Conditions have changed since January, and we might expect some additional stimulus from the Fed at the next FOMC meeting.
Many observers have wondered why the Fed seems to be completely disregarding its objective to try to maintain full employment. If the Fed’s long-run targets call for an inflation rate of 2% and an unemployment rate below 6%, then any balancing of the tradeoff between the two objectives would imply we’d want to see an inflation rate above 2% as long as unemployment remains as high as it presently is.
Part of the answer, as noted on Friday by Federal Reserve Bank of Atlanta President Dennis Lockhart, may be concerns that the stimulus options currently available to the Fed raise their own set of risks. Lockhart also discussed the conclusion of some observers that if the U.S. economy were as far below its current potential as some observers claim, it’s puzzling why we’ve continued to see a low but persistently positive rate of inflation over the last 3 years. The failure of inflation to decline over this period might be taken by some as one indicator that there actually is not that much potential for the Fed to achieve significant additional improvements in the unemployment rate.
Insofar as this has been a concern, the abatement in inflation over the last few months gives a renewed reason for the Fed to act. The most recently reported year-over-year change in the PCE deflator, the Fed’s favored measure of inflation, came in at only 1.5% in the latest release. Thus, even if the Fed didn’t care at all about unemployment, its announced objective in terms of inflation would suggest the desirability of further easing on grounds of that objective alone.
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There’s another reason why a lower inflation rate is relevant for anticipating the Fed’s next step. While the hawks on the FOMC are generally perceived as wanting to avoid inflation, they also are committed to avoiding deflation. Although we may disagree about how much a higher inflation rate might benefit the economy, there is much wider agreement that deflation would make our problems worse and is something the Fed can and should avoid.
And the Fed’s policymakers seem to have taken note of the recent abatement of inflation. At the January 25 FOMC meeting the highest anticipated inflation rate for 2012 reported for any FOMC participant was 2.5%. By contrast, after the most recent meeting, the highest reported rate was 2.0%. There now seems to be essential unanimity within the FOMC that inflation is coming in below their target at the same time that a lower unemployment rate is achievable. That means that any way you slice this cake, you’d want to see some additional stimulus.
FRB Atlanta President Lockhart summarized the situation this way:
my support for the current stance of policy rests on a forecast that sees a step-up of output and employment growth by year-end and into 2013. If the economy continues on the track indicated by the most recent incoming data and information, that forecast will become untenable, as will the policy premises underlying it.
Or, to wipe away a little of the Fedspeak, if things don’t improve quickly, Lockhart thinks the Fed needs to do more. And here’s Bill McBride’s take-away:
In the press conference [on June 20], Bernanke made it clear that further accommodation is very likely if employment indicators don’t improve soon. He also pointed out that the Fed can’t do any more “twisting” because of the lack of short duration securities.
And that strongly suggests QE3 following the two day meeting ending August 1st.
I say, don’t bet against the Fed. And for sure don’t bet against Bill McBride.
We are still running deficits of 8% of GDP and both parties howl at the mere mention of a modicum of fiscal responsibility. Monetization of the deficit is the path of least resistance for central planners of all stripes.
We will get QE3, and QE4, and QE5, until a dollar or bond market crisis forces the central planners to stop. That appears to be quite a way off at this time.
PCE is the “Fed’s favored measure of inflation”. Hmmmm . . . I wonder why? Oh, that’s right, it masks the effects of QE.
http://www.indexmundi.com/commodities/?commodity=food-price-index&months=180
http://www.indexmundi.com/commodities/?commodity=metals-price-index&months=180
JDH, in another post can you shed some light on the LIBOR scandal which seems to be growing larger by the day. I recall various posts by you an/or Menzie that used the LIBOR rate in various analyses.
http://www.cnbc.com/id/48184067
Timothy F. Geithner, who served as the head of the New York Fed during the crisis years, and other regulators raised concerns about Libor. But they did not stop the problems
Velocity of M2 Money Stock (M2V)
Velocity of M2 is at its lowest point since 1960 around 1.6,when it has been very high in 2000.
The slow velocity of money, may as well confirm that inventories are in digestive mood and that prices are sticky. This money velocity has already been propelled by 2 QE.
The chart of money stock MZM is recording the past QEs
http://research.stlouisfed.org/fred2/series/MZM
The chart of velocity of MZM records its slow turnover
http://research.stlouisfed.org/fred2/series/MZMV
A Reconstruction of the Federal Reserve Bank of
St. Louis Adjusted Monetary Base and Reserves.
Trough above paper, Fed St Louis economists are showing the perispatic movements of the money stock, trough the ages(Please see P 15, and following)
http://research.stlouisfed.org/publications/review/03/09/Anderson.pdf
It is of interest to underline the introduction to the content as written by the economists.
“It is commonplace today for monetary policy analysis, both in theory and practice, to be conducted
without reference to the monetary base or other monetary aggregates”
My sense is that it’s still a bit too early for QE3 (using inflation data through the end of May), although if things continue to follow their current trends, I would say we’ll have QE3 much sooner than later and August would sound about right. More thoughts here (the link will go live on Monday, 16 July 2012, around 5:00 AM PDT).
