I just posted a draft of a short book with this title (click on the link for the book draft), resulting from the Karl Brunner Lecture I gave last fall.
"The Fiscal Theory of the Price Level (FTPL) posits that the aggregate price level is determined by the government's budget constraint, rather than solely by money supply. It argues that if the real value of government debt is not backed by future budget surpluses, prices will adjust until the debt's real value matches future surpluses."
Does this mean if a nation's central bank buys up a portion of the national debt, or other interest-bearing assets, (QE, LSAP), that the result is deflationary?
The Bank of Japan has bought about 50% of that nation's huge bundle of JGBs. Recently Bank Indonesia bought about 20% of that nation's debt.
Of course, the Fed has a large balance sheet--should it be larger?
Dear Prof Cochrane, in 2005 I did a study on real interest rate lags for a hedge fund. The response was overwhelmingly positive since it gave insight on when the market would shift. At that time we were entering into dangerous waters in the FX and fixed income markets as clients took on increasing large short volatility positions. The Fed was halfway through the rate hike cycle and volatility was steadily dropping. That did not make a lot of sense, but people were making a lot of money. The trick was not to lose it.
Real rates seem easy to calculate until you realize that one of the numbers in the calculation is fugazi. While my charts were popular, they only served to show that markets were very slow to react to financial theory. In short, I could paint a picture with charts but could not time the market with any accuracy. If you can help clear that up, we will all be in your debt.
Thank you for sharing the draft of Inflation and inviting comments before you send it to the publisher. I watched your lecture from last February last night and I read your draft. I wanted to offer some initial thoughts while they’re fresh.
First, congratulations. I think this manuscript succeeds at something that has been missing in the inflation debate: a coherent, integrated framework for thinking about inflation under interest rate targeting and fiat money institutions. The combination of fiscal theory with a stripped-down New Keynesian mechanism is especially powerful. It gives readers a complete model — not just a valuation equation, not just an IS/Phillips structure — but a closed system in which interest rates and fiscal backing jointly determine outcomes. That is a major contribution in a short book.
The treatment of 2021–2022 is the intellectual centerpiece. Your back-of-the-envelope calculation comparing the unexpected fiscal expansion to the magnitude of unexpected inflation is particularly effective. It moves the argument from rhetoric to arithmetic. The corporate valuation analogy also works extremely well. Framing government debt as a portfolio whose value must equal the present value of expected surpluses makes the mechanism intuitive, even for readers outside macro.
I also think Chapter 3 may be the most important section of the book. The “unpleasant interest rate arithmetic” result — that interest rate increases without fiscal adjustment can only move inflation intertemporally — is both unsettling and clarifying. It forces the reader to confront the coordination problem between fiscal and monetary authorities. The long-term debt channel is handled cleanly, and the logic is much easier to follow here than in longer technical treatments.
A few constructive suggestions:
1. Expectations and timing. The fiscal story for 2021–2022 is plausible and coherent, but critics will ask: when exactly did expectations of non-repayment shift, and how do we know? You discuss the change in rhetoric and policy direction in early 2021, which is helpful. It might strengthen the argument to sharpen the timing dimension slightly — perhaps by tying it more explicitly to market measures of long-term inflation expectations or debt maturity structure. Even a short paragraph clarifying why 2020 deficits did not immediately produce inflation would make the narrative harder to dismiss.
2. Policy implications of the interest-rate result. The conclusion that central banks cannot fully control inflation without fiscal cooperation is extremely important. You state it clearly, but the institutional implications could be pushed a bit further. The reader is left sensing that inflation targeting may depend implicitly on fiscal backing — which is a powerful insight. A slightly stronger concluding treatment of fiscal-monetary coordination (or the absence of it) would elevate the policy impact of the book.
3. Tone and persuasion. The manuscript is admirably direct. In a few places, however, the rhetorical edge may distract from the argument’s strength. Since this is positioned as a broad distillation for policy professionals and nontechnical readers, a slightly more institutional framing (less administration-specific language) might widen its reach without softening the substance.
4. Zero-bound and QE contrast. The comparison between the 2008–2015 period and 2020–2022 is one of the cleanest quasi-experiments we have. You touch on this, but I think it deserves slightly sharper emphasis. The contrast between large balance sheet expansions without inflation versus direct fiscal transfers with inflation is one of the book’s strongest empirical distinctions among theories.
Overall, I believe this manuscript could become the clearest short statement of fiscal-monetary regime thinking under interest rate targeting. It is rare to see the pieces assembled this compactly.
I appreciate the opportunity to read this at such an important stage.
Excellent! I read it almost immediately upon receipt. I now understand the principles of the fiscal theory. Gotta study it some more. Mostly agree with Lyle Bowlin's comment.
