope I'm wrong about that, but I'm starting to see some signs in Europe that the front might be crumbling. And that is my main concern.

Beckworth: Well, one more question about Europe and then we'll move on to fiscal dominance. But one silver lining from this, at least in my view is that this energy crunch or the lack of energy coming from Russia has really forced countries to reconsider their energy policies. And so Germany is thinking about keeping nuclear reactors online and other countries are thinking of making new ones, even in the US, there's this new push or new embrace of nuclear energy, which for me is long overdue. Do you think that's going to be a lasting trend in Europe or not?

Lustig: I tend to agree with you. I think this has been a wake-up call. As you know Germany has been in the process of shutting down most of its nuclear power plants over the last decade or so, especially in the wake of the Fukushima disaster. But I think if you're sort of rational, you have to recognize that when you're weighing the probability of a nuclear mishap in one of these nuclear power plants, which of course they're small, they're not negligible, but they're small. If you're weighing that against the cost of being completely dependent on a country like Russia, for your energy supplies, I think most reasonable people will conclude that they ought to take an order closer look at nuclear energy as a fairly clean and reliable source, at least for the foreseeable future. And so I'm hopeful that Germany and other countries will reconsider nuclear energy as a viable source of energy in the next decade or so at least.

Beckworth: Yeah, same here. And I also hope they look at geothermal energy and other alternative forms of energy just beyond renewables. Ones that can make a meaningful difference. Okay. Let's move on to our first topic, fiscal dominance and inflation.

I'm hopeful that Germany and other countries will reconsider nuclear energy as a viable source of energy in the next decade or so at least.

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Fiscal Dominance and Inflation

Beckworth: So, you have written a lot that touches on this area. Last time you were on the show, we talked about your paper titled *US Government Debt Valuation Puzzle,* really fascinating to look at how do we reconcile the market value of debt with the standard asset pricing theory of government debt. And you have a more recent paper that touches on this as well, titled *What Drives Variation in the US Debt/Output Ratio? The Dogs that Didn't Bark.* So, you've written a lot on fiscal solvency issues, public finance concerns in the US and other places. But particularly in the US, because it's so unique. And on Twitter, we've had conversations about this idea of fiscal dominance. So, maybe for our listeners spell out what is fiscal dominance and what are your thoughts about it being something we need to worry about in the future?

Lustig: So, the notion of fiscal dominance comes from a paper that as you know, was written by Tom Sargent and Neil Wallace, about 40 years ago. In fact, last year was a 40 year anniversary of the paper and there was a conference in their honor. And what they had described was essentially a game between central bankers and fiscal policymakers. And the basic idea is quite simple. They say, look, essentially the budget constraint, the government budget constraint, will at the end of the day, always be satisfied. The question is: how? If fiscal policymakers can move first and commit to a path of deficits, they might force central bankers to accommodate them and ultimately print money and create inflation. That is a fiscal dominance regime. That's what they had in mind when they talk about fiscal dominance.

Lustig: But there is an alternative outcome where central bankers credibly commit to low inflation and they force fiscal policymakers in turn to follow and run large surpluses instead. So, essentially what Tom Sargent and Neil Wallace envisioned is a game of chicken between these two actors. And their concern is of course that in some scenarios central bankers will blink. They'll blink and as a result, they'll be forced to accommodate fiscal policymakers. And when I translate their work to today, I think we're not only concerned about central bankers directly creating inflation by printing money, but we're potentially also concerned about the potential outcome of financial repression where real interest rates are just kept artificially low in a regime of what most people would call financial depression. I think that's an alternative description of what fiscal dominance would mean today.

Lustig: Is that a reasonable concern? Well, personally I think it is. If you look at the US, the Congressional Budget Office, as you know, makes these annual projections. They're not forecasts, they're just projections based on current law. What the Congressional Budget Office does is it says, look, here is the path of surpluses or deficits that we anticipate the federal government will produce. And those don't look very promising.  The Congressional Budget Office projects deficits of around 3.9% between 2021 and 2051. That really puts us on a path that puts the debt to GDP ratio at around 200% in 2051. Again, these are projections, they're not forecasts. They're not in the business of trying to forecast fiscal corrections. Nevertheless, that does suggest that the US might not be on a fiscally sustainable path. And that obviously raises concerns about how the central bank, the Federal Reserve would respond to what fiscal policymakers seem to have embarked on.

Beckworth: Great description there, Hanno. Let me kind of step back and look at this basic idea of fiscal dominance and you spelled it out very well. But it's just so fascinating to me from an intellectual perspective, because when you think of macroeconomics in the US, at least during the 1980s, 1990s, maybe early 2000s, this period of great moderation and one of the heroes… at least some people would attribute the Fed, the central bank, doing this great job… managing price stability, keeping the economy relatively stable.

I think we're not only concerned about central bankers directly creating inflation by printing money, but we're potentially also concerned about the potential outcome of financial repression where real interest rates are just kept artificially low in a regime of what most people would call financial depression. I think that's an alternative description of what fiscal dominance would mean today.

