Ethan Ilzetzki on the International Implications of Fed Policy, Business Cycle Theory, and the UK Crisis

Although it’s easy to blame recent inflationary trends on the Fed’s actions, measuring the true effects of monetary policy is much more difficult macroeconomic exercise.

Ethan Ilzetzki is an associate professor of economics at the London School of Economics and a research fellow with the Center for Economic Policy Research. Ethan is also a returning guest to the show, and he rejoins David on Macro Musings to talk about the international implications of Fed Policy and the strong dollars as well as Ethan’s thoughts on business cycle theory in light of the recent inflation surge. David and Ethan also discuss Ethan’s takeaways from the UK crisis, how to evaluate and contextualize monetary policy shocks, the contemporary applications of the fiscal theory of the price level, 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: Ethan, welcome back to the show.

Ethan Ilzetzki: It's great to be back. Thanks for the invitation, David.

Beckworth: Well, it's great to have you back and I was delighted to see you participate in the Jackson Hole Conference this year. You discussed a paper that covered the fiscal theory of the price level. We're going to get to that today as well. So when I mentioned we'll be talking about your thoughts on how do we make sense of this inflation experience and what the different business cycle theories inform and tell us, that was what I was talking about. I'm looking forward to that part of the conversation as well as the international implication of Fed policy and the strong dollar. But before we do that, Ethan, you are in the UK.

Ilzetzki: I am.

Beckworth: So you have lived through an amazing time over there and you're an economist and better yet, you've written a policy brief, a report on this crisis that you went through with the mini budget with the former prime minister and her finance minister. So maybe just summarize what happened and then your thoughts, your takeaways as you have written them up in this policy brief.

Ethan’s Takeaways from the UK Crisis

Ilzetzki: Yeah, it's been quite an interesting month, quite a wild ride. So just in terms of the facts of what had happened, the Prime Minister was replaced in the UK. There was sort of the equivalent of a primary in the conservative party that brought in a new prime minister, Liz Truss. And she came in with a number of policy proposals that she had campaigned on and these were formally announced in what they called a mini budget, was sort of not a formal budget process, but changes to the budget that they were bringing in with the new administration, which they brought in on September 22nd. And within minutes of the finance minister here, the Chancellor of the Exchequer announcing these new measures, bond prices started to go down across the board on UK bonds.

Ilzetzki: The value of the pound went down by about 5% that same day and there was a major concern that we are headed for a financial meltdown. There were other things we'll get into maybe in a bit, problems on the balance sheets of pension funds that resulted in the following days, which required the Bank of England to intervene, bailing out essentially, at least temporarily, the UK pension fund. So this was an interesting period. I can talk about the budget itself in a moment, but in terms of the consequences of the budget, they were dramatic. They were very sharp and sudden.

Beckworth: And you wrote a policy brief or more of a short paper. It's actually fairly long on this crisis and you walk through it and you look at what you think are the key takeaways. So let me throw one argument that's being made and I want you to give me your take on that. And that is, this incident shows that it is the return of bond vigilantes, the markets are out in force disciplining bad behavior. The UK was out of fiscal space and acting irresponsible. So what is your take on that?

Ilzetzki: Yeah, so I followed events closely and I waited for the data to come in to make any judgment. So I was open to that possibility. At our time at Treasury we saw some fiscal crises like the Argentine crisis, Uruguay crisis, so we're no strangers to sovereign default crises. And it's not impossible that something like that would happen even in a wealthy, high income economy like the United Kingdom. However, the facts don't really point in that direction. So what would we expect to see if the investors were concerned about fiscal sustainability of the United Kingdom? Or put differently, what would we expect financial markets to do if they thought that the UK has risk of defaulting on its sovereign debt or unable to satisfy its obligations?

Ilzetzki: Well, there are two ways the UK could possibly fail to repay its sovereign debt. One of them, very unlikely, would be that it outright announces a default on its sovereign debt or tries to restructure its sovereign debt. I say that's highly unlikely because a country that issues debt in its own currency, whose corporations all borrow in that currency, has no reason to outright default on its sovereign debt. Instead, it could slowly erode the value of its debt through higher inflation. Which brings us to the second way that could happen is that the UK would either explicitly inflate away its debt or just nudge the central bank a little bit more to have higher inflation to reduce the debt burden of the country.

Ilzetzki: Now, when we look at what the bond market was actually doing, and there's no one individual in the bond market, but this is kind of the average response in some sense or the marginal response of the investors. What we see is that the borrowing rates of the United Kingdom went up, but it was mainly the real borrowing rate that was going up rather than only the nominal rate. In fact, the implied inflation expectations of the market went slightly down following the mini budget, following this fiscal announcement. In other words, there is no indication that bond investors were worried about the UK government or the central bank inflating away the debt, which would be the main way in which the government would implicitly default on its debt.

There is no indication that bond investors were worried about the UK government or the central bank inflating away the debt, which would be the main way in which the government would implicitly default on its debt.