1. Inflation bent down the same quarter the Biden administration passed it anti-inflationary bill. Biden did it by increasing spending to push future GDP and therefore future taxes. I think you should try to dive into that explanation or try to refute it.
2. Given changes in the world, Fiscal Theory must pay more attention to the ability of government to collect taxes. An example: moving from fiat to digital currencies will reduce the power of governments in tax collections. Another example: weakening the dollar and using other currencies for international trade weakens the US capability to collect taxes corporations owe the US.
Thank-you for furthering my education. Just my humble opinion, but I think somewhere in a college education, basic economics should be taught. The rambling thoughts of an old hermit.
Something I'm not clear on: you talk early on about people getting rid of government debt and buying goods and services or real assets instead. What about the people who are buying the debt that the first group of people are getting out of. Are we looking primarily at a reallocation of aggregate asset holdings?
The first group could, as you say, buy real assets, but would that include buying shares, whose prices will rise with inflation? As I recall from the global financial crisis episode and the recovery from it there was a fair bit of discussion to the effect that by taking interest rates down to the lower bound the Fed was driving up the prices of bonds to the point where it made sense for people and insitutions to cash out and put their funds into the stock market. The post-COVID inflation would still be driven by too much money chasing too few goods, especially with so many sectors operating under manditory or self-imposed temporary capacity restrictions, but it would be more of an old-policy-school situation.
We do have "a basic theory of how central banks might lower inflation going forward by raising interest rates." In the most direct case, a higher policy rate by the central bank results in it selling more securities at lower prices. Its sales of securities to counterparties reduce the supply of the monetary base while by assumption the demand remains steady. After some intermediate steps involving the relationship between the monetary base and broader monetary aggregates, inflation falls. This process has been known for a century, I think.
A less direct case is that the monetary base doesn't change but the central bank increases demand by signaling that it is more ready to tighten the supply than markets had thought. That is a credibility channel.
In my view, the fiscal theory of the price level obscures at least as much as it reveals because it is not a general theory. An economist who has spent more time thinking about the fiscal theory and is more articulate on the subject than I am is David Glasner, who has written some of his thoughts here:
Thanks for this!
"The Fiscal Theory of the Price Level (FTPL) posits that the aggregate price level is determined by the government's budget constraint, rather than solely by money supply. It argues that if the real value of government debt is not backed by future budget surpluses, prices will adjust until the debt's real value matches future surpluses."
Does this mean if a nation's central bank buys up a portion of the national debt, or other interest-bearing assets, (QE, LSAP), that the result is deflationary?
The Bank of Japan has bought about 50% of that nation's huge bundle of JGBs. Recently Bank Indonesia bought about 20% of that nation's debt.
Of course, the Fed has a large balance sheet--should it be larger?
Dear Prof Cochrane, in 2005 I did a study on real interest rate lags for a hedge fund. The response was overwhelmingly positive since it gave insight on when the market would shift. At that time we were entering into dangerous waters in the FX and fixed income markets as clients took on increasing large short volatility positions. The Fed was halfway through the rate hike cycle and volatility was steadily dropping. That did not make a lot of sense, but people were making a lot of money. The trick was not to lose it.
Real rates seem easy to calculate until you realize that one of the numbers in the calculation is fugazi. While my charts were popular, they only served to show that markets were very slow to react to financial theory. In short, I could paint a picture with charts but could not time the market with any accuracy. If you can help clear that up, we will all be in your debt.
I really look forward to your book!
Thank you for sharing the draft of Inflation and inviting comments before you send it to the publisher. I watched your lecture from last February last night and I read your draft. I wanted to offer some initial thoughts while they’re fresh.
First, congratulations. I think this manuscript succeeds at something that has been missing in the inflation debate: a coherent, integrated framework for thinking about inflation under interest rate targeting and fiat money institutions. The combination of fiscal theory with a stripped-down New Keynesian mechanism is especially powerful. It gives readers a complete model — not just a valuation equation, not just an IS/Phillips structure — but a closed system in which interest rates and fiscal backing jointly determine outcomes. That is a major contribution in a short book.
The treatment of 2021–2022 is the intellectual centerpiece. Your back-of-the-envelope calculation comparing the unexpected fiscal expansion to the magnitude of unexpected inflation is particularly effective. It moves the argument from rhetoric to arithmetic. The corporate valuation analogy also works extremely well. Framing government debt as a portfolio whose value must equal the present value of expected surpluses makes the mechanism intuitive, even for readers outside macro.
I also think Chapter 3 may be the most important section of the book. The “unpleasant interest rate arithmetic” result — that interest rate increases without fiscal adjustment can only move inflation intertemporally — is both unsettling and clarifying. It forces the reader to confront the coordination problem between fiscal and monetary authorities. The long-term debt channel is handled cleanly, and the logic is much easier to follow here than in longer technical treatments.