That this is coming is also evident in the spate of “the Fed is playing politics” pieces I’ve been coming across. The idea seems to be 2 fold: make it seem like the Fed is “rooting” for Obama rather than the economy and perhaps intimidate it into doing less or nothing at all. You don’t see these if there is no risk of Fed action.
Great analysis Menzie. Do you think it’s possible the Fed would purposely hold off on QE3 until after the November elections to avoid risking the appearance of being political pressured to stimulate the economy? I think this is something we must consider; the Fed will want to preserve its identity as a politically independent agency especially in the face of Republican opposition to further easing. Your thoughts on this?
There seems to be a disconnect between the actual incentives that motivate employers to hire an additional worker and the incentives the FED can produce.
Firms are looking at the tradeoff between the additional cost of a worker versus the worker’s expected contribution to profit.
What can the FED do that will make a significant change in that tradeoff? The FED can drive the cost of holding funds higher if it inflates. However, food and commodity prices will jump higher long before a jump in the incomes of the 10’s of million people with ~fixed incomes (i.e. UI benefits, pensions, sticky wages) so that the short term impact of inflation will be strong and negative. It would probably kill the rebound it autos as spending shifts to necessities.
I think the FED is really in a bind here.
The rise in the exchange value of the U.S. dollar has curbed inflation in 2012. But inflation will continue to decelerate in 2013 (beginning in Dec 2012), without open market operations of the buying type (if the sellers represent the non-bank public).
Because POMOs between the CBs & the Fed don’t increase the money supply (are asset swaps), the Fed should buy municipals (securities held principally by the non-bank public), or exclude the CBs from bidding for governments during specific open market purchases.
The best move the Fed could make would be to copy what the ECB did (eliminate remuneration on excess reserve balances). Apparently economists either never studied the 1966 credit crunch or forgot what happened (or just don’t understand).
The payment of interest on excess reserve balances has induced dis-intermediation within the non-banks (where the size of the non-banks shrinks, but the size of the commercial banking system remains the same).
The financial press claims this would reduce liquidity. The opposite is true. There’s a difference between money & liquid assets. Keynes wasn’t that smart. And negative yields will allow the free market to work its magic (acquire securities, if not extend loans).
IOeR’s (remunerated IBDDs) both 1. absorb existing bank deposits within the CB system, as well as 2. attract monetary savings from the Shadow Banks).
Lending by the CBs expands both the volume and the velocity of CB deposits (where savings don’t equal investments). Whereas lending by the non-banks increases the velocity of CB deposits (where savings are matched with investment). I.e., lending by the CBs is inflationary but lending by the non-banks is non-inflationary (other things being equal).
To lower the unemployment rate & lower the fiscal deficits the FED needs to eliminate IOeR’s & then gradually get the CBs out of the savings business. What would this do? It would make the CBs more profitable if that is desirable (size isn’t synonymous with profitability).
By encouraging the flow of savings thru the non-banks real-investment would accelerate, & thus real-gDp would accelerate, etc.
Yes James, think so too (i.e. McBride is right).
Obama gave Ben a call, election time is coming soon. Stocks will be higher, mission accomplished.
Please Mr. Bernanke. For the love of god don’t do it.
I am trying to live on my savings, but it is close to impossible with interest rates near zero and it becomes more uncomfortable every day as inflation increases. Rewarding speculators and punishing savers is poor economic policy in any environment.
If QE1 and QE2 haven’t worked, why would you think that QE3 will do anything other than push us one step closer to the edge of the abyss.
W.C. Varones both parties howl at the mere mention of a modicum of fiscal responsibility
In this case “fiscal responsibility” would mean increasing spending. Austerity is not responsible policy.
Monetization of the deficit is the path of least resistance for central planners of all stripes.
That’s especially true if Congress is run by a bunch a yahoos who refuse to consider tax hikes to pay down existing debt. Since you oppose monetization, does this mean we can mark you down as an advocate for higher tax rates?
tj There seems to be a disconnect between the actual incentives that motivate employers to hire an additional worker and the incentives the FED can produce
One thing that motivates firms is the expectation of increased demand. Outright deflation is not helpful in that regard, so anything the Fed can do to stave off deflation would be helpful. The Fed can also increase inflationary expectations, which would drive up the nominal interest rate above the zero bound such that the real labor clearing rate can move into slightly positive territory. If that happens, then the I=S equilibration on the goods side of the economy can happen via normal interest rate adjustments rather than via reductions in income and output.
However, food and commodity prices will jump higher long before a jump in the incomes of the 10’s of million people with ~fixed incomes (i.e. UI benefits, pensions, sticky wages) so that the short term impact of inflation will be strong and negative. It would probably kill the rebound it autos as spending shifts to necessities.
This is nonsense. Higher commodity prices is not the same as higher inflation. You’re confusing a commodity price spike with inflation. In order to have inflation you also have to have higher wages baked into all aspects of the economy. Most of the economy is services, not goods. Think of inflation as price inertia. Commodity price spikes is not an example of price inertia. And it’s a little hard to see how you can simultaneously claim that there will be inflation and then in the very next breath say that there will be a retrenchment in consumer spending. If commodity prices go up, then auto prices would become relatively cheaper. Higher gasoline prices depress car sales because gasoline and cars are complements. Higher wheat prices do not reduce car sales because wheat and cars are substitutes.
