Yes, the Fed could produce a higher inflation rate

From the responses to my remarks last week on monetary policy, I see that my words were interpreted by some readers differently than I’d intended, for which I apologize. Let me try again.

Let me begin by summarizing the two main points I was trying to make. First, I pointed out that, in the current environment, large-scale asset purchases by the Fed are essentially a swap of short-term for long-term government debt. I asked whether those who criticize the Fed for being too timid would also criticize the Treasury for likewise being too timid in keeping so much of its borrowing long term. I answered for them (and on this I did not see any of the Fed’s critics dispute my proposed answer) that there were clear fiscal management dangers if the Treasury were to aggressively move the federal debt into extremely short-term securities. I therefore suggested that if we would see some potential danger associated with such a strategy if adopted by the Treasury, then we should also see some danger about such a strategy if adopted by the Fed.

Second, I pointed out that the direct stimulative effects of a debt maturity swap were decidedly minor.

The conclusion I draw from these two observations is that we might have to push on this lever extremely hard to get anything accomplished, and that pushing on the lever is not without its own dangers. My position is therefore that the Fed is correct in viewing this particular tool as one that should be used with caution.

Now for some of the responses. Brad
DeLong
observes that although Federal Reserve deposits at the moment are essentially equivalent to short-term Treasury obligations, once we get away from the liquidity trap they will not be. Insofar as some of today’s created reserves turn into M1 instead of T-bills at that future date, Brad argues, the time path would be more stimulative and, through an expectations effect, that could make a difference today. This is in fact my view as well, and one of the reasons why I insist that the main mechanism by which large-scale asset purchases could make a difference is not through their direct mechanical consequences for interest rates, but instead comes from their value in sending a credible signal for future Fed policy.
And that’s why I think the main task for the Fed is not to decide how much LSAP we need, but instead to articulate a clear framework within which those measures are implemented that is also mindful of the particular fiscal management challenges that these policies tie us into. I suggested that the current policy, which I read as not allowing inflation to fall below 2%, works well for both objectives.

Scott Sumner is dismayed at my focus on the concrete steps the Fed would need to take to implement more stimulus. Scott is a strong advocate of the view that if the Fed were simply to announce a particular target, everything would fall in place to make sure it happens. For clarification, I fully agree with Scott and Brad that it would be possible for the Fed to achieve a higher inflation rate than 2%. My concern is with the robustness of the particular strategies for implementing such an objective. In particular, the fiscal management problem I am referring to is one of a rapid flight from dollars and loss of confidence in the Fed and Treasury. As I explained in my original post, this is the exact opposite of deflation. A strong Fed commitment to avoid deflation should not provoke market fears about the ability of the Treasury and Fed to manage their short-term liabilities. The question on which I and some of the Fed’s critics may differ is whether there is a similar robustness to the Fed’s announcing that what they’re trying to produce is, say, 3.5% inflation. My fear is that the practical instruments available to the Fed are too blunt, and the stability of the expectations equilibrium too tenuous, for us to be confident that the Fed could manage a multi-trillion dollar balance sheet if financial participants develop sudden doubts about how it will play out.

Notwithstanding, I agree that there is room for the Fed to look for a more expansionary objective. To repeat my earlier conclusion:

Perhaps there is a clear way to communicate an alternative, more ambitious goal, such as keeping nominal GDP growth above 5%, or temporarily focusing on getting unemployment down to 7%. If articulated narrowly and with some caution, these might allow the Fed to do more while still preserving confidence in what I have described as the logistics of managing potentially volatile short-term government debt.

But unlike many of my fellow academics, I worry about those logistics and am convinced that it is a mistake to ask too much from monetary policy.

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40 thoughts on “Yes, the Fed could produce a higher inflation rate

  1. Simon van Norden

    “I answered … (and on this I did not see any of the Fed’s critics dispute my proposed answer) that there were clear fiscal management dangers”
    In response to your post last week, I asked whether you could be more clear about those fiscal management dangers. As I pointed out, you are talking about the management of a stock of short-term debt by a government which has the authority to create legal tender. I suspect that you’re labelling “fiscal management dangers” is some combination of concerns about exchange rate or price level targets. On the other hand, you’re also saying that you’re concerned about “logistics.” I would still like to see your concerns made explicit.

  2. W.C. Varones

    … which is to say macro-economists suffer from not paying enough attention to incentives at the individual consumer and business level.
    We would all be much better off if Bernanke took a remedial Micro-economics 101 course.

