Quantitative easing

The U.S. Federal Reserve yesterday finally took the step many of us had been urging for some time.

Let’s start with the Fed’s summary of current conditions:

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The second paragraph is similar to the wording that the Fed introduced in its previous January statement. The Fed is trying to communicate that it sees the very low inflation rates (and threatened deflation) of recent months as unhealthy for the economy and something it intends to prevent. The Fed is very mindful of the role of expectations in the current setting, and wants with this statement to communicate clearly to the public that it’s not going to allow deflation.

What’s new in yesterday’s statement is what the Fed says it’s going to do about it.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

What’s with all these numbers appearing in the statement? Traditionally the key number that the members of the FOMC would vote on and that the Fed would communicate to the public with a statement like this would be a target interest rate that the Fed had settled on for the fed funds rate, an interest rate charged on overnight interbank loans. But that traditional policy tool has been fundamentally irrelevant for months now, as the fed funds rate scraped along the zero lower bound. The Fed has accordingly finally settled on an alternative way of framing its quantitative strategy in terms of specific quantitative expansions it intends to implement.

This is what I have been urging the Fed to do. Personally I would have focused more on purchasing long-term Treasuries (particularly TIPS) rather than the agency issues, but this should get the job done. And the job, in my mind, is to make sure that the Fed prevents deflation.

Let me be very clear that I am using the term “deflation” here in a very specific and narrow way. I am defining deflation (as do most academic economists) as an increase in the real purchasing power of each dollar bill outstanding, as measured by a decrease in the level of a broad price index such as the CPI or PCE deflator. I think that deflation is an important condition for the Fed to avoid because deflation magnifies and aggravates the real burdens of debtors (dollar sums owed become an even bigger real burden), which would drive us even deeper into our current problems.

There’s a second reason why I believe achieving a modest rate of inflation (my number is 3%) should be job 1 for the Fed. The goal of fiscal stimulus is to increase aggregate nominal demand. The notion is that there is sufficient slack in the economy that we could increase nominal GDP without causing nominal prices to increase, and thus generate an increase in real incomes. Once we get to the point where that stimulus starts to produce inflation, we know we’ve done all we can with the policy of demand stimulus.

I have favored federal fiscal stimulus as the preferred policy tool for purposes of investment in infrastructure that could be justified on the basis of the direct productivity of the projects themselves and preventing fiscal contraction at the state and local level. However, monetary policy to me makes more sense as the tool to use for the goal of increasing total nominal spending beyond the level achieved by those first two categories of fiscal stimulus. And I frankly have never understood the position of those who claim that policies such as that adopted by the Fed yesterday will have no consequences for the purchasing power of a dollar.

I emphasize that I am decidedly not suggesting that either fiscal or monetary policy stimulus are capable of solving all of our problems. Real debt imbalances, both domestic and international, frictions in moving resources out of housing and autos and into other sectors, and the profound problems with our financial system all place important physical constraints on what any stimulus package, monetary or fiscal, is capable of achieving. Once we get to 3% inflation, that to me will be a clear indication that we’ve accomplished all we can with tools to stimulate aggregate demand.

I would also like to say a word about the short-run versus the long-run outlook for inflation. I am fully in agreement with those who worry that the prospective new debt issue by the U.S. Treasury and risky asset position of the Federal Reserve put in play some powerful forces for inflation over the longer run that may prove quite difficult to contain. But while I agree that this is quite an important issue, I believe it would be dead wrong to interpret yesterday’s statement from the Fed as confirmation that we are now starting down that path. The actions by the FOMC yesterday were, in my opinion, not influenced in the slightest by those long-run pressures, but instead were motivated entirely by the short-run concerns I outlined above. I believe the Fed shares my goal that what we want to see is 3% inflation, no more, and that when we get there, they’ll stop.

What will be the indication that we’ve done all we can with this tool? I would urge the Fed to be watching the exchange rate and commodity prices quite closely for an indication that the deflation tide has turned.

The Fed has declared pretty loud and clear that it is not going to allow deflation. So here’s my personal investment advice: don’t bet against the Fed.

 


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52 thoughts on “Quantitative easing

  1. Mario Sanchez

    If the concern with deflation is that it “magnifies and aggravates the real burdens of debtors… which would drive us even deeper into our current problems,” why use the narrow definition of CPI or PCE deflators? Don’t balance sheet compression and asset devaluation and equity (home and otherwise) devaluation also aggravate the real burden of debtors by dramatically increasing the true cost / opportunity cost of debt repayment? Wasn’t that exactly Greenspan’s point in his famous “irrational exuberance” speech when he said that “we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy?”

  2. JDH

    Mario Sanchez: Absolutely all sorts of factors influence the burden of debt repayment. But the purchasing power of the dollar is the one item that the Federal Reserve has direct responsibility for.