MMMMM? Seems we have a new algorithm; the McBride Algorithm based on the Krugman Algorithm.
It goes:
1) Bill is always right
2) I think Bill is wrong
3) Return to 1)
Joke Joke
Pleas laugh
wait, inflation drops when the Fed stops stimulating, but they think there is no slack?
maybe expectations are more powerful for wage setting than the fed thinks (for those of us with a job, then there’s the rest). if only 20% of wages are rigid downwards, and the rest receive a raise based on expected inflation, the fed still gets a low positive rate of inflation. maybe if they could boost expectations about how fast they were willing to let the economy grow without choking it…
The World’s Greatest Moral Monster, Bernanke, continues to fiddle despite the certainty that millions of lives are destroyed as he dithers about the slim chance that inflation just might provide a small discomfort to the creditor class.
It takes an incredibly incompetent or indifferent Federal Reserve to undershoot both of their mandates. What is the point of having an “independent” Federal Reserve if they are not independent of the bankers whose interests they serve?
Instead of “perispatic” please read peristaltic
Thus, even if the Fed didn’t care at all about unemployment, its announced objective in terms of inflation would suggest the desirability of further easing on grounds of that objective alone.
If the Fed did not care about inflation above its target for 2003-07, why should it worry about a little dip below 2% based on temporary factors – a dip in oil price that is already reversing. You advocates of loose policy are SO ASYMMETRIC in your arguments it is unbelievable. You dismiss inflation above your own targets as temporary – even if it persists for four years. But any dip below 2% has to be countered with QE – 0% rates are just not good enough. What has QE accomplished so far? Except lowering bond yields (which might be just because of an economy stuck in the mud) – you guys have nothing to point to. 10 year yields are at 1.5%. Why should they be even lower? And what effect does raising food and energy inflation have on vast number of people who are unemployed or have not gotten a wage hike in half a decade. Have you even asked yourself this question?
From Williams of the SF Fed –
These policies are still relatively unfamiliar to the public. Consequently, their effects on the public’s inflation expectations, appetite for risk, and so forth are difficult to predict. This adds an element of uncertainty and raises concern about unintended consequences. In addition, LSAPs may create distortions to asset prices or financial market functioning. These negative effects have received scant attention in the research literature and are not well understood.
I see NO research on any negative consequences of QE. So every economist is sure that there are NO negative consequences of these policies. Why does that give me the jitters?
2slug,
If an increase in wages and prices = inflation and if an increase in wages without an increase in commodity prices = prosperity, what is the present increase in commodity prices without an increase in employment and wages?
Obamanomics!
JDH wrote:
Many observers have wondered why the Fed seems to be completely disregarding its objective to try to maintain full employment. If the Fed’s long-run targets call for an inflation rate of 2% and an unemployment rate below 6%, then any balancing of the tradeoff between the two objectives would imply we’d want to see an inflation rate above 2% as long as unemployment remains as high as it presently is.
That old vampire of a Phillips Curve will just never die no matter how many stakes it drives into its own heart.
Keynes was right about one thing. There is such a thing as a zero bound on interest rates and there is a liquidity trap. Keynes problem is that he didn’t recognize it in relation to the Austrian ACBT.
When the boom of the business cycle runs its course and the bust comes additional monetary expansion will simply pile up. The FED has tried over and over to generate inflation but it keeps running into the economic crash. Banks cannot find qualified borrowers because so many are in economic straights and any qualified borrowers are afraid to borrow because of their already high debt ratios or the uncertainty of the economic especially tax climate.
The FED probably will enter into QE3 but it should have about the same effect as QE1 and QE2 and that means virtualy nothing.
Here is something you might want to consider if you are an investor. QE3 has to find a home. Because of the economic crisis that will not be inflation (sorry professor). Most of the excess will flow into commodities and investment goods (no change here. Insanity is still defined the same only way): increased excess bank reserves, gold, oil, and collectables will provide a resting place.
A portion of QE3 will flow into the stock market because investors will assume a short-term sending binge, but just as we have experienced recently, Sunday morning after the Saturday night drinking binge comes the sickness and headaches of the hangover. The stock rise is a trap that will take suckers for a sudden and sharp fall.
2slugbaits
In this case “fiscal responsibility” would mean increasing spending. Austerity is not responsible policy.
Running 8% GDP deficits four years after the financial crisis is “austerity?”
Methinks you’ve had a bit too much of the Krugman Kool-Aid.
Too many commenters seem unaware that QE has implications beyond our borders.
March 2012 Reuters:
“Brazilian President Dilma Rousseff, a career economist, slammed rich nations for ““unleashing a tsunami of cheap money that was cannibalizing poorer countries such as her own, forcing them to act to protect struggling local industries””. She said that these capital inflows are due to low interest rate polices in developed nations and that her country is flooded with easy money by investors trying to secure higher yields. Her statement came hours after Brazil announced an extension of taxes on foreign loans, a form of capital control. Rousseff further stated that ““We have a currency war that is based on an expansionary monetary policy that creates unequal conditions for competition”” and concluded ““we will continue to develop (our) country by defending its industry and ensuring that the strategy used by the developed countries to exit the crisis does not cannibalize emerging markets”.”
