Why QE will (and should) lead to inflation past the Fed target
I think QE was necessary, and I think the Fed has done a good job implementing it. But one thing we have to be honest about is that it WILL, if it is done right, lead to inflation past the target at some point in the future.
There are many ways we can view the process of the Fed expanding its balance sheet and buying up a mix of Treasury and risky private debt:
- They are increasing the money stock directly, which if it gets spent will increase the money supply stimulating the economy,
- They are buying up long term debt, pushing down longer term interest rates directly,
- They are taking on risk at a point in time where people may be too “risk averse”.
All these considerations have their pro’s and con’s – but none of them directly imply that the Bank will deviate from its inflation target in the future. Instead it is a fourth, and arguably the most important, part of QE policies that ensures they will do so – their use of the Fed balance sheet to influence their own future behaviour, making the “optimal path” for monetary policy time consistent.
Aimless call of the day
From Bloomberg:
U.S. Representative Mike Pence, chairman of the House Republican Conference, said he plans to introduce a bill tomorrow that would end the Federal Reserve’s dual mandate, forcing the central bank to focus on inflation.
“It’s time for the Fed to be solely focused on price stability and not the recently announced QE2,” said the 51- year-old lawmaker.
Inflation and inflation expectations are below what the Fed considers consistent with it’s mandate to keep price growth stable. As a result, even if the Republicans changed the mandate policy wouldn’t change.
In fact, the whole idea of a “dual mandate” is really just pleasant advertising – as the Fed believes that it can only stabilise economic activity insofar as it ensures that the inflation rate is at trend. In essence, even with a “dual mandate” they continue to respond to demand shocks (and not respond to supply shocks) in a way that is consistent with a “single mandate” to control inflation.
Good points on QEII
Following QEII I noticed a bunch of snark, sarcasm, and general analysis focusing on what we know (how an increase in the money stock, or inflation expectations, impacts upon the general economy) – this was troubling, as I wanted to find some analysis of exactly how QEII is supposed to function 😀
That is why it was good to see a post from Marginal Revolution, and a post from Econbrowser, discussing a few of the issues to keep an eye on.
I would still agree overall with Scott Sumner’s point that we should judge the policy based on where market expectations for future inflation move – however, the idea that there could be a sharp step change in inflation expectations at some point in the future, that the transition path of QEII is uncertain, that there are costs from a potential “asset bubble” in exchange rate markets, and that countries with weak financial institutions may struggle are important risks.
IMO though, these are risks – they do not suddenly indicate that QEII is bad policy. And in fact, I would say ex-ante, with inflation expectations below the Fed’s implicit target and unemployment above the natural rate QEII made some sense. An explicit inflation target, or even direct transfers to households, may have mad more sense – but were obviously not practical in a political sense.
Dumb statement of the week
Dr. Bernanke unfortunately does not understand economics, he does not understand currencies, he does not understand finance,” (Jim) Rogers, 68, said in a lecture at Oxford University’s Balliol College yesterday
From here.
Look, the guy can disagree with Federal Reserve policy – it would be nice if he actually explained why – but even if he doesn’t he can. But saying that one of the worlds top economists doesn’t understand economics really just shows that he doesn’t understand the discipline of economics.
Hey, he can disagree with the discipline of economics – but without understanding it how can he say that someone else doesn’t?
And when he says “debasing your currency” he shows his true colours – he doesn’t understand monetary policy or inflation targeting. There is no “magic” value for money, it isn’t some god given level of what it should be. The whole point of “printing money” at the moment is because inflation is below their target, their mandate is to hit a certain level of inflation, and by default they need to increase how stimulatory policy is to do that – if QE2 appears to be the wrong way of doing this, or will lead to unintended consequences, then criticise it on those grounds FFS.
As an investor I’m sure he understands investing – but this sort of attack on Bernanke indicates that he might not have the same level of mastery in economics. Ben Bernanke might not be as good at investing – but he is one guy I’d sure listen to when it comes to economics.
November 10 Fed meeting
The November 10 Fed meeting is more important for New Zealand then I think we currently recognise. The decisions they make over the next two days are going to have a profound impact on the general monetary policy environment around the world – and New Zealand will not be immune.
Once they finally announce what they are doing I’ll be sure to stab down some thoughts.