Ilzetzki: There are other kind of more minute aspects, for example, that it is mainly short run interest rates that jumped up while medium term, say five year interest rates, went up by far less, which is exactly the opposite that you would expect if you were afraid of a sovereign default event because there are more ways to default on your debt within five years than there are for you to default on your debt in the upcoming year.

Beckworth: So there was no sovereign debt crisis, per se, is what you're arguing, at least in terms of what the market was saying?

Ilzetzki: Yes. I don't think there was any evidence of concern about debt being inflated away or outright default.

Beckworth: So there was still plenty of fiscal space left. The government still could step in. So how would you define this problem? What was it then that led to this? Was it a liquidity problem, a plumbing problem in the financial system of the UK? How do you think about that?

Ilzetzki: Okay, so let me just push back a little bit on one thing in your question, which is the issue of fiscal space. So in terms of just outright ability to borrow, there is no indication that the government would be unable to issue more debt, that nobody would touch the sovereign debt of this country. But it was at a higher price to the government, and so any reasonable government should internalize the fact that interest rates go up and try to borrow a little less when interest rates go up. So fiscal space did decline and did impose some hard choices on the UK government. But the sentiment of what you said is exactly right, that the way we usually talk about fiscal space is how close a government is to the slippery slope where it just slides off into the abyss of sovereign default and the UK was nowhere close to that at any point in the crisis.

Ilzetzki: Now, coming to your question on what I think actually happened, it's now useful to go back to discuss what was actually in the mini budget. What was the proposal? So this proposal was actually quite expansionary. It had 4% of GDP in public spending devoted to supporting households’ energy bills, which maybe we'll talk about that a little later, but I think also was just very bad economics. This is exactly what we teach undergraduates you shouldn't do is put price caps on things and just pay people to buy things that are in short supply. But that's kind of the microeconomics of why this was a bad policy, but it was just very expensive. It was 4% of GDP. Secondly, rather than looking for some way to finance that, the government said we're going to finance that by cutting taxes by another 1.5% of GDP. So it summed up to a fiscal package of taxes and transfers of roughly five and a half percent of GDP, which is really big. Actually, it's bigger than the covid support that the UK government gave.

Beckworth: That's amazing.

Ilzetzki: Yeah. So it's a remarkably expansionary policy. Now, unlike say fiscal stimulus in 2008, now we are in a supply constrained economy. Energy sources are scarce here in the UK. The productive capacity of the economy is shrinking. And any macroeconomic model would tell us that when you push more demand on a contracting supply, or if you want to put it differently, on a very steep Phillips curve for the more wonkish listeners, then this can only lead to higher inflation.

Ilzetzki: And in fact, what we saw in the market response is, to me, surprisingly close to what the models we teach graduate students in introductory macro for graduate students, the textbook models say of Jordi Gali or other similar kind of New Keynesian macro models. What would happen if you have a massive fiscal expansion and you are at a steep point on the Phillips curve? Well, we have other equations in that model and the most relevant for our discussion now is the Taylor Rule. So the central bank should be expected to raise interest rates, at least one to one with the added inflation that this massive stimulus would stoke. And indeed, what markets were predicting is that the Bank of England would raise not only nominal interest rates but real interest rates, that is, raise interest rates by enough, slightly more than enough to quash the inflation that this fiscal package was generating.

Beckworth: So much happening there. Let me go back to the five and a half percent. That's huge. And it's pretty surprising given that it came from a conservative party in the midst of a high inflationary period. And again, it's more the supply side constraints. Was this large package something that was endorsed by the majority of the Conservative Party? Because it just seems a little surprising, one, it's so big and in an inflationary period. Two, you mentioned there were price caps on top of that. That's very much against the grain of a free market-y kind of political party.

Ilzetzki: Yeah, so we're seeing this not only in the UK, unfortunately, but around the world that conservative parties aren't necessarily conservative when push comes to shove. Maybe everybody becomes liberal with a public person, a foxhole, to paraphrase that. I don't think this was universally accepted. In fact, Liz Truss's, main contender in the primary competition was Rishi Sunak, who has now since replaced her as prime minister. And he was much more fiscally conservative in his platform and was warning, in what I thought at the time, was just excessively alarmist terms that her policies would lead to a financial crisis. I think he was more lucky to be exactly on the mark than a prescient. But nevertheless, like many parties, there is a divergence of opinion. I think the support… I feel like I have to comment on the energy support packages, because some variance of those are happening in other countries. For example, in continental Europe, which is… it's a very standard impulse of policy makers and I think of citizens too to say, well, energy prices have gone up, so help me buy the more expensive energy.

Ilzetzki: But when we look at the reality of this, it's a short supply of energy. You can't increase the amount of energy to go around, ultimately, and simply paying people to try to buy something that's in short supply is going to be ineffective at best and counterproductive at worse. The policy was also strange in that it guaranteed these price guarantees to households for two whole years and who knows where we're going to be a year from now. So in addition to it being very expensive as budgeted, it was also very uncertain. And to make things worse, they made the very rookie mistake of not allowing the Office of Budget Responsibility, which is kind of like the Congressional Budget Office, to price this. And they said, well, just trust us. We know how much this is going to cost. We're not going to let independent experts cost this budget. And I think that added to the panic in the market.

