Money Mischief_ Episodes in Monetary History - Milton Friedman [86]
Recently, Robert Hetzel has made an ingenious proposal that may be more feasible politically than my own earlier proposals for structural change, yet that promises to be highly effective in restraining the inflationary bias that infects government. He proposes that
the Treasury be required through legislation to divide its issue of bonds at each maturity into a standard bond and an indexed bond. Interest and principal payments on the indexed bond would be linked to a price index. The Treasury would be required to issue the two forms of bonds in equal amounts.
The market yield on the standard bond, which makes payments in current dollars, is the sum of a real (inflation-adjusted) yield and the rate of inflation expected by investors. The market yield on the indexed bond, which pays interest in dollars of constant purchasing power, in contrast, would simply be a real yield. The difference in yields on the two kinds of bonds would measure the inflation investors expect over the life of the bonds. (1991, p. A14)
In explaining his proposal, Hetzel notes:
The long lag between monetary policy actions and inflation means that it is difficult to associate particular policy actions with the rate of inflation. Changes in expected inflation registered in changes in the difference in yields between standard and indexed bonds would provide an immediate and continuous assessment by the market of the expected effects on inflation of current monetary policy actions (or inactions).
A market measure of expected inflation would constitute a useful restraint on inflationary policy. Fed behavior judged inflationary by the market would produce an immediate rise in yield on standard bonds and an increase in the difference between the yields on the standard and indexed bonds. Holders of standard bonds, but not indexed bonds, would suffer a capital loss. Indeed, all creditors receiving payment in dollars in the future would feel threatened. The ease of associating increases in expected inflation with particular monetary policy actions will encourage creditors to exert a pressure that would counteract political pressures to trade off price stability for short-term output gains. (1991, p. A14)
In explaining his proposal, Hetzel notes:
The long lag between monetary policy actions and inflation means that it is difficult to associate particular policy actions with the rate of inflation. Changes in expected inflation registered in changes in the difference in yields between standard and indexed bonds would provide an immediate and continuous assessment by the market of the expected effects on inflation of current monetary policy actions (or inactions).
A market measure of expected inflation would constitute a useful restraint on inflationary policy. Fed behavior judged inflationary by the market would produce an immediate rise in yield on standard bonds and an increase in the difference between the yields on the standard and indexed bonds. Holders of standard bonds, but not indexed bonds, would suffer a capital loss. Indeed, all creditors receiving payment in dollars in the future would feel threatened. The ease of associating increases in expected inflation with particular monetary policy actions will encourage creditors to exert a pressure that would counteract political pressures to trade off price stability for short-term output gains. (1991, p. A14)
Equally important, a market measure of expected inflation would make it possible to monitor the Federal Reserve's behavior currently and to hold it accountable. That is difficult at present because of the "long lag" Hetzel refers to between the Fed's actions and the market reaction. Also, the market measure would provide the Fed itself with information to guide its course that it now lacks.
An extension of Hetzel's proposal would be the enactment of