  3. 2slugbaits

    JDH Thanks for the clarification. Your original post had a lot of blog interest and it seems just about everyone read it differently. Of course, a second bite at the apple is no guarnatee of a successful communication either, so I want to make sure I’m understanding your points.
    1. You’re claiming that although the Fed might be able to credibly commit to a 2.2% inflation target without upsetting too many folks, a 3.2% target is likely a bridge too far. In other words, the Fed really only “controls” inflationary expectations within a very constrained range.
    2. More importantly, the reason the target is so constrained isn’t because there is anything particularly sacred about a 2% target versus a 4% target, but rather that a 2% target is stable and convergent while a 4% target might lead to 5% inflation, which would lead to 6% inflation, etc. And this gets to the point about the bluntness of the logistical tools available to the Fed.
    3. The Fed faces two opposite credibility issues. On the one hand there is a very real risk that if Bernanke got up and announced that the Fed would now target to a 3% inflation target rather than 2%, would anyone actually believe him? Some folks may interpret that as an admission by the Fed that this is just temporary Kentucky Windage and the real target is still just 2%. In that case the Fed looks impotent and further erodes its power without actually changing inflation expectations. On the other hand, some would worry that if the Fed has trouble fighting deflation (and inflation for 2009, 2010 and 2011 was under 2%), then perhaps the Fed won’t be able to control inflation on the other side of the target.
    Perhaps there is a clear way to communicate an alternative, more ambitious goal…
    The problem is that the Fed doesn’t seem inclined to go even this far, and that’s the point critics have been making. Why not just schedule a news conference and announce a new target rate (or better yet, an altogether new metric with a brand new name) and take concrete actions that would appear consistent with that new target? The Fed isn’t being blamed for not taking reckless action; the Fed is being blamed for not wanting to take any actions that might result in blame if things don’t go well. It’s like the captain of a ship claiming that if he must go down with the ship, so too must the passengers. Even though Bernanke is follically challenged, we’d at least like to see that his beard is on fire.

  4. dwb

    The question on which I and some of the Fed’s critics may differ is whether there is a similar robustness to the Fed’s announcing that what they’re trying to produce is, say, 3.5% inflation.

    i am puzzled by the fact that there appears to be an implicit threshold or critical point that requires caution. A 5% inflation target might be destabilizing for inflation expectations, but i strongly doubt a 2.1% or 2.5% target is. The Austrailian for example CB has a 2-3% inflation target band- no social unrest going on down under.
    As phrased, it sounds mostly like “unsafe at any speed” above 2%.
    To put it differently, what precisely does “narrowly and with some caution mean” – 2.5%? 2.75%? 3%? where are we safe and where are we in hot water here (compared to the certainty of 14% shadow underemployment)?
    Also, Nick Rowe put it succinctly: no one really expects the Fed to hit 5% ngdp (it does not hit 2% PCE either):

    “We will never be able to keep actual NGDP exactly on target, but as long as people expect near-future NGDP to stay at target, actual NGDP cannot wander far. If actual NGDP falls below the target path, people will expect temporarily higher than normal inflation and/or real GDP growth, both of which would make demand higher than it otherwise would be, and help prevent actual NGDP falling as much as it otherwise would.”

    The problem during the recession was that employers cut far and fast because they panicked and did not know how far, how deep the recession would be. now, they have no idea if the fed is committed to closing the output gap.
    Seems to me that ngdp targeting is superior to a balanced Taylor rule because it seeks to minimize the variance of p*y along a (say) forward 5 year path.

  5. Andy Harless

    You read the current policy as “not allowing inflation to fall below 2%,” but this interpretation isn’t consistent with the Fed’s announced projections, which show 2% as the top of the range rather than the bottom.

  6. dwb

    WC Varones
    David Einhorn has an awesome column exposing the futility and counter-productivity of Fed easy money here.
    When you have reduced monetary policy to jelly donuts (or Fisher’s monetary cookies) you have lost the argument.
    It’s no shocker Einhorm worries about low interest income because thats most of his income.
    Down here on Planet Work-For-A-Living most people get their income from wages, compensation and so on, not from interst income. The marginal propensity to consume among people who primarily receive interest income like einhorn and romney is very low.
    getting people to spend more and increasing AD, using up spare capacity now, provides a foundation where rates can rise later on – which prevents permanenty depressed rates, as in Japan.