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Beckworth: And the focus is just on the central bank. You look just at the central bank is doing all this heavy lifting. But what you're suggesting and what's implicit in this story is that there's got to be behavior behind the scenes from fiscal policy that helps support the Fed during this period. So, we previously had Eric Leeper on the show and he had a paper I really liked. A 2010 Jackson Hole paper titled, *Monetary Science, Fiscal Alchemy.* And he has this term in the paper, "the dirty little secret," and he describes it as follows. For monetary policy to successfully control inflation, fiscal policy must behave in a particular circumscribed manner. So, for the Fed to be successful, you got to have your fiscal house in order and making decisions that lead to that path. And what you've suggested is maybe we are not on that path going forward. So, fiscal dominance would change that calculus. Fiscal policy and the US Treasury would require the Fed to provide seigniorage to support, to keep the government solvent, at least in nominal terms. And your worry is that we might be headed down that path.

Lustig: That's right. So, if you look at the fiscal fundamentals, when Volcker took over at the helm of the Fed in the early 80s, they were quite different. The US debt to GDP ratio was into the 30% range. The US was actually running small primary surpluses. So, we were in a very different fiscal situation. And in that situation, Volcker had enough room to maneuver. He raised interest rates quite dramatically. That had a major impact on the federal government's cost of funding. It pushed R far above G. If you look at R as the return on the entire portfolio of treasuries, that number went way up as a result of Volcker's actions. But it didn't really cause a lot of fiscal trouble for the federal government because it was in a very different situation. And so right now, of course, we're in a regime where the debt to GDP ratio is well above a hundred percent. If you just look at the federal government, I'm not even taking into account the debt of local and state governments. The government has embarked on a path of primary deficits for the foreseeable future, unless there is a large fiscal correction. And so I think Eric Leeper is absolutely right to say, look, in that kind of a situation it is natural to think that bond market investors will start to potentially be concerned about how this will be resolved. And one way as you suggest is for the central bank ultimately to blink. And that could happen in a number of different ways.

Lustig: It could happen simply by monetizing deficits, but it could also happen in more subtle ways, trying to manipulate the yield curve, engage in some form of financial repression to try and accommodate the federal government's spending. So, I think that is a very plausible way of looking at things. It's going to be much harder to credibly fight inflation if households and investors are concerned about the underlying fiscal situation, that is essentially the point that Tom Sargent and Neil Wallace made, is that ultimately central banks don't have complete control over inflation because there is this game of chicken in the background.

Beckworth: So, what about a place like the Eurozone? We were just talking about it. The central bank is in some sense, very separate from the government. I mean, I know it's linked to the EU and there's laws written. But in the US, they're clearly linked. And you write down a model, there's an intertemporal budget constraint, a government budget constraint that shows a linkage between money and government finances. But how would you think about this in terms of the Eurozone?

Fiscal Dominance in the Eurozone

Lustig: Right. The Eurozone is a very interesting case to study right now. Because what we're seeing in Eurozone is worrisome from the perspective of fiscal dominance. We've seen the ECB try to embark on a path of quantitative tightening as the Fed has done in the US. And they've run into some strong headwinds. Right away what happened, and this is how many observers have predicted by the way. So, this doesn't come at a complete surprise, is that yields in the periphery and especially in Italy started to shoot up. Why did this happen? Well, over the past couple of years, the ECB had essentially crowded out private investors in sovereign bond markets. They had absorbed more than the issuance. And what essentially had happens is that the ECB lost track of what the true willingness to pay was of private investors for IOUs issued by countries like Italy.

Lustig: So, that's worrisome because what you see here is that the ECB then immediately had to backtrack and come up with an anti fragmentation program. That is what they called it in order to try and control these spreads. They rolled out something called the TPI, the Transmission Protection Initiative, which is designed to try and cap spreads on peripheral debt. It's worrisome because this is exactly what you would anticipate in a fiscal dominance regime, where essentially the member states of the Eurozone, who by the way, have a large degree of fiscal sovereignty, much more so than US states in the US. They've essentially chosen a path of deficits and the ECB is being forced to accommodate that path.

Lustig: And what's fascinating about this is that members of the governing council of the ECB last year were giving speeches saying, do not be concerned about fiscal dominance. We're not in a regime of fiscal dominance. We're simply coordinating monetary and fiscal policies. And they said, the reason that this is obviously not fiscal dominance is because we're simply in the liquidity trap. And so there's no danger of us ending up in a fiscal dominance regime. One year later, what we realize now, when we're clearly no longer in a liquidity trap, we have achieved liftoff from the zero lower bound, but the ECB is still being forced to accommodate fiscal policymakers. So, that I think is very concerning.

Lustig: Can we learn from the Eurozone when you translate that to the US? well, it's definitely, I think, a warning sign. Obviously the fiscal architecture of the Eurozone is much more complicated. And so perhaps that is something that we should talk a bit more about. There are obviously big differences between the dollar zone, the US, and the Eurozone. And by the way, I should acknowledge that the ECB as a result faces a much more complex task as a result of this.

One year later, what we realize now, when we're clearly no longer in a liquidity trap, we have achieved liftoff from the zero lower bound, but the ECB is still being forced to accommodate fiscal policymakers. So, that I think is very concerning.

