The wrong sort of inflation

October 15, 2010

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.


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QE achieves one thing: huge misallocation of resources. Who would risk to start a new business if now it is clear that stock market is actually part of the Fed’s reaction function? As a result, we will get sluggish growth and more government, in the end,resulting in more protectionism. Besides, inflation is a rather odd concept. Fed’s “core” inflation nowadays is something which is stripped off any meaningful substance (and goods). The only things that are left in the basket are “made in China goods” + rents. That’s probably ok and it allows to keep monetary policy accomodative and talk about deflation, but at the same time, we see that prices of “store of value” goods (the goods for which people are ready to run down savings or save) are skyrocketing. Not only gold, but also, for example, the costs of any meaningful education have sharply increased since 2007.

Posted by tk2 | Report as abusive

Great article, John.

Hoenig’s the man!

And BTW, if you’re looking for bubbles, and fairly big ones, you don’t have to look too far, or into the future:
Home prices are still inflated by various subsidies.
Stock prices are inflated by cheap dollars and big expectations for recovery, whatever that means.
Gold, obviously.
US debt, which explains the above bubbles, and is particularly annoying.

It seems like Obama is trying to print his way out of the hole, and thus avoid a certain defeat in 2012

Posted by yr2009 | Report as abusive

Mr. Hoenig and Mr. Kemp are absolutely right. For 25 years wages have not risen in the US while inflation continued and consumers bridged the gap with credit. Now the credit window has slammed shut but the Fed is still stuck in an outmoded model of targeting a 2% per year inflation rate because they are afraid of deflation. Notice how their measure of inflation excludes food and energy prices because of “volatility”. Well, last year’s rise in food and energy is now a hard number but you don’t hear the Fed suggesting that we now go back and factor that into their measure of inflation.

So, if your wages are not going up to match inflation, deflation is not a bad thing for the consumer. It means everyday items like food, clothing and gas are holding steady or decreasing in price, which is bad for the companies trying to make a profit. Inflation is good for the big banks, Wall Street and the Fortune 1000 because it keeps the assets they have from losing value faster than the cost of the debt service.

The Fed’s model for the economy is clearly broken. What worked for 25 years is not going to work now. What is 2% per year inflation compounded over 10 years going to do to the consumer when wages still do not rise to match it and the consumer is unable to bridge the gap with credit?

Now they want to pump even more money into the system? Money managers are going to put all that liquidity to work somewhere. As noted in the commentary, that somewhere is going to be short term; commodities, portable/liquid assets; all things that banks, Wall Street and large companies can make money on.

I certainly don’t have an answer for this, but surely there must be people out there who do. But I am not including Mr. Bernanke or Mr. Geithner in my short list, it is obvious they are bankrupt when it comes to a fresh approach.

Posted by stanrich | Report as abusive

What is funny is the comment

“It seems like Obama is trying to print his way out of the hole, and thus avoid a certain defeat in 2012″

Clearly you do not understand that the Fed is isolated from the reach of the White House, it is it’s own entity. Obama has No say except to name the chief, who is a GOP guy?

Posted by jmjjmj1 | Report as abusive

its become ridiculous for a incompetent like bernanke to be running the federal reserve.the US is in a depression and its growing unemployment is a national disgrace.its time to start making real changes.replace obama who has clearly failed to do the job he was elected for and clean out all of the people he brought with him…

Posted by plange01 | Report as abusive

Inflation is the key to solving many woes:
– printing money will make dollar drop and help exports
– will counter effect of China’s cheap yen policy
– will partly counter effect of cheap overseas labor
– will alleviate homeowners with underwater houses
– will spur more customer and corporate buying to hedge inflation
– will feel normal for financial power brokers who call the shots

Print baby Print!
This time give it to main street not wall street.
This time give it to our future not go nowhere jobs (higher education and huge reward/grants for technological achievements in manufacturing and green energy)

Posted by Butch_from_PA | Report as abusive


“Clearly you do not understand that the Fed is isolated from the reach of the White House, it is it’s own entity. Obama has No say except to name the chief, who is a GOP guy?”

Do you wish to imply that Obama chose to let Bernanke keep his job because of bi-partisan considerations?
Interesting idea. I think it’s funny.
Bernanke is Obama’s guy now, IMHO.

Posted by yr2009 | Report as abusive

yep benanke has been a real disappointment. obama too. their thinly veiled hostility toward american society in the interest of a small elite is shocking.

ultimately this may be healthy because they have made obvious the self dealing, corrosive, parasitic behavior of our financial-government complex.

the power will eventually return to the citizens of this nation – the sooner the better.

@Butch_from_PA: reread your economics text book. there is no free lunch. inflation is not going to achieve the panacea you describe. quite the opposite, ‘monetary policy’ is mechanism for the power brokers you describe to establish greater control of the population. you think the team that came up with 100% payout of aig obligations to GS and the other parasites foreign and domestic had a sudden change of heart? now these all stars are going to determine what your money is worth?

i wish i had that kind of optimism.