  7. Walter Sobchak

    “My fear is that the practical instruments available to the Fed are too blunt, and the stability of the expectations equilibrium too tenuous, for us to be confident that the Fed could manage a multi-trillion dollar balance sheet if financial participants develop sudden doubts about how it will play out.”
    My way of expressing that doubt last week was pointing out that the Fed was trying to run a bank with a leverage ratio > 50::1. Cranking that ratio up to 110::1 will not make a stable outcome more likely.

  8. JDH

    Simon van Norden: The problem I refer to is what happens when the current holders of short-term Treasury securities and Federal Reserve deposits no longer feel like holding those assets. The answer that many economists would give would be, well, at some interest rate they would want to hold them. But if the Treasury and the Fed say, no problem, we’ll just pay you a sharply higher rate in order to make sure you keep lending to us, that higher rate may make it harder and harder to sustain the debt burden. But then lenders come to doubt even more that the government has real resources with which it can make those interest payments, leading them to demand an even higher rate in order to be persuaded to lend.

    You correctly observe that no one should doubt that the Fed can deliver dollars as promised, because it can always create more of them. But the scenario I am describing is a flight from the dollar itself. In the mean time, normal functioning of dollar-based credit markets is severely disrupted.

    Please note I am not predicting this is about to happen next week in the U.S., and I am not saying that the reason we can’t expand the balance sheet further is because that will make the inflation rate in 2012 too high. Instead, I raise it as a potential concern about the stability and robustness of a system in which a significant portion of the government debt is held in the form of reserves, and as a potential cost to bear in mind as we ponder the potential benefits of expanding that portion. As long as the goal is to prevent deflation, I see the arguments for going ahead with such an expansion quite compelling. But if the goal is instead to generate more substantial inflation, I begin to have some more concerns.

    2slugbaits and dwb: The special thing about 2% is the Fed has invested an awful lot of previous capital in saying this is what they want, so that when they say that’s what they’re trying to do, people can believe it. Having the public believe it, both in terms of being confident we’re not going to see deflation, and in terms of believing that the Fed’s balance sheet is not going to cause the U.S. to turn into Zimbabwe, is the single most valuable policy tool the Fed can have.

    The problem I see with the Fed announcing anything else is that people may logically start to think, well, if they can change it from 2% to 3.5%, they can change it from 3.5% to 5%. If the Fed starts such speculation, can it easily stop it?

    Andy Harless: My expectation is that if the PCE deflator begins to come in below 2%, we will see more quantitative easing from the Fed. And if we do, I would support it.

  9. 2slugbaits

    JDH The problem I see with the Fed announcing anything else is that people may logically start to think, well, if they can change it from 2% to 3.5%, they can change it from 3.5% to 5%.
    Fair enough, but I think the Fed could substantially mitigate this risk if it announced that it now believes an inflation target consistent with what was observed during the 1990s was a better target both in terms of growth and in the Fed’s ability to hit that target. Couch things in terms of admitting that the 2% target was itself a mistake and that while the Fed could maintain that target, there is little point in maintaining a bad target just for the sake of obstinancy. If explained in that way I don’t think people would start waving the bloody shirt of Weimar inflation…except of course the usual suspects (e.g., shadowstates) who believe we’ve been Zimbabwe for the last three years anyway.
    W.C. Varones We would all be much better off if Bernanke took a remedial Micro-economics 101 course.
    Hmmmm…microeconomics 101 predicts that recessions are impossible and markets always clear. Are you saying that Bernanke should pretend recessions never happen?

  10. dwb


    The special thing about 2% is the Fed has invested an awful lot of previous capital in saying this is what they want..The problem I see with the Fed announcing anything else is that people may logically start to think, well, if they can change it from 2% to 3.5%, they can change it from 3.5% to 5%. If the Fed starts such speculation, can it easily stop it?

