Monetary Policy and the Term Structure of Prices

Warren Mosler

President, Valance Co. Inc.

www.moslereconomics.com

September 22, 2017

Inflation

• Inflation is academically defined as a continuous increase in the price level
• Monetary authorities can’t identify, measure or report the rate of inflation as academically defined
• Monetary authorities can report past changes in proxies of the price level
• Monetary authorities can forecast future changes in proxies of the price level

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The Term Structure of Prices

• Pricing includes a specified delivery date
• The term structure of prices is the matrix of prices that includes prices for future delivery dates, which are defined as forward prices
• For non perishable items the term structure of prices Is a function of the price for immediate delivery plus storage costs.
• Storage costs include a cost of funds and are thereby a function of rates.
• Therefore:

The term structure of policy rates is the inflation rate

as academically defined.

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Explanatory Model

• Assume an economy with only one item, gold, is produced, bought and sold
• Assume the current price of gold is $1,300 per oz.
• Assume a permanent 0% policy rate
• The price of gold would then be $1,300 per oz. for all future delivery dates
• This means current buyers and sellers of gold can buy or sell gold for $1,300 per oz for any future delivery date
• Therefore the rate of inflation as defined as the continuous change in the price level faced by current buyers and sellers is 0%.

Explanatory Model (continued)

• Next assume the term structure of policy rates shifts to 10%
• The term structure of prices faced by buyers and sellers will increase continuously at 10% (compounded) for future delivery dates.
• Academically, this defines a 10% rate of inflation.
• Again, the policy rate is the rate of inflation.

Expanding the Model

• Forward prices of perishables are also a function of the term structure of rates
• Forward prices of perishables are a function of forward prices of the components of supply and demand
• Forward costs of inputs are a function of the term structure of rates
• Forward demand is a function of the term structure of rates

Monetary Policy

• Monetary policy is about setting the term structure of policy rates
• Central bank mandates always include inflation
• Central banks labor to understand the channels from their policy tools to their mandates
• Central banks currently have recognized their models are not reliable

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Monetary Policy (continued)

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• I know of no indication that central banks have recognized that the term structure of prices is a direct function of their policy rate
• I know of no indication that central banks have investigated how the term structure of prices per se might influence their mandates