Inflationary Expectations
Here’s Paul Krugman in 1998 making the case for an effort to create inflationary expectations:
Let us now bring this discussion back to earth, and to Japan in particular. Of course the Bank of Japan does not announce whether its changes in the monetary base are permanent or temporary. But we may argue that private actors view its actions as temporary, because they believe that the central bank is committed to price stability as a long-run goal. And that is why monetary policy is ineffective! Japan has been unable to get its economy moving precisely because the market regards the central bank as being responsible, and expects it to rein in the money supply if the price level starts to rise.
The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.
This sounds funny as well as perverse. Bear in mind, however, that the basic premise – that even a zero nominal interest rate is not enough to produce sufficient aggregate demand – is not hypothetical: it is a simple fact about Japan right now. Unless one can make a convincing case that structural reform or fiscal expansion will provide the necessary demand, the only way to expand the economy is to reduce the real interest rate; and the only way to do that is to create expectations of inflation.
It seems to me that central banks, as institutions, value their reputations as credible inflation fighters. The fact that such a reputation has benefits for central banks—or is perceived as having benefits—could lead to poor policy in situations of severe recession. Certainly the European Central Bank, which is right now probably the most important central bank in the world, has made it very clear that it regards maintaining a low level of inflation as its top priority. And the Bank of Japan was put to the test over this issue and clearly chose not to take this path. The Fed in the United States has never been as clear, but certainly shows no sign of taking this advice and trying to create inflationary expectations.
33 Responses to “Inflationary Expectations”
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November 14th, 2009 at 6:12 pm
Yea, time is a bitch. It’s pretty ironic that, in a crisis caused by long term malfeasance, everyone tries to boost they’re credibility by talking about dealing with long term problems, when just the opposite is often needed to get out of the crisis. I think that for Westerners in general and Americans in particular, it just seems wrong to say that imprudent thing under most circumstance is the most efficacious in one special circumstance. Probably has something to do with Calvinism, or some-such other form of perversity.
The other irony is that the rest of the developed economies, while also not following Krugman’s Inflationary Expectation prescription, are taking his secondary and tertiary measures, (i.e. fiscal expansion and job creation/retention programs) and running with them. We barely passed an anemic stimulus, and are arguing about whether or not we should have. God only knows if congress can be forced into doing anything about unemployment.
November 14th, 2009 at 6:21 pm
I doubt that spending debased currency will fix what ails us.
November 14th, 2009 at 6:21 pm
Wow for Krugman, really. Again it is amazing how some folks went so easily and without acknowledging from ridiculing those that said these policies could lead to inflation to actually cheerleading inflation.
I do have a question though. It is fine to say that negative real rates will encourage borrowing, but who, pray tell, besides the Fed is going to be willing to lend at negative real rates?
Also, is this implication here that if you create inflationary expectations nominal interest will stay the same, but the real rate will decline because of inflation? I am pretty sure that if the Fed turns credibly inflationary, nominal rates will go up, again because no one wants to lend at negative real rates.
November 14th, 2009 at 6:47 pm
“I doubt that spending debased currency will fix what ails us.”
Actually, it will. We’re not talking hyper-inflation here, far from it given the fact that deflation is still the worry. A weaker dollar means more capital is invested in the real US economy, which means more exports and less imports, which means more production and jobs. Counter-intuitive, no?
November 14th, 2009 at 7:34 pm
Leave Bob Roddis alooone!!!!!
November 14th, 2009 at 8:07 pm
i tell ya the truth: if i’m a european central banker with a sense of history, and as a result of that sense of history i know that post-wwi hyperinflation in germany helped lay the groundwork for fascism, i too might value my reputation as an inflation fighter above all things.
November 14th, 2009 at 8:22 pm
Right. c.f. Weber, Max. “The Protestant Ethic and The Spirit of Capitalism”.
Although I wouldn’t call it “perversity”; it’s gotten us to where we are as a country. I’m not a conservative but I have to give credit where credit’s due.
November 14th, 2009 at 8:22 pm
To howard
True enough. However, and I’m not trying to be glib here, might I recommend…getting over it!
November 14th, 2009 at 8:27 pm
Brahma makes a valid point, but I would argue that what has gotten us to this point is actually ingenuity, experimentation, and little bit of luck.
November 14th, 2009 at 8:47 pm
Doug wrote:
I’m confused. Whose rates are we talking about, again? I’m pretty sure that in the quoted snipped, Krugman was talking about the central bank rate. What it seems you’re talking about is the rate that banks lend at the retail level, or the rate at which investors are willing to buy bonds.