  3. Ed

    Well by looking at the price of Oil, RBOB gasoline and Gold, if inflationary situations are desired then I think they will get that.
    However, I am in disagreement with the notion of having higher inflation even at 3%. The problem is at this point many many many people are not getting any wage increases. As an academic at a state institution I will not be getting any increase in salary until 2011 or 2012 based on state mandate. An inflation rate of 3% would cause a significant real wage decline. A little math shows my salary would be worth around 91% of what is is currently. Hence putting me back to my wage of 2006. This is a three year set back. Many people will fall into this and defaults on credit will increase if this strategy is pursued with out wage increases.
    Also the devaluation of the currency that results from this quantitative easing will make most import more expensive and further exacerbate the cost of living.
    Be wary of what you wish for. A slow recovery with little or no inflation is better for most people than a slow recovery with higher inflation.

  4. HAL

    So, when 3% inflation is achieved and then it continues to rise more than the Fed wants, what do you propose that the Fed do? Slam on the brakes and reignite the recession again? This seems to me very much like alternately stepping on the gas and then slamming on the brakes while driving a car. The passengers tend to get dizzy.

  5. DickF

    Professor,
    The minute I heard the new I thought of you.
    Price of gold – up $69 or 14% today
    Price of oil – up $3 or 6% today (over $50)
    Initial response by market – up 91 or 1% Yesterday
    I guess we will see your theory proven in real time. Good luck!

  6. scb

    The policy of the Fed seems to match the magnitude of the problem. My question is whether this policy increases the probability of a double-dip recession when the 3% inflation goal has been achieved and there is a contraction in the debt purchases and an increase in interest rates?

  7. ned

    “I believe the Fed shares my goal that what we want to see is 3% inflation, no more, and that when we get there, they’ll stop.”
    Even Bernanke in Congressional testimony acknowledged that the more long-term “assets” they acquire, the more difficult it will be for them to fight emerging inflation.
    Besides, if they attempt to reverse course, or even stop, they would be risking, if not causing, the very things they are doing everything to prevent.
    I think you are far too optimistic. Also, isn’t the exclusive focus on the short term what got us here?

  8. techy

    as another Ed has mentioned, what if we only get inflation in commodities but deflation in wages, real estate and equities??
    i do agree that at this point i see government stimulus as the only thing which can put a floor to the employment market….else people will keep losing job due to lower consumer spending leading to business contraction.
    another thing is if USD continues to go down, thats good for exports and local manufacturing which translates into more jobs in usa.
    i am not sure the exporting countries will let dollar depreciate much because that will be win-win for usa, its debt gets reduced and local manufacturing becomes viable.
    Am i missing something big?

  9. Mario Sanchez

    JDH:
    Yes, purchasing power of the dollar is the Fed’s responsibility. But so is financial market stability. And limiting dollar “purchasing power” to consumer goods – and only to rental (not purchase) of dwellings – completely ignores a very dangerous type of purchasing power stability.

    We have known for a very long time that irrational asset inflations and the real economic collapses they cause lead to problems that are as dramatic and prolonged – or more so – than other types of financial and monetary imbalances. And that while it’s not easy to measure and control in real time, and not politically popular in our form of government, it is imperative for the Fed to take these factors into account. I will stand firmly by the above 3 sentences with complete confidence because they are a summary of Greenspan’s most famous and well known speech.

    So, if not the Fed, who? If not this decade, when? If not via indices that are designed to measure these broader views, how?

  10. GNP

    I thought the fed target was 2% inflation.

    Some of this additional liquidity may manifest itself in higher commodity prices but I’m guessing the rest will flood into equity markets. Where is the market power to automatically pass on price increases as experienced in the 1970s and 1960s?

  11. MarkS

    From my perspective, the “quantitative easing” implemented by the FED will continue to perpetuate the fundemental problem America has in its financial markets: OVERLEVERAGE. Subsidies to mortgage securities avoids losses on both the instruments and their derivative products, perpetuating indebtedness. I would prefer that losses be realized as they occur, thereby reducing the debt burden, while it weeds out firms that have engaged in faud and looting.
    I’m with Ed, a slow recovery with low inflation allows both households and businesses to plan and budget properly over medium to long terms. Inflating the system does little other than benefit the incumbants at the top of the banking food chain, while the middle to lower classes are eroded by necessities (food and fuel) escallating far faster than wages.
    It seems more credible to me that the FED is supporting Agency bonds and debt as a counterweight to Chinese and institutional sales of these instruments. Now is the time to do maintenance to mortgage backed securities, while the rate of ARM resets is low. 2010 and 2011 will be years of increased pressure on the mortgage market, providing the fuel for a double-dip recession. The money provided by the FED purchases will most likely end up providing the “new equity” to bolster reserves at the top of the financial system: (The Black Hole).

  12. JDH

    Mario Sanchez: If your point is that the Fed should have been less expansionary in 2002-2004 given the contribution low rates made to destabilizing house price appreciation, of course I agree completely with you (as I hope everyone would).