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Beckworth: It's more complex Hanno, but it still illustrates this linkage that's kind of lurking underneath the surface. And that linkage between fiscal policy and monetary policy. And so even though the EU doesn't have a common treasury, common fiscal policy of a meaningful size, the ECB is effectively doing fiscal policies, is what it sounds like.

Lustig: Yes. That is certainly one way to think about it. Now, obviously, if you talk to folks at the ECB, they would definitely push back against this. For one thing, the ECB does not have a mandate to engage directly or indirectly in fiscal policy. They actually have a very narrow mandate to pursue price stability. Their mandate is much narrower than the Fed’s mandate. In fact, it explicitly says that they can only pursue other objectives that are consistent with the European union's economic objectives, if it doesn't come at the cost of price stability. I think the legal wording is without prejudice to price stability. So, these are very strong words and they severely limit what the ECB can do. So, when they talk about this, and this is what worries me a bit, is they use different language. They couch this in terms of, well, we're protecting the monetary transmission mechanism.

Lustig: So, their view of things is, look, if spreads in Italy start to move for reasons that are not justified based on Italy's fundamentals, we have to intervene to protect the transmission of monetary policy. The problem with that description, I think, is that I'm not sure market participants will believe it. I think market participants will probably think, “hmm, I think what you're really doing is you're accommodating fiscal policymakers.” The other challenge I see is that it's hard to see how a central banker in real time would be able to sort out what part of variation in spreads can be attributed to fundamentals and what part cannot. That to me seems like an impossible task. So, I think they've set out on a mission that is potentially dangerous for two reasons. One is it doesn't fit neatly into their mandate. And the other one is it does sort of seem to create the impression that fiscal policymakers in member states are moving first and the ECB is kind of left to accommodate them.

Lustig: There's one more concern, which I think central bankers should be worried about. Which is that if you are perceived to be providing a backstop for fiscal policymakers, you actually may inadvertently give more power to populists who don't behave responsibly. And I think we've seen an example of that recently in Italy, where populist forces have actually forced the Draghi government to fail and Draghi was forced to resign. I'm not saying the ECB is directly responsible for this, obviously. But it is certainly true that if you provide a back stop, then there are less incentives for politicians to choose wisely when it comes to fiscal policy.

Beckworth: So, if the demands on the ECB get enough. So, right now you could say implicitly or effectively, the ECBs doing a little fiscal policy on behalf of Italy and maybe other countries in the EU. And maybe you could argue that backstop was always there implicitly because you didn't have a common treasury to allocate resources across the EU. But going forward, if the demands become really intense… So, it becomes very apparent we got fiscal dominance at work… Do you think the ECB at some point would say, no? I mean, does it have the ability to say no? Because it is very independent. I mean, much more so than the Fed is, say, to the US government. Is the ability there and the desire there to say, no, we won't cross say this line right here, which will push us completely into subservient to these countries?

Lustig: That's a great question. And David, I can't say I have a clear answer to that. I would say that the history of the Eurozone has been exactly about this, about investors trying to figure out what the exact nature is of the implicit agreements and coordination between monetary and fiscal policy. I was rereading Tom Sargent's Nobel prize lecture last week in preparation for this podcast. And what Sargent says is, look, at the end the day, monetary and fiscal policy are always coordinated. The budget constraint will be satisfied, but it might be in obscure ways and the more obscure the coordination is, the costlier it is. There's going to be more uncertainty. And so you definitely want to avoid these sort of obscure coordination mechanisms. And it seems like the Eurozone has chosen a very obscure coordination mechanism and it leaves investors struggling to figure out where the backstops are and who ultimately is going to be paying for all these deficits that member states will probably be seeing over the next few years.

Lustig: So, that is exactly the challenge that investors face. What's interesting about the history of Eurozone is that right after the Euro was created in the early 2000s, we were in an environment where bond market investors had essentially decided that they were indifferent between Italian bonds, German bonds, Spanish bonds, Dutch bonds. They were essentially trading at the same yields, which is kind of remarkable because the fundamentals were radically different, very different debt to GDP ratios. As you probably know, there were these Maastricht criteria that you had to satisfy in order to become a member of the Eurozone club. But they weren't enforced very tightly and so even at the start of the monetary union, there were big differences in debt to GDP ratios. But bond market investors initially ignored them. Around comes the great financial crisis in 2008 and then things changed. So, it looks like initially bond market investors had decided there must be backstops and guarantees.

Lustig: When the great financial crisis arrived, these backstops were tested. Bond market investors were proven right, partly at least. There were backstops. Countries did receive at least partial bailouts. The big message that was sent I think is that the ECB does not want to tolerate countries trying to default or restructure their debt even. And so what they've embarked on instead is a path of trying to get countries back on a fiscally sustainable path. The problem is that for some countries like Italy, that path may only be viable if real rates remain extremely low, if your debt to GDP ratio is 150%, and your economy is not growing. And this is a shocking fact about the Italian economy, it really hasn't grown in real terms over the past decade or so. Then that severely limits the path towards fiscal sustainability. It's a very narrow path. And I think the ECB has inadvertently maneuvered itself into a position where it has to try and keep Italy on that path. And that's going to be a tough one to execute without causing collateral damage, I fear.

