MacroMania

In my previous post (Inflation and Unemployment), I reviewed what I thought was a fair characterization of the way the Federal Reserve Board staff organize their thinking about inflation and unemployment, as well as how this view of the world was at least partly responsible for the "hawkish" overtone of current Fed policy. I also suggested that the inflation and unemployment dynamic might be better understood through the lens of an alternative theory that emphasized the supply and demand for money (broadly defined to include U.S. treasury debt).

I want to thank Paul Krugman for taking the time to critique my post and draw attention to an important issue that concerns U.S. monetary policy makers today (see: Immaculate Inflation Strikes Again). I was only a little disappointed to learn that I agreed with almost all of what he wrote in his column. But if this is the case, then what are we debating? And more importantly, how does it matter, if at all, for monetary policy?

The amount of disagreement in macroeconomics is often exaggerated and I think this has definitely been the case here. While we may disagree on some things, we seem to agree on the most important part, namely, on the present conduct of U.S. monetary policy.

Krugman begins his piece by stating three questions. Let me state the questions, followed by my own answers and comparisons.

1. Does the Fed know how low the unemployment rate can go? I have quipped before that this is one case in which the Fed can definitely count on a zero-lower-bound being in effect (and this is not just in theory, Switzerland had virtually zero unemployment throughout the 1960s, with low inflation I might add). But what this question is really asking is how low can the "natural" rate of unemployment go? I agree with Krugman: we don't know. But I'll further add: we don't even know if a "natural" rate of unemployment exists in the first place. It's just a theory, after all (which is not to say it shouldn't be taken seriously, only that we need to keep that important caveat in mind).

2. Should the Fed begin tightening now, even though inflation is still low? This is legitimately debatable--and the FOMC is presently debating it. My own view, on balance, seems presently more aligned with the "doves" on the committee. And so I also agree with Krugman on this score, namely, that the Fed could be tightening too aggressively. Krugman suggests that there are several reasons supporting his view and he mentions a few of them. They are all legitimate reasons, in my view. But I could add more reasons, based on my own preferred theory of inflation. The demand for money (broadly defined to include U.S. treasuries) appears to remain elevated. This disinflationary force has been in place for a long time and could, as I explain here, account for the lowflation phenomenon (see also here). If you follow that link, you'll note that I quote Krugman approvingly in regard to his view about monetary policy in a liquidity trap. Perhaps I am wrong, but I read Krugman here as not recommending that the Japanese lower their unemployment rate to raise inflation. Instead, he appeals to the model I alluded to in my post: a monetary-fiscal theory of inflation. If the Japanese want inflation, just cut taxes and finance social security spending by printing JGBs (as I recommended here). I'm not sure what this has to do with "immaculate" inflation. (I did learn from Nick Rowe that "maculate" is indeed a word.)

3. Is there any relationship between inflation and unemployment? I think it would be odd for any macroeconomist schooled in general equilibrium to suggest that the answer to this question is unequivocally no. The answer is yes. The real question is what type of relationship? In labor market search theories of unemployment, where firms and workers bargain over a joint surplus, a low unemployment rate can result in a higher real wage because workers have greater bargaining power. If a decrease in the unemployment rate leads to a rise in the real wage, it could, ceteris paribus, have an effect on the price-level (and, if prices are temporarily sticky, the adjustment could come along other margins). But an increase in the price-level is not the same thing as an increase in the inflation rate (though short-run price-adjustment costs can transform a price-level effect as a short-term rise in measured inflation). For workers to afford buying goods in the presence of ever-rising prices, their bank accounts are going to have to grow accordingly. Ultimately, this can only happen in aggregate if the aggregate quantity of money is growing, either through the banking sector or through the increase in the supply of outside money (including treasury debt). This is the sense in which I think inflation has to be a monetary phenomenon and that, moreover, the actual rate of inflation is ultimately not governed by whether unemployment is living above or below its "natural" rate, whatever that is.

So perhaps there's some room for debate on point 3. But we should be careful not portray the question as an "either/or" issue. We could just be two blind men, feeling different parts of the elephant--the two interpretations are not necessarily inconsistent with each other. We should try to work this out. On the plus side, it seems we are led to the same policy recommendation. This is something worth noting. (I plead guilty on the score of needlessly antagonizing people who "believe in" the Phillips curve. Rather than suggesting we abandon the theory, I could instead have suggested we supplement it with the monetary view.)