  13. ReformerRay

    Prof. Hamilton,
    You abandoned your position on TIPS entirely too easily. Your earlier discussion persuaded me that FRB should invest in TIPS rather than what they have done. The earlier discussion said that purchase of TIPS now, while they are cheap, would have the result of increasing inflation while ownership of TIPS after inflation gets going would provide a profit for FRB and would reduce inflation when they are sold.
    Do you still support your earlier postion? Are TIPS still cheap? Or did the private sector make money by buying TIPS while they were cheap?.
    You provide data and arguments to support your positions. By contrast, Bernanke and Geithner just throw out the conclusion that failure of AIG would create unacceptable disruption of the financial system. If I trusted them, I would give them the benefit of the doubt. Maybe they do know which firms would fail if AIG went under. But i do not trust them. I think they are merely extrapolating from what happened after Lehmans. That is not a good argument. Lehman’s was a unique event. That was when the world learned that the mighty Wall Street mega firms could not be trusted to keep their money safe. That lesson having been learned, the demise of AIG will provide no new lesson. It will merely confirm what the markets have been saying for months – that AIG is dead as a private enterprise.
    I want you or someone like you who can provide a rationale for his decision to succeed Geithner.
    But I am not entirely pleased with your position. You are too willing to think that the future of this recession will follow the experience in the 1930′s when purchasing power was directly tied to employment and when employment declined purchasing power declined. The only force that could stop the process was Federal government intervention.
    Today we have a very large purchasing power lying dormant that is independent of employment. I refer to folks retired and on disability, folks who managed to profit from the current troubles (I suspect this is a lot of money), the various safety nets for the bottom part of the income distribution and the business firms that have downsized before necessary in order to preserve capital.
    Profit figure reported by BEA lag reality by several months. Neverthess, their profit numbers have not declined along with everything else (so far).
    In short, I see automatic stabilizers which will prevent defaltion continuing forever and which will power the economy forward, ONCE HOUSE PRICES COME DOWN TO THE LEVEL APPROPRIATE TO CURRENT INCOME, and consumer credit declines to a level that can be susained with current income.
    Count me as one who wants current downward trends to continue and be joined by downward trends in money spent to shore up the banking system.
    Don’t delay the rush to the bottom. The quicker we hit bottom, the quicker this nightmare will be over.

  14. ReformerRay

    Waste no tears for the Academic who is getting no wage increases this year. Years ago I had steady employment with no threat of being fired but several years of no wage increase, sometines with inflation present. I came out ahead because I worked as long as I wanted to. And I adjusted my expenses to my current and projected income.

  15. techy

    ReformerRay.
    you say that housing price will bottom.
    dont you think for that to happen atleast unemployment has to bottom…if not more people will be declaring bankruptcy unable to serve their mortgage…and it will also create more fear in the populace further halting consumption.
    How can we have inflation when the consuming capacity of the population is being reduced due to wages decreasing??
    similar thing is happening with business contraction….leading to further loss in consumption.
    in other words housing is becoming cheap….but at the same time people are losing jobs (and fearful of losing jobs)elminating house owners completely from the market.

  16. stunney

    The inflation bug’s mind works on the basis of fear; specifically the fear that rising prices deter and ultimately destroy savings and investment.
    And the inflation bug is 100 percent correct.
    To see this, all we need to do is to compare the price level for consumer goods and services today with the level prevailing in 1933. Yes, that’s right; prices today are much higher than they were in 1933.
    And what has been the effect? Yes, just as the inflation bugs predicted, investment has plunged dramatically in the last 75 years, rendering the U.S. a byword for staggering, decades-long economic decline.
    And those living on fixed incomes or from savings have, en masse, been forced to beg whatever crumbs they can garner from illegal immigrants working as crop pickers or car washers. The creation of Social Security merely exacerbated the pauperism that our decades-long monetary inflation has wrought.
    The only exceptions are those wise and fortunate souls who have hoarded gold.
    If only we as a nation had not inflated our currency starting in 1933, our children and grandchildren would have all the marvellous pre-1933 era blessings afforded by Sound Money policies.
    But the inflation bug at least can be consoled by the KNOWLEDGE that he was RIGHT, and that the inflationists were wrong.
    Now, there are some who will say the right-wing inflation haters are merely absurd cranks, or absolutely whacko crackpots, or indescribably moronic simpletons, who are fed these stupendously erroneous ideas about monetary economics by the propaganda machine that serves the interests of the ruling plutocracy. But as the simple, clear, and dramatic analysis of the facts which I have provided above PROVES BEYOND ALL DOUBT, these idiotic douchebags actually have the facts on their side. Not, to be sure, the liberal-socialist-collectivist so-called facts, but the facts as derived from the ridiculous, off-the-wall, fruitloop worldview of the inflation bug.
    QED

  17. Aaron McDaid

    I agree with James Hamilton that fiscal infrastructure stimulus is the best way to increase employment and real GDP, and that it will stop deflation in its tracks if done on the correct scale.