The Brazilians have since eased their capital controls but it is unwise to think that the ‘currency war’ is not a factor worthy of mention.
I’ll say what I’ve been saying since 2008:
The problem is fiscal policy. QE needs to be done in conjunction with smart fiscal policy (ie, major spending cuts and policy to help recap households, like a 1Q income tax moratorium). The focus on near term GDP is also a problem.
We don’t need stimulus (we are in expansion). We need risk reduction. That means recapping people with bubble mortgages (which will also recap banks or go to investment). That will get us to higher long run growth and sooner.
Slug, I’m fine with running a deficit while interest rates are low, but spending needs to be brought down to at least 2007 levels first.
We are in expansion, there is no stimulus option. What we need is to reduce risk and uncertainty. That means getting cash into the hands of consumers, particularly those with bubble debt.
Alex: I expect the Fed to act before the election, quite possibly on August 2. I think many members of the FOMC are uncomfortable with the degree to which this has become politicized, and I expect them to act solely on the basis of economic considerations.
Walter Sobchak: Are you sure you have the right mix of bonds and stocks in your portfolio?
Return-free risk: The Fed has two objectives– full employment and 2% inflation. If you have two things you’re trying to achieve, the natural thing to do is to sacrifice the inflation objective a little– go with above 2% for a while– if you think that as a result of doing so you could make faster progress with unemployment. When inflation falls below 2%, it’s a no-brainer– both policy objectives say you should act. That’s why it looks asymmetric to you.
And as to your claim that no one considers the costs, please read the Lockhart speech to which I linked. If no one was worried about the costs, the Fed would have acted on this long ago.
Ray Lapan-Love: Why does U.S. policy cause inflation in Brazil but not in the U.S.? Countries like Brazil would love to blame their problems on the U.S. You have to be pretty gullible to accept their statements at face value.
Ray Lapan-Love,
An excellent post. I am in total agreement.
Professor, US monetary policy is creating inflation all over the world not only in Brazil. It is not causing inflation in the US because the US is in a very serious economic slump. Monetary expansion looks for a return and it isn’t in the US. Interst rates are artifically low in the US, held down by FED purchases on Treasury securities. The BRIC countries are investing and growing and their interest rates reflect producing economies.
Dollars are exchanged for the BRIC currencies then used to invest in BRIC countries increasing both demand and curreny levels in these growing economies.
Because these economies are so dependent on the US they cannot easily reduce their money supply to curb inflation without also facing exchange rate problems with the dollar. Essentially these other countries are almost forced to absorb our inflation as the FED artifically holds down US interest rates.
I wonder how the current drought conditions affecting US agriculture output will affect the Fed’s behavior. Especially with corn prices jumping over 30% in the past month, it seems reasonable to expect sharp divergences between headline and core inflation measures. At the very least, this shock would confound any attempt to gauge the effect of QE3 using commodity markets, leaving the Fed relatively few sources for information to measure the impact of a new expansion.
While this jump in prices may be driven by a production shock rather than any monetary phenomena, it will make it more difficult for the Fed to adopt expansionary policies without being accused of political capture. Of course, one could just as easily argue that the Fed failing to act for fear of such accusations is itself a form of political capture.
I’m glad I don’t have Bernanke’s job. It does seem reasonable to renew the expansionary monetary policy given current price levels, but I wonder how they will be able to tell when enough is enough.
Professor,
The US has been abusing its reserve currency status since WWII. It was this mismanagement of the dollar that caused Nixon to take us off of the gold standard. The other countries of the world finally said enough is enough and Nixon knew the US was in a position of losing all of its gold. Rather than lose the gold he floated the dollar and kept the gold. This was much the same as the UK defrauding the world economies in 1931.
Because there is no other reserve currency the dollar functions much as it did under Bretton Woods today. But monetary mismanagement is threatening the US monetary position. The countries of the world are desperately searching for an alternative and when it comes the US is going to go through a serious economic shock.
Hey returnriskfree, I don’t think anyone is “calling” for QE3, just trying to predict what the Fed will do in order to make money. Keynesian Economists want fiscal stimulus, not monetary, because, as you say, there’s only so much monetary stimulus can do. The Treasury really needs to start printing dollars and handing them out to poor people in return for some type of government service. Sound familiar? I think Roosevelt tried it. Maybe it didn’t work in a macrosense but it sure put food on many tables.
JDH,
As Ricardo has said in part, it is the carry trade with massive amounts of dollars, that causes the bulk of the problems in the developing nations. They are of course concerned about their currencies appreciating and thereby slowing exports.
2slugs
Higher wheat prices do not reduce car sales because wheat and cars are substitutes.
Huh? You eat cars? hmm, the price of wheat is rising, I think I’ll buy a car instead!
My point is that an effect of QE, or expected increase in inflation, can be a decline in the dollar, and and increase in energy and commodity prices.