Does the debate over question 3 matter? Yes, it could, because different interpretations of how the world works usually--though not always---implies something different about optimal policy. The Phillips curve theory of inflation suffers from a free parameter problem: the natural rate is unobservable and hence, one can always appeal to a shift in the natural rate to explain away discrepancies with the data. However, the monetary theory I prefer also suffers from a free parameter problem: money demand is not directly observable either. I can always appeal to some unobserved shift in money demand to explain away discrepancies with the data. For this reason, it would be useful for economists to identify "robust" policies--policies that can be expected to deliver good results regardless of which theory best describes the world we are living in.

Is the Phillips curve view of inflation contributing to a policy mistake? I wanted to suggest in my post that it is, although this is not necessarily a fault of the theory as much as how it is applied. That is, there may be no policy mistake in the making if the FOMC simply lets its estimate of the natural rate fall freely as evidence of impending inflation fails to materialize. However, this is not what is happening. As Jim Bullard explained to me, he believes that Phillips curve proponents have a (strictly positive) lower bound on their estimate of the natural rate. The unemployment rate is so low now -- how can it possibly go any lower -- this has to lead to inflation in the near future -- it just has to. We'd better start raising now, before we find ourselves behind the curve.

Here is where the "monetarist" view could temper such resolve. Granted, the global outlook is looking relatively rosy, and fiscal policy seems expansionary--these are both inflation risks from a monetarist perspective. On the other hand, there is considerable uncertainty in this outlook, not the least of which is presently being fueled by talk of a global trade war. In uncertain times, consumers and investors are likely to lower their demand for goods and services--increasing their demand for safe assets, like U.S. dollars and U.S. treasuries. We can see these concerns weigh on long-bond yields. Market-based inflation expectations (like the 5yr-5yr forward) seem well-anchored. Current inflation is running below target. All of this suggests that the Fed can afford not to move aggressively at this time (to be fair, the FOMC regularly emphasizes the "data dependent" nature of its policy path). And yes, this is consistent with PC advocates that are willing to let their estimate of the NRU decline in line with the evidence.

This post is already getting too long and so I wouldn't blame you if you stopped reading here: the main points I wanted to make have been made. Still, I have a bit more to say, so in case you are interested...

Krugman presents the following data for Spain. He writes "Consider, for example, the case of Spain. Inflation in Spain is definitely not driven by monetary factors, since Spain hasn’t even had its own money since it joined the euro. Nonetheless, there have been big moves in both Spanish inflation and Spanish unemployment:"

Krugman asserts because Spain doesn't have its own monetary policy, that monetary factors were not responsible for swings in Spanish inflation and unemployment. But my interpretation of the great crash and subsequent rise in unemployment is that it was caused by a large positive money demand shock (where again, I stress, by money I include safe government debt). This positive money demand shock (flight to safety) is just the opposite side of what Krugman and others would label a negative aggregate demand shock. So once again, I think Krugman is digging moats (perhaps unintentionally) where he could be building bridges.

The other thing I should like to point out about the Spanish data is whether it suggests that low unemployment forecasts future inflation (which is really what my post was about). A naive reading of the data above suggests that low unemployment actually seems to forecast low inflation. Again, this suggests caution in using the unemployment rate to forecast inflation.

Finally, on Krugman's broader point: "economics is about what people do, and stories about macrobehavior should always include an explanation of the micromotives that make people change what they do. This isn’t the same thing as saying that we must have “microfoundations” in the sense that everyone is maximizing; often people don’t, and a lot of sensible economics involves just accepting some limits to maximization. But incentives and motives are still key."

I wholeheartedly agree.

The FOMC decided on March 21 to increase the target band for the federal funds rate by 25 basis points, to a range of 1.50-1.75%. This despite inflation running persistently below the Fed's 2% target, only moderate wage growth, and inflation expectations firmly anchored.
What is the FOMC thinking here? To be more precise, what is the dominant view within the FOMC that is driving the present tightening cycle? Remember, the FOMC is made up of 12 regional bank presidents plus 7 board of governors (at full strength) possessing a variety of views which are somehow aggregated into a policy rate decision. I think it's fair to say that the dominant view, especially among Board members, is heavily influenced by the Board's staff economists. So, maybe what I'm really asking is: what is the Board staff thinking?