    (Does the rest of this comment make sense? Apologies if it’s nonsense!)

    The converse is not true; inflation of 3% is possible alongside a deepening recession. Even if the deflationary expectations are removed, there are still many other factors dragging the economy down such as the overwhelming debt levels.

    Hence, we could quickly find that nothing has changed other than the reemergence of inflation and inflation expectations. In such a scenario, the government could not implement a proper fiscal stimulus without causing even more inflation and expectations thereof.

    Only fiscal stimulus, preferably based on spending and infrastructure, will get the economy properly functioning again. Such a stimulus will give us a certain amount of inflation ‘for free’. Then, any extra inflation caused by the Fed is just unnecessary and dangerous.

    I suspect the Fed knows this and were giving the government ample time to implement such a fiscal stimulus. But the Fed have lost faith in the government and are doing what little they can.

  18. ReformerRay

    Unemployment reduces purchasing power. The price of housing goes down as purchasing power goes down. All these changes are at the margin. What % of purchasing power is destroyed by what % decline in employment? We don’t know. What % of housing prices go down as a result of what % decline in purchasing power? We don’t know.
    What other factors (other than the ones listed above) influence purchasing power and price of houses? Possibly several. But the strength of each of these other influences is not constant over time.
    In short, we know that influences exist and that results depend upon influences. But the exact magnitude and strength of influences changes through time and CANNOT BE PREDICTED.
    None of us knows what will happen. We recognize that the future will be built out of the past. So, we anticipate the future but we cannot know it.
    We can also mold the future. If Obama would say: “No more money to AIG” that would, in my opinion, reduce the ultimate debt to be acquired by the federal government. I think it would also help cleanse the banks of toxic assets, which I think would move toward a bottom.
    I think the high level of purchasing power that exists today compared with 1933 requires assuming that the experience of 1933 will not be repeated.
    But I do not know the details.

  19. Confused

    I would like to interject a very simple non-academic point of view, being an outside observer.
    Inflation might be viewed as a deterioration of the FEDs assets, since the currency is inevitably backed by the asset side of the FEDs balance sheet. The T-bonds and T-bills held by the FED are only as good as the tax payers ability to make good on this debt. It is the action of the treasury issuing enormous and unsustainable quantities of this paper that increase the risk of inflation, not the action of the FED. As the tax payers liabilities become ever more onerous, the balance sheet of the FED deteriorates. It seems to me that the FEDs actions of late, buying up mortgage backed securities, extending credit to non-traditional borrowers is a good move and has little impact on inflation. The FED is diversifying its holdings away from mainly treasuries. I dont consider treasuries as risk less. The only thing risk less about them is that you will get the nominal face value back (whatever that may be). Looking at the FED as a mutual fund I would not want most of the holdings based on a very stressed and overburdened tax payer. I think the FED should increase its holdings of mortgages, that will regain there value at the mere whiff of inflation. To take it a step further why should the FED not further diversify its holdings to AAA bonds and other AAA securities. This would give me much more faith in the U.S. dollar and therefore inflation. The FED needs to back the currency by more than empty promises from the treasury. Inflation erodes the value of bonds but inflates hard assets. Could someone out there please explain why the FEDs purchases of asset backed securities at distressed prices would damage the value of the currency?

  20. Get Rid of the Fed

    “There’s a second reason why I believe achieving a modest rate of inflation (my number is 3%) should be job 1 for the Fed.”
    So, what number do you want for wage inflation, short term interest rates, and long term interest rates?

  21. MikeR

    JDH: “If your point is that the Fed should have been less expansionary in 2002-2004 given the contribution low rates made to destabilizing house price appreciation”
    Not to bring up old debates, but the Fed just can not control interest rates by targeting the Fed Funds rate alone. That is why they are using quant easing now. Monetary aggregates were stable in 2002 – 2004. Should they have engaged in quantitative “tightening” back in 2002 – 2004? Greenspan tried to deflate the stock market bubble of the ’90′s and he as laughed at (Irational exhuberance speech anyone?)
    I will hang up and listen for my answer.

  22. JDH

    Get Rid of the Fed: As I am conceiving of the policy options, the Fed has but one instrument (the dollar value of purchases of long-term assets) and must choose a single objective that it might hope to achieve with that instrument. Since I have specified that objective to be 3% inflation, your other variables are going to have to be whatever results from implementing the prescribed policy.

    It would be nice if we could command that each variable should go to some desired level, but in my view of the world, that’s not an option. I’m suggesting that if the Fed achieves 3% inflation, it’s done as well as is feasible in terms of the general frontier of what’s available.

    Ed: University of California professors enjoyed a 5% nominal salary cut in 1993, and I don’t know why you assume that you are immune from that at your current institution in present circumstances. You may be correct that if there is 3% inflation, your nominal salary won’t be cut. But that doesn’t mean that your nominal salary won’t be cut if the inflation rate is 0%.

