Other than government bonds? That's a rhetorical question. They can.
David Andolfatto has gone over to the Dark Side, and all the lefty keynesians are celebrating their new convert to Big Government Deficits. (Tongue in cheek warning.)
Not so fast.
David imagines a world where the demand for (central bank money + government debt) is rising over time, and the government refuses to run big enough deficits to increase the supply of government debt at the same rate as the increasing demand, and he says that this must (sooner or later) inevitably mean the central bank is unable to prevent inflation falling below target.
David's key assumption is:
"[A1] The central bank cannot forever monetize [government] debt at a rate faster than it is being issued." [added by me]
He continues:
"Assumption [A1] is relatively weak because it does permit a central bank to grow the money-to-debt ratio temporarily. It just can't do so forever.
If [A1] holds, then the endgame is clear. Eventually the growth in the money-to-debt ratio must cease. At this point, inflation must decline back to the rate implied by the fiscal anchor. The cards are stacked against the central bank in this game. Sumimasen, Nippon Ginko."
(I had to Google the last bit, which I think means "Sorry, Bank of Japan". Which is strange, because Japan is the last country I would mention if I wanted an example of a government that had low inflation because the government deficits and debt were too small.)
OK, let's take an extreme case. Suppose the federal government runs a budget surplus, for year after year, pays off the national debt completely, and refuses to ever run a deficit in future. (That's not a very sensible fiscal policy, but let that pass.)
What can the central bank do, if it wants to increase the money supply to prevent inflation falling below target, and the government issues no bonds for the central bank to monetise (buy)?
Simple. It buys something else. Where is it written that central banks can only buy central government bonds? OK, OK; there may be laws restricting what central banks can buy, but laws are made to be broken changed, if circumstances warrant. At best David would have a legal restrictions theory of lowflation, where those legal restrictions would be silly legal restrictions in the circumstances where David's theory of lowflation would apply.
Central banks could buy: provincial/state government bonds; foreign government bonds; municipal bonds; commercial bonds; commercial stocks; real assets like land and houses; etc.. Central banks can (and do) lend money to commercial banks, which is like buying commercial bank bonds (isn't that basically what the ECB system does?).
If a central bank runs out of assets to buy, and can't find anyone who wants to borrow from the central bank (sell the central bank an IOU) then yes, we've got a problem. Then, and only then, would the central bank have to give money away (helicopter money) to prevent inflation falling below target.
Paradoxically, it is precisely when the central bank is expected to create too little money, and targets too low an inflation rate, that the real demand for central bank money Md/P will be highest, and the bank is in the greatest danger of running out of assets to buy, because it already owns all the assets in the economy.
Roger Farmer wants central banks to buy stocks, not government bonds. I'm not sure whether Roger is right, but if the central bank ran out of bonds to buy, I would say go for it.
Worthwhile Canadian Initiative 
Scott,
What makes you think that “the Fed” is “confident” it can target inflation at 3% or 4%?
Some FOMC members strongly believe in the Phillips curve. According to this religion, if the unemployment rate continues to fall, inflation must rise. (Never mind that the PC appears to slope in all different directions.)
Others appear “confident” that inflation will revert back to target because…well, because it always has in the past.
It was nice meeting you in St. Louis the other day. You owe me a lunch, remember. 🙂
@David,
“In my view, one cannot just “will” the inflation rate higher by announcing a higher inflation target, especially at the ZLB. Fiscal support is needed. This is just the algebra of the consolidated government budget constraint, which has to hold in any sensible model (as it does in reality).”
You have persuaded me that in the long run an inflation target not supported by appropriate fiscal policy would be unsustainable.
However I’m not seeing how this affects short term monetary policy. In the short term it is assets swaps that create new money that drive inflation, and if govt borrowing doesn’t match this then the money/govt debt ratio goes up but that has little or no immediate economic effect.
I do not think people right now are thinking “the fed can’t hit its inflation target because fiscal policy is out of line with the target and its balance sheet would go too big”, but rather “the fed can’t hit its inflation target right now because of other higher priority goals it has that will prevent it doing what is needed to do so”. The reason that the money/govt debt ratio is currently so high is probably because of unusually high demand to hold money. A higher inflation target would (logically) reduce this demand and might actually lead to a lower not higher ratio.
@Market Fiscalist
In the short-run, inflation is determined (in my model) by both the growth rate in the supply of nominal debt and the growth rate in the real demand for that debt (in a more general open economy model, this demand growth could be coming from foreign sources, generating trade deficits, which is what we are in fact witnessing in the U.S.).
So, if fiscal authority grows nominal debt at some (more or less) fixed rate, then disinflation could be the byproduct in an elevated growth in the real demand for government debt.