    Respectfully I both 100% agree with this statement and 100% disagree. Fed credibility is its best asset.
    However, I think your statement illustrates the bind the Fed has got itself into: the Fed has built up credibility on the wrong thing.
    The Fed is a dual mandate central bank and both sides of the mandate need to have credibility. The fact that the Fed views 2% as sacrosanct means that there is 100% credibility on the inflation target and 0% on employment. Back in the 70s, had I not been so youthfully focused on Star Wars, I would have said exactly the opposite: 0% on inflation, 100% on employment. The fact that the employment side of the mandate has 0% credibility is also partly responsible for the large panicked cutbacks in Q42008, and why we are not closing the output gap sooner.
    Both parts of the mandate need to have 100% credibility and therefore the issue is how to quantify the inflation employment tradeoff . (For example, ala the conditional target proposed here a couple months back). Quantify in a way that does not lead to the speculation you are rightly worried about.
    Now, If the Fed stated that it would tolerate “x% higher inflation as long as real output was x% below potential” it both quantifies the tradeoff and ends the speculation you are worried about, because its clear exactly how much inflation it will tolerate. The Fed is supposed to be following a balanced Taylor rule (which is clearly untrue if you believe 2% is sacrosanct) and in my mind the statement I just made is consistent with the Bernanke Jan 2010 presentation on the balanced taylor rule using inflation and the output gap.
    Which of course, is just a lesser cousin to ngdp targeting.

  11. Joseph

    All of this hand wringing about what might happen to inflation is getting a little old after hearing it for over three years now.
    Ben Bernanke should go down in history as one of this century’s greatest moral monsters, like Andrew “liquidate, liquidate, liquidate” Mellon did in the last. Bernanke has decided that 20 million ruined lives in not too big a price to pay to ensure that creditors never suffer one moment of discomfort. People secure in their jobs think that a tiny risk of inflation is the greatest risk in the economy. People without jobs think otherwise.

  12. Thorstein Veblen

    First off, thanks to James for several thought-provoking posts.
    However, again, like other commenters, I’m feeling too stupid to know what these “clear fiscal management dangers” might mean in the context of the Fed doing more QE. The Fed can create as much money as it likes, and it can reverse QE or even raise rates should inflation get out of hand. I don’t see why the exit strategy should be the reason to let the economy burn.
    Fed vs. Treasury, Fed moves last in monetary policy. So, I criticize the Fed. Monetary policy is the Fed’s job, not the Treasury’s job.
    On your second point, once again, if the effects of QE were nonexistant/minor, your conclusion should be that the Fed should do more, and do it permanently. That’s a justification for bold action, not for being timid.

  13. acerimusdux

    “what happens when the current holders of short-term Treasury securities and Federal Reserve deposits no longer feel like holding those assets”

    I’m not convinced there is any need for them to hold these assets. If they exchange their dollars for other assets, goods, or services in the US, that just fuels economic growth. If they do it abroad, for foreign currencies, the dollars end up in currency markets leading to some exchange rate adjustment, helping to reduce our trade deficit.

    Now if there were a sudden mass move of this sort, sure that could be disruptive. But I see no reason such sudden changes in behavior would be any more likely with a 3% target rather than a 2% target. Unless the belief is that the moment of change itself would be disruptive.

    But I don’t see why changes in inflation targets should be any more disruptive than changes in interest rate targets. And interest rate changes are disruptive, in the short term, when they occur, but markets seems to adjust quickly enough.

    Maybe there is an argument here that inflation targets should be increased gradually, in the way that interest rates are, but
    I don’t see the argument for a permanent 2% target. Even that target itself is a fairly new policy target, it’s not as though it’s some longstanding tradition. I think markets would see this as the Fed simply using it’s policy discretion, as needed, to make adjustments to current economic conditions.

  14. Jon S

    I think in order to be valid the negative effects of raising the inflation target that you hypothesize must be immediate and cataclysmic — it must be a sudden and very dramatic fear of seignorage, or abandonment of the dollar, or ascent of inflation expectations, that produces a panic.
    If your concerns are long run only, then the flip side of the coin is that higher inflation brings relative prices in line with equilibrium values faster, producing a more robust recovery, and a gradual weakening of the dollar produces export-led growth. Both effects reduce the debt burden.

  15. Ricardo

    Professor,
    There are as many definitions of deflation as there are economists in the world. How do you define deflation when you talk about preventing deflation? Are you talking about a general price decline? Are you talking “to few dollars chasing too many goods?” Are you talking about a declining purchasing power of a dollar? Or something else?

  16. JDH

    Joseph: I see that you find comfort in the belief that you are on the side of the morally just, while those who disagree with you represent the forces of evil. Perhaps you should consider opening your mind to the possibility that there may be an objective debate as to what policies would in fact be most beneficial for working-class Americans.

    acerimusdux: The U.S. debt doesn’t disappear just because creditors don’t want to hold it. Any of the debt that is short term has to be continually refinanced. And as I explained in my original post, the situation with Federal Reserve deposits is even more fundamentally constrained. An individual bank may try to “exchange their dollars for other assets, goods, or services in the US”, but that does not cause reserves to disappear, it just passes them on to another bank. Conditions must change to persuade creditors to roll over their debt and banks to hold on to their reserves. The possible adverse consequences of those changes are the crux of the issue I am discussing.