Perhaps they're thinking along the following lines. Thanks in part to a recent change in U.S. fiscal policy and in part to a relatively robust world economy, the U.S. economy seems poised for a growth spurt of unknown duration. As the economy expands, so too does the demand for investment and credit which, in turn, puts upward pressure on market interest rates. If the Fed does not follow this pressure upward (by raising its policy rate) then it risks inefficiently "subsidizing" investment spending and credit creation (leading to excess credit and spending). There might even be some justification for raising the policy rate more aggressively than what the market would dictate on its own, if it is judged that the imminent growth spurt was due to an "irrational" exuberance or if it is otherwise judged to be unsustainable (and subject to a sharp correction).

The view above may constitute an element of the way a few hawks on the committee are thinking when they cite financial stability concerns. But economists at the Board are probably not thinking exactly in this way because it offers no direct link to the Fed's dual mandate of promoting price stability and full employment. Price stability is interpreted by the FOMC as a long-run PCE inflation rate of 2% per annum. And while there's no official measure of "full employment," for all practical purposes it is defined as a situation in which the unemployment rate is at its "natural" rate.

What is the "natural" rate of unemployment? The Board defines the term here. According to this statement, it corresponds to the lowest sustainable level of unemployment in the U.S. economy. How do we know what this lowest sustainable level is? The statement implicitly answers this question by mapping "lowest sustainable level" into some notion of a "long-run normal level" of the unemployment rate. In short, take a look at the average unemployment rate over long stretches of time and assume that it roughly corresponds to what is sustainable. In his recent press conference, Fed Chair Jay Powell explicitly mentioned that any such estimate will a have large confidence interval--that is, we don't know what the natural rate is and we suspect it may change over time. (He might have mentioned that we're not even sure this theoretical object exists in reality but, of course, we could say this of any theoretical construct in economics, including supply and demand curves.)

In any case, here is a plot of the U.S. civilian unemployment rate since 1948, along with the Congressional Budget Office's estimate of the "natural" rate of unemployment:
The unemployment rate does appear to be a relatively stationary time-series. What's interesting about the U.S. data is that the unemployment rate only appears to rise in periods of economic recession (when GDP growth is negative). Moreover, there's evidence of a cyclical asymmetry: when it rises, it rises sharply, but when it declines, it does so relatively gradually (these patterns are not so evident in other countries).

The Board's concern, at present, is the fact that the unemployment rate fell to its (estimated) natural rate of 4.7% early in 2017 and has since declined steadily to 4.1% today. Given a relatively robust global economy, and given the recent fiscal stimulus in the U.S., the unemployment rate is projected to decline even further in the foreseeable future. This, evidently, is bad news. Why? Because it's unsustainable (read: likely to end badly). The economy is presently operating above its long-run potential level.

What does any of this have to do with inflation? Inflation is the rate of change of the price level (the "cost of living" measured in dollars). Sometimes people speak of wage inflation--the rate of change of the average nominal wage rate. Way back in the day, William Phillips noted an apparent inverse relationship between the rate of wage inflation and the unemployment rate. Others noticed a similar inverse relationship between the rate of price-level inflation and the unemployment rate. This statistical relationship became known as the Phillips curve.

The standard interpretation of the Phillips curve, a version of which is used by the Board staff today, goes something like this: To the extent that business cycles are caused by movements in aggregate demand (e.g., bouts of optimism or pessimism) then one would expect the general level of prices to rise when aggregate demand is high and to decline when aggregate demand is low. Moreover, one would expect firms to recruit workers more intensively when aggregate demand is high than when it is low, so that the unemployment rate should decline in a boom and rise in a recession.  In this way, aggregate demand shocks cause unemployment and the price-level to move in opposite directions. One would expect the inflation-unemployment relationship to reverse if a recession was instead triggered by a supply disruption (e.g., an oil price shock).

Importantly, the consensus view is that there's no long-run trade-off between inflation and unemployment (or, if there is, it seems to go in the opposite direction). Here's the relationship between inflation and unemployment in the U.S.
Apart from the oil supply shock episodes, inflation and unemployment do tend to move in opposite directions in recessions. But recessions are short-lived, and the relationship between these two variables during economic expansions is much less clear. For example, inflation and unemployment both fell from December 1982 to January 1987, from June 1992 to March 1995, and from August 2011 to October 2015.