Beckworth: Yeah. And just to flesh this out a little bit more, and then we'll go back to fiscal dominance in the US. But let's say that's what the ECB does. It keeps rates really, really low, negative even, for the sake of Italy. What that would mean for a place like Germany though, is overheating. That'd be far below the fundamentals of what would be warranted in a Taylor rule, in a place like Germany. So, you would see higher inflation in Germany, which would kind be a real loss to them as well as it would affect their real exchange rate. And so you effectively would see real transfers from Germany to Italy by the fact that the prices would be different in these two countries. And so you're still forcing this transfer. I mean, there's both… you could think of the transfer by backstopping the spreads, but also there'd be a real transfer in terms of different prices causing trade flows and real exchange rates to adjust in a way that mimics or effectively creates real resource flows from one part of the European union to the other part.

This is a shocking fact about the Italian economy, it really hasn't grown in real terms over the past decade or so. Then that severely limits the path towards fiscal sustainability. It's a very narrow path. And I think the ECB has inadvertently maneuvered itself into a position where it has to try and keep Italy on that path. And that's going to be a tough one to execute without causing collateral damage, I fear.

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Lustig: That's right. So, I talked earlier about this sort of obscure coordination between monetary and fiscal policy and one of the effects would be that you're effectively generating large transfers from one set of countries within the Eurozone to another set of countries. And as you pointed out, that raises some important questions like is that sustainable? Are the citizens of these countries going to accept these transfers? If you look at real rates at the short end of the maturity spectrum in Europe, they are deeply negative, even now. If you look at Belgium where I'm from. I was born in Belgium. The short rates on deposits is still close to zero, but the actual inflation rate is around 10% and has been there for a few months now. So, essentially the rate at which depositors… and that's a large fraction actually of the population, as you know stock market participation in Europe is much lower than in the US…

Lustig: -the rate at which these households accumulate wealth is, well, it's deeply negative. And obviously that can't go on for too long. So, there are these implicit transfers that are the results indirectly, perhaps of ECB policy. And I think it'd be interesting to do more work, to try and quantify these transfers. And that's not a trivial task. It would involve actually looking at the portfolio composition of a typical German household, a typical Italian household, a typical Dutch household. And then try and think, well, how do these very low real interest rates affect these different portfolios and what is ultimately the impact on welfare of households in these different countries? And that I think is something that central bankers haven't really grappled with, but it's a very important question.

Beckworth: Well, I just think it's so fascinating because it's still a transfer of real resources, but without explicitly doing it. If you told the Germans, hey, we're going to tax you and send money down to Italy, they would be screaming. They'd be probably protesting in the street. But if instead you cause Germany's real exchange rate to go up and Italy's to go down, and so maybe more Germans travel to Italy for vacation, or they buy Italian goods and there's effectively the same thing happening… It's harder to see and maybe they can't put their finger on what, something's not right. But they know, and they can't connect to pieces of the puzzle. But it's doing the same thing. So, I think it's very fascinating. It speaks to this complex and more subtle approach. But let's go back to fiscal dominance in the US because we touched on that earlier and you highlighted the condition, the CBOs projected primary deficits, as far as the eye can see. You mentioned close to 200%, I believe, by 2050.

Beckworth: We just added around five trillion dollars to the US national debt. So, we're about a hundred percent of debt to GDP ratio. And of course those CBO forecasts or primary deficits have always been smaller than what's actually materialized. In fact, one of your papers speaks to that. I mean the forecasts have always been more conservative than what actually has occurred. So, that paints a very grim picture, and one where you could see fiscal dominance taking hold. And then I would add to that, the Federal Reserve seems pretty confident. I mean, I want to just briefly state their official statement of long run goals and monetary policy strategy, it's like their constitution, states, “the inflation rate over the long run is primarily determined by monetary policy.” So, they're taking a monetary dominance view. So, you have potential for fiscal dominance, the Fed doesn't see it.

Beckworth: And here's another party that doesn't see it. And I want you to help me reconcile this with the grim facts you outlined. The second party that doesn't see it appears to be the bond market itself. So, the 10 year Treasury right now is about 2.8, last I checked. 30 years around 3%. And some of that's come down a little bit because of fears of a recession. But still we added all of that debt. We have these grim forecasts and yet the Treasury yields have a real hard time getting far above say 3%. So, how do you reconcile that with the facts that you outlined earlier that look like fiscal dominance on the horizon?

Reconciling Treasury Yield Trends With Impending Fiscal Dominance

Lustig: Yeah, this is a great point. I think you're absolutely right. The bond market right now in the US doesn't seem to anticipate a fiscal dominance regime where the Fed is forced to accommodate fiscal policy by just monetizing deficits. A couple of things I want to mention here is one thing, we should be mindful of the fact that in the US, the Federal Reserve has also, through its quantitative easing program and its large scale asset purchases, had a major impact on yields for the past couple of years. If you exclude T-bills the Federal Reserve during the pandemic has bought consistently more than issuance. And obviously that has to have a major impact on bond yields. In March, when the Fed embarked on a path of quantitative tightening, what you saw when you looked at real yields is that there was a dramatic increase. I think TIPS yields went from minus 1% to around 0.8%.