In a liquidity trap scenario, no amount of money-bond swaps is going to matter: these operations in no way affect how rapidly the total supply of nominal debt is growing. The central bank can “wish” whatever inflation target it wants. It’s not going to get it if the money-to-debt ratio is bounded (for whatever reason at all).
That’s my story, and I’m sticking to it! 🙂
@ David Andolfatto
“‘Strange’ is different [from] saying it is ‘wrong’. :)” Granted; the point is not that your reference to Japan was (implicitly) a false statement, rather that it was rhetorically inappropriate.
@ Scott Sumner:
“I don’t like the italics, makes me look like an angry crank. :)”
No, even in italics you come across as a mellow, genial crank!
@David,
If demand for debt is assumed to stay constant then in your model, in the short-run,inflation is determined purely the growth rate in the supply of nominal debt.
Are you saying that this is the case irrespective of how much of that debt is monetized ? So if the govt sells loads of bonds and spends the money raised it will be inflationary even if the CB monetized none of the newly created debt ?
Or do you mean that when the CB does monetize debt it is only inflationary if accompanied by a corresponding increase in total debt ?
(second one makes sense to me as a long term effect)
@ Market Fiscalist
See here: http://www.sfu.ca/~dandolfa/coordination_games.pdf
Does’t the Switzerland National Bank already buy all kinds of assets, including assets on the stock market?
What a bunch of bogus junk. Central banks are given access through assets allocation. They don’t really “buy” anything. They can remove “dirty objects” like toxic MBS markets don’t want to deal with or need to leave their balance sheets so they can become liquid, that is it and the policy rate. They can do the same thing with government debt if needed, but that is basically the government saying it because they backstop these 12 banks.
Saying there is a current “depression” is silly. There is no depression. With the passing of the Boomers demographically and the end result of the last innovation wave, the velocity of money is slowing down and growth is no longer needed or wanted frankly. The economy is already built up. A inflation “target” at 2% isn’t a midrange goal, but the likely level when unemployments hits its crescendo and the next cyclical recession is nearing.
“Does’t the Switzerland National Bank already buy all kinds of assets, including assets on the stock market?”
Many nations decide, for strategic reasons, to hold foreign bonds or other assets, and the agent for these purchases is the central bank, whereas the owner of the assets is the treasury. In this sense, the central bank acts as a broker for the Treasury in the same way that your own personal broker executes trades on your behalf for assets in your account, or in the way that your own personal bank might have a vault in which you can store some of the gold that you own.
But because the central bank holds these assets and executes the trade does not mean that the central bank owns them, all such assets are owned by the Treasury, not the bank. Actually all of the central banks assets are owned by the general government because the treasury owns the central bank outright, and so it is responsible for covering the bank’s losses — as swiss taxpayers are now finding out, or as British taxpayers found out when Soros “broke the Bank of England”.
People forget that the central bank is an intermediary for the general government. The general government gives some leeway for the central bank to make independent purchases of government debt, or of other types of debt specified by statue, but the central bank is not an independent actor here, it is a broker or trustee, and all of its assets are owned by the general government, even if the central bank is given a prescribed form of independence vis-a-vis interest rate policy.
David, The Fed has produced an average of 2% inflation since 1990. That doesn’t just happen by accident, and it was not done via fiscal policy. So they can do it. It’s actually easier to get 3% or 4% inflation than 2%, because there is less of a zero bound problem. When Bernanke’s been asked about a higher target, he doesn’t say it’s impossible, he says it’s unwise. I don’t recall any Fed official ever saying the target rate could not have been set at 3% or 4%. Volcker seemed able to target inflation at 4% from 1982 to 1990. Academic economists believe the Fed could raise its inflation target, they disagree about the wisdom of doing so. Many recommend this option (Blanchard, Rogoff, Krugman, etc.) I suppose its possible that a few people at the Fed believe it’s impossible to target a higher trend rate of inflation, but have they written any papers claiming that view, and explaining why?
And again, the Fed would not be contemplating an increase in their target rate if they didn’t think they had the tools to keep inflation at 2%.
I’m not a fan of Phillips Curve analysis, so I won’t comment on those peculiar views. I do not believe inflation is caused by economic growth.
And yes, I do owe you a lunch. Get the Fed to set up a NGDP futures market and I’ll buy you 100 lunches. 🙂
@Scott Sumner:
JKH, sorry for my late reply.
Brian said: “In “overdraft” economies, the central bank lends to private banks, instead of buying government bonds.”
Why doesn’t that mean buy a demand deposit (or something extremely similar)?
Assume a run on a solvent commercial bank with an ECB like central bank. Demand deposits get converted to currency. The commercial bank does not have enough currency. The central bank “lends” to the commercial bank by buying the “reissued” demand deposits (a type of bond) and selling currency. This keeps the commercial bank from having to sell assets.