    Jon S and others: No one will answer my original question. Would you have concerns if the Treasury were to convert all of the outstanding U.S. debt to 4-week Treasury bills? If so, what is the nature of those concerns, and why do you think that replacing long-term Treasury debt with monetary base is immune from those same concerns?

  17. JDH

    Richard H. Serlin: One likely consequence of a tax on reserves would be that banks would try to hold more of them in the form of cash. Among other logistical challenges, it could take over a year to print the physical cash to satisfy such a demand if we were to use existing bill denominations.

  18. Joseph

    JDH: “Perhaps you should consider opening your mind to the possibility that there may be an objective debate as to what policies would in fact be most beneficial for working-class Americans.”
    You talk about objectivity and I see people like Cochrane and Fama making ridiculous arguments that wouldn’t even pass an Econ 101 exam. I see folks squealing about the risk of inflation, for over three straight years now as 10-year bonds go below 2%. I see Europe go into a second recession as finance ministers talk about “expansionary austerity”. These same ministers espouse policies requiring everyone to save at the same time, a mathematical impossibility. The common thread in all of these policies is religious ideology trumping the facts. And you implore me to be more objective?
    There becomes a point at which willful ignorance, clinging to dogma, becomes evil.

  19. ArkansasAngie

    Me thinks you give animal spirits too much credit. When dealing with wild animals (people included) when they turn around and bite their handlers it isn’t their fault … it’s the handler’s fault.
    How about we stop with the manipulation of expectations and get own with actually changing the dynamics.
    Printing money to maintain the status quo is not change to believe in

  20. dwb

    just to be clear, i dont subscribe to fiscal crisis issue. if the Tsy sells all Bills and at some point rates go up, its because real rates and inflation has accelerated. i dont subscribe to the default risk idea for a sov that controls its own currency (there is an equivalence between inflation and default/devaluation).
    high rates mean the Tsy needs to cut the deficit, we are at full employment, maybe raise taxes or cut expenditures.
    if the fed swaps assets, eventually it will sell them at a loss when rates are higher anyway.
    which loss is npv worse? i would hope the fed selling short Bills now is. it means weve reached full employment sooner (a kind of moving future deficits to the present).
    i should live so long to see this problem.
    as i said, the main benefit of such a program is committment to reducing the output gap.

  21. acerimusdux

    JDH:

    Ahh, I think I see more clearly now. Not that there is currently any great risk of a run on the currency, but hypothetically if one were to occur, you would certainly be better off with more of the debt financed long term. Any dollars sitting in reserves could exit quickly for another currency putting pressure on exchange rates. But long term debt holders would have to sell to other buyers. They might have to take loses to do so, raising long term rates, but the bonds stay out there.

    At this time, I think some currency adjustment would be beneficial, so I’m not too concerned. And if it went too far, then I suppose the Fed could reverse course at that time. But that still means the Fed would essentially be making a bad trade, buying long bonds now at high prices and selling later at low prices.

    Meanwhile, with negative real rates on 10-year Treasuries, I think you have to ask whether the government shouldn’t be borrowing more at those terms, rather than refinancing at shorter terms.

    So what it comes down to, I think a higher inflation target might be beneficial in the long run, but I think you would need some help from fiscal policy to achieve it. The smart investment right now is for government to actually borrow and spend at those low rates, not to refinance short term and wait for those lending terms to deteriorate.

  22. Get Rid of the Fed

    “For clarification, I fully agree with Scott and Brad that it would be possible for the Fed to achieve a higher inflation rate than 2%.”
    How exactly (be specific)?
    What happens if price inflation goes to 3.5% from 2%, wages stay the same, and then real GDP goes down?
    What if this is not an aggregate demand shock as you would define it?

  23. JLR

    Please forgive my ignorance:
    What is the difference between the expectation effect lauded by DeLong and the confidence issue derided by Chinn?

  24. TallDave

    I think it’s a bit too much to ask that after gov’t inflated a multi-trillion real estate bubble, the markets reallocate production back to full employment within a few years. We screwed up, and so there is going to be pain, and the responsible course monetarily is to keep things liquid enough for the transition to happen without moving so aggressively as to inflate another unsustainable bubble.
    Fiscally, we’re not going to get more productive with clean energy, high speed rail, and other negative-value boondoggles — we’ll just end up like Europe, forced to choose between devaluation and default as the fiscal debt bubble meets reality. Low interest rates should not be mistaken for a mandate for mass misallocation, and the steepness of the Plank curve tends to imbue such notions with a false confidence.