    Certainly there are circumstances in which a cut in the real wage (either reduction in nominal wage with cost of living fixed, or increase in cost of living with nominal wage fixed) is the only way to keep the number of people employed from falling. I see no reason to maintain that this proposition should not hold for university professors.

  23. JDH

    MikeR: I advocate a quantity target for the sole reason that the usual interest rate target has become irrelevant. When things return to normal, I will return to suggesting an optimal policy in terms of a target for the fed funds rate.

    I am saying that the target for the fed funds rate 2003-2004 was too low.

  24. Ed

    JDH and Reformer Ray.
    I was not stating that because I am an academic things are worse for me. In the contrary actually. Typically academics are more insulated from economic difficulties. My point in stating that I was an academic was to show that no one is immune. And real wage deflation is a real problem to an individual not a corporation. If a corporation can get away with paying less they will love it (note one of his first act, the pres limited companies from doing this.)
    Sorry for divulging too much information.

  25. HZ

    Funny just a couple of days ago you wrote: “If you know for a fact that the inflation rate is going to be 3%, your time might be better spent arbitraging the nominal-TIPS spread rather than arguing with me”, when my point was that with 3% inflation the current 10 year notes are cost free financing. But since I like this blog post a lot better I will let that pass :-)
    Another point about inflation though: don’t you need wage growth to pick up to get inflation? There may be a class of people (mainly in the medical profession) that have managed to put themselves in a position of pricing power (even more so with universal health care without a national provider pricing policy), the rest of us does not seem to have that luxury. So we will need a tidal change in the economic structure (maybe a very hard dollar crash?) to get significant inflation and Fed will have plenty of time to respond so long as it is not emasculated by then.

  26. James Morley

    Just to follow up on the TIPS issue, the New York Fed had a followup statement yesterday (here) which suggests that it will be purchasing TIPS as part of this new program.
    Also, my preliminary thought on the Fed’s announcement is that communicating policy in terms of the dollar amount of Treasury purchases rather than an explicit target for a specific long-term rate was sensible. If inflation expectations start to recover and there is upward pressure on long-term yields, the Fed will not be bound to keep them down. I.e., the policy instrument is quantity of purchases, not a particular long-term interest rate, while the policy goal is positive, but low inflation, which is likely to be consistent with higher 10-year Treasury yields than we currently see.

  27. Rajesh

    An interest rate target would implicitly imply a target inflation rate. A dollar amount does not imply whether rates are too high or too low.
    Investors are left to guess when (and if) the Fed will make purchases. This is $300 billion over six months. Is that $50 billion each month or will the Fed only step in an purchase notes when it sees the market become disorderly.
    I agree that the Fed action will help but I think an interest rate ceiling would be more transparent. They can raise or lower the ceiling at each FOMC meeting or even between meetings if they need to.

  28. Fullcarry

    It seems like we are forgetting Minsky’s admonition. The problem with inflation targeting is that eventually the economy will organize in a way that would require even higher inflation.
    That is precisely the fix we are in right now. We need to devalue our debts. It might be fashionable to call this deflation but it is nothing of the sort. It is only deflation in the prices we would like to see go up. The average price level hasn’t dipped in any appreciable way.

  29. Sam

    As expected, the FED fired its last bullet. Mr. Bernanke does not seem to understand or want to understand that you cant get something out of nothing, i.e. you can’t created demand for real goods and services by printing money, because money is a medium of exchange and not a good based on labour that produced it that you can exchange. A construction worker exchanges its labour (that built a house) for a pound of meat that a farmer produced (using his labour). That is economy, that is exchange of goods. What Mr. Bernanke does, is he pushes a button on his computer, adds money to his electronic account and then thinks he can exchange it for something valuable. What is he giving in return? Nothing really. So there is no real economic output on the side of the FED, so there won’t be jobs created and goods exchanged for other goods. Mr. Bernanke’s academic theories, tested on real living people, are falling flat on its face and we’are headed for Great Depression 2.0, because “the student of Great Depression”, the “helicopter Ben” just does not get it – You can’t create something out of nothing.

  30. HZ

    Sam,
    Money neutrality is false here because debt is fixed in nominal money. Credit implosion causes real demand to collapse — that is what the Fed is out to prevent.

  31. David Pearson

    JDH,
    As you may imagine many think that your view on the prospects for long term inflation is overly optimistic.
    First, it would be useful to know what assumptions you make about the eventual recovery. Is it going to be strong enough to withstand a removal of stimulus? What dynamic (private investment, housing investment, etc.), exactly, will be driving that strength? At what stage in the recovery will inflation hit your target, and are you assuming we must erase the output gap before the target is reached?
    One can easily conjure up a scenario where expectations cause economic actors to hedge against future inflation. That hedging behavior causes inflation in hard assets, which drives the CPI above 3% during an incipient recovery. What does the Fed do? Abort the recovery? If they do, then what effect does that have on long term unemployment? What is the effect of long term unemployment on societal/political pressures?
    The prognosis for stimulus removal is cloudy, to say the least. Its only not cloudy if the Fed promises to stomach a recession to stop inflation at 3%. Given that the Fed, today, has no stomach for a recession, then what are the chances they will have it then, with large numbers of long term unemployed?

