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Report

Teaser, summary, work performed and final results

Periodic Reporting for period 2 - INFL (New perspectives on inflation)

Teaser

Summary

The research in this project aims to deepen our understanding of inflation by exploring the interaction between what central banks do, how people form expectations, and how both of these interact with financial markets and with the resource flows that come with them. The last twenty years in Europe (as well as the UK and the US) have seen inflation lower and more stable than ever before in recorded history. At the same time, three concerns have emerged. First, there is increasing concern that central banks have lost their ability to raise inflation, and especially that inflation expectations in financial markets have become unanchored. Second, with a large and growing public debt, and central banks that have large balance sheets with many government bonds in their assets, there is a realization of a growing tension between the actions of the central bank and their fiscal implications for the ministers of finance. Third, with the undertaking of many unconventional policies by central banks in response to the financial crises, choices must be made on which of these policies to keep in normal times or not.

This research answers these questions. It uses insights form finance and economic history, together with new methods, and unconventional approaches on the solvency of a central bank or the use of monetary policy tools, to understand what determines actual and expected inflation. It uses new data, and introduces new models, that can provide a deeper understanding of the dynamics of inflation.

Work performed

So far, 13 scientific articles were produced, 5 of which are already published, 4 are being revised in submission, and 4 others are still in first-draft form. Already 20 keynote lectures have been given over the past three years disseminating the work, and 11 students have been employed part time in the activities of the research. Two significant prizes were awarded to the PI, the prize for best macroeconomist under the age of 40 with European nationality, and the prize for best researcher working macroeconomics or finance under the age of 40 that is based in Europe.

Scientifically, the main results are: First that central banks can and go insolvent, whenever they are independent and do not have full fiscal backing. Second that keeping a large (but not too large) balance sheet so that the interbank rate and the deposit rate at the ECB are approximately the same provides for a better conduct of monetary policy. Third, that in a fiscal crisis, quantitative easing is not neutral because reserves are different from government bonds in that they are default-free, are only held by banks, and are the unit of account. Fourth, that looking at the evolution of inflation over the past decade, its remarkable stability can be decomposed into some elements of luck and much good policy. Fifth, that central banks have a very limited ability to lower the fiscal burden facing fiscal authorities. Sixth, that targeting long-term rates risks making inflation more volatility and potentially unanchored, as the experience in the US in the 1940s and in the UK in the 1950s attests to.Seventh that the central force through which the central bank controls inflation in modern monetary models is arbitrage in financial markets, not the price setting of firms. Seventh that because inflation is sluggish and the maturity of the public debt held by the public is relatively low, the ab ility to inflate away the debt is quite limited.

Final results

New methods have been introduced to measure expected inflation and its persistence, to assess the solvency of the central bank, to measure the fiscal footprint of central bank actions, to combine financial analysis with economic history to understand the intervention of central banks in debt markets, and to measure the sensitivity of the public debt to inflation. These all pushed the state of the art in the study of inflation. Until the end of the project, I will be pursuing the interaction between market and survey inflation expectations, the fiscal footprint of macroprudential tools, and the development of a risk management framework for central banks.