A few constructive suggestions:
1. Expectations and timing. The fiscal story for 2021–2022 is plausible and coherent, but critics will ask: when exactly did expectations of non-repayment shift, and how do we know? You discuss the change in rhetoric and policy direction in early 2021, which is helpful. It might strengthen the argument to sharpen the timing dimension slightly — perhaps by tying it more explicitly to market measures of long-term inflation expectations or debt maturity structure. Even a short paragraph clarifying why 2020 deficits did not immediately produce inflation would make the narrative harder to dismiss.
2. Policy implications of the interest-rate result. The conclusion that central banks cannot fully control inflation without fiscal cooperation is extremely important. You state it clearly, but the institutional implications could be pushed a bit further. The reader is left sensing that inflation targeting may depend implicitly on fiscal backing — which is a powerful insight. A slightly stronger concluding treatment of fiscal-monetary coordination (or the absence of it) would elevate the policy impact of the book.
3. Tone and persuasion. The manuscript is admirably direct. In a few places, however, the rhetorical edge may distract from the argument’s strength. Since this is positioned as a broad distillation for policy professionals and nontechnical readers, a slightly more institutional framing (less administration-specific language) might widen its reach without softening the substance.
4. Zero-bound and QE contrast. The comparison between the 2008–2015 period and 2020–2022 is one of the cleanest quasi-experiments we have. You touch on this, but I think it deserves slightly sharper emphasis. The contrast between large balance sheet expansions without inflation versus direct fiscal transfers with inflation is one of the book’s strongest empirical distinctions among theories.
Overall, I believe this manuscript could become the clearest short statement of fiscal-monetary regime thinking under interest rate targeting. It is rare to see the pieces assembled this compactly.
I appreciate the opportunity to read this at such an important stage.
Thanks for these wonderful and thought provoking comments. I'll see how to reflect them in the next draft. -John
A public service and possible to be common sense like….. Look forward to read it.
Excellent! I read it almost immediately upon receipt. I now understand the principles of the fiscal theory. Gotta study it some more. Mostly agree with Lyle Bowlin's comment.
Two comments that go independently
1. Inflation bent down the same quarter the Biden administration passed it anti-inflationary bill. Biden did it by increasing spending to push future GDP and therefore future taxes. I think you should try to dive into that explanation or try to refute it.
2. Given changes in the world, Fiscal Theory must pay more attention to the ability of government to collect taxes. An example: moving from fiat to digital currencies will reduce the power of governments in tax collections. Another example: weakening the dollar and using other currencies for international trade weakens the US capability to collect taxes corporations owe the US.
I can't wait to read your work on inflation.
https://www.johnhcochrane.com/research-all/inflation
Proofreaders and copyeditors are scarce enough; a structural or story editor is a gift from heaven!
Thank-you for furthering my education. Just my humble opinion, but I think somewhere in a college education, basic economics should be taught. The rambling thoughts of an old hermit.
Something I'm not clear on: you talk early on about people getting rid of government debt and buying goods and services or real assets instead. What about the people who are buying the debt that the first group of people are getting out of. Are we looking primarily at a reallocation of aggregate asset holdings?
The first group could, as you say, buy real assets, but would that include buying shares, whose prices will rise with inflation? As I recall from the global financial crisis episode and the recovery from it there was a fair bit of discussion to the effect that by taking interest rates down to the lower bound the Fed was driving up the prices of bonds to the point where it made sense for people and insitutions to cash out and put their funds into the stock market. The post-COVID inflation would still be driven by too much money chasing too few goods, especially with so many sectors operating under manditory or self-imposed temporary capacity restrictions, but it would be more of an old-policy-school situation.
We do have "a basic theory of how central banks might lower inflation going forward by raising interest rates." In the most direct case, a higher policy rate by the central bank results in it selling more securities at lower prices. Its sales of securities to counterparties reduce the supply of the monetary base while by assumption the demand remains steady. After some intermediate steps involving the relationship between the monetary base and broader monetary aggregates, inflation falls. This process has been known for a century, I think.
A less direct case is that the monetary base doesn't change but the central bank increases demand by signaling that it is more ready to tighten the supply than markets had thought. That is a credibility channel.
In my view, the fiscal theory of the price level obscures at least as much as it reveals because it is not a general theory. An economist who has spent more time thinking about the fiscal theory and is more articulate on the subject than I am is David Glasner, who has written some of his thoughts here:
https://uneasymoney.com/2024/07/21/thought-and-details-on-the-fiscal-theory-of-the-price-level/