  32. Tommy

    I can understand and, mostly, agree with the idea that we must first attain short-term stability when it comes to a proper percentile of inflation. Once that can be reached and then contained, the U.S. Treasury, Federal Reserve, the American people, and the Federal Open Market Commitee can then set their sights on achieving long-term inflation stability and security.
    However one cannot be reached without the other and it’s important to point out that there are those that are unaffected by the very low inflation rates, job losses and declining equity. Of course the future is never certain, especially where monetary gain and loss is, but those with somewhat secure jobs and income should do their part to help stimulate the economy, along with the Federal purchasing of securities.

  33. GreenAB

    i dont get it.
    it is NOT the problem, that savers are holding back money and REFUSE to consume (houses, cars, everything).
    the opposite is true: the consumer is tapped out.
    so far we have seen no deflation yet.
    yes gas prices are falling and provide a bit of a relieve.
    but thats all!
    this minor stimulus is offset by rising unemployment and stagnating/falling wages.
    again: the problem is not a high savings rate like in japan or germany.
    the only effect the fed will accomplish is the same when they started cutting rates agressively in autumn 2007:
    they weaken the dollar and hence IMMEDIATELY IMPORT INFLATION.
    this will put corporate margins and consumers balance sheet under even more pressure at a time, when some disinflation would be needed.
    as they did in 2007, theyll MAKE THINGS WORSE.

  34. Young Economist

    Why FED distorts risky-asset prices to reduce risk premium create more severe deflation and more economic contraction and Why FED addicted to expand more intervention by printing?
    1. Distortion of risky-asset prices relative to riskless assets by FED will cause investors preference shift from investing less in risky asset from lower required rate of return than that private can accept into investing more on riskless asset from higher relative price. This is why Japan failed to create the growth from Quantitative easing method.
    2. Private sectors will shift more money into riskless assets and sell more risky assets from the lower distorted prices by FED and meanings that the first Quantitative easing method is not working. I mean currently we see all assets are priced in from FED actions both long bond yields and US dollar, but from now, the yield will move higher again from preferences shift of investors and US dollar is also appreciating again. Next FED is forced to use more Quantitative easing and at the end FED are addicted to print more money to buy nearly all risky assets and economy is not picking up and price is also deflated.
    3. The main concern is if FED stop using Quantitative easing or there is the shock (like corporate default), that will create reversal of risky-asset prices and there will be massive loss to the investors joining with FED to hold those distorted-pricing assets; surely, this system will collapse to change the recession and the deflated price to the great depression and the severe deflation.
    4. Therefore, FED action to support asset price is wrong and they can bail out all private investor and speculators in financial market but they definitely cause all people to face the disaster of economy.
    I am still confident that the intervention is disaster for economy because it just transfer loss from the specific investors in Wall street into every people in the country; however, not everyone prepare for the loss that FED have done, so total social loss will be more massive than letting Wall street investors lose.
    Only way to solve this crisis is that FED and US government should build the system and policy to ensure that if no intervention or market-distortion policies, the economy can sustain the growth whatever high or low in the long run.

  35. Robert Mugabe

    Printing money is great. And they say US doesnt produce anything, anymore. Loosers. Personally, I would love to have dollar wallpapers in my living room.

  36. Dave Cohen

    I quote

    Real debt imbalances, both domestic and international, frictions in moving resources out of housing and autos and into other sectors, and the profound problems with our financial system all place important physical constraints on what any stimulus package, monetary or fiscal, is capable of achieving.

    Bingo!

    When are the Fed, the Treasury, the President, etc. going to face the music and stop pretending that there’s going to be some kind of rapid turnaround?

  37. Charles

    Dave Cohen, I don’t think the Administration or the Fed have been pretending that there will be a rapid turnaround. The most optimistic the Fed has been was a prediction, now apparently withdrawn, that the recession would end by the end of the year. But the end of the recession doesn’t mean that things are back to normal. As Nouriel Roubini has said, the chances for an L-shaped recession, in which there is no burst of growth at the end, are significant.

  38. MikeR

    JDH, Thanks for the link. I very much like the taylor rule and when rates get close to zero, even he admited (in one of his older papers) that intervention such as quant easing becomes necessary.

  39. Kelly Stevens

    Prof. Hamilton,
    Richard Koo’s recent book on Japan’s “Great Recession” calls into question the effectiveness of increasing bank reserves when the private sector is paying down debt. According to him, the large increase in reserves had no affect on the money supply, the price level, or output. Could lower mortgage and other interest rates lead mostly to faster deleveraging and not more aggregate demand?