Posted by benebene | Report as abusive

How can money supply manipulation affect this?—Over 42,400 FACTORIES have been lost in the US since 2001…and all their suppliers and the technical jobs that it took to run the factories…and the materials suppliers, and the widget producers, etc etc.
—(Richard McCormack, The American Prospect, Dec 21, 2009)

Think: why is it that unemployment is likely to stay high?

Posted by Lita7 | Report as abusive

[…] Ben Bernanke’s Fed is beset by demons of its own design. The Great Debate This entry was posted in Global News and tagged inflation, Sort, wrong. Bookmark the permalink. […]

Posted by The wrong sort of inflation | One Stop Everything News | Report as abusive

fed policy of qe will unfortunately end up with higher cost push inflation (due to energy, commodities price hikes) but lower inflation of consumer goods (less money available to spend on these). so look forward to high PPI feeding through to high CPI but low or even negative core inflation -> result lower profits for companies and further cost reductions-> higher unemployment.

there is in the end no quick fix solution to the fact that unemployement in developed countries is bound to rise and employment in cheaper countries will fall. restructuring, reeducation, imposing austerity, lower living standards for the west takes a long time to achieve.

Posted by shivers1 | Report as abusive

John, you are spot on in criticizing the Fed for its over-reliance on monetary economic theory. But you are also wrong to believe that this is nothing more than the low ebb of some economic cycle.

The problem with the Fed’s over-reliance on current economic theory and models is that economists have completely missed a critical parameter (perhaps THE most critical parameter) that drives today’s economy. They have missed it because they refuse to consider the effects of an ever-growing population. The effect they’ve missed is not a shortage of resources or environmental degradation – effects they dismiss with the belief that mankind is ingenious enough to conquer all such obstacles to further growth. Rather, the effect they’ve missed is declining per capita consumption and rising unemployment as a result of over-crowding.

Badly overpopulated nations are utterly dependent on manufacturing for export in order to sustain a decent standard of living for their bloated labor forces. No currency wars or QE is going to alter that fundamental economic reality. If the U.S. wants to restore a balance of trade, it needs to reject 18th century trade theories that never accounted for the effect of population density and undo the mistake it made in 1947 when it signed the Global Agreement on Tariffs and Trade. While free trade may work when the trade is between two nations roughly equal in population density, it’s a sure-fire loser for the less densely populated nation when dealing with others that are badly overpopulated. Until economists wake up to this reality, trade imbalances and high unemployment will persist.

This isn’t an economic cycle. It’s the logical outcome of never-ending population growth that continues to swell the labor force even as per capita consumption declines. Trade with badly overpopulated nations only exacerbates the effect. Our woes won’t end until that fundamental issue is addressed.

Posted by Pete_Murphy | Report as abusive

The Fed doesn’t see enough inflation. Look at copper, precious metals, oil, grains, cotton and beef. The last QE has capitalized the emerging markets and is chasing hot assets.

I think the Fed really sees biflation or stagflation, but this diverges from their classic expectations. The analysis is dysfunctional….we are “fighting the last war”.

Posted by pickaroonwyo | Report as abusive

Finally someone is realizing that Hoenig is the only smart one on the Fed. I am his biggest facebook fan!

Posted by minipaws | Report as abusive

Mr Hoenig is correct. QE caused the misallocation and waste of trillions of dollars. Most of it just increased speculation in the stock market, and prevented the market from correcting itself. It artificially inflated stock prices while increasing unemployment and reducing demand. It created an increased disconnect between the value of the real economy and the price of stocks. Further QE will further increase that disconnect. Sooner or later, that disconnect will correct itself. The longer the FED prevents the correction, the worse it will be when it happens.

The real economy suffers from a lack of demand. QE has devalued the US dollar in real terms and that increases the cost of products, further reducing the purchasing power of consumers in the largest consumer economy in the world. That reduces demand. It does not increase it. Reduced demand means businesses must lay off workers or shut down their businesses. That increases unemployment and reduces demand even further.

If that wasn’t bad enough, the FED has borrowed trillions of dollars to deflate the currency and that money must be repaid. And that is only the money that was borrowed “on the books”. Who really knows how much “off the book” money the FED has spent for “unnofficial” QE and government bailouts. The FED refuses to be audited.

Instead of all that money being available to grow the economy and increase employment in the future, it will have to be used to repay the debt. That means QE will slow the private sectors ability to regrow the economy and may even force it into recession.

If that wasn’t bad enough, we have the Government adding massive new entitlement programs we can’t afford and thousands of burdensome new laws that business will have to comply with. Not only does that force businesses to waste employee time and resources complying with thousands of new laws, it also reduces business efficiency and competitiveness in a global economy, increases the cost of doing business, increases government enforcement costs, and increases economic uncertainty. It’s hardly surprising businesses are reluctant to hire new workers under those conditions.

QE1 was a dismal failure in terms of the real economy. Now the FED wants to repeat it and make the problem a trillion dollars worse? It didn’t work on the real economy the first time. We can’t afford to repeat
Bernanke’s failure again.

Posted by consideration | Report as abusive