In the short run the relative price of a car can fall, as you argue, but if my income is fixed then I will have less income left to buy the relatively cheaper car. You seem to be looking only at substitution and ignoring income effects.
I understand a commodity price spike does not lead to sustainable inflation, but it does get measured in the PCE, CPI, etc. It does create a problem for consumers with relatively fixed incomes.
These are, of course, short term issues. That is my point. An increase in prices ~today causes a decrease in the number of goods purchased ~tomorrow, so your inflation policy has just created a negative real shock to output.
The fact that sustained inflation may never materialize is irrelevant. The damage was done in the short run. The U.S. economy is not strong enough today to withstand a short run negative shock.
Frankly I don’t think it matters much. QE1&2 have already flooded the system with reserves. More would not make it cheaper for the government or banks to raise funding, and so would not stimulate lending or facilitate fiscal stimulus.
Many commenters seem to think QE will help Obama and so the FOMC must do it. Remember that Bernanke was originally a Bush appointee. There’s far more agreement between Obama and Romney over monetary policy than disagreement.
Also, by the way, Keynes did not write about a zero bound liquidity trap. He wrote about a situation in which long term yields fell so low they failed to attract investors out of cash. He said he knew of no actual case because nobody had been so aggressive lowering long term yields. He never met Bernanke.
One day someone will start talking about a measure called risk-adjusted GDP.
A family that charged their credit cards to the limit then paid down the cards with home equity loans from a house that they bought with a 125% LTV mortgage could be having second thoughts about their former behavior even if they aren’t insolvent.
While the Fed is helping them stay solvent if they have an ARM by keeping long term rates low, it may be simply making it easier for that family to pay down debt rather than increase consumption.
Keynes would say the family has low animal spirits, but if he asked the family why it was not spendinig money, the family might define it as a return to sobriety and prudence. And as the family restrains its spending to create a less precarious financial picture, it is improving the chances for a return to sustainable growth in spending.
When we see such behavior by consumers in the aggregate, we can say the glass is half empty and call it an output gap, or half full and call it a salutary balance between consumption and debt reduction. On the grand scale we could develop a measure of risk-adjusted GDP. Spain at one point had great GDP numbers but if it has been measured as risk-adjusted GDP then the number would have been strongly negative for many years.
I realize the practical difficulty in defining such a measure and defining what is too much debt. My main motive is to get people to think of the behavior of today’s consumers as healthier than allowed for by a narrow focus on GDP alone.
And yes the Fed needs to be on guard to prevent a deflationary spiral, which is an entirely different animal from a recession. We are a long way from that chasm and if it happens the Fed can step in and stop it by means that Prof. Hamilton has outlined many times in the past.
My concern is that by trying to respond to every little turn toward recession with stimulus, the Fed is making things worse. The Fed’s job should not be to alleviate all human suffering but to act like the Red Cross to provide stabiity during emergencies.
Ray Lapan-Love: Why does U.S. policy cause inflation in Brazil but not in the U.S.?
This doesn’t seem so difficult a story to construct. Monetary policy can expand the money supply, but the mechanism by which that money gets into the real economy is through wealthy entities that hold assets whose values are goosed – and whose yields correspondingly shrink – in response to the policy. Those entities have an incentive to put their money to work (they have more, and their safe alternatives yield less, thanks to QE), but not necessarily to put them to work in the U.S. Monetary policy at the zero lower bound doesn’t compensate for a tepid economy that has a poor outlook for new ventures – it only makes the safe alternatives look worse in comparison – so capital flows to growing economies such as Brazil’s instead.
Bruce Hall what is the present increase in commodity prices without an increase in employment and wages?
What increase in prices? Look at JDH’s chart. Where’s all this Zimbabwe Ben inflation you and others here keep chirping about? The real 10 yr rate is negative, indicating that the market does not see any inflation on the horizon. In fact, banks are now charging customers to hold savings accounts, so the real rate is deep in the negative territory. What does your economic model predict about the future path of inflation when real interest rates are negative?
aaron We are in expansion
A mighty weak one.
I’m fine with running a deficit while interest rates are low, but spending needs to be brought down to at least 2007 levels first
Huh? You might want to rethink that statement. So you’re saying that running a structural deficit is fine with you, but you’re opposed to running cyclical deficits??? That seems to be the logical conclusion. In any event, you might want to look at the BEA data, because government consumption and investment spending is falling and is very close to where it was in 2007. That’s bad.
tj Yes, cars and wheat are substitutes. If car prices go up people tend to buy other commodities that do not move with the price of cars. When there is a general increase in the price level, then real wages fall, but nominal wages do not fall. Nominal wages are downwardly sticky. With a lower real wage businesses find it more attractive to hire labor. And if prices increase for the goods that businesses produce, then they will tend to produce more of them. Why is this surprising? We’ve known for a long time that there is a short run Phillips curve that trades off lower unemployment and higher inflation.
I’ve noticed in some of your posts that you seem to have this notion that people spend less when there’s inflation. This is deeply wrong. It is true that people have less real purchasing power if inflation outpaces wages, but that does not mean people spend less in nominal terms. In fact, people will tend to save less and spend a greater share of their income. You really need to rethink your whole understanding of inflation.