For example, T-bills are available at a very low rate now, but that’s actually forcing investors who want actual yield into the corporate bond market; i.e., goading them to lend to corporations who want to borrow in order to make capital expenditures.
November 14th, 2009 at 8:53 pm
Central banks lead by the Fed and the BOJ have been pursuing policies which are expansionary for over two decades. By expansionary I mean meant to expand credit and money, money in all it’s iterations. In other words they have had a very very strong inflationary intent.
Here is the crucial thing. Much of that money has first gone into the financial sphere and then stayed there and that in turn has lead to rolling asset bubbles. For some reason which I think is bizarre the increase in financial asset prices and real estate, and a few other assets, is never called inflation and thus never understood as inflation. Meanwhile in the real transaction for goods and services economy inflation is mild to non existent and absolutely non existent in wages.
For some reason this is difficult for people to understand. Get your mind around this. In the NY Times today a story says that the entire cash receipts of agriculture in the states of Conneticut, New York and New Jersey in the year 08 was $6.4 billion dollars. Not the profits but the totality of sales.
Meanwhile GS alone is going to make perhaps $50 billion in profits this year. Somehow that is not considered an artifact of inflation.
Central banks are pursuing an inflationary path and have for a generation. Every call for more further inflates the financial economy while the real economy languishes. The US GDP contracted from top to bottom perhaps 5%. Excactly why has 5% lead to an crisis with employment rates at 70 year lows? Something is wrong with this picture and members of the elties, which include MY have no clue.
November 14th, 2009 at 9:01 pm
Brahma seems to be correct @10, furthermore, a credible weakening of the Dollar would be boon to the real economy. Hell, it might even get China to let their currency to float. I hope I’m not killing any sacred cows here, LOL. The possibilities for second order effect are too numerous to count, and are mostly positive; at least in the medium term. (Brahma, please excuse my pathetic attempts at humor.)
November 14th, 2009 at 9:14 pm
People should read this paper:
http://www.newyorkfed.org/research/staff_reports/sr404.html
It is by Mike Woodford and Vasco Cúrdia. Its at the NY Fed webside
“Conventional and Unconventional Monetary Policy”
Read especially pages 35-36. The issue is not inflation exactly. Woodford, who is a world expert on this stuff, shows that the optimal policy when coming out of a crisis in which short term rates are at zero is not inflation targeting but rather price level targeting. Target a general price level somewhat higher than the current one – and hit the target. This will remove the deflationary expectations that are with us now as we hear the Fed promise to go back to business as usual just as quick as they can. This promise ramps up deflationary expectations, as the present level of deflation is permanently baked into prices.This was the error in Japan, an error that years of gigantic budget deficits could not overcome. The policy framework Woodford uses is the the New Keynesian one, but the same point has been made at this website for more than a year: Take a look.And read the Woodford paper. It is very compelling – but you must read it.
http://blogsandwikis.bentley.edu/themoneyillusion/?p=2872
November 14th, 2009 at 9:29 pm
I am forced to disagree. The US has been pursuing a strong Dollar policy, in a rather arbitrary and capricious way, on and off, for a very long time. This is evidenced by the fact that the Dollar is still the world’s reserve currency despite our declining real economy and ever-growing trade imbalance. The net effect of this inconsistency has been to the advantage of bondholders and the investor class in general. Inflation has been as stable here as anywhere else.
The point if this strategy is to create widespread belief that money will stay cheap (not the status quo at all) and thus induce domestic consumption and investment in real domestic output (read: jobs). The best part is the Fed can renege on the deal whenever the required level of recovery is achieved, thus inducing thousands of investment bankers to commit suicide.
November 14th, 2009 at 10:14 pm
The problem, Matt, is that while expectations of inflation may stimulate spending and demand, inflation is also a form of default. It would not behoove the United States government to more or less signal that it intends to default on its debts.
November 14th, 2009 at 10:36 pm
inflation is also a form of default.
Having a cold is also a form of dying from viral pneumonia.
November 15th, 2009 at 4:07 am
As I closely follow our descent into oblivion, the greenest green shoot I’ve been able to find over the last 4 or 5 months is the precipitous drop in the dollar throughout September enabled the United States to increase its exports by $3.5 billion.
Hey, it sounded good. It seemed like a stat I could finally sink my teeth into. Here is where the United States could plant its last remaining battle flag, make a stand, and strive to become, once again, a viable nation-state on the international stage.
Oh yes. I’m talking import/exports. The plan would be this: instead of drowning in trade deficits, we complete a successful and determined struggle to reach the surface, tread water for a spell, and with steady due diligence, learn how to swim again.