When we look at the reality of this, it's a short supply of energy. You can't increase the amount of energy to go around, ultimately, and simply paying people to try to buy something that's in short supply is going to be ineffective at best and counterproductive at worse.

Beckworth: So in your note you mentioned there is some lasting damage from this event in terms of housing finance, mortgages and such. What would you recommend the new prime minister do moving forward to minimize the pain and to get through this rough patch of energy costs soaring and the Fed tightening policy effectively around the world?

Ethan’s Prescription for the UK

Ilzetzki: So here in the UK, I would say the interest rates have come down a little bit since the new prime minister came in. But even absent the fiscal problems, interest rates have been going up and it's still not clear that they won't rise again. In the UK, this is particularly pernicious because of mortgages and what maybe US listeners would be surprised to hear is that in the UK, fixed rate mortgages are only available up to a duration of five years. So the 30 year fixed rate mortgage that many listeners maybe have simply doesn't exist in the UK. And what this means is that the average UK household or homeowner has to refinance their mortgage every three years. The pass through of interest rates to households is much faster here in the UK than it is in the US. And what this means is that the UK, with almost certainty, is going to face a mortgage affordability crisis this winter with all the associated side effects of house price declines, increases in leverages, fire sales of houses, possibly mortgage defaults.

Ilzetzki: This is avoidable. But unfortunately, we come to this at a point ... what would be the normal playbook is for the government to come in and do some bailouts here and there, hopefully more targeted and strategic and not across the board. But the UK government is in no position, given what we just said, to go out and borrow a large sum of money to do this. And so I think that there has to be some thinking about potential forbearance plans. The government shouldn't announce this in advance. There's obvious moral hazard problems with this, but I think there should be some preparations made for the possibilities that a large segment of the mortgage market will be in severe stress. And I think it can be mutually beneficial for banks and for households if mortgage payments are slightly delayed, slightly rescheduled.

Ilzetzki: We've seen some, actually, recent examples in Ireland, in Australia… quite successful and not particularly interventionist. In Australia for example, it was entirely voluntary by the banks. It wasn't the government that pushed them into doing this, so I think that's something to consider. The other point I would say is that… just introduce that 30-year mortgage, it's not possible that the UK banking system, one of the leading financial centers, cannot absorb the risk of a 30-year collateralized loan on housing. So I think the government should try to nudge the financial sector and this is actually a good time to introduce that because of the inverted yield curve. So, actually, long term lending is cheap, while short term lending is actually quite expensive.

Beckworth: That's interesting. And you would think there would be an appetite, like you said, for a 30-year mortgage from the UK. I do believe once we get past the pandemic, the other side of this high inflation, we're going to be back to the same structural forces that have been affecting us beforehand, including the aging of the planet and that aging planet wants long term liabilities they can hold, someone else's liabilities they can hold as they grow older, more risk averse. And that seems to be something that would make sense. So it'll be interesting to follow that.

Ilzetzki: Absolutely, absolutely. The natural market for these type of assets would be pension funds, and particularly UK pension funds who are pound based. And we don't have to get into the details of the crisis in pension funds here, but part of the problem here was that they were extremely exposed to one specific asset, which is the 30-year gilt or which is the equivalent of the 30 year UK Treasury bond. And if they had a more diversified portfolio of long term relatively safe assets, some of the financial problems we saw would not have emerged.

Beckworth: I want to go back to this other point about mortgages that you made in that the US is unique right now with this 30-year mortgage. And if you look at central banks and other parts of the world, advanced economies that have shorter mortgages… So I was reading about Canada recently and I think to some extent in Australia, they are beginning to show signs that they're going to pivot. They're not going to keep increasing rates as rapidly. And one reason is, as you alluded to, the transmission mechanism is much quicker. Now, we do have signs in the US that housing is beginning to contract, sales, housing starts, new homes being built, they're all coming down, but the pinch, the pain, the tightening of the screws is being felt much more intensely in other parts of the world because they have this much shorter horizon to refinance. And I look at myself, I refinanced my 30-year mortgage in 2021 at about three and a half percent.

I think there should be some preparations made for the possibilities that a large segment of the mortgage market will be in severe stress. And I think it can be mutually beneficial for banks and for households if mortgage payments are slightly delayed, slightly rescheduled.

Beckworth: I'm sitting comfortably on it right now. In fact, I'm doing pretty well given the rate of inflation and everything going on. And so the Fed has a lot much longer haul to affect someone like me than if I had a three, five year mortgage. And I want to use that, Ethan, as a segue into the second topic and that is kind of the global impact the Fed has on the rest of the world. There's lots of signs in the US here that we still are struggling with inflation. Wage inflation's high, rent inflation. Market rents are coming down, but the CPI measure of inflation is still high and it's probably going to be high going into early next year.