Lustig: So, that's 180 basis points increase in a month and a half, two months. A large part of that increase has subsequently, interestingly been reversed. And we can talk about why that happened. I think that's because the bond market thinks that the Fed is not going to keep tightening as much as they originally thought they would. But what that tells me is that as soon as the Fed signals that it's going to stop these large scale asset purchases, bond markets respond in a quite dramatic way. It's not as dramatic as what we've seen in the Eurozone. But it does suggest that perhaps the Fed had been really distorting the long end of the yield curve. Because these are quite dramatic moves in real interest rates we've seen, to go from minus 1% to 80 basis points in a matter of weeks. That is quite dramatic when you look at TIPS yields. I'm not going to say it's unprecedented, but certainly it’s…

Beckworth: It's huge. Yeah. Yes. For sure.

Lustig: If you look at mortgage markets, by the way, you've seen even bigger moves. Very dramatic increases in mortgage rates since the Fed announced in March, that it would stop its large scale asset purchases. So, there is a sense that perhaps when we look at the bond market that the signal has been jammed. So, that's, I think, a more general point that we have to be aware of. So, monetary policymakers rely on the bond market to provide signals, which I think is a very natural thing to do. The problem arises when your policies directly impact, especially the long end of the yield curve, you might be looking at your own shadow. And I think that's almost inevitable. Even now, even though the Fed announced the end of its quantitative easing program, bond market investors will anticipate that if there are bad shocks in the future that the Fed might reembark on a program like this one. I think that's very likely and that's going to be priced in. So, the point more generally is that I think maybe central bankers have more control over real rates, even long term real rates, than we previously taught. And there's actually some evidence recently uncovered by academics that supports this view. And maybe we can talk about that later. But you think that's important thing to keep in mind.

The point more generally is that I think maybe central bankers have more control over real rates, even long term real rates, than we previously taught. And there's actually some evidence recently uncovered by academics that supports this view.

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Beckworth: Yeah. I like the way you framed that the central bank, the Fed, is casting its shadow on the long end of the yield curve. That's the nice way to frame it. So, my question to you though, is how big is that shadow? And I'll concede that the Fed kept rates really, really low, longer than needed during this pandemic. And they signaled through their Summary of Economic Projections, even though that's a conditional statement or forecast. It definitely created the impression they're going to hold rates at zero through 2023, 2024, and markets priced that in and so long term yields, in addition to QE, both of those really held down rates, and arguably held them down below the neutral rate or the equilibrium rates. And that's one reason we saw this big surge in inflation or one of the reasons we saw the surge in inflation. But if I go back, Hanno, like 30, 40 years, I see a long secular decline in real rates, across many countries, advanced economies in particular. And yes, let's concede that maybe the Fed and the ECB definitely tweaked things around recently. But how much of that decline do we want to attribute to central banks versus secular forces, demographics and other things like that?

Explaining the Long-term Decline in Real Interest Rates

Lustig: That's a great question. And I think we don't have a clear answer yet. So, certainly I'm not going to deny that there are structural forces like demographics, you mentioned slow down and growth in most advanced economies that have put downward pressure on long term real rates. And you do see evidence of that around the world. But I think in the past decades, especially since the great financial crisis, I think the impact of actions of central banks around the world have been quite dramatic on the long end of the yield curve. And a great example of this, I think, is Japan. And Japan actually is an interesting country to think about, especially in the context of the question of coordination of monetary and fiscal policy. So, when you look at the Japanese flow of funds, you notice that the bank of Japan has actually been absorbing more than issuance.

Lustig: If you exclude T bills since 2015, private investors, as a result, have been net sellers of Japanese government bonds since 2015. So, there it's clear and undeniable that the long end of the yield curve probably is not really reflective of the marginal willingness to pay for a bond in the marketplace. It's just sort of set by the bank of Japan. In fact, they have an explicit policy of yield curve control. There's some interesting questions when you start thinking about this that I think we should think more about in macro and finance, like how can they get away with that? So, the first thing any finance grad student would say is, well, why don't hedge funds short these bonds, because obviously they're overpriced. And hedge funds occasionally, I think, try to take short positions in Japanese government bond markets, but that typically involves quite a bit of pain and there are limits to arbitrage.

Lustig: We've known that for a while. And I think that's what potentially lets the bank of Japan [inaudible] the long end of the yield curve for long periods of time. I just give Japan as a dramatic example of what central banks can do. And I think there's definitely a lot more work to be done. Going back to your question in terms of sorting out how much can be attributed to fundamentals and how much can be attributed to what the central banks have been doing. With respect to this, there's this important concept in monetary policy called R star, which is sort of this notion of the long term equilibrium real rate. And there's some important work that was done by John Williams, actually, trying to figure out, how do we measure this thing, because it's an important ingredient into the monetary policy making process.

