Friday, April 03, 2009

Inflation vs. Deflation

by Calculated Risk on 4/03/2009 09:43:00 PM

It looks like the FDIC cancelled Friday ...

From Simon Johnson and James Kwak of Baseline Scenario writing in the WaPo: The Radicalization of Ben Bernanke

... Shortly after joining the Fed in 2002, Bernanke gave a speech describing how the Fed could prevent deflation, i.e., a general decline in prices. The key theme was that, in a pinch, the Fed could simply print more dollars -- for example, by buying long-term bonds on the market -- which reduces the value of each dollar in circulation and therefore raises the dollar price of goods and services. "Under a paper-money system," Bernanke explained, "a determined government can always generate higher spending and hence positive inflation." In a time of economic overconfidence, the discussion seemed largely academic. But it is now clear that Bernanke intends to follow through on it.
Tim Duy at Economist's View responds: Johnson and Kwak vs. Bernanke
The implicit assumption is that the Fed is expanding the money supply via a policy of quantitative easing with the explicit goal of raising inflation expectations. First off, as Bernanke said once again today, he does not describe policy as quantitative easing:
In pursuing our strategy, which I have called "credit easing," we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices.
Pay close attention to Bernanke's insistence that the Fed's liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment - a commitment to contract the money supply in the future. Is this any way to boost inflation expectations? See also Paul Krugman:
In that case monetary policy can’t get you there: once the interest rate hits zero, people will just hoard any additional cash – we’re in the liquidity trap. The only way to make monetary policy effective once you’re in such a trap, at least in this framework, is to credibly commit to raising future as well as current money supplies.
If Bernanke really intends to raise inflation expectations, he is making an elementary error by reiterating his intention to shrink the Fed's balance sheet in the future. The current increase in money supply is thus transitory and should not affect future expectations of inflation. I can't see him making such an elementary error, which suggests that Bernanke's word should be taken at face value; he intends policy to be "credit easing," not the oft-cited "quantitative easing."
It would seem the bigger concern in the short term is deflation, and I've been assuming the Fed was trying to raise inflation expectations - and I've been calling the Fed's policy "quantitative easing".

Dr. Duy writes:
Bottom line: I reiterate my concerns that the media and market participants are using the term "quantitative easing" too loosely. I understand that this complaint falls on largely deaf ears. If Bernanke is using quantitative easing to boost inflation expectations, then I think we need to seriously address the likely ineffectiveness of any such policy when Fed officials repeatedly promise to shrink the balance sheet in the future.
Mark Thoma at Economist's View has more: Inflation and the Fed
This is, in essence, a question about whether inflation expectations are anchored or not, and that is also the key question is this discussion of the odds of deflation by John Williams of the SF Fed. He argues that the previous decades can be broken into a recent time period in which expectations appear to be well-anchored, the time period 1993 through 2008 is cited in the linked discussion, and a time period in the late 1960s and the 1970s when inflation expectations do not appear to be anchored (based upon Orphanides and Williams 2005). The paper also notes that recent surveys of professional forecasters are consistent with anchored expectations.

But past history shows us that expectations can move from one state to the other, from untethered to tethered, and there's no reason that cannot happen again, but in the other direction. So here I agree with Martin Wolf, it's dependent upon the credibility of policymakers. So long as people believe that the Fed is committed to preventing an outburst of inflation, and that they are capable of carrying through on that commitment, expectations will remain well-anchored. But if people believe that that Fed's hands are tied because of the harm reducing inflation would bring to the real economy, an out of control deficit, or due to political considerations that force them to accept inflation they could and would battle otherwise, then we have a different situation and long-run inflation expectations will change accordingly.
I recommend the paper Professor Thoma linked to: The Risk of Deflation by John C. Williams, San Francisco Fed Director of Research
The evidence indicates that a substantial increase in slack can lead to deflation, but the depth and duration of the deflation depends on how well anchored inflation expectations are. Two policy implications can be drawn from this and other research on deflation. First, a central bank should take appropriate actions to stem the emergence of substantial slack in the economy and thereby reduce the risk of deflation. Second, it should clearly communicate its commitment to low positive rates of inflation. An example of such communication is the Federal Open Market Committee's recently released long-run inflation forecasts. Such words, backed by appropriate actions, reinforce the anchoring of inflation expectations and reduce the chances of a deflationary spiral.
I need to think about this.