But no. Unfortunately, buried in the FINE PRINT, was data that showed US trade deficits in September actually increased at the fastest rate in more than a decade. Despite it being a banner month for American exports, the United State, as per usual, bled thick red ink for 31 days.
Oil, you see, was our undoing. Rising oil prices meant we had to spend an additional $20.5 billion in September, and that easily swept away any export gains accrued from the dollar’s demise.
So take heart heart, Matthew, perhaps there is a green shoot after all. Even if the Fed does not see fit to create inflationary pressures, the price oil will probably do it for us.
But remember, these things can get tricky, we must continue to ward off evil spirits with faith and prayers, because capricious oil might see fit to go beyond the imaginary, and create all by its lonesome double-digit inflation of the real and devastating variety.
November 15th, 2009 at 7:58 am
The only reason for a central bank to be seen as tough on inflation is so that expectations allow it to undertake greater discreationary policy to fight economic downturns. The only other reason is if the central bank is completely in the thrall of credit holders. The ECB is just insane at this point. And people need to understand that inflation at level we’re talking about (5-7%) is hardly a great evil.
November 15th, 2009 at 8:02 am
Matt has a big mortgage and a small bank account, so what’s not to like about inflation?
November 15th, 2009 at 8:48 am
The Fed did exactly what Krugman proposed when he proposed it in 1998, and had been doing it on and off, mostly on since 1987.
The way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs.
Fed policies and words since 1987 have explicitly been in support of inflation. The inflation of stocks and financial assets. Often supplying near zero interest rates, to its primary dealers who are the worlds largest banks and financial institutions, and assuring them that the slightest bit of deflation of their assets they would step in and supply unlimited liquidity to the markets.
With these guarantees in hand players were free to create and bid up countless trillions worth of dodgey assets like Mortgage Backed Securities on inflated homes to receivables on no money down loans to slackers at Guitar Center which just brought about the 4th largest bankruptcy in US history CIT, not to mention the current 1.3 quadrillion dollars of financial derivatives, which isn’t as bad as it sounds. The money at risk on this paper is only $60 trillion, equal to the worlds annual GDP.
I know nobody understands these derivatives but think about it this way. They are dazzlingly complex abstractions conceived to have a ‘value’ of 1.3 quadrillion dollars according to some computer screen. When a number has a dollar sign and then 15 zeros let me suggest it is inflated. Meanwhile all of GM’s factories probably have a ‘value’ of a couple of billion. Of course those are real brick and steel so cannot be abstracted and thus not inflated.
The sudden deflation of so much inflated paper has now brought us again to the Fed giving zero interest rates, to its primary dealers, who are busily bidding up orchestrating the re inflating of, you guessed it, stocks and derivatives. The Fed and central banks around the world have never been as explicitly inflationary path as over the last year. It isn’t enough so there will be more and your home and your income will continue to deflate while XX more trillions will go into inflating X quadrillion in derivatives.
November 15th, 2009 at 10:10 am
I thought that setting the federal funds rate real low — and then letting the Five Big Banks buttfuck the consumer with 20 percent interest on credit cards –was how the Government was transferring big money from the citizens to Big Banks without the embarrassment of actually publicly taking the money from the citizens (via taxes) and giving it to the Banks (via gifts.)
November 15th, 2009 at 10:25 am
This post is a joke, right?
Little Matty and The Krugmaniac are paid to spout this nonsense just to see how many pea-brains lap it up, right?
November 15th, 2009 at 11:07 am
This post is not stupid or silly. It reflects the broad consensus view about what constitutes monetary policy and how that policy works. It is a coherent story as far as it goes, trying to make simple sense of an infinitely complex economic reality. It is the story our elites including those in charge of our giant corporations and our policy makers tell endlessly. Some of those actually believe it.
When FNM was hovering at $60 dollars a share all through the middle of this decade many who hold alt views like the ones I botch trying to express here were beside themselves in awe and disgust that this monster based upon layers and layers of false assumptions could be seen as being worth a dime, period, much less a share. It is now worth a buck or two a share as it lives on as a zombie while taxpayer pour $15 billion a quarter into it now. This was all perfectly predictable. It was all of a piece with the story told here about the central bank fostering inflation.
Don’t let that influence you however. This time, for sure, the inflation bias of the Fed is really really going to work.
November 15th, 2009 at 1:29 pm
That always coherent hoaxter, Krugman, with his coherent story on a related topic March 11, 2003:
With war looming, it’s time to be prepared. So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits.
…
Last week the Congressional Budget Office marked down its estimates yet again. Just two years ago, you may remember, the C.B.O. was projecting a 10-year surplus of $5.6 trillion. Now it projects a 10-year deficit of $1.8 trillion.