  40. DickF

    JDH wrote:
    Ed: University of California professors enjoyed a 5% nominal salary cut in 1993, and I don’t know why you assume that you are immune from that at your current institution in present circumstances. You may be correct that if there is 3% inflation, your nominal salary won’t be cut. But that doesn’t mean that your nominal salary won’t be cut if the inflation rate is 0%.
    Certainly there are circumstances in which a cut in the real wage (either reduction in nominal wage with cost of living fixed, or increase in cost of living with nominal wage fixed) is the only way to keep the number of people employed from falling. I see no reason to maintain that this proposition should not hold for university professors.
    This discussion simply demonstrates how ingrained myth and fallacy have enter the US psyche. From 1800 until the 1900s the general price level did not change. Only after the Keynesian/monetarist revolution have we had sever problems with inflation and deflation.
    But today there is the general assumption that we must have wage increases and price increases. Why? There is simply no logic at all to justify why general prices should change. We have totally lost the understanding that it is goods and services that make us prosperous not the price of trinkets.

  41. gaius marius

    Richard Koo’s recent book on Japan’s “Great Recession” calls into question the effectiveness of increasing bank reserves when the private sector is paying down debt. According to him, the large increase in reserves had no affect on the money supply, the price level, or output. Could lower mortgage and other interest rates lead mostly to faster deleveraging and not more aggregate demand?
    i second kelly stevens. quantitative easing is going to be a whole lot of nothing because we have a big problem hiding a second, much bigger problem.
    the big problem of the financial system, i have some (strained) confidence, will be resolved. through forbearance or recapitalization or equitization, the banking system will not be allowed to implode of its own accord. it will soon enough be in a position to lend.
    but to whom?
    we have had a massive asset shock that has wrecked the household balance sheet. you’ve all seen the charts of home equity and household net worth post-lehman. many millions of americans now have a modicum of free cash flow but are either insolvent or underreserved for an uncertain future and rapidly approaching retirement.
    these people are highly likely to respond by directing free cash flow away from consumption and toward paying down debt and building savings for the forseeable future. as a result, aggregate loan demand in this country is plummeting. even if banks wanted to lend, the only people who want to borrow are the profligate and the desperate — both awful credits.
    koo’s critical insight onto the japanese situation is that — contrary to near-universal teaching in economics — economic units do not always work to maximize profit; under rare but periodic conditions, they instead work to minimize debt. japan fell into that trap from 1990-2005, just as the united states did from 1929-53.
    it is going to take several years for american houshold balance sheets to be repaired through income, and in that time monetary policy will be as effective as japanese QE was, which was as effective as throwing rotten tomatoes at the economy. they can push $300bn or $3tn or $30tn into the banking system — the effect will be a big, fat null (unless you imagine the size of the excess reserves pile on the fed’s balance sheet matters) because new debt won’t be taken out by households whose balance sheets weren’t in great shape before their houses and stock portfolios collapsed.
    the best we can do from here is put the government in place as the borrower of first, last and only resort through fiscal stimulus — dredging private savings out of the banking system and spending them to prevent the fallacy of composition from annihilating the economy. asset prices will in the meantime continue to decline well below realistic valuations relative to incomes as private financing is drained away.

  42. Anonymous

    Prof. Hamilton,
    You write “I am defining deflation (as do most academic economists) as an increase in the real purchasing power of each dollar bill outstanding, as measured by a decrease in the level of a broad price index such as the CPI or PCE deflator.”
    Sounds like I want some more of this deflation. Why wouldn’t I want an increase in the real purchasing power of my dollars?
    You then state “I think that deflation is an important condition for the Fed to avoid because deflation magnifies and aggravates the real burdens of debtors (dollar sums owed become an even bigger real burden), which would drive us even deeper into our current problems.”
    O.k. Sounds like too many people borrowed too much and are in debt up to their eyeballs. God forbid we aggravate the burdens of debtors!
    What am I missing? Sounds like you want my dollars to buy less while making it easier for me to go further in debt.
    Now that is intriguing.

  43. GreenAB

    @Dick F: “why the price increases”
    our capital system demands ever rising corporate profits.
    once you get to saturated markets and population growth slowing substantially the only way to increase your profits is by raising prices (and cut costs).
    now were at a point when the exponential growth in coporate profits (compared to gdp growth) cannot longer be sustained on the consumers balance sheet.
    deflation is needed to repair those balance sheets. a logical natural process.
    unfortunately this would mean plummeting corporate profits and the country spiraling into depression.
    how do we get out of this mess?
    im not sure.
    but whta i know is that this system in need of evergrowing profits is not sustainable.

  44. ReformerRay

    Yes, this situation is different. The level of consumer debt and consumer fear of the future is high. How high? Relative to past situations?
    Past experience may not be available as a guide for a situation when a large portion of a rich population is suddenly confronted with uncertain future prospects, many consumers in debt, a Federal government heavily in debt and not adverse to incresing debt, declining employment and a habit of consuming more than we produce each quarter.
    Bernanke thinks the experience of the great depression is relevant to guide action today. WRONG… At the moment, the U.S. economy needs to continue to shrink. He needs to cool it, let the financial firms collapse that cannot survive and keep some ammunition for the period after housing defaults are being matched by housing purchases.

