Is the title sentence a logically monstrosity? I think so. How can one not expect something to happen, but nonetheless expect to expect it in the near future? I’ll leave that to the epistemologists but in some weird way I think this post’s title reveals how monetary policy went off course.
As I await the employment report, I am reflecting on the flow of information over the past week and find myself somewhat dismayed by the apparent policy implications. The spate of FedSpeak in recent days leaves one with the uneasy feeling that monetary policymakers are more willing to use unconventional monetary policy to support Wall Street than Main Street. The most hawkish appear eager to normalize policy at the earliest opportunity possible, and even the dovish, grasping onto green shoots, appear to think they have done enough to support recovery. It is as if the FOMC has concluded that the risks are now entirely one-sided toward inflation.
. . .
With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.
This line of argument leads one to believe that withdrawing monetary stimulus would be a significant policy error, especially if investment growth remains constrained as we saw this decade. In fact, it would lend additional credence to reports that the Fed needs to do much, much more – a massive, unsterilized expansion of the balance sheet – should they even hope to stimulate sufficient investment demand to absorb underutilized labor. Instead, FOMC members appear to be concerned that stimulative policy will be the root cause of the next financial crisis. That, however, appears to me to confuse monetary with regulatory policy. The former should speak to inducement to invest, while the latter speaks to protecting against significant misallocations of capital.
Then Duy quotes Richmond Fed President Lacker from a Bloomberg interview:
The Federal Reserve will need to raise interest rates when the economic recovery is “firmly” in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.
Duy’s reaction is exactly how I would have reacted:
Seriously, raising rates even if unemployment is 10%? LACKER SAYS THIS ON THE DAY WE GET CORE PCE INFLATION SLIDING TO 1.3% Y-O-Y! This redefines the term “hawk.”
From where does this fear of inflation emanate? That brings us to perma-hawk Philadelphia Fed President Charles Plosser:
“Unfortunately, slack was poorly measured and turned out to be not as significant as first estimated. Thus, the Fed’s monetary expansion led to rising inflation for the balance of the 1970s. One lesson learned during this episode is that inflation expectations can matter a great deal, and if they become unanchored — that is, if the public comes to believe that the Fed will not do what is necessary to preserve price stability — then inflation can rise quickly regardless of the amount of so-called slack in the economy. The price we paid to regain control of inflation and the Fed’s credibility to do so came in the form of the 1981-82 recession and was a steep one.”
Again, Duy’s reaction to Plosser hits the nail right on the head:
The experience of the 1970s is such a tired and faulted analogy. To generate a wage-price inflation spiral, you need to explain the mechanism by which rising inflation expectations (which don’t exist anyway) get translated into high wages. I do not see that current institutional arrangements in the US allow this; nor do we see it in the data:
Reading this is both exhilarating and depressing. Exhilarating because it’s good to see other economists talking about the need for more monetary stimulus, and depressing because it is one more blog that I need to read, and I am already overwhelmed. Read the whole post.
Now let’s take a recent look at inflation expectations:
Period TIPS Spreads CPI futures Average
2 year 0.50% 0.94% 0.72%
5 year 1.41% 1.71% 1.56%
On theoretical grounds you’d expect the CPI futures to overstate inflation (as risk averse people hedge against inflation risk in this market.) And the TIPS spreads should understate inflation expectations (because non-indexed bonds are slightly more liquid, and hence offer a bit lower expected return.) So I think the average is a reasonable ballpark estimate of inflation expectations. And I’d add that recent actual inflation is also low, as is the consensus forecast of economists. That doesn’t mean the forecasts won’t be wrong, but it does suggest that the consensus forecast, however measured, is for low inflation.
So given that the Fed is widely viewed as shooting for about 2% actual inflation, shouldn’t they be trying to raise inflation expectations, rather than lower them? You might argue: “It’s more complicated, the Fed isn’t a strict inflation targeter.” That’s right, as in the Taylor Rule, they also look at real output relative to capacity. And in every single new Keynesian model you can name, the Fed is supposed to err on the side of higher inflation when output is below trend, and aim for lower than normal inflation when output is above trend. So under strict inflation targeting the Fed is making a tragic mistake, they should be trying to encourage higher inflation expectations, and yet for some reasons they are encouraging lower inflation expectations. And under a more realistic “flexible inflation targeting” regime? Well then they are making an even more tragic error, they are even further off course. Tim Duy’s frustration is exactly appropriate. Fed policy right now can only be described as bizarre. It is not clear why they are doing what they are doing.
So let’s speculate a bit. It seems to me that the Fed is for some strange reason assuming that there is a logical distinction between inflation expectations and expectations of inflation expectations. In other words, they see that inflation expectations aren’t a problem right now, but they expect them to be a problem in the near future unless they tamp them down with some hawkish talk. But that commits a fundamental logical error; the Fed is ignoring the fact that those inflation expectations (both market and private forecasters) are formed with knowledge of current and expected future Fed policy, including the 0.25% target rate and the massively bloated monetary base that everyone seems worried about.[BTW, I wish the Fed would stop calling it “base” money; bank reserves are now essentially T-bills. Only currency is still interest-free. And monetary theories of inflation are based on explaining the supply and demand for non-interest–bearing money.]
Here’s what the Fed doesn’t seem to realize. If the market thinks inflation will be too low under current and expected future Fed policy, then the Fed needs to send out more dovish signals not hawkish signals. They need to get 2-year inflation expectations up to around 2% or 3%. And that would require a much more expansionary monetary policy. Yes that’s right, I’m suggesting we go back to how things used to be in 1958 and 1983, when very steep recessions were followed by very rapid recoveries. Why not? Instead, everyone is estimating really high unemployment for years to come. Correct me if I am wrong, but I don’t recall the 1958 and 1983 recoveries leading to double digit inflation. Sure we’ve got some structural problems, but in 1983 we were in the midst of a painful downsizing of the so-called rustbelt’s manufacturing capacity as a result of technology and foreign competition. That was a huge structural problem, similar to our overbuilt housing stock. Indeed, because of population growth the housing overhang may be solved more quickly than that earlier structural adjustment. And yet RGDP grew very fast in 1983-84.
So if the markets don’t expect high inflation that means the markets don’t expect to expect high inflation. And the Fed shouldn’t either. For the umpteenth time, there are no lags between monetary policy and changes in inflation expectations.
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