It's hard to tell from this data alone whether low rates of unemployment portend higher inflation because in the background we have the Fed raising interest rates when there are signs of inflationary pressure. On the other hand, it's probably just as reasonable to expect the opposite. That is, in a deep demand-driven recession that drives the unemployment rate up and the inflation rate down, the high rate of unemployment at the trough should forecast higher future inflation (assuming that inflation is expected to return to target).

Is there any evidence that a low unemployment rate during an expansion forecasts higher future inflation? My feeling is that the empirical evidence is weak on this score. If so, then it is odd that so many people seem to believe that "low unemployment causes higher inflation." One can see this idea manifest itself in headlines like this: Fed's Mission Improbable: Lift Unemployment--But Avoid Recession (by Greg Ip of the WSJ). I reproduce a few of the opening paragraphs here for convenience:

Massive tax cuts, robust federal spending and a synchronized global upswing are expected to push annual growth in economic output to 2.7% this year and 2.5% next—past what Fed officials consider its long-run sustainable rate of 1.8%—according to projections Fed officials released after their meeting Wednesday. 

To sustain such growth, the Fed projects employers will have to dig deep into a diminishing supply of workers. That will cause unemployment, already at a 17-year low of 4.1%, to sink to 3.6% by the fourth quarter of 2019, a level last seen in the 1960s. That’s well below the “natural rate” of 4.5%, which is the rate Fed officials and many economists think the economy can sustain without eventually producing inflation. 

But it faces a problem: In theory, unemployment will eventually have to go back to 4.5%, or inflation will head even higher. Yet since records begin in 1948, unemployment has never risen by 0.9 points, except in a recession.

This almost makes it sound like the Fed is trying to increase the unemployment rate.  Of course, this is not how Fed officials would describe their intent. The goal is to ensure that the economy does not embark on an "unsustainable" (bound-to-end-badly) growth path. To hedge against this event, the Fed will have to raise its policy rate to keep aggregate demand and inflation in check. The collateral damage in this hedging strategy is for the unemployment rate to rise (hopefully in a smooth manner and to more sustainable levels).

I think it's time for economists to stop relying so heavily on the Phillips curve as their theory of inflation.There are two good reasons to do so. First, it's bad PR to (unintentionally) suggest that workers are somehow responsible for inflation. Second, and more importantly, it would help avoid policy mistakes like raising the federal funds rate too aggressively against low unemployment rate data.

To see the potential for policy mistakes, recall how in December of 2012 the FOMC adopted the so-called "Evans rule" (named after Chicago Fed president Charlie Evans):

In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

I pointed out  here at the time that while the Evans rule was meant to signal a more Dovish policy, it was inadvertently signalling a more Hawkish policy. As it so happened, the Fed did not raise its policy rate when the unemployment rate broke below 6.5% in April 2014. But it might have, and markets likely hedged against this possibility, resulting in a tighter than desired monetary policy.

In any case, back to the current tightening cycle and the factors influencing it. A few FOMC members are asking what the apparent rush to raise rates is all about. Jim Bullard, president of the St. Louis Fed has long been a vocal advocate for data-dependent policy. Inflation remains below target and long-term inflation expectations are on the low side as well. According to Bullard, the Fed can afford to be patient (and to move rapidly as conditions dictate).

One counterpoint to this view is the idea that the Fed needs to "get ahead of the curve." Again, the notion is that while inflation remains below target, we are confident that it will soon return to target and we can see inflationary pressures building up in the horizon (as evidenced by the very low rate of unemployment, among other things). I saw Charlie Evans push back against this idea pretty effectively on a recent CNBC interview. According to Evans, the "getting ahead of the curve" idea is largely a byproduct of an era where inflation was almost always above target. In the past six years, however, we've been operating in an environment where inflation has been persistently below target. Getting ahead of the curve is perhaps not as pressing an issue as it once was. A doubling of the inflation rate from 1.5% to 3% is not as disconcerting as a doubling from 4% to 8%.

I think that Minneapolis Fed president Neel Kashkari has a pragmatic approach to the problem (see the reasons he gives here for why he dissented for the 3rd time against raising the policy rate).  Suppose we subscribe to the notion that a below-natural-rate of unemployment portends future inflation. Suppose further we admit that we do not know where the natural rate of unemployment resides (as mentioned above, Fed Chair Jay Powell alluded to the uncertainty surrounding this estimate). Well, then why not just assume that the natural rate is declining as long as we see no evidence of price or wage inflation pressure?