  25. Jim Glass

    Some thoughts:
    1) I suggested that the current policy, which I read as not allowing inflation to fall below 2%, works well for both objectives.
    The PCE over the last 48 months has averaged 1.68% annual. Looking forward, the markets are predicting inflation over the next 10 years of 1.47%, as per the Cleveland Fed. How is this read as “not allowing inflation to fall below 2%”?
    It looks to me much more like “not tolerating inflation above 2%”, and that that is how the markets see it too.
    After all, in reply to Krugman, Bernanke didn’t say “we acted strongly to keep inflation from falling below 2%” … he said they acted to keep inflation from falling below 0%.
    2) The entire post is about the merits of a 2% inflation target and the risk of going over it. Nothing in the post mentions the existence of the Fed’s legal double mandate: price stability and employment. Even allowing to the aging of the work force, unemployment would be 10% today but for the collapse in work force participation. That’s an historic worst, but there is no mention of the cost of this. Bernanke admits employment is far below the Fed’s target. Why is this legal mandate going ignored in the discussion?
    Given *dual* mandates, and assuming the Fed takes 2% as its inflation mandate (currently at an historic “best”) how much should it concede on inflation to gain on employment (at an historic worst)? Surely it should give something. For an extra million employed per year, what, 2.5 on inflation, 2.75, 3?
    If the Fed should give *nothing* over its 2% preferred inflation number to improve employment from a long-term worst, then we have a single mandate. How is this justified?
    3) The special thing about 2% is the Fed has invested an awful lot of previous capital in saying this is what they want … Having the public believe it, both in terms of being confident we’re not going to see deflation, and in terms of believing that the Fed’s balance sheet is not going to cause the U.S. to turn into Zimbabwe, is the single most valuable policy tool the Fed can have.
    First, why doesn’t the Fed invest some capital on meeting its employment mandate?
    Second: Zimbabwe?? Over 2% inflation might create fear of the USA turning into Zimbawbe? From 1982 thru 2006 inflation averaged 3.1%, was anybody afraid of becoming Zimbabwe, or of any problems remotely like that, even in its highest years? (Back even before then when inflation was double-digit and I had 14% CDs in my IRA, I’d no fear of the US becoming Weimar).
    With 1.68% over the last four years and 1.47% projected for the next 10 (and the rush to the dollar for safety from the euro, etc.) how is invoking fear of out-of-control inflation (Zimbabwe!) not Hawtry’s “crying fire amid Noah’s flood”? (I just re-read Friedman and Schwartz on the Depression, now available in a separate volume, and Sumner is right, it’s amazing how people where invoking “inflation!” all the way through.)
    When I look at the scales being loaded up here, it seems the “risk of slightly exceeding the (self-imposed) 2% inflation mandate” scale has thumb, wrist, elbow, shoulder and Zimbabwe leaning down on it, while the “benefit of closing the huge shortfall from the employment mandate” scale has nothing at all on it, just air.
    4) For some years from the 1990s on there was talk of the Fed being interested in pursuing “opportunistic disinflation”. That is, the Fed wanted lower inflation but not the blame for causing the unemployment that comes with it. So it would wait for a recession for which it was not popularly blamed, then react meekly to it, get the lowered inflation it wanted, and let others take the blame for all the unemployment.
    Now everybody involved might deny this is what it is engaging in today, and believe they are telling the truth — but judging by actions rather than words, as per revealed preferences, it sure seems to me like its wish has become true.