Beckworth: A number of things like that that suggest the Fed is still worried about where inflation is going. And we're recording this on the day of what's likely to be the Fed's fourth 75 basis point rate hike, rapid increases. And the Fed has a domestic US mandate, but it has a huge bearing on the rest of the world. And you've written about this before, there's a global financial cycle literature. So maybe summarize that literature for us and tell me, are we seeing the predictions of that literature being born out in what's happening today?

The Global Financial Cycle and Impact of Fed Policy

Ilzetzki: Let me kind of divide the question into two things. There are two aspects. One is, the dollar has strengthened dramatically relative to almost all other currencies. And there's a question of what are the implications, first of all, why this has happened but also what are the implications for the rest of the world of having a strong dollar? For the US, actually it's very limited importance, both because the US is a relatively closed economy still and because most international trade is denominated in dollars, so the US is kind of hedged against this.

Ilzetzki: The second issue is that higher US interest rates mean, essentially, that world interest rates are higher, whether other central banks follow the Fed or don't. The US interest rate is the main player in town. And so this is going to tighten financial conditions, not only in the US, but also around the globe. And so that brings us to the global financial cycle literature work, for example, by Helene Rey and Silvia Miranda-Agrippino who have written very interesting work on the spillovers of US monetary policy to the rest of the world. And for example, that literature, I think, makes a very persuasive case that the main factor determining asset price swings, along a broad class of assets, is US-based and very specifically, US monetary policy based. But at the moment, the Fed is trying to quash risk taking. It's trying to quash exuberance in financial markets.

Ilzetzki: And I don't see any way in an integrated world and in which the US is still the major player, the largest central bank player in that world, that there is a way for the US to slow down its own economy, and as part of that, its financial markets, and not to have an effect on assets more broadly. You can see that in recent events where if I want to know what happened to the S&P 500 today, I could equally look at pretty much any other stock index of any country and I won't get the exact number right, but I definitely, directionally, will get it almost exactly right on a day to day basis. And that tells us that there is kind of a single factor here and it's quite reasonable that single factor is driven, or very influenced, by US monetary policy.

Beckworth: Financial conditions are tightly integrated across the globe, but the real economy is a little less so, or maybe much less so because as you said, we don't import a lot relative to the size of our economy. And that's part of the debate right now. We have this meeting today, so we're recording this in early November when the FOMC is going to raise rates again, another 75 basis points. And one of the big questions we're looking forward to in this meeting is, will they indicate they're going to slow down, begin to pivot? And I think the challenge is, you look at financial conditions, even in the US, the inversion of the Treasury yield curve, the strong dollar, the stock market, they're all screaming that maybe a recession is ahead, you need to slow down. But if you look at, as I mentioned, wages, service inflation, those are going up, all these things indicate there's still some inflationary problems.

Beckworth: Now, the problem with those indicators, in my view, is that they're lagging indicators. They were the last ones in 2021 to indicate we were going to have an inflation problem. So the Fed, I think, took it easy, maybe fell behind the curve and there is, I think, a reasonable fear it might be falling behind the curve now because it's looking at these lagging indicators to kind of guide policy. So it's a tough spot for the Fed to be in right now. But going back to the global focus, let's flesh out these linkages, these connections. And there's two that I can think of, and you're much more the expert than I am on this. And this is one that speaks to your work that you've done. One is that a lot of countries either implicitly or explicitly link to the dollar in some fashion. And another one is, there's a lot of debt out there denominated in dollars. But you have this great paper with Ken Rogoff and Carmen Reinhart where you walk through this. And I'll encourage listeners to go back to a previous episode with Ethan and we discussed this. But go ahead and summarize that paper for us and how it helps us understand this current moment we're in.

That literature, I think, makes a very persuasive case that the main factor determining asset price swings, along a broad class of assets, is US-based and very specifically, US monetary policy based. But at the moment, the Fed is trying to quash risk taking. It's trying to quash exuberance in financial markets. And I don't see any way in an integrated world and in which the US is still...the largest central bank player in that world.

*Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?*

Ilzetzki: The dollar is the world currency insofar as a world currency exists. And what I mean by that is that if we look at trade, something like 60% of all international trade is denominated in US dollars. And this is true even in bilateral trade of countries, neither of which is the US. So using the dollar as a vehicle currency in trade among third parties not only when trading with the US. Financial assets are disproportionately denominated in US dollars. When corporations borrow, they either borrow in their domestic currency when they're small or if they're big enough, they will either borrow in their domestic currency or in the US dollar. And that's pretty much it. Borrowing in Euros, for example, among non-European corporations is almost non-existent. And this is even true in countries, for example, that have a peg to the Euro. Central bank reserves, something like 60%, are denominated in US dollars.

Ilzetzki: So the US is really the dominant currency, what we call in our work, the anchor currency in the international monetary system. What this means is that as soon as we see a strong dollar of the sort we are seeing right now, we will start to see balance sheet mismatches, either financial or commercial. So what this would mean is, for example, a firm trying to sell a product that is denominated in dollars and its price may be kind of rigid in dollars, but seeing the dollar strengthen and therefore that good becomes more expensive when say trying to sell that good in Europe. Our standard theories would say a strong dollar makes it harder for the US to export, but now it makes it harder for every other country, for Japan, to export to Europe as well.