Lustig: And what he came up with in joint work with Laubach is a really interesting way of trying to figure out how R star moves over time. Essentially looking at past interest rates through the lens of a sophisticated filtering mechanism. And what they document is a large decline in R star over the past decade and a half, maybe from, say, 3% all the way down to 0.5%. And this has had a major impact on the way central bankers, not just in the US, think about where they should set rates. But what I'm worried about and other people have, by the way, expressed this concern as well, is that central bankers are really looking at their own shadow there.

Lustig: They're looking at the consequences of their actions over the past decade and a half where they've consistently kept rates very low. And then that leads them to conclude that there are these structural forces that force long term, real interest rates to be very low. And so they're in some sense navigating by stars that they're manipulating themselves. And I worry that can throw them off course quite dramatically. So, I think we should reexamine the evidence of the decline in R star and maybe consider a possibility that what we're really picking up there is, to a large extent, the effect of Fed policy… and this by the way is relevant not just in the US, but it's also very relevant in the Eurozone, I think.

I think we should reexamine the evidence of the decline in R star and maybe consider a possibility that what we're really picking up there is, to a large extent, the effect of Fed policy… and this by the way is relevant not just in the US, but it's also very relevant in the Eurozone, I think.

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Beckworth: I guess, to be fair to the central bankers and to Fed officials, for example, it's hard to know the counterfactual here. And so let's go pre pandemic. I think pandemic, you make a strong case that they overdid it. And in fact, we have prima facie evidence, inflation goes through the roof, even accounting for supply side inflation. I think most economists would agree that some of that inflation was due to an overheated economy because policy was too accommodative, but let's go back to 2010. So, 2010 say to 2019, and it could be the case the Fed is casting a shadow on yields, but the Fed doesn't know that for sure. And for example, the Fed tried to raise rates several times and it weakened the economy. So, 2015, 2016, it is talking up all these rate hikes and instead, what happened… the dollar goes up and it kind of slows down the global economy a little bit and bleeds into the US.

Beckworth: Or 2018 it was tightening rates. In fact, it was inverting the yield curve back then in 2019, it backed off because it saw what was happening. And we had low inflation during this time. The labor market continued to grow with these rates. So, if I'm looking at just basic output gaps or inflation, new Keynesian model… if I'm doing that, I can understand why they would interpret that previous decade as, they're just kind catching up or falling down to the R star. Now I know there's another argument some make, and maybe we'll get to this in a minute about asset prices blowing up during this time. But how do you think about that? I mean the previous decade, low inflation, slow growth. How would you wrestle with that?

Lustig: That's a great point, and I think we should acknowledge that the job of the central bankers is very complex and so they have to, in real time, try to figure out, well, what is this R star? What is the equilibrium real rate of interest? What is the natural rate of unemployment? There are all these ingredients into the monetary policy making process. And most of these are really hard to measure, but you mentioned a couple of really important data points. So, one is valuations in financial markets. I think central bankers ought to come to terms with the fact that when they're in the business of moving long term interest rates, there's going to be first order effects on valuations in the stock market and in other asset markets. And what we've seen is in fact, consistent with that, we've seen valuations rise dramatically in stock markets, not just in the US, but we've also seen house prices go up dramatically.

Lustig: And all of this is consistent with the notion that real rates are quite low relative to the growth rate of the economy. And so as a result of that, we see multiples go up in asset markets. And so perhaps central bankers ought to be more mindful of the effect they have on valuations, because that has potentially important ramifications for things like the wealth distribution for wealth inequality. And maybe… but that's a harder question even for actual consumption inequality, ultimately. So, that's, I think, one important fact to consider. What really worries me more generally, is that coming out of the pandemic, if you looked at where interest rates were relative to say an old school Taylor Rule or any other sort of metric, there were completely out of whack, it wasn't even close, right? In March, if you did sort of an old school Taylor Rule, even with the Fed’s new R star of 0.5%, you would expect to see fed funds rates in the vicinity of 5%, and instead we were still at zero.

Lustig: So, that's a huge gap. In the Eurozone these gaps are even larger. And so that raises some red flags that perhaps our models have been drifting and we've been drifting off course, and that there should be a major reexamination of how we navigate when we're setting monetary policy, because it does seem like we were pretty far away from where we ought to be coming out of the pandemic. Of course, having said that, the pandemic was a really large and in some ways an unprecedented shock, we didn't have a lot of data we could rely on to predict what was going to happen. And so in that sense, it's a very complex thing to navigate for central bankers.

Perhaps central bankers ought to be more mindful of the effect they have on valuations, because that has potentially important ramifications for things like the wealth distribution for wealth inequality...but that's a harder question even for actual consumption inequality, ultimately. So, that's, I think, one important fact to consider.

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Beckworth: Yes, and the Fed itself has acknowledged they should have acted sooner. I mean, Chris Waller had a paper that he presented at the Hoover Monetary Policy Conference where he said, I think these are exact words, "Had we known then what we know now we should have tightened starting in the middle of 2021." And Chair Powell has said as much as well that they should have tightened sooner. And so maybe give him some grace, because this was a pandemic, but clearly it does seem in hindsight, that policy was too accommodative relative to where a neutral rate would be, the Taylor Rule or any kind of prescribed mechanism. It is interesting, Chair Powell gave a talk, I believe 2017 or 2018, at Jackson Hole about navigating by the stars. And he made this point: we shouldn’t. We should rely less on them because they are so hard to identify, so hard to follow. And that speaks to your point that if we follow too religiously… say the Williams 0.5%, we might get something wrong. So, I guess we need more robust rules or more robust ways to do monetary policy that acknowledges our ignorance in moving forward.