  26. Jim Glass

    Jon S and others: No one will answer my original question. Would you have concerns if the Treasury were to convert all of the outstanding U.S. debt to 4-week Treasury bills? If so, what is the nature of those concerns, and why do you think that replacing long-term Treasury debt with monetary base is immune from those same concerns?
    I’ll try to answer that question. No, the Fed is not immune from those concerns, but putting them in realistic scale matters. Who believes the Fed must buy $11 trillion of public debt to get inflation up to the 3.0-3.5% norm of 1982-2006? To assume for argument’s sake an unhappy case I won’t repeat the claims of how targeting higher inflation will likely reduce rather then increase the need for purchases to increase the money base. But there are other real differences between the Fed buying long bonds and the Treasury issuing only short ones.
    OK, let’s imagine the Fed announces a 3-3.5% inflation target or Sumnerian 6-6.5% NGDP target, whatever. But markets so believe the Fed is really secretly still committed to under-2% inflation that the Fed has to buy say $2 trillion of long securities to convince them otherwise. Then there is an inflation overshoot, so long bond rates go up say 3 points.
    The Fed takes a market value loss on its long bond portfolio (though not necessarily a loss on bonds held to maturity) which it now unwinds to control the inflation, which is offset for the govt by all the interest received by the Fed on all its bond purchases from QE1 onward and remitted to the Treasury, plus the tax increases that result to the govt from the inflation and higher nominal prices (at least) plus from the presumably stronger economy. All this is very different from the Treasury just funding itself with 4-week T-bills. Is the net result really a disaster?
    Remember that at least in the Sumnerian-Friedman analysis the economic benefit of the Fed buying the long bonds comes not from reducing the maturities of T-securities to get a slight reduction in interest rates, but from the “hot potato” effect that increases the velocity of money, with the change in interest rates being a consequence rather than a cause.

  27. Ekim

    Lower CPI prices are a blessing for consumers, and should not be resisted. Printing inflation has just led to serial Minsky, and endless global bank bailouts.

  28. 2slugbaits

    Jim Glass A quibble. My understanding is that the Fed’s long run target is 2% headline CPI. The Fed uses the core PCE as a kind of instantaneous dashboard metric to see if the economy is moving along that long run path. In any event, I take your point that whether you look at PCE or headline CPI the Fed still missed both targets in 2009, 2010 and 2011.

  29. Jim Glass

    Lower CPI prices are a blessing for consumers, and should not be resisted
    How did the consumers of 1929-32 — the greatest beneficiaries of this “blessing” ever! — feel about this when polled in the 1932 election?
    It seems your belief is based on an heroic assumption that you take as a given.

  30. Tom

    The best thing about your latest pieces on QE is that you’re thinking of Fed and Treasury policy together. The popular tendency is to analyze each of them in isolation, which just doesn’t work.
    Treasury could achieve practically exactly the same result with a short-weighted issuance term structure as is currently being achieved with a middle-weighted term structure plus Fed “twist”. The latter combo is more laborious and expensive, so there’s really nothing to speak for it except perhaps showmanship.
    I also agree that excess reserves are de facto a form of short-term public debt, on which we currently pay 0.25% annual interest. The net result for Treasury when the Fed issues reserves to buy a Treasury bond is that Treasury no longer has to pay the coupon on the bond, but instead has to pay (to the Fed, which passes it on to a bank) the 0.25% interest on the reserves.
    However, you did way overstate things saying that Fed issuance of reserves in exchange for Treasury bonds is equivalent to an exchange of short-term Treasurys for long-term Treasurys. It is much more than that, for more reasons than DeLong gives.
    The most crucial point is that Fed purchases of Treasurys don’t just create base money, they also create deposit money. This can happen directly when the Fed buys Treasurys from a non-bank (the Fed credits the seller’s bank with reserves and the bank credits the seller’s account with deposit money), or indirectly when the Fed buys Treasurys from a bank (crediting it with reserves) which in turn buys Treasurys from a non-bank (and transfers the reserves to the seller’s bank which credits the seller’s account with deposit money). Hence M2 is up by $1 trillion since Lehman without any growth in bank credit.
    I’m against the upward manipulation of inflation, which suppresses growth by reducing real incomes in this commodity-short, labor-surplus environment. But there’s no doubt it can be done, and has been done.

  31. Benjamin Cole

    “First, I pointed out that, in the current environment, large-scale asset purchases by the Fed are essentially a swap of short-term for long-term government debt’
    I think this is wrong. The Fed can buy Treasury bills by printing money. It is the exchange of cash for USA IOUs.
    When the Fed conducts QE, it prints up money (digitally today) and buys Treasuries or other securities.
    I would prefer Treasuries. Why? We are deleveraging the nation.
    Also, when enough Treasuries are bought, the sellers have two choices: Invest the money into other assets (raising asset values, good) or spending it (good).
    If someone says the QE will accomplish nothing, I still say good. We have retired debt and helped deleverage the nation for our children.
    The Fed can either retire the debt, or keep it on its books permanently, and funnel the interest payments to the Treasury, thus reducing taxes on productive working people and enterprises.
    The arguments agains QE are feeble and peevish, while the upsides are huge.
    Side point: Why do the same people who say it is impossible for speculators to raise oil prices also say that if the Fed prints too much money then speculators will raise oil prices?