Ilzetzki: Even more pernicious is on the financial balance sheet because these things happen very quickly, which is, corporations borrowing in US dollars. This occurs around the world. And as I mentioned, insofar as a firm doesn't borrow in its own currency, it will do so in dollars, but then having its liabilities are in dollars but its assets will be denominated in local currencies. So think of a bank financing itself by borrowing in dollars, but it has some local currency mortgages that it's lending out. It very quickly can find itself insolvent in this circumstance. Now, the current situation, and I'd be happy also to talk about the reasons in a moment for the strong dollar because I think my view may be different than what many others have discussed on this.

Ilzetzki: But the good news is that the strong dollar has affected countries where it doesn't matter so much and in countries where it would matter a lot, [they] actually have not seen their currency weaken so much relative to the dollar. So if you actually decompose the effective value of the dollar, that is the trade weighted dollar index, to high income countries and to developing countries, actually, developing countries only see a mild depreciation relative to the dollar. And those are the countries where you see most of the balance sheet mismatches. High income countries, the dollar affects them but they're much more hedged against this type of risk. So we're seeing the pound depreciate heavily against the dollar, the Euro, the yen dramatically. And maybe Japan, I would be a little more worried about that and we're seeing their interventions as a result. But in Europe and the UK, take the UK, close to home for me, for example, the UK, as a whole, is long on the dollar. So that's because the UK borrows in pounds, but say its pension funds are invested globally including in the United States. And so actually a strong dollar improves the balance sheets of UK financial institutions and households, for that matter. So the strong dollar, it could be a problem, but so far it has affected those that are the least vulnerable to it.

Beckworth: We'll keep our fingers crossed and hope that luck holds up. We'll see what continues to happen to the dollar. So maybe speak to that, why do you think the dollar has appreciated so much?

Ilzetzki: The reason I didn’t want to bring this up is that a lot of the discussion has attributed the strength of the dollar to Fed policy. And as a result, some of the policy recommendations, we hear these discussions about maybe we need to go back to a Plaza Accord, like the US agreed to with other countries in the 1980s to engineer a devaluation of the dollar. And I think that for the most part the diagnosis is wrong and therefore also the analogy and the policy recommendations are wrong. I think as a first approximation, this is a real phenomenon rather than a monetary phenomenon.

The good news is that the strong dollar has affected countries where it doesn't matter so much and in countries where it would matter a lot, [they] actually have not seen their currency weaken so much relative to the dollar.

Ilzetzki: We have a major shock this year to the world economy in the form of the Russian invasion of Ukraine, the higher oil prices, the higher food prices as a result. And this has affected European, Japanese, UK economies much more severely than the US. The US is actually a slight net exporter of these goods. And so in fact, the US terms of trade have improved. To some extent from an international position, the US has benefited from the price swings that we've seen here. To take the UK for example, the UK is running an 8% of GDP current account deficit. It has never seen this since the Second World War. Traditional macro theory says when you're importing more than you're exporting, your exchange rate needs to decline so that you import a little less and maybe are more successful in exporting more to finance these imports.

Ilzetzki: Were we to intervene too heavily against these market forces, we would make it actually harder for these adjustments to occur. We would force a country like the UK to borrow more and we see why that could be a problem. So let me also say why I think monetary policy is not the main culprit. If you look at what has happened to the differential between say a medium term interest rate, 10-year interest rate in the US and Germany between a 10-year interest rate in the US and the UK from January to today, it's barely changed. It's almost exactly the same. And so whatever the combined effect of monetary policy and its expectations has actually not led to such a large interest rate differential, partially because markets are expecting other economies to react as well. The exception to this rule is Japan that is taking a very dovish policy and therefore part of their depreciation is policy, but that's their policy, their divergence in policy from the rest of the world rather than something that should be put at the feet of the Fed to consider.

Beckworth: So this is a nice segue into the next discussion I want to get into with you, Ethan. And that is, what exactly is the Fed doing? How do we think about it and how do we think about these other central banks? So you've just made an argument, if I understood you correctly, that some of these rate moves are endogenous to the underlying real shocks hitting the economy as opposed to being driven by some central bank somewhere else doing all the driving. There's some role, I know you recognize there's some role for both, but you think we're overlooking the real shock story here, which is fair enough. But that, again implies, though, that some of what the Fed, for example, is doing is simply a response to or endogenous to the state of the US economy. So in macroeconomics, there's this huge literature, as a grad student, even as undergrad, you learn about monetary policy shocks versus a systematic response.

Beckworth: And I know, traditionally, you teach your undergrads, well it's the shocks that really have a punch, at least some of the older models. I've always had some problems with that and I think as we've seen the importance of the financial system and such, I think that's maybe less true. But I would like to get your take on this notion of what is a monetary policy shock and can we use this discussion to make sense of ... Is the Fed truly engineering a shock or is it merely a systematic response to what's been going on in the US economy, albeit delayed?