Lustig: And another thing these, sort of, past two years has taught me is that central bankers are… they're just people like you and me and they're subject to the same biases. So, if you look at the sample that they've personally lived through in their professional lives, for most of people on the FOMC or on the ECBs governing council, they really haven't seen high inflation in a long time. Maybe for some of the most senior people they've seen inflation in their professional lives in the 80s, but that's a long time ago. And I think one thing we all have in common as humans is that we put way too much weight on recent experience. That's just a very natural thing to do. We're natural extrapolators, and there's some great work, for example, by Ulrike Malmendier and Stefan Nagel on this very topic documenting that when people develop expectations about macro variables, they put a lot of weight on what they have seen.

Lustig: And these central bankers hadn't seen inflation in a long time. And I think in a way it almost led them to put not enough weight on the models, but instead sort put more weight on, well, what they had recently seen. And what they'd recently seen is that they were consistently, as you were saying, undershooting their inflation target. And I think as a result of that, they were probably consistently saying things like, “well, I think this spike in inflation is transitory.” I think if you sort of think about this underlying bias, that's sort of a very natural outcome. This is a point that Jason Furman made in a column he wrote on this very topic. When I was a kid, I thought I wanted to be a pilot and I took flight training. And when they teach you how to fly in bad weather conditions, what they actually do is they put on a hood, because your natural tendency, when you're in the clouds as a pilot, is to look outside.

Lustig: But that actually is a bad idea, because if you trust your instincts and you rely on the horizon, you see you're actually going to end up flying upside down in the clouds. And so they force you to look at your instruments only by putting on a hood. And so it's almost as if central bankers kind of instinctively took off the hood. And instead of relying on the models that they had, they were just looking outside and saying, well, we haven't seen inflation in a long time. This is probably a not real. So, that's a very, I think, natural tendency we all have and central bankers are no different in that sense.

Beckworth: Hanno, you're a very talented man. I didn't realize you're a pilot as well as an economist.

Lustig: Well, I wasn't a very good pilot. That's why I became an economist.

Beckworth: Well, no, it's great to hear that. I know you do sailing. You do flying. You do economics on the side. So, very fascinating. But going back to the Fed maybe following its gut or taking for granted that inflation would be low. I mean, I'm in that camp too. I'll admit, I made a mistake and I had the unfortunate outcome of writing an Op-Ed for the New York Times with a friend of mine and they picked the title, but this was something that reflected what we wrote in the piece. February, 2021. And in that piece we argued inflation wasn't a problem. And that title was, *Stop Worrying About Inflation.* So, we were way off, completely wrong.

Beckworth: And most forecasters were. I guess that's the thing, not just Fed officials, but you look at consensus forecasts... So, there were a few people, yourself, maybe Larry Summers, Jason Furman, and looking back the way I make sense of this now is like 2020, the federal support, the fiscal support was probably warranted given what we did to the economy, but 2021, it was an unneeded helicopter drop. It was literally this big drop. And so you have this one time pop in the price level or a temporary surge in inflation, that's beginning to wind down. And you mix that in with inflation from supply side distortions as well. But I guess the helicopter drop of 2021 probably wasn't needed or at least not on the scale that it was done. And so I guess, how did people like you see that so early?

Detecting Early Trends in Post-Pandemic Inflation

Lustig: Well, first of all, I mean, I want to sort of commend you for actually acknowledging that you were wrong when you were thinking about inflation last year. And as you said, you're in good company. I think a lot of people were. I wouldn't give myself too much credit. I was just mainly concerned. I think if you put me on the spot and forced me to exactly articulate why I thought inflation might be a problem, it would've been hard. I was just worried that we were running an experiment where we were pushing the outside of the flight envelope and that's when bad things could happen. But as you said, there were other people like Larry Summers and Jason Furman who were very good at articulating exactly why they thought that last 1.9 trillion, I guess it was in January, that package was going to tip us over the edge and cause output to go above potential output and cause price pressure.

I think if you put me on the spot and forced me to exactly articulate why I thought inflation might be a problem, it would've been hard. I was just worried that we were running an experiment where we were pushing the outside of the flight envelope and that's when bad things could happen.

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Lustig: And they were absolutely right about that. I think what I learned from this is that the US ought to think carefully about the plumbing of the transfer payments. Because part of the reason I think we probably spent too much is because it is very hard in the US for the federal government to get money to people who need it. That is where I think where the Europeans have an edge on the US, I think. In most European economies… in the Eurozone, for example, governments have very easy ways of targeting transfer payments very carefully. In the US, for a variety of reasons, partly because of the federal system and because each state has its own system, I think it's much harder to do that. And perhaps that is why the federal government was a bit careless and not careful enough in targeting payments. But the other thing I think we have to acknowledge here, and this kind of goes back to Sargent and Wallace, where we started, is that I think central bankers in spreading this message of very low rates may have inadvertently contributed to the idea in Washington that maybe there really are no fiscal limits.