  32. RebelEconomist

    Despite the resistance you are stirring up here, JDH, I actually think you under-state the case for a 2% inflation target when you argue that “The special thing about 2% is the Fed has invested an awful lot of previous capital in saying this is what they want, so that when they say that’s what they’re trying to do, people can believe it.”
    The 2% target came about because Greenspan used to say that the Fed aimed to constrain inflation to a level at which it was not a significant factor in business and household decisions, which Greenspan informally put at about 2%. At 2% people don’t bother with indexing mechanisms etc as much as they might at 3% and certainly at 4%. The result is that low inflation tends to be naturally more stable inflation too. Even if the Fed had targeted 4% inflation for years, I would say that a change to 2% would be preferable.

  33. 123

    JDH,
    Scott Sumner has argued that a switch to a 5% NGDP level path would immediately reduce money demand, so the Fed will have to shrink the balance sheet, or raise the interest on reserves without any delay. I
    presume you believe that additional expansion of Fed’s balance sheet would be probably needed to facilitate hitting the NGDP target? Is this correct?
    I also guess that both you and Scott Sumner agree that the long term consequences of NGDP level targeting include lower variability of interest rates and lower size of Fed’s balance sheet, so the only disagreement between you and Scott is about the short-term dynamics.

  34. GregorSchubert

    “No one will answer my original question. Would you have concerns if the Treasury were to convert all of the outstanding U.S. debt to 4-week Treasury bills? If so, what is the nature of those concerns, and why do you think that replacing long-term Treasury debt with monetary base is immune from those same concerns?”
    I will try to give this a shot too to answer your plea:
    The nature of the “concern”:
    In the case of replacing outstanding long-term bonds with short-term bills, the main concern would be refinancing,as you note correctly. In order to repay its short-term bills, the Treasury needs to make whole on its promise to give the holders money, and the shortening of the maturity means it needs to do so soon. This exposes the treasury to refinancing risk: as the economy recovers or the Treasury looks less creditworthy, it will have to pay a higher interest rate to attract enough money to pay its outstanding bills.
    However, to some extent that is the point of the whole exercise, right? The “liquidity trap” argument that is usually cited to support the mechanical effect of LTAP is based on the notion that flooding the markets with more risk-less assets than they want to hold will lead some of them to stop piling into risk-less assets and hold something risky instead. Voila, credit markets come back to life, investment resumes and the economy springs back to life. So the main concern with this conversion of long-term into short-debt (accepting the mechanical argument for the moment) is how to reduce the amount of risk-less assets (call them 4-week-bills or money) back down to normal once the money demand goes back down to normal in the recovery.
    However, interest on reserves and the ability to sell bonds to take money out of the market should take care of that – I don’t think anyone sees an issue for the Fed in dampening a recovery if it wants to and the original concern in this argument was the opposite one, right?
    While I agree with you and Scott Sumner that expectations are what really matters in this world, I think that in the hypothetical world where the mechanics of replacing long-term bonds with bills matter anyway, the issues would be minimal both for the Treasury in this “fiscal” operation and the Fed in the corresponding “monetary” operation.

  35. William B

    I’m not a critic of the Fed, so I can’t fairly answer the Treasury question. Instead I’ll ask, why is the market obsessed with the short end on the yield curve? Perhaps fears of inflation and a ballooned balance sheet are obvious to market participants and calm steady guidance from the Fed is critical to keep the peace.
    I haven’t heard mention of the notion that the Fed is merely subsidizing government spending through lower rates. Would this make the inflation argument a moot point in the long run? Or is the concern more about the inability to cheaply finance public debt if inflation does spiral out of control.
    Finally, if government spending is the goal, where is the model that shows that the U.S. continues to dominate global economics, supporting a view of spend to save. Data suggest the trend is otherwise. Slash or spend arguments also seem mundane, at least for Europe. Basic accounting suggests that the Europe area may not have a choice.

  36. Belinda

    I’m against the upward manipulation of inflation, which suppresses growth by reducing real incomes in this commodity-short, labor-surplus environment. But there’s no doubt it can be done, and has been done. quoted from Jim above.
    I too agree with this. The sad part is the fact that when inflation raise and savings rates stays the same, our retirees will receive the biggest blow.
    Best regards,
    Belinda

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