Evaluating Monetary Policy Shocks and Its Current Context

Ilzetzki: I've been quite engaged in work on both fiscal policy shocks and monetary policy shocks, how to measure them, what are their consequences. And so let me explain from an empirical point of view as a researcher in macroeconomics, why we're so obsessed with shocks and what's their importance. So there are two reasons why we try to look for what we call a monetary policy shock or a fiscal policy shock. Let's focus on monetary policy for the moment. So the first is the question of causal inference or exogeneity. So the Fed does not just randomly change interest rates at a whim. We hope that will not happen. And there are reasons why the Fed is moving interest rates. So every time we see the Fed changing the rates, when today the Fed decides to move the rate by 75 basis points or more or less, there's a reason why it's doing it. It's the high inflation and everything that led to that high inflation.

Ilzetzki: So we'd like to tease out which portion of the move in monetary policy is not just simply responding, kind of a reverse causation type of thing, to current events but rather is causing the subsequent events. The other reason we're interested in shocks is because of anticipation. Let’s say the Fed moves by 75 basis points today, as is anticipated, it will be as is anticipated. And a lot of the effects of the 75 basis points move will have already been priced in and actually already taken effect. So we've seen, for example, mortgages, we talked about mortgages earlier, increasing to very high levels. So if you were not so wise to have refinanced in 2021, you would now be facing perhaps double the interest rate on your mortgage than you did then. But part of that increase is already the expectations of all the future increases in the federal funds rate over the upcoming 30 years.

Ilzetzki: And so we're trying to tease out what is new today in the Fed's move than what happened before. Now, I think this past year has been fascinating to observe. What do we normally do as researchers to tease this out? There are two common strands of methodology. One is what I would call kind of a control variable approach where we try to, either through a vector autoregression or through looking carefully at the Fed minutes to try to tease out which portion of the Fed's move, is not related to the state of the economy. And that could be because we happen to have a particularly dovish Fed or hawkish Fed at the moment, or it could be because the doves beat the hawks in the debate this time around or vice versa. And so something kind of just random in the system that makes interest rates move a little more or a little less than the circumstances dictated.

Ilzetzki: The other approach is using financial market data and seeing, at the moment of the announcement, how much has really moved, what is the new information in the Fed's announcement relative to say what futures are predicting, future contracts are predicting, the Fed will have done in that meeting? Now when we look at the events of the past year, it might make empirical researchers eat a little humble pie and I think we'll learn a lot from the events of this past year. It's still too soon to know and it's hard to run the data in real time. I don't have access, for example, to futures data in real time. My best guess of what we will see is that, for the most part, the shocks to monetary policy this past year will be for the most part dovish shocks, they will be negative declines in the fed funds rate.

Ilzetzki: And this is a little mind boggling because the actual interest rate has gone up this whole time. But our measures of monetary policy shocks, I suspect, will say the opposite. Just to give you an example, I didn't look at futures for today's meeting yet, but last FOMC meeting, the markets were pricing in, I think it was an 82 basis point increase. What does that mean, because the Fed never moves by 82 basis points. So what does that mean? That means that some people were betting on a 75 basis point increase. Some were betting, taking a contrarian view and saying, I think that Fed's going to go even harder on the economy. So the monetary policy shock that occurred on the day of the announcement was actually a decrease, a very, very slight one, but a decrease in the interest rate because that was the new news that they went for the expected 75, and not for the contrarian, shocking 100 basis points.

Ilzetzki: The other thing that we're seeing is the Fed is very concerned about what these market expectations are. The Fed wouldn't like to go in and say the market thinks 75, but I'm going to shock them with a hundred. I mean if they do that, there must be a very good reason why maybe they have some more information or maybe they're trying to make a real point here. But there is some reason that goes beyond some kind of surprise or shock if the Fed defies market expectations. So I think we have a little bit of a challenge to tease out what is the true effect of monetary policy as opposed to all the surrounding events, financial and real, that lead to that shock.

My best guess of what we will see is that, for the most part, the shocks to monetary policy this past year will be for the most part dovish shocks, they will be negative declines in the fed funds rate. And this is a little mind boggling because the actual interest rate has gone up this whole time.

Beckworth: And this is the eternal challenge of macroeconomics identification. How do you truly isolate something caused by monetary policy that wasn't itself a derivative of some other development in the economy or caused by something else. So macro economists have their work cut out for them, no doubt. And I understand the motivation. Why care about that little percent extra that was truly exogenous, because you want to truly and cleanly show the link between monetary policy and the economy. So here's my question and one of my maybe critiques of these identification approaches and this is the anticipation horizon. So with financial markets, for example, you look at the expected value maybe the day before or right before the meeting and if there's a difference between what they actually did and what the markets were anticipating, that's the shock.

Beckworth: And so my question is what if the people make plans six months before that with a certain expectation? So I take out a mortgage, I mention I refinance, I have expectation of a certain income flow, and then a year later the Fed comes along can completely blows up my plans. I lose my job because of a recession. I guess my question is, it seems to me that the identification may be very narrow in missing some of the other effects it has based on anticipations made longer in the past or have longer horizons for decision making. So what are your thoughts on that?