Tom Also, by the way, Keynes did not write about a zero bound liquidity trap. He wrote about a situation in which long term yields fell so low they failed to attract investors out of cash. He said he knew of no actual case because nobody had been so aggressive lowering long term yields
You’ve sort of got the story right, but you’re misreading Keynes’ snarky tone. What Keynes actually meant in that passage was that ne never met any central banker who wasn’t trapped into believing the Treasury View and so the economy never really had the opportunity to prove his point about a liquidity trap. You’re misinterpretation is pretty common, but if you stop and think about it for a moment then it should be obvious that Keynes was being sarcastic and took it as a chance to slam the Treasury View. Afterall, it was Keynes’ disciples who put a lot of effort into fleshing out the liquidity trap idea, so it hardly makes sense to interpret Keynes’ remark as being one that argued against a liquidity trap. The central point of late 1930s Keynesian economics was that the LM curve was flat and that the only policy tool available was a somewhat vertical IS curve.
@slug: I didn’t give any interpretation, but I don’t buy yours. Keynes was simply laying out theoretical extremes. He wasn’t engaging in any polemics in that passage. I think it was Hicks who introduced the term liquidity trap, based on that Keynes’ passage. The idea of the zero bound short rate as liquidity trap comes from Krugman on Japan in the 90s. Krugman attributed his idea to Keynes without explaining how it differed.
2slug: “What increase in prices?”
Eh, go to the grocery store. Even at Costco, meat is expensive.
Oh, wait. We shouldn’t include anything that might be a major part of day-to-day existence.
Okay, oil and gasoline prices have fallen as a result of extremely weak U.S. and global demand. I guess that’s good news out of bad news. But compare prices now to 2 or 3 years ago. Gasoline is still a buck more than 3 years ago. That’s at least 20%… a pretty damn good clip for 3 years.
Since wages have barely moved, I’d say my original remarks are valid.
Bruce Hall Eh, go to the grocery store. Even at Costco, meat is expensive.
So what’s your point? That’s not what inflation means. One-off price spikes in specific commodities because of supply shocks is not the same thing as inflation. Again, look at JDH’s chart. Or go look at MIT’s billion price index…and keep in mind that their index only refers to goods. Most of consumption is services, and those have been flat.
Since wages have barely moved, I’d say my original remarks are valid.
If your wages along with everyone else’s wages haven’t budged, then you might want to ask yourself how inflation would be able to gain a foothold in the economy. I think you’re confusing inflation with your sense of feeling poorer.
Tom Keynes was simply laying out theoretical extremes. He wasn’t engaging in any polemics in that passage.
I agree that part of what he was doing was laying out theoretical extremes, but Keynes never missed an opportunity to fire a shot across the bow. The General Theory is loaded with snide and snarky comments. Here’s what Keynes said:
There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hithero. Indeed, owing to the unwillingnss of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test.”
That last sentence simply drips with sarcasm. He’s basically calling the central bankers a bunch of cowards and if they actually had the stones to try and test the waters at the zero bound they would find that there would be a liquidity trap….although he prefers the phrasing of an absolute limit to the “liquidity-preference. But it means the same thing as Hicks’ liquidity trap.
The idea of the zero bound short rate as liquidity trap comes from Krugman on Japan in the 90s
No, this is wrong. Krugman says that he got his IS-LM from Dornbusch & Fischer. So lets go to their textbook:
In discussing the effect of monetary policy on the economy, two extreme case have received much attention. The first is the liquidity trap, a situation in which the public is prepared, at a given interest rate, to hold whatever amount of money is supplied. This implies that the LM curve is horizontal and that changes in the quantity of money do not shift it. In that case, monetary policy carried out through open market operations has no effect on either the interest rate or the level of income. In the liquidity trap, monetary policy is powerless to affect the interest rate.
There is a liquidity trap at a zero interest rate. At a zero interest rate, the public would not want to hold any bonds…
So Krugman’s definition is the same as Dornbusch & Fischer back in th 1970s. What Krugman did was to take this standard definition of the liquidity trap (also see Laidler’s definitions in his work on money demand functions) and marry it with James Tobin’s lectures that combined: (1) ZIRP; (2) a negative Wicksellian labor clearing rate; and (3) a Fisher effect that dominates the Pigou real balance effect. From all that Tobin derives an upward sloping AD curve at the zero bound. Krugman also derives an upward sloping AD curve at the ZIRP. Krugman took that framework (although I don’t believe he gave Tobin enough credit…but nevermind) and connected all this to the need for the central bank to promise to act irresponsibly in order to generate inflationary expectations.
While I do not dispute you conclusion, why is it that all economist appear to shift their frameworks when the data suits them? As an expert on energy prices, you know that headline PCE is depressed by falling gasoline prices – so called base effects – while core PCE is moderating around the Fed’s long-run target. Similarly, DeLong and Krugman love to trot out spot breakevens, arbitrarily choosing the five-year maturity to prove their point when it suits and switching to forward inflation-expectations when energy prices are rising. When evaluating the Fed’s reaction function, please do your readership a service and utilize the statistics they use in their policy framework and which you know quite well are more econometrically appropriate.