Anything wrong with my scenario?
Also, does the fed have two ways of operating? One is open market operations. The other is lending thru the discount window. Is lending thru the discount window like an ECB type system?
Nick said: “Brian: we can imagine a world (like in the New Keynesian model) where people can have both positive or negative balances in their chequing accounts at the central bank. And where the positive and negative balances exactly cancel out, so the central bank has no assets or liabilites except those negative and positive balances, and where the interest paid on positive balances equals the interest charged on negative balances, so the central bank earns zero profits (ignore admin costs).”
Brian said: “Nick, I did not completely follow your response. The central bank always needs to have net financial assets if there is currency (notes and coins) outstanding (as they are a liability). Meanwhile, banks might need reserves under some banking system rules. This means that the monetary base is a positive number.”
Brian, could the assets be intangible?
Also, you need to replace positive bond balance that is a liability of some entity anywhere Nick says negative balances in their chequing accounts. I think that will help.
There is no such thing as a “negative balances in their chequing accounts”. For example, assume you have $500 in your checking account. You write a check for $1,500. It goes thru because you have overdraft protection. Here is what happens. $500 gets transferred from your checking account. Your checking account balance does not go negative. You borrow $1,000 in demand deposits by issuing a bond to the bank. The bank gets the bond. You get $1,000 in demand deposits in your checking account. The $1,000 gets transferred. At no time did your checking account balance go negative.
For David Andolfatto, can you post at your site without any of the accounts in the drop down list? Thanks!
@Too Much Fed,
I’m not sure what you’re asking. I think you are asking whether anyone can post a comment at my blog without signing in on an account from the drop down list (like Google, Twitter, etc.)? If so, I’m not sure…I can go check some settings. If this is not what you’re asking, then send me an email: david.andolfatto@stls.frb.org
David: I’m on the farm in england, using the farm computer, so I can’t copy and paste. But I basically agree with your May 5th reason for why defaltionary spirals cannot happen, IF the central bank prevents M collapsing to zero (which is what central banks actually did do, and more, because they increased M). But simply setting a nominal i, and letting M be demand-determined, is consistent with M collapsing to zero.
Nick, hope you managed to find some bluebells in the woods, and family and friends are well. Good luck licking everyone and everything into shape. The Gatineau mosquitos emerged approximately 1:47 p.m. last Saturday afternoon.
Too Much F.,
The ECB operates such an “overdraft” system.
The standard (pre-QE) ECB balance sheet consists mostly of lending to banks funded by currency issued and bank reserve balances. Thus, the non-government sector finances part of the banking system indirectly via currency and reserves and the rest directly through deposits and other forms. I believe this form of bank lending by the ECB is known as “refinancing operations”. Unlike deposits, these are secured loans, but the monetary effect is the same.
The standard (pre-QE) Fed balance sheet consists mostly of Treasuries funded by currency and reserves. So the non-government sector funds the government in part indirectly via currency and the rest with bonds and bills.
Your scenario is fine (roughly) for either system. This is last resort lending, which both the ECB and the Fed can do at their option. Lending through the discount window is such last resort lending. Whereas the ECB’s refinancing operations are standard ongoing procedure.
I’m sure that there is some way to create inflation, but I have been expecting, for at least 20 years, deflation to start at the beginning of this century due to the obvious demographics: Baby-boomers retiring, dropping out of the work-force, and withdrawing their savings. Upon reflection, I should have also included the death of the preceding generation in that analysis.
Is the government able to create enough money to counter the demographics? I rarely come across any post that includes demographic analysis alongside NGDP targeting analysis.
David Andolfatto said: “I think you are asking whether anyone can post a comment at my blog without signing in on an account from the drop down list (like Google, Twitter, etc.)? If so, I’m not sure…I can go check some settings.”
That is what I am asking. Let me know what you find out.
JKH said: “The standard (pre-QE) ECB balance sheet consists mostly of lending to banks funded by currency issued and bank reserve balances.”
So the assets of the ECB (pre-QE) are bonds from the commercial banking system?
“Unlike deposits, these are secured loans, but the monetary effect is the same.”
I’m thinking a demand deposit is a bond/loan that is secured by the assets of the commercial bank?
Also, is the price fixed for these “secured loans” (the central bank and commercial banks buy and sell from each other at a fixed exchange rate that just happens to be 1 to 1)?
“Whereas the ECB’s refinancing operations are standard ongoing procedure.”
Pre-QE, the ECB did no open market operations, just “discount window lending”. Right?
Lastly, assume an ECB central bank system, all the commercial banks are solvent, every entity knows that, and each of them experiences a bank run because demand for currency increases unrelated to solvency concerns. Would the ECB ever deny convertibility to currency?
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