David A. Price interviews Stéphanie Schmitt-Grohé in the latest issue of Economic focus (Federal Reserve Bank of Richmond, Q3 2022, pp. 24-28).
On the problem of using surprise inflation to finance public debt:
When Martin [Uribe] and I was interested in the subject of price stability, there was an influential paper on optimal monetary and fiscal policy which concluded that when there is a change in the budget deficit or government spending, to respond by adjusting taxes distorting – say, taxes on labor income – is not good from a welfare point of view. What you can do instead, the argument goes, is have surprise inflation. So if you get, say, an increase in government spending and you have to fund it, then if nobody expects inflation, you can just have a one-year inflation surprise. And this literature concluded that this was, in fact, the best thing to do: keep tax rates stable and fund fiscal surprises with surprise inflation.
Martín and I wondered what would happen to this result if we introduced rigid prices – the idea that prices are expensive to change – in the situation. Our contribution was to show in a quantitative model that the trade-off between surprise inflation and fiscal smoothing was largely resolved in favor of price stability. With price stickiness, volatile inflation reduces welfare. This somehow reversed the previous result. …
A question that comes up a bit, I think, is how is the United States going to finance a massive budget deficit that created the big pile of debt? Are we going to use surprise inflation? Here, our research would say no, it’s not optimal to do that.
On what historical experience has to say about temporary and permanent inflation:
We find ourselves in a bit of an unprecedented situation. Inflation rose rapidly. And so we [Schmitt-Grohé and co-author Martín Uribe] reflected on this rather unusual development for the post-war period.
We wanted to answer the question that I think everyone is interested in: is this rise in inflation temporary or permanent? Our idea was that during the post-war period – since 1955, let’s say – the only major inflation was the inflation of the 1970s. And that was inflation that slowly built up and then also ended relatively slowly – faster than it accumulated, but relatively slowly – by Paul Volcker in the 1980s. So we thought, since the current inflation is unprecedented in the post-war period, what will we see if we go back a little further in history?
Because we wanted to go back in history, we used the database of Òscar Jordà, Moritz Schularick and Alan Taylor, which dates back to 1870. We saw that the macroeconomic stability we had in the post-war period was particular, at least compared to what we have seen since 1870. There have been many more episodes of high and variable inflation. So we just wondered if we gave the purely statistical model a longer memory by allowing it to go back in time, how would it interpret the current rise in inflation?
We found that if we estimate the model back to 1955, which is what most people do when they talk about cyclical fluctuations – in fact a lot of people only start in the 1990s or look at the last 30 or 40 years, the so-called period of Great Moderation — the model is led to interpret the entire current rise in inflation as permanent. But if the model has the ability to look further back in time, where we’ve had more episodes of a short-lived and large spike in inflation, the interpretation is that only 1 or 2% of the current rise in inflation is of a more permanent nature. nature.
An example to look at is the 1918 Spanish flu in the United States. It was also a period of peak inflation, but inflation had already started a year or two before the flu pandemic. There were similarities to now, namely a pandemic and high inflation. There was a slight increase in the permanent component of inflation in the years around the flu pandemic, but most of it was transitory.
On the multiple benefits of starting your post-doctoral career in economics as a research economist at the Federal Reserve:
I would say four things were great about this job. In the beginning, you have almost all your time for research. So you come out of graduate school, you have all the papers for your thesis, and you try to polish them to send them to journals. The Fed gives you time to do it. I would say that you have more time to do this if you work in the research department of the Fed than if you start teaching at a university because you have to do one or two class preparations, which takes time. So that was a big thing.
A second big thing is that they used to hire – it’s probably still true – something like 20 or 30 PhDs a year from the top graduate schools. And they were more or less all in macroeconomics. If you attend a university, you most likely have at most two or three junior colleagues in your field. But at the Fed, you had a large cohort of them that you could interact with and talk to over lunch – there was a culture of going to lunch together in the Fed cafeteria – so it was empowering that way.
Another thing that was great was that you had to do some policy work. The Board of Governors wants to know what the research staff thinks about current economic problems and what economic policy would be the right one. Once or twice a year, you had to write a memo that you read aloud during the FOMC briefing. So your audience was Alan Greenspan and the other governors. So you have to work on interesting questions and you have understood what the relevant questions are. The process gave you a pipeline of research questions that you could work on later.
Finally, because the Council is such a large institution, it runs quite a large program of workshops with outside speakers. Almost too many speakers came – more than one a week. You have met all the major personalities in your field because they came to give a workshop or they came to visit the Fed for a day or two.