If we abandon the traditional Phillips curve view of inflation, what do we replace it with? I think that the traditional money supply/demand approach provides a firmer foundation for understanding inflation (see here, here and here). In particular, we can expect the price-level to rise as households and firms attempt to dispose of excess nominal wealth balances (as when government debt is issued too rapidly when an economy is near full employment--a situation much like today). Conversely, we can expect the price-level to decline (or inflation to slow down) as the demand for safe nominal wealth rises (as in times of crisis). The framework is perfectly consistent with the Phillips curve, but with the direction of causality mainly reversed. That is, we can "blame" unexpected swings in inflation/deflation (emanating from deeper forces) for influencing the unemployment rate, and not the other way around.

Conventional wisdom is that a central bank can anchor the long-run rate of inflation to a target of its own choosing. This belief is evident where ever a government has charged its central bank with a "price stability" mandate (commonly interpreted nowadays as keeping a consumer price index growing on average at around 2% per annum over long periods of time).

What exactly is the mechanism by which a central bank is supposed to control the long-run rate of inflation (the growth rate of the price-level)? And is it really the case that a central bank can defend its preferred inflation target without any degree of fiscal support?

Asking these questions reminds me of the old joke of an economist as someone who sees something work in practice and then asks whether it might also work in theory. In the present context one might point to the success that central banks have experienced with inflation-targeting. It works! And remember how the Fed under Paul Volcker (Chair from 1979-87) slew the 1970s inflation dragon with its Draconian anti-inflation policy? What else do we need to know?

Well, how did Volcker  do it exactly? The conventional view is that Volcker tightened monetary policy sharply by contracting the rate of growth of the monetary base (which paid zero interest at the time). The unexpected shortfall in bank reserves led to a sharp increase in short-term interest rates and a severe recession (1981.2-1982.4). As is typically the case in a recession, the rate of inflation fell, a phenomenon commonly attributed to the decline in aggregate demand for goods and services as unemployment rises and as incomes fall. 


But what kept the inflation low after the recession ended? Why did the inflation rate continue to decline as the economy grew (and as the unemployment rate fell)?
 
It's hard to argue that inflation expectations were declining. While inflation expectations fell with inflation from 1980-82, the median one-year-ahead inflation forecast from the University of Michigan survey remained flat at around 3% for the rest of Volcker's tenure. Although we have no direct market measure of long-term inflation expectations for that period, the 10-year treasury yield is probably not a bad proxy. And while the 10-year yield does decline in the 1981-82 recession, it remains elevated relative to historical (low inflation) norms and begins to rise in 1983 from just over 10% to 13.5% in 1984.


One could argue, I suppose, that the Volcker Fed kept inflation in check by raising its policy rate aggressively against signs of rising inflation expectations (the Fed had by this time abandoned targeting monetary aggregates).  Thus, despite a growing economy, the Fed's interest rate policy kept realized inflation in check, even as expected inflation remained elevated. 

Then, in the second half of 1984, long-term yields (long-term inflation expectations) began to decline. Shortly after, the Fed's policy rate declined as well. Inflation continued to decline modestly. All the while, the economy continued to grow (the unemployment rate continued to decline). Why did inflation remain low and why did inflation expectations decline?

One could argue, I suppose, that the aggressive action taken by the Fed in the first half of 1984 (not to mention the even more aggressive actions taken earlier in Volcker's tenure) finally convinced markets that the Fed was committed to keeping inflation low. This had the effect of keeping short-term inflation expectations low, which motivated wage and price setters to factor in lower cost increases. And it had the effect of lowering long-term inflation expectations, driving long-bond yields lower (as bondholders require less compensation against the loss of purchasing power of money due far in the future). The decline in longer-term inflation expectations c. 1984-85  also evident in the median 5-10 year forecast of inflation from the University of Michigan survey.


So that's the basic story. A central bank that credibly promises to snuff out any hint of rising inflation (and inflation expectations) can keep inflation anchored at a preferred long-run target of its choosing. Ironically, the threat of raising the short-term interest rate against inflationary pressure is what keeps nominal interest rates low. Moreover, if a central bank can credibly commit to a long-run inflation target, the effect is to keep longer-term bond yields low as well. The fact that things didn't work out so smoothly for Volcker early in his regime was because the Fed lost credibility in the 1970s and this credibility took time to rebuild.