Lustig: And as a result of that, there was maybe a lot of pressure amongst folks in Congress to spend more than what was wise and prudent. So, there is this interaction ultimately between monetary and fiscal policy. If fiscal policymakers get the sense that central banks have their back, they're going to be less careful. And certainly in March of 2020, that is the message central bankers sent to policymakers. And actually in the Eurozone, this is fascinating… they sort of explicitly, at the ECB, talked about this, the fact that they would tailor the size of their asset purchases to the issuance of governments.

Lustig: So, they sort of explicitly said, look in deciding how much we're going to buy, we're going to look at how much governments issue. That's a dangerous message, right? Because well, politicians who cut spending and raise taxes, usually don't get reelected. And so if you tell them, look, we have your back. If they're good politicians, they're going to respond to that I think. So, that's perhaps a cautionary message that I take away from this is that central bankers ought to think more the way Sargent and Wallace think about these things. It really is a game. There's strategic interaction there. And if you think that surpluses are just these exogenous objects that come out of nowhere, that could lead us astray perhaps.

Beckworth: Game theory for macroeconomics.

Lustig: Game theory for macro. That's right. That's essentially, I think a big part of Tom Sargent's research agenda is that you have got to think about strategic interaction.

Beckworth: Well we are running low on time. So, I want to end on one question here and I want to step back to the longer trend decline in interest rates. And so let's say we get past this moment, the Fed’s doing things right, the ECBs doing things right. They're following their Taylor rules, but we still have demographic pressures. We have low productivity growth pressures keeping rates low. And so let's just say that world exists, say five, 10 years down the road and it sends a signal to Congress. What you were just mentioning, “hey, we can get things on the cheap.” It incentivizes Congress to spend. It makes them feel like there's no budget constraint if there's low rates. So, what do we do if it's not the central bank's fault, so, we can't get them to behave better. But if it's due to the fundamental forces in the global economy and people are knocking at the door of the US Treasury, “Give us more debt. We'll pay low rates.” How do we deal with that in a productive and stabilizing manner?

I think central bankers in spreading this message of very low rates may have inadvertently contributed to the idea in Washington that maybe there really are no fiscal limits...And as a result of that, there was maybe a lot of pressure amongst folks in Congress to spend more than what was wise and prudent.

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Addressing the Fiscal Pressures of Low Rates in the Future

Lustig: That's a great question. I think that is going to be one of the biggest challenges. What worries me when I look at the political debate in Washington, and to some extent by way, this is true in Europe as well, is that on either side of the political aisle, it is hard to find people who express concern about the federal government's budget. And that's kind of remarkable, because as we discussed at the start of the show, the CBO paints a pretty grim picture, but there is no sense of urgency. And I think you're right. I think that's partly as a result of the fact that people think, well, look, real rates are going to be low in the foreseeable future and the federal government won't have any problem rolling over the debt. The danger is, of course, that real rates are partly low because bond market investors anticipate low growth. We could have some more bad shocks.

Lustig: Fingers crossed, hopefully we won't get another big pandemic, but other bad things could happen in the next couple of decades that have a negative impact on the federal government's budget. And that could really put us on a course towards a serious fiscal crisis. In a way I think we should be more cognizant of the fact in the US that we're in a very special position. We're, sort of, the world's safe asset supplier. The dollar is the reserve currency. And that gives us more room to maneuver when it comes to fiscal policy. We've relied on fairly inelastic demand from foreign investors. They kept buying treasuries for the past two decades. During the pandemic that changed a bit. Foreign investors were less keen on buying treasuries. That was a bit of a red flag. Going forward, we ought to recognize that we don't know when we will exhaust this exorbitant privilege.

Lustig: If you look at a history and you look for historical analogs, you could look at the case of the UK, which I've done in some recent work. And before the first world war, the UK was in a fairly similar position, had a lot of fiscal capacity, because it was the world's safe asset supplier in some sense. After the first world war, the UK lost that privilege and was borrowing at rates that were consistently higher than the US. Whereas before the first world war, they were borrowing at very low rates. So, there does seem to be this extra fiscal capacity a country gets just by virtue of being the world's safe asset supplier. But that's not a privilege that's to be taken lightly. It can disappear.

Lustig: And right now, of course, maybe you could say, look, I don't think there are any contenders. It is certainly true that it is a bit of a beauty contest. Your relative fundamentals are what matters. And I would argue that the Eurozone probably is not a great contender right now for the privilege of being the world's safe asset supplier, but that could change. So, I think it's something we should be mindful of. But that is a very difficult task we have of trying to get back towards a path that is fiscally sustainable. Yeah.

Beckworth: Yeah. So, the key here is how do we responsibly handle this gift, this exorbitant privilege instead of using it as a temptation to have no constraints on what we do as a government, as a society. Okay, with that, our time is up. Our guest today's been Hanno Lustig. Hanno, thank you so much for coming back on the show.

Lustig: Thank you, David. This was a real pleasure. Thanks very much.

Photo by Anna Rose Layden via Getty Images

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