Modern Monetary Theory, Part 3: MMT and inflation

A basic premise of Modern Monetary Theory (MMT) is that a country that enjoys sovereign control over its money supply is effectively unconstrained by capital markets in the amount of borrowing the government can do to finance public sector deficits. This is because the country’s central bank can buy the debt instruments (i.e. bonds) issued by the government by essentially “printing money” to pay for the bonds. The central bank can further mitigate the government’s direct cost of borrowing by charging a zero-interest rate on the debt instruments purchased.

Proponents of MMT acknowledge that there is a potential limit to printing money to finance government deficits. Namely, at some point, increased government spending facilitated by MMT could lead to increased inflation. These proponents, for the most part, acknowledge the potential for MMT-based policies to contribute to inflation, but they argue that such inflation can be addressed by the government cutting back on deficit spending by raising taxes.

In effect, those who support MMT essentially view the inflation rate as the signaling mechanism for governing the size of the fiscal deficit that is financed by the central bank’s printing press. If inflation is a “problem,” cut back on the use of the printing press to finance deficits. When inflation is not a problem, there’s no reason to burden the economy with taxes or positive interest rates.

While there are other elements of MMT that deserve additional attention, including government-guaranteed jobs at an established minimum wage, we leave those for future blog posts. In this post, we focus on whether MMT proponents are unduly complaisant about inflation problems that might arise from their proposed policies.

As a first point, while hyperinflation can ultimately destroy an economy, even modest rates of inflation can do significant damage if actual and expected rates of inflation diverge. If producers and workers are able to anticipate inflation accurately, they can appropriately incorporate those expectations into their calculations about the market clearing prices they should charge for the goods and services they supply. Likewise, lenders can accurately estimate the real interest rate they expect to earn, while borrowers can anticipate the real interest rate they will pay. Since the allocation of resources in an economy depends upon relative prices, perfectly anticipated inflation should not affect the allocation of resources, since it should not distort relative prices.

Put somewhat differently, inflation becomes an economic problem when participants in the economy have difficulty distinguishing between changes in the overall price level of goods and services and changes in relative prices across different goods and services.

For example, to the extent that producers interpret price increases for their product as signalling greater demand relative to available supply, they will increase production of their product. However, if the price increases are an artifact of inflation (i.e. the prices of all goods and services are increasing, on average), increasing production is a misuse of resources, since the price increases are not a valid signal that consumers want more of the product in question.

Conversely, if the producers interpret price increases as manifestations of inflation, they may simply raise their prices to cover expected cost increases without necessarily increasing output. If the correct interpretation is that demand for their specific product was increasing relative to supply, a failure to increase output will lead to shortages.

In short, divergences between expected inflation and actual inflation contribute to economic inefficiencies that harm economic growth. This harm is exacerbated by a tax system that does not adjust for the effects of realized inflation on interest income and capital gains which, in turn, discourages growth-promoting capital investments.

A second and related point is that it’s difficult to accurately forecast inflation rates. Available studies have looked at survey-based measures and market-based measures, where the latter rely upon differences between yields on inflation-adjusted debt and non-inflation-adjusted debt instruments. Both survey and market-based predictions of inflation have been shown to have large error terms. Put simply, they are poor predictors.

Indeed, apparently the most accurate recent prediction “algorithm” for the U.S. inflation rate in recent years anchors inflation forecasts to the Federal Reserve's two per cent per year target. Since economic behaviour and resulting inflation rates are influenced by peoples’ expectations of inflation, central banks in developed countries have announced inflation targets and attempt to set monetary policy so as to stay close to the announced targets. To the extent that central banks are relatively successful, their actions can minimize the economic distortions created by unanticipated increases or decreases in average price levels.

While central banks have not been perfect in matching actual inflation rates to the widely targeted two per cent per annum rate, a challenge for proponents of MMT is to make a credible argument that using fiscal policy (i.e. increasing or not increasing taxes) is a more robust tool than monetary policy to minimize the difference between actual and expected inflation.

Since tax rates are set in a highly politicized arena, whereas central banks are at least nominally independent of political control, one’s intuition might lead to a conclusion that actual inflation is likely to become more variable and less predictable if MMT is implemented with consequent damage to economic efficiency. This issue will be the subject of future blog posts.