I think there's a lot of merit to this view. But I still have a nagging doubt that U.S. fiscal policy had little or anything to do with Volcker's success at keeping inflation low. What exactly am I talking about--didn't Volcker accomplish his goal despite the Reagan deficits? 

People tend to remember the famous Reagan tax cut (the Economic Recovery Act of 1981). The deficit grew very rapidly soon after because of the tax cut, but also because of the severe recession and also to some extent because of the Fed's high interest rate policy (which increased the interest expense of government debt). But as Justin Fox points out here, people frequently forget about the tax increases that came steadily throughout the Reagan administration (and into the Clinton years.)


As the diagram above shows, the year-over-year growth rate of nominal debt in April 1983 hit a peak of about 22%. The growth rate of debt turned around sharply after that, dropping to 14% in July 1984. After popping briefly to 17.5% in October of 1984, it started to decline, slowly at first, and then more sharply in 1986.

The ups and downs in the picture probably do not matter as much as the underlying trends. What matters is whether people generally believe fiscal policy to be anchored in the sense of keeping the long-run rate of nominal debt growth low. (Note: another notion of "anchored" fiscal policy corresponds to keeping the debt-to-GDP ratio stable, even though stability of this ratio is consistent with any inflation rate). If the claim is that the Volcker Fed could have lowered inflation permanently without fiscal accommodation, then it could have done so with debt continuing to grow indefinitely at (say) 20% per annum. There would have been no reason to reverse the Reagan tax cuts!

So, the thought experiment is this: suppose that the political pressure to reduce the Reagan deficits was absent. Could Volcker have kept inflation low?

Who knows what would have happened to economic growth. It may have gone up, down, or roughly followed the path it took. Let's take the middle ground and assume that growth would have remained unaffected. Let us further assume that the U.S. government is never going to default on its debt. (There is, of course, no reason for why a sovereign government issuing debt constituting claims against the currency it issues need ever default. If default does occur, it is a political decision and not an economic one.)

Alright, so now we have nominal debt growing at 20%. Suppose inflation does not change and suppose inflation expectations remain anchored. Then the Fed will have no reason to raise its short-term interest rate. And bondholders will have no reason to demand higher long-term yields.  But lo, then there's a free lunch at hand.  The government can simply use its paper to finance its expenditures without resorting to taxes. At best this might hold for a highly depressed economy, but it seems unlikely to hold for the case we are considering (robust economic growth and low average unemployment).
 
Something has to give. But what? If inflation and interest rates don't budge, then the public is being asked to hold an ever-increasing quantity of debt at the same real (inflation-adjusted) rate of interest. Assuming that the foreign sector doesn't fully absorb it, the increasing level of debt must crowd out domestic investment at some point. The private sector will attempt, at this point, to attract funding by offering higher returns on its debt-offerings. How does the real yield on government bonds rise if the nominal interest rate and inflation remain fixed? Is the Fed supposed to increase its policy rate in the face of declining investment (crowding out)?

One thing to keep in mind is that the permanent tax cuts will have made the private sector wealthier. It seems likely that at some point, they will want to spend this wealth. Of course, in aggregate, the public cannot dispose of the government bonds it holds--the bonds can only pass hand-to-hand. But this smells like a classic "hot potato" effect -- people will try to spend their wealth, driving the price-level higher (reducing the real value of the outstanding government debt).

So, suppose that inflation starts to rise (along with expectations of inflation). In response, the Volcker Fed increases its policy rate sharply and restates its commitment to keeping inflation anchored. The effect of the rate increase might be to slow economic growth and keep inflation in check for a while. But remember, the fiscal authority doesn't care in this thought experiment--it just keeps printing debt as rapidly as ever. The inflationary pressure has to return. So the Volcker Fed raises its policy rate again. And again. And again. And again. This is not going to work.

It is of some interest to note that Volcker himself did not appear to believe that the Fed could unilaterally keep inflation low. At least, I say this judging by the way he often criticized the Reagan administration for its loose fiscal policies. According to Volcker 1982 (see here), huge government deficits were responsible for high interest rates (the Fed's high-interest policy). In other words, fiscal policy was responsible for the price-level pressure that necessitated the Fed's high-interest rate policy.

The clash between the Fed and the administration at that time makes for some interesting reading (see also here). In light of the recent shift in fiscal policy, one wonders whether a similar conflict might be in the works in the not too-distant future.