Ilzetzki: I think this is part of the challenge of empirical research when concerning ourselves with causal inference. So there is always a risk when we're looking for that true exogenous variation in anything, be it fiscal policy or monetary policy or any other policy, that we're throwing away the baby with the bath water. And in some sense, that's your complaint. Old theories of monetary policy told us that only unanticipated monetary policy can have an effect. Anything that's pre-announced, pre-known, that's endogenous, will have no effect and only surprises to money can have an effect. Ask anybody who is trying to refinance their mortgage today whether it matters whether this was anticipated or not. It's more costly to borrow money. And of course, you could have jumped in two years ago, but not everybody does that. And so the endogenous part of monetary policy does have an effect, I think.

Ilzetzki: I think that is absolutely true. But I think it's just a practical problem of knowing what the impact of that is because now to take recent events, for example, it's hard to think of a way to try to tease out what effect did the, say, 400 basis points in aggregate that the Fed will have increased the Fed funds rate this year, how much did that slow the economy down or say the stock market down or anything else relative to the war in Ukraine? The fact that inflation itself is very high, the fact that oil prices are high. So we have a lot of things going on and so far, we're not smart enough to find a way to tease out the importance of the lion’s share of the movement in monetary policy.

Beckworth: Well Ethan, we have just opened up the door for some smart and promising young graduate students to come along and do a better job of identifying the total effect of monetary policy. Now, you mentioned fiscal policy shocks, so let's move to fiscal policy in the time we have remaining. And I mentioned earlier you were at the Jackson Hole Symposium, it's like the number one conference in the world, I dare say, for monetary policy makers and academics to attend. So Ethan, you being there is a sign that they highly value your work and your thoughts. And you discussed a paper that dealt with the fiscal theory of the price level. The authors were trying, I believe, to make the case that it was actually a fruitful way to look at the world with this high inflation. So maybe summarize that paper briefly and give us your thoughts on that theory or any other theories you want that can make sense of the inflation surge we're going through.

We have a lot of things going on and so far, we're not smart enough to find a way to tease out the importance of the lion’s share of the movement in monetary policy.

Applying the Fiscal Theory of the Price Level to the Current Inflationary Environment

Ilzetzki: Sure. So I was fortunate enough to have the opportunity to discuss this really interesting paper by Francesco Bianchi and Leonardo Melosi, and they argue that this theory called the fiscal theory of the price level, which I'll explain in a moment, has a lot of explanatory power to explain the inflation surge beginning in 2021 and continuing into 2022. What does the fiscal theory of the price level say? It says when a monetarist would say that the supply of money determines inflation, they say, look, it's all dollar denominated government liabilities that affect the price level. So it doesn't matter whether it's the central bank issuing money, which is a liability ultimately of the federal government, or whether the Treasury is issuing that debt. And so they use a model to argue that a large share of the inflation surge of 2021 and the beginning of 2022 was because of expansionary fiscal policy during COVID and the additional borrowing that that led to.

Ilzetzki: The way this would work is that bond markets become concerned is, again, coming back to the beginning of our discussion, bond markets are concerned that the US government will have no way to finance its obligations without inflating away its debt. It's going to explicitly or implicitly strong arm the Fed to inflate away its debt. And those expectations lead people to deflate away the debt on the spot by expecting more inflation and seeing that more inflation realized. I should actually add one last point of that paper, which I think is quite important given recent events, is that they had a policy recommendation there too. They said that given that the federal government is simply unwilling to follow a sustainable fiscal path, that it's actually dangerous for the central bank to try to beat them down.

Ilzetzki: And in fact, we would be better off if the Fed submitted to the fiscal authority and realize the worst fears that we have, that there might be a little bit of monetary financing. My response to this very interesting and provocative paper, I think intentionally kind of intellectually provocative and I think useful in that sense, is that it really just does not fit the patterns of any international data or historical data we've seen. Fiscal irresponsibility seems to be neither a sufficient nor a necessary condition for high inflation. So to give an example and you can go read my discussion on the Jackson Hole website or my website. To give an example, if we go back to the 1970s, the whole discussion in this literature is the Great Society programs and the Vietnam War and whether those are good policies or bad policies, those are US domestic policies.

Ilzetzki: They could explain inflation in the United States, but the US was pretty much the median high income country in terms of inflation and you had dozens of different countries experiencing pretty much exactly the same inflation. The same is true of 2021, where the inflation rate in the US, UK, Eurozone is just one to one with each other. It would just have to be a sheer coincidence if the fiscal irresponsibility of these places is exactly perfectly coordinated. Surprisingly, Japan, which actually is,, to some extent the least fiscally responsible in the bunch, has seen the lowest inflation. So there are other explanations like monetary policy and the magnitude of the actual real shocks that these countries have faced, which actually fit the data much better than this kind of arcane theory of the price level. If I could return to the UK for a moment, I think that this laboratory actually, it was kind of an experiment of whether this fiscal theory really works very well. And we saw with the UK that everything bad that could happen happened, but actually inflation expectations went down.

