The Fed has become desperate, not because the American economy is currently falling apart, but because the economy has stubbornly failed to respond well to the policies of the “best and the brightest.” And now, as if to welcome the impending chairmanship of Janet Yellen, stories are surfacing in various places about the growing consensus inside and outside of the Fed for inflation. There is not enough inflation to stimulate adequate economic growth. Just a little more, or maybe even a lot more (perhaps as high as 6 percent) is needed as Ken Rogoff of Harvard is suggesting.
The arguments being used today are not exactly the same as those of the 1970s, yet I have the feeling that I have been here before. It is important to distinguish theory from what policy economics is about. Policy economics often comes down to rather simple ideas. The real world has a way of making a mockery of today’s sophisticated macroeconomic theory. For one thing, policy has to be relatively simple if it is to be transparent.
So “we” want more inflation. The first thing to consider is how to get it. Bank reserves are high but interest is paid by the Fed on them. So presumably we could stop doing that. On the other hand, the Fed wants the banks to be better capitalized to avoid liquidity and possibly solvency problems. The easiest thing then would be to flood the system with still more bank reserves but not pay interest on these additional reserves. However, what might work to raise the rate of inflation by a small amount on the current conditions might be too much for comfort later on.
So once we get the rate of inflation up, what happens then? We should have a once-and-for-all decrease in the demand to hold money out of income and assets as the cost of holding money rises. This will produce a further spike in the price level – perhaps confusing economic agents about the new steady state inflation rate. They may believe it will be higher than the Fed wants them to believe or intends.
How is all of this supposed to raise output and employment? If the prices of outputs rise relative to inputs, firms may expand production. Some inputs like raw materials are likely to rise at the same pace as output prices. And what is input to some firms is output to others. In order to avoid shortages the input prices of some goods will have to rise as well. Expanding profit margins must depend on some inputs not increasing in price as fast as output prices.
We are back to the money illusion. Suppose labor is deceived and its price relative to those of other inputs and outputs falls. So they are hired and work more at less real pay than they thought they were getting. How long will this last before the Fed must ramp up the inflation? We know the rest of the story from the 1970s and early 80s.
What also irks me about this is that if it works as intended then it is redistribution from, say, the elderly to those who are newly employed (except that they are employed under a money illusion). The elderly who are conservative about their savings have already suffered from near zero interest rates.
But the problems lie also in the distorted production and investment effects. If longer-term real interest rates fall further then there will be more activity in the producers’ goods industries than will be sustainable when real rates later rise. There will also be more risk taking in financial investments as the real rate falls.
Keep in mind that someone has to be deceived in the system for the output effects to take place. The question is who, where, and for how long?
It would be a lot better if greater attention were given to the micro-causes of stubborn unemployment and falling labor participation rates. To discuss the roles of the massive expansion of food stamps, unemployment insurance extensions, easier disability eligibility, upcoming Obamacare costs and uncertainty, and so forth is more difficult for those who do not want to offend “progressive” constituencies. Luckily, many of us do not mind being offensive when it can do some good.