David A. Price interviews Stephanie Schmitt-Grohé in the most recent issue of Econ Focus (Federal Reserve Bank of Richmond, Third Quarter 2022, pp. 24-28).
On the problem of using surprise inflation to finance government debt:
When Martín [Uribe] and I got interested in the topic of price stability, there was an influential paper on optimal monetary and fiscal policy that concluded that when you have a change in the fiscal deficit or government spending, responding by adjusting distortionary taxes — say, labor income taxes — is not good from a welfare point of view. What you can do instead, the argument went, is to have surprise inflation. So if you get, say, an increase in government spending, and you need to finance that, then if nobody’s expecting inflation, you can just have a one-year surprise inflation. And that literature concluded it was, in fact, the best thing to do: Keep tax rates steady and finance surprises to the budget with surprise inflation.
Martín and I wondered what would happen to this result if one were to introduce sticky prices — the idea that prices are costly to change — into the situation. Our contribution was to show in a quantitative model that the tradeoff between surprise inflation and tax smoothing was largely resolved in favor of price stability. With price stickiness, volatile inflation is welfare-reducing. It sort of overturned the previous result. …
One issue that I think has been coming back a little bit is how is the United States going to finance a massive fiscal deficit that created the big stack 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 a little bit in an unprecedented situation. Inflation has gone up rapidly. And so we [Schmitt-Grohé and co-author Martín Uribe] were thinking about this pretty unusual development for the postwar period.
We wanted to answer the question that I think everybody is interested in: Is this inflation hike temporary or permanent? Our idea was that during the postwar period — since 1955, say — the only big inflation was the inflation of the 1970s. And that was an inflation that built up slowly and then was ended also relatively slowly — quicker than it built up, but relatively slowly — by Paul Volcker in the 1980s. So we said, since the current inflation is unprecedented in the postwar period, what will we see if we just go further back in history?
Because we wanted to go back in history, we used the database of Òscar Jordà, Moritz Schularick, and Alan Taylor, which goes back to 1870. We saw that the macroeconomic stability that we had in the postwar era was special, at least compared to what we see since 1870. There were many more episodes of high and variable inflation. So we just asked if we give the purely statistical model a longer memory by allowing it to go back in time, how would it interpret the current increase in inflation?
We found that if we estimate the model since 1955, which is what most people do when they talk about cyclical fluctuations — actually, many people only start in the 1990s or look at the last 30 or 40 years, the so-called Great Moderation period — the model is led to interpret the entire current increase in inflation as permanent. But if the model is given the chance to look back further in time, where we had more episodes of a short-lived and large inflation spike, the interpretation is that only 1 or 2 percent of the current increase in inflation is of a more permanent nature.
An example to look at is the Spanish Influenza of 1918 in the United States. That was also a period of an inflation spike, but inflation had started already a year or two before the influenza pandemic. There were similarities to now, namely a pandemic and high inflation. There was a small increase in the permanent component of inflation during the years around the influenza pandemic, but the majority of it was transitory.
On the multiple benefits of starting your post-PhD economics career as a research economist at the Federal Reserve:
I would say four things were great about the job. At the beginning, you have almost all of your time for research. So you come out of graduate school, you have all the papers of your dissertation, and you’re trying to polish them to send to journals. The Fed gives you the time to do that. I would say you have more time to do that if you work in the research department at the Fed than if you start teaching at a university because you have to make one or two course preps, which takes time. So that was one great thing.
A second great thing is they used to hire — probably this is still true — something like 20 or 30 Ph.D.s a year out of top graduate schools. And they were more or less all in macroeconomics. If you go to a university, most likely you have, at most, two or three junior colleagues in your field. But at the Fed, you had a large cohort of them with whom you could interact and talk at lunch — there was a culture of going for lunch together in the Fed’s cafeteria — so it was stimulating in that way.
Another thing that was great was that you had to do a little bit of policy work. The Board of Governors wants to learn what the research staff thinks about the economic issues of the moment and what economic policy would be the correct one. Once or twice a year, you had to write a memo that you would read aloud in the FOMC briefing, so your audience was Alan Greenspan and the other governors. So you got to work on interesting issues and you got an understanding of what the relevant questions are. The process gave you a pipeline of research questions that you could work on later.
Lastly, because the Board is such a big institution, it runs a pretty large program of workshops with outside speakers. Almost too many speakers came through — more than one per week. You got exposed to all the major figures in your field because they came to give a workshop or they came to visit the Fed for one or two days.