  45. The correct analogy?

    From an entirely lay perspective, more and more, the most appropriate analogy appears to be WW II, not the Great Depression. I’m amazed that the world appears to have just done the economic equivalent of putting all its bombs on small springs and then detonated them on itself. Was Eisenhower right after all? Is it time for the White House to put in a Victory Garden again?

  46. DickF

    Professor,
    I know that you believe that monetary policy is most important in stimulating the economy so I hope that this recent move by the FED will be a test of your economic theory and that you will take it to heart. The recent move by the FED is exactly what you called for and so if there is no recovery you must reevaluate some of your funamental theories.
    There is little doubt that the recent move by the FED will lead to stagflation. We will see as you have requested a rise in prices but we will see unemployment continue. The economy will stay in decline though it appears at the moment to be at a support point such that if the administration, congress, or the FED do not hit it again with a shock it should stay in its current range. The market’s discomfort with inflation is already pulling it back from its recent moves upward.
    I am asking you, if there is no recovery, when inflation starts, that you do not justify the failure of your theory with thoughts of it not being enough of some other rationalizations from the talking heads. Rather, open your thoughts to classical ideas (I know you know them). Begin to consider them anew. Read (or reread) Mises Human Action especially chapter 1 where he talks about the foundation of economics.
    Finally, consider that it is both personal and economic freedom that brings prosperity and that will bring recovery in our current situation. As Ronald Reagan said government intervention is not the solution it is the problem.
    I admire your reason and judgement. It takes courage to step from the path and take a new road.

  47. gaius marius

    There is little doubt that the recent move by the FED will lead to stagflation.
    wadr, df, there’s very considerable doubt. i suspect QE will be the standout non-event of the crisis, and that we’ll continue to deflate for so long as the monetary lines of transmission to the economy are broken by a lack of loan demand. i suspect we have entered a very different paradigm in which monetary policy will mean little and do less.

  48. JDH

    DickF: If the measures that the Fed adopts still result in deflation, then I will definitely advocate doing more until deflation is stopped.

    If the measures do not result in recovery, I certainly will not advocate doing more. I do not in fact claim that the measures will result in recovery. What I claim is:

    I emphasize that I am decidedly not suggesting that either fiscal or monetary policy stimulus are capable of solving all of our problems…. Once we get to 3% inflation, that to me will be a clear indication that we’ve accomplished all we can with tools to stimulate aggregate demand.

  49. GNP

    My mistake. The informal target may still be 2%; the range may still be 1% to 3%.

    But then I could be confused. Or simply daft. (?)

    Hmmm. What is an economic agent and investor to conclude after years and years of talk of the US federal reserve adopting an inflation targeting framework? A formally mandated inflation targeting framework isn’t really that necessary or useful? Clear communication is to postponed until ‘after the flood’? (Perhaps the endearing personal appearance on television show 60 minutes–a show that was over one year in the making–is just what the monetary policy doctor ordered?)

    Or Bernanke and some colleagues would strongly prefer to adopt and implement a formal inflation targeting mandate but there exists much opposition among those who support “maximum employment” and robust material growth?

    No, this little investor will not bet against the fed. But what exactly does “betting with the US federal reserve” mean?

    Increase cash and fixed-income portfolio allocations until some indeterminate time down the road because asset values appear poised to continue to decline? That’s how I interpret the noisy signals of fed hesitations and panic mode decisions.

    Increase allocations to gold-weighted instruments because a jump in inflationary expectations at some point seems now more likely than ever? (Even if gold is a disasteful and intrinsically useless store of wealth and probably already well into overshoot terrritory.)

  50. Vangel

    I love the approach because it will give those that are prudent and mindful the opportunity to make a fortune by buying energy and precious metals. But what about the other people, who have their savings in treasuries and will see their purchasing power erode by the Fed’s expansion of the money supply? Or those that see the Fed’s punishment of savers as a signal to keep borrowing and spending?
    Why would people believe that keeping the price of houses artificially high and keeping insolvent gambling houses on Wall Street afloat as a good thing? Haven’t they learned from the major errors made by Hoover/FDR in the 1930s or the Japanese in the 1990s? The best thing to do is to look at history and that tells us that the thing to do is to cut taxes and cut government spending. Let’s abolish the Fed and protecting the virtuous by taking away from governments the power to depreciat our savings away to bail out the reckless.

  51. John

    So – how can one hedge against quantitative easing and the erosion of value of debt and savings ? I personally buy farmland where I see most intrinsic value, or rather raw land (in South America) that has sufficient fertility to be farmland at some point.
    I like that it is so easy to understand how much there is and ever will be.
    How do you hedge ?

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