My own guess is that there are risks to further Fed “easing” (which seems to be something of a misnomer at this point). There seems little question that it spurs the dollar carry trade. I frankly doubt that it has any other substantive effect, other than possibly to temporarily support asset prices. And if China (and much of the rest of Asia) keeps a currency peg, the effects on the euro area could be more serious than any benefit to the U.S. economy.
I wonder also whether Ben is asking himself whether further Fed measures might not finally reveal the fed’s impotency, which could also be dangerous. Maybe “don’t bet against the Fed’ (or ‘don’t fight the fed’) will go the way of some other sayings, like ‘over any ten year period stocks always outperform bonds’ and ‘housing can never go down.’
Inflation/deflation, doesn’t matter. The price distortions will make things worse.
Inflation won’t go up for the reasons 2slug suggests. Wages won’t go up and that will keep consumption down. People will reduce their consumption to pay the higher prices on things they need/want most and others will fall.
More debt will go bad.
And, I’m also not sure about running big deficit, especially for longer than a quarter or two(again, dependent on major spending cuts). Maybe we’ve already blown our wad and then some.
Menzie recently posted a scary chart. Our interest expense has ballooned despite these fantastically low interest rates.
A solid recovery would drive that expense up.
Fortunatly/unfortunately, those prospects are slim as gov spending will keep private growth down.
2007 outlays were 2.7T, They are 3.8T for 2012 and projected to rise.
2slugs
Your claim that food and autos are substitutes is really stretching the notion of substitues. As the price of food rises, people switch to buying autos? What planet?
It is true that people have less real purchasing power if inflation outpaces wages, but that does not mean people spend less in nominal terms. In fact, people will tend to save less and spend a greater share of their income.
You have wandered off the path here. My inititial claim was that there is a disconnect betweeen the actual incentive to hire at the firm, and the incentives the FED can produce. You agree with loss in purchasing power. So your claim is that a general reduction in the purchasing power of consumers incents firms to hire. Really? What planet?
The price of many goods, e.g. autos, will not rise as fast as the initial FED induced spike in food/energy/metals. The immediate response is that firms sell fewer goods, e.g. autos, layoffs will follow.
Real incomes fall for those on ~fixed incomes, currently a large fraction of housholds. The long run is irrelevant. The negative response to the FED shock is immediate and slows growth.
General and sustained inflation never has a chance, we continue to wallow. The FED is impotent in this scenario to jump start growth.
Watch and learn.
Average car age is something like 11yrs.
If people must buy cars at higher prices, they won’t be able to afford much food, rent, etc. It will put a little downward pressure on those prices. They will all be substituted.
aaron: “Inflation won’t go up for the reasons 2slug suggests. Wages won’t go up and that will keep consumption down. People will reduce their consumption to pay the higher prices on things they need/want most and others will fall.”
Selective inflation? For the things people need the most? “… others will fall” … for example?
Meanwhile, as California cities go bankrupt, the Federal government and the State of California want to spend $100 billion or so on a high speed rail system. So much for this administration having a clue about the economy.
http://www.timnerenz.com/2012/07/dodging-bullet-train.html
Face it 2slug and arron, the socialist theory of economics favored by this administration is one big FAIL. Spend, tax, and disincentivize free markets. Pick winners like Solyndra; pick losers like oil and coal.
… and aaron… “If people must buy cars at higher prices, they won’t be able to afford much food, rent, etc. It will put a little downward pressure on those prices. They will all be substituted.” Sure. They can’t get a job so they are going to forego food and shelter to buy a new car? How about another scenario… they find a suitable used car, find a less expensive place to rent, and become more selective in their food shopping. People figure out how to balance their spending… something this screwed up government can even fathom.
Big Ben is pessimistic about the economy. Maybe because the “government will help create new shovel ready jobs with QEs” is “BS”. The government’s policies are anti-business and business knows it. Don’t like oil exploration [drilling permits down 36% 2011 vs 2008 – Bureau of Land Management], loves penalties that are taxes, killing coal generated electric power [total/coal MW produced down significantly in 2011 vs 2010 – EIA]. Jobs? Forget about it.
It’s just the price we have to pay for hope, change, and re-forming our economy.
BH, my point was that inflation won’t go up a lot because most people will have less real discretionary money to spend (all car prices will go up, not just new, luxury cars).
Producers margins will shrink. They will only be able to target a small market of wealthy people.
Companies will not increase production because the broader population will not have discretionary money for them to seek.
I’m saying there won’t be high inflation because the economy will not grow.
aaron,
Peter Schiff would disagree. Of course, a lot of people don’t agree with his “sky is falling” scenarios … even if he was correct the last time. [long link — copy and paste]
http://finance.yahoo.com/blogs/breakout/america-heading-towards-collapse-worse-2008-europe-says-155504860.html;_ylt=AihQwzlcIHucHtC8X6BhwSyiuYdG;_ylu=X3oDMTNyZDZpczNxBG1pdANGUCBUb3AgU3RvcnkgTGVmdARwa2cDMThlZDE0YTYtOWYyMy0zZmZiLTg4ODktNTYyMzE0YTlmOGM1BHBvcwMzBHNlYwN0b3Bfc3RvcnkEdmVyAzYwOTFiYjAwLWQwMmItMTFlMS1iYWY3LTZkOTFkYjFkYWE0Nw–;_ylg=X3oDMTFpNzk0NjhtBGludGwDdXMEbGFuZwNlbi11cwRwc3RhaWQDBHBzdGNhdANob21lBHB0A3NlY3Rpb25z;_ylv=3
tj Real incomes fall for those on ~fixed incomes, currently a large fraction of housholds. The long run is irrelevant. The negative response to the FED shock is immediate and slows growth.
