The wrong sort of inflation
Chairman Ben Bernanke’s Fed is beset by demons of its own design.
Terrified by memories of the 1930s and Japan’s more recent experience in 1990s and 2000s, the academics who now dominate the Federal Open Market Committee display a hyperactive compulsion to tinker with monetary policy in a bid to solve all the problems besetting the U.S. economy.
But if inflation is always and everywhere a monetary phenomenon, as Milton Friedman argued, Fed policy has a smaller role in solving real-economy problems such as a gaping trade deficit, moribund housing market, sluggish growth and joblessness.
Expectations of another substantial round of quantitative easing (QE2) have gone too far for the Fed to pull back now. The Fed must press ahead or risk a massive, disorderly correction across all asset classes (bonds, equities, commodities and currencies).
But once the trigger is pulled members of the FOMC should resist the temptation to tweak further and give the normal cyclical processes of recovery and structural reforms time to work.
Never before has the Fed had so much theoretical firepower at senior level.
Academic economists dominate the FOMC: Bernanke (Princeton); Vice Chairman Janet Yellen (Berkeley); New York Fed President William Dudley (former chief U.S. economist for Goldman Sachs); St Louis Fed President James Bullard (former research director at the St Louis Fed); as well as Cleveland Fed President Sandra Pianalto and Boston Fed President Eric Rosengren (both with research department experience).
Academic prowess has become the road to power, sidelining supervisors and those with operational and markets experience. Committee members with backgrounds in banking, markets and other areas of expertise are in a minority.
But proficiency with theory may be leading the Fed to overestimate its ability to steer the economy and micro-manage inflation and growth outcomes. There is a risk that the real economy and financial markets are being turned into a giant laboratory experiment to test theories about how monetary policy works.
Just because the only tool to hand (monetary policy) is a hammer does not mean that every problem (jobs, growth, the trade deficit) is a nail. Knowing when to step back and allow the economy and markets to work naturally is just as important as knowing when to intervene.
Speaking earlier this week to the National Association of Business Economists (NABE) in Denver, Kansas City Fed President Thomas Hoenig rebuked his colleagues for giving in to pressure to do “something, anything” to get the economy back to full employment.
“While QE2 might work in clean theoretical models, I am less confident it will work in the real world. Again I will note that the FOMC has never shown itself very good at fine-tuning exercises or in setting and managing inflation and inflation expectations to achieve the desired results.”
Hoenig is a committee veteran and its longest serving member (appointed in 1991). His experience in rate-setting seems to have taught humility about what the committee can achieve and the terrible temptations to tinker and ignore the side effects of policy interventions.
Hoenig questioned whether more asset purchases would really reduce long-term interest rates much on a sustained basis in current conditions. Even if they did, it might not have much impact. “[T]he effect on economic activity is likely to be small. Interest rates have systematically been brought down to unprecedented low levels and kept there for an extended period. The economy’s response has been positive but modest.”
“Dumping another trillion dollars into the system” would simply spur financial speculation. “There simply is no strong evidence the additional liquidity would be particularly effective in spurring new investment, accelerating consumption or cushioning or accelerating the deleveraging that is hopefully winding down.”
Meanwhile QE2 would risk “a further misallocation of resources, more imbalances and more volatility.” There is no guarantee the Fed could bring about a carefully calibrated rise in inflation and expectations. Aggressive liquidity injections would just as likely be ineffective or trigger too much inflation.
Hoenig doubted the Fed could exit from QE2 in a timely and prudent manner: “I do not believe that the Federal Reserve, or anyone else, has the foresight to do it at the right time or right speed. It may work in theory. In practice, however, the Federal Reserve doesn’t have a good track record of withdrawing policy accommodation in a timely manner.”
Hoenig seems to have better arguments. Proponents of QE2 have struggled to define its objectives (whether a target for the inflation rate or the price level, and at what level); how it is supposed to work (by lowering borrowing costs or inflating asset prices); how big the effects might be (equivalent to a yield reduction of 15-20 basis points, or 50); let alone how any of this translates into more output and jobs.
Speaking last week, New York Fed Executive Vice President Brian Sack, who runs the System Open Market Desk that would be charged with implementing the policy, was confident it would work but vague about how or how much.
Sack sidestepped criticism about the side effects of the programme: “In terms of the costs of balance sheet expansion, the assessment is perhaps even more complicated. I will not attempt a comprehensive discussion of all the potential costs as that assessment falls to the FOMC”.
If QE2 is undertaken in sufficiently large amounts, there is no doubt it will eventually show up in inflation somewhere in the system.
But with so little idea about how liquidity injections work or are transmitted around the markets and the economy, the Fed has almost no idea how much inflation they would eventually produce, or even in what sort of prices or where in the world. Most of the benefits from ultra-low interest rates and QE in Japan seem to have leaked abroad via the yen carry trade.
Even the prospect of QE2 is already producing lots of inflation — just not in the right products (it is showing up in asset prices and commodities rather than prices for consumer goods and services) or the right location (Fed policy is stoking inflation in emerging markets and commodity producing countries rather than back home in the United States).
The Fed may to some extent be able to “choose” its inflation rate by controlling the growth in liquidity, as Friedman believed, though whether links between the quantity of money and inflation are sufficiently stable to calibrate policy accurately is very doubtful. But what it cannot do is to choose what type of inflation it gets (assets, commodities, manufactured goods) or where (North America, Europe or emerging markets).
The current pattern of inflation — with rapidly rising prices for assets and commodities rather than goods and services at home, and in emerging markets rather than the United States — is eerily similar to the inflation reported between 2004 and 2008.
Inflation is showing up in demand and price increases for liquid assets (bonds, equities, commodities) where investors do not have to make long-term commitments (unlike investments in buildings, equipment and jobs). It is occurring in those parts of the global economy which are already strongest and where bottlenecks are worst (emerging Asia).
The pattern of rises suggests problems besetting the United States at the moment have nothing to do with a lack of inflation, liquidity or demand; they are structural. Only the gradual working out of the economic cycle and long-term adjustments can take care of them.
Hoenig is right. It is time to stop over-reacting to the monthly data releases and start focusing on the long-term and structural reform.