And on August 27, 2009:
So don’t fret about this year’s deficit; we actually need to run up federal debt right now and need to keep doing it until the economy is on a solid path to recovery. And the extra debt should be manageable. If we face a potential problem, it’s not because the economy can’t handle the extra debt.
November 15th, 2009 at 1:31 pm
The risk is hardly inflation. The risk is deflation. The importance of the Woodford paper is that he gives a rational for central bank action that counters deflation without the Krugman rhetoric of a central bank promising to “credibly promise to be irresponsible” – something no central bank will even do – and for reasons clearly shown on this blog. The political opposition to inflation is virulent – and no central bank ever has or even will promise higher that 3% inflation.
Woodford shows that targeting a price level is exactly not not not being irresponsible. Woodford is no radical and he is no flamer, as Krugman is. He is a cautious and moderate advisor to actual and real central bankers – who are cautious and moderate people. And he shows,in very clam language, that targeting inflation as we move out of the crisis is profoundly dangerous. Doing so is far too deflationary. Target a price level, somewhat higher than now, and commit to hitting it. That is the correct policy. It will get us out of this without becoming another Japan.
November 15th, 2009 at 1:35 pm
Many typos – too bad. But even = ever and clam = calm
November 15th, 2009 at 2:11 pm
The problem that Krugman has now, and had back when he proposed this for Japan, is that he doesn’t really understand the monetary system or the fact that monetary policy isn’t really that effective at either increasing or decreasing inflation (and to the extent that it is, it in the opposite direction of what he thinks.) So as usual, he’s talking nonsense.
November 15th, 2009 at 4:11 pm
[...] monetary stimulus. Thus I was pleased to see that in the past few days both Krugman and Yglesias have addressed the issue, although in somewhat different [...]
November 15th, 2009 at 6:14 pm
@10
The Fed rate is kept low or perhaps made negative through inflation not as an end for itself, but supposedly in an effort to reduce interest rates throughout the economy to encourage borrowing as a way to stimulate economic activity. So ideally those negative real rates would translate into private lending, or at least they would be supposed to get, by design, a lot closer to negative real rates.
The problem is that once the fed commits to inflation, it cannot control as effectively the extent to which the market will price those expectations into private lending.
So the only way the fed committing to inflation to create a negative real interest rate will help new economic activity, is if you believe that lenders and investors will actually be willing, in the face of such a commitment, to accept the same, or not very much higher, nominal rates they get now. That seems pretty wrong to me.
The other way committing to inflation could help, but which does not seem to be Krugman’s idea, is it would reduce the real value of existing debt. There are only so many times you can try that trick, however, before lenders start securing the value of their investments in other ways.
November 15th, 2009 at 10:39 pm
Krugman was wrong in that there was never really any question as to if the BOJ’s monetary base expansion was temporary or permanent. There was no possible way they would ever contract it. Just as there is no possible way the Fed can ever implement and ‘exit strategy’ now or soon or really ever. The question is an academic one not a practical one.
Since it is 11 years on now from the article how has the BOJ’s inflationary policies worked out? Well last time I looked Tokyo real estate has not returned to it’s old highs were it was worth more than all America. Their banks are still sitting on the losses 20 years on. I’ll give you a little hint and suggest in 11 years US home prices will not average 5 times median income either.
Well I suppose I’ve headed straight into the weeds here but it’s all weeds. The idea that these clown bankers can run the world by first blowing bubbles and then trying to reblow them after they collapse is insane. The efficacy of monetary policy tends to be blunted by the fact that nobody really knows WTF it is or what it will do or where the effects will spurt out. It’s all rather funny in a tragic way.
November 15th, 2009 at 10:44 pm
Krugman: Different situations are different from each other.
[...Bob Roddis' head explodes...]
November 16th, 2009 at 12:23 am
“Well I suppose I’ve headed straight into the weeds here but it’s all weeds. The idea that these clown bankers can run the world by first blowing bubbles and then trying to reblow them after they collapse is insane.
As long as we’re heading into the weeds, why not try to make some money on the way?
November 16th, 2009 at 8:59 am
Before the thread dies let’s take an inflation snapshot on this Monday morning. Stocks up strongly, gold at new record high, oil perky but below the recovery highs, grains and beans continuing the new uptrend and just about every commodity is up as well, even Treasuries are up.
Dollar down, state and Federal tax receipts imploding at 10% to 20% YOY rates, and only 200K jobs being lost a month. Mortgage aps plumeting and prices still trending lower.
The Feds management of inflation expectations is working out well.