I think this statement is a window into where you’re thinking has gone off track. You’re confusing the bad times caused by inflaiton and the bad times caused by recession. You seem to think that as real wages shrink from inflation people curtail spending. Think about that statement for a moment. What you’re saying is that as people have less real income they consume less. But nominal wages are downwardly rigid, so what actually happens is that in response to inflation people consume a larger share of their nominal income and save less. You seem to think that people save more and consume less with inflation. This is just wrong. If your theory were correct, then it would imply that the marginal propensity to consume increases with income…a highly dubious proposition. If the price level goes up but wages stay constant, real purchasing power goes down, but people compensate by consuming more and saving less. And if there’s inflation with interest rates at zero, then you’d really have to be a fool to increase saving!
We aren’t in an inflationary world right now. Not even close. We’re struggling with a balance sheet recession, which means people do indeed want to save more in order to repair balance sheets. And deflation makes saving more attractive. The real dilemma today is that people with jobs need to save more to repair balance sheets, which argues for low inflation or deflation. But many of those same people have debts, which argues for higher inflation. And if the economy is to grow it needs higher inflation. So what’s a central banker to do? Those things are fighting each other. The optimal solution would be for the government to step in and increase its consumption. This would stimulate real economic growth, it would generate some inflation if the Fed accommodated monetary policy, and it would help households repair balance sheets by providing safe financial assets that kept income from leaking out of the economy (i.e., it would provide an alternative to the mattress). This gets to an old rule, which says that if you have more than one policy objective you need more than one policy tool. The Tea Party’s absurd fear of government spending is leaving us with one relatively weak policy tool (i.e., QE3) tasked with satisfying two different policy objectives.
BTW, you’re misunderstanding the point about cars and wheat. If you don’t like wheat, then pick some other commodity that’s a substitute for cars. The point is the same. Of course, wheat is used to brew high end unfiltered wheat beers, and I think it’s safe to say that an increase in the price of cars reduces demand for luxury features on car purchases and increases demand for substitute luxuries like microbrewery unfiltered wheat beer. Unless of course you like to drink and drive at the same time, in which case beer and cars would be complements.
Bruce Hall Face it 2slug and arron, the socialist theory of economics favored by this administration is one big FAIL. Spend, tax, and disincentivize free markets.
Even Ricardo knows the difference between socialist economics and textbook Keynesian macro. The economy was improving up until the point that the stimulus faded out. The economy has been slipping ever since the knownothing Tea Party types took over the House along with their fellow filibustering travellers in the Senate.
Pick winners like Solyndra; pick losers like oil and coal.
The private sector has its share of bad picks, so there’s nothing terrible about the government having a few. And it was only a few. In fact, it turns out that the government had a higher success rate than Bain Capital. You should also that while businesses should be risk averse, government projects should be risk neutral. For example, see a very famous book on this topic:
“Public Investment, The Rate Of Return, And Optimal Fiscal Policy,” by Kenneth Arrow & Mordecai Kurz.
It’s a classic in the field. Warning…it’s kind of mathy.
2slugs
I appreciate your balanced tone and agree with many of your points.
But nominal wages are downwardly rigid, so what actually happens is that in response to inflation people consume a larger share of their nominal income and save less.
I agree for the average consumer, but I fear that the people who can least afford it will not be able to save less. The reason is that they already save 0. You can argue that borrowing is saving less, but many are tapped out with no credit. These are the people that a quick increase in the price level wwould hurt the most. I think it’s disingenuos to talk about income inequality on the one hand, but turn around and throw the people at the bottom under the bus, on the other.
The monetary easing without looking at the benefit and cost of easing is the reckless policy. I think too much stimulus to create speculative investment and reckless lending create short-term economic boom but at end the economy will go into recession and crises. Now everyone think QE3 is important to drive growth and stop declining inflation but if there is QE3, the negative consequence is the rising inflation to at least 4% from higher commodities prices especially food and energy prices. The long-term bond yield will jump forcing rising mortgage rate by at least 2% and cause the housing collapse again. I think we can see why QE2 creates rising inflation from 1% to 4% due to energy and food price hikes and ignite rising long-term bond yield and force FED to have limited power to control economy for awhile. I think operation twists that lower long-term yield and FED can control inflation will support economy to grow under housing problem. If FED uses QE3, we can see US economy will go into recession with housing demand collapse again and rising energy and food prices causes lower real purchase power. I think we have no threat of deflation but the current lower inflation comes from lower food and energy prices not core inflation, actually that is good news from higher real purchasing power.