Beckworth: That's a good point.

My response to this very interesting and provocative that it really just does not fit the patterns of any international data or historical data we've seen. Fiscal irresponsibility seems to be neither a sufficient nor a necessary condition for high inflation.

Ilzetzki: And so if this was sort of an event of bond markets fearing that the government would strong arm the Bank of England into submission, we would not see what we saw. And coming to the policy recommendations, the UK also provides an excellent counter example or a counter-argument to the bank should just roll over and allow a more expansionary policy. I think what that ignores is the strategic game between the Treasury and the central bank. We saw the Bank of England sticking to its guns saying we're going to have to raise interest rates more because this fiscal expansion is leading to more inflation. And it took about three weeks for the prime minister to resign. So fiscal policy responds to reality and blinked first in this case. So at least 1-0 here in the UK for monetary dominance and I hope it stays that way.

Beckworth: So just to speak quickly to the policy recommendations in that paper, I think it's also important to note that most of the public, and definitely the market, they see the price level being determined by the central bank. There's a lot of confidence and even if the fiscal theory of the price level were true, what does the market believe? What does the public believe? And if you were going to just completely give up on monetary policy, they would panic. They would, I think, be concerned. And so I think it's important to deal with the truths that are believed, even if they aren't necessarily the truth. And so I think it is important for central banks to do some heavy lifting here, even if indeed FTPL were the true theory of the world.

Beckworth: But let me step back and I want to raise some questions about theories of the price level, including the FTPL. So let me just throw three out. You mentioned these, I believe, in your paper, but you got the fiscal theory of the price level, a monetarist's theory and then kind of a New Keynesian theory. So the fiscal theory of the price level, we've talked about. Quickly, the monetarist theory says the nominal quantity of money relative to its real demand. Now, the key hang up in the monetarist model is we don't observe the real money demand, we have to estimate it. It's an unobservable. New Keynesian model, it's the Phillips curve. And in the Phillips curve you have this thing called the output gap, which is also, we don't observe, you have to estimate it.

Beckworth: Now for the fiscal theory of the price level, they also have this problem. They’ve got to know the net present value or the discounted present value of future real primary surpluses. So all three theories have these unobservables. It's hard to falsify them in some extent. So I'm curious in this paper, going back to your earlier discussion, how did they identify this unobservable, this primary surplus that we don't observe, in order to make the case that indeed the FTPL is a good explanation of what we're seeing?

Identifying Unobservables in the FTPL

Ilzetzki: I think, for the most part, that specific paper didn't go into the details of what you're asking. There are few papers, actually quite interesting papers, that make an effort to do that. Hanno Lustig was on your program, I think a few weeks ago, and he has a couple of interesting papers that try to quantify the convenience yield of holding US government debt. You have written on this topic as well. Markus Brunnermeier and co-authors have a really interesting paper on a bubble component, bubble has a negative connotation, but in this point, it is really just a different formulation of holding dollars because you think other people will want to use dollars as well, which is part of the global dollar dominance that we discussed earlier.

Ilzetzki: So yeah, the real missing component here… we can measure these things implicitly by looking at the residual of what does an asset pricing model fail to find, to explain in the current price of US treasuries or German bunds or whatever asset it is we have. But where I think all of these theories fall a little short is trying to understand what are the drivers of the deeper forces that make the dollar such a convenient currency to hold. It's not because it's green and it's not other kind of mundane factors, there's some reason why the dollar is the global currency, which we go into in the papers. I discussed before that I've written with Carmen Reinhart and Ken Rogoff, but I think more importantly they also don't give us a sense of what could reverse the dominance of the dollar, what could make the dollar a less convenient currency to hold, what could burst the bubble, the 80-year dollar bubble that we are riding on.

Where I think all of these theories fall a little short is trying to understand what are the drivers of the deeper forces that make the dollar such a convenient currency to hold. It's not because it's green and it's not other kind of mundane factors, there's some reason why the dollar is the global currency.

Ilzetzki: And I am, in fact, quite bullish on the dollar. I've heard a lot of voices when Russia invaded Ukraine and started borrowing in renminbi that this is the end of dollar dominance. And I think the reasons for the dollar being the dominant currency go quite deep and would require an even larger shock than what we've seen this year. Hopefully, one we will not see anytime soon to see it end.

Beckworth: No, absolutely. And if I could summarize why I think it will last, and I'm bullish too and why I am a bubble believer of sorts in terms of the dollar bubble is network effects, path dependencies. Those things are hard to break. You would need to break up the US, have some cataclysmic world war, like you said. I believe it's definitely going to be there for a while. So these are interesting discussions, these different theories. Again, great opportunities for budding young grad students to figure out how to measure these unobservables. And I look forward to more work on this. Well Ethan, our time is up. It's been great, as usual. Our guest today has been Ethan Ilzetzki. Ethan, thank you for coming on the program.

Ilzetzki: Thanks, David.

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About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.