Quantitative Easing

Robert Waldmann

Can the Fed do any more to stimulate the economy ? The question is back. The answer is only by making credible promises about the fairly distant future. My view is that this means no. I review the issue after the jump.

Long ago Paul Krugman proposed that the Bank of Japan target inflation. In the new millennium this is called quantitative easing. The idea is that when an economy is stuck in a liquidity trap, the real interest rate can only be cut by causing expected inflation. The monetary authority can achieve this by promising to cause inflation when it can. It can only after the economy is out of the liquidity trap. So only if the monetary authority can pre-commit to high inflation when things are back to normal and it will want low inflation, can it stimulate investment in an economy in a liquidity trap.

The argument (due to Krugman of course) is that right now the monetary authority can only push on a string. Private agents are willing to hold unlimited amounts of money given the current short term safe interest rate of almost exactly zero. Only when agents want to do something else with their wealth will it be possible to cause inflation by pouring in more money than people are willing to hold at current prices.

The proposal is that the Fed pump huge gigantic amounts of money into the economy (oops it has already) *and* promise not to buy that money back when prices finally start rising. I quote Brad DeLong

Quantitative easing–pouring a whole bunch of cash in the system with the idea of never reversing the money stock expansion could boost spending and employment considerably by creating expectations of inflation and so reducing the spread–but the Federal Reserve is not going there, and regards the idea with horror, shock, and shame.

I note that the first step, pouring a whole bunch of cash, has been done already and that it isn’t needed for the scheme to work. The Fed doing nothing with the idea of pumping a whole bunch of cash in the system when unemployment is back to normal would work just as well.

Brad also has another approach

I do wonder how much good would be done if the FOMC were simply to stand up and announce that they were raising their long-term GDP-deflator inflation target from 2% to 3%. It might do a lot of good. And it is certainly something the Fed could do without cracking its credibility as committed to low inflation.

It might, but it might not. The Fed can’t keep inflation as high as 2%. The announcement is an announcement about policy in the distant future.

OK assume that the Fed has a precommitment technology so it can set future policy now. Should it commit to higher inflation ?

This is a purely academic deeply hypothetical question. I love those. I have two arguments for no.

1) First a major effect of promising inflation in the future is to drive down the dollar. This would help the US economy at the expense of other countries. One of those countries is called China which is investing huge amounts of Yuan in an effort to keep up the dollar. A Fed vs People’s bank of China war over the exchange rate is a terrifying prospect. Basically the Fed might win, the PBC decide to cut it’s losses by shifting to Euros and suddenly US nominal interest rates are very very far from zero.

Recall what Ben Bernanke used to do. He studied the depression. One lesson is that competitive devaluations were a very bad policy for everyone. He must be thinking of that lesson. I’m sure he is trying to maintain exchange rate peace in our time with the PRC.

2) Aside from that, the policy only works if managers and/or shareholders are smart and managers care about the long term interests of shareholders. That is it works if pigs fly.

The policy is to have inflation low to negative until the unemployment rate returns to normal (because there is no way to avoid this) then have high inflation once it returns to normal (by making unemployment lower than the NAIRU). This means that long term bonds will be cheap (have high yield) and that the return from holding them will be lower than the stated yield (their market price won’t rise steadily as maturity approaches but rather will stay the same until the economy exits the liquidity trap).

The assumption is that firms decide how much to invest based on demand and long term real interest rates. This simple formula fits the post wwII data. However, for that period current inflation is a reasonable forecast of future inflation. The proposal is to make a rapidly changing path of expected inflation. The effect of such expectations on investment can’t be determined from available data.

The argument for investing is that the firm can issue say a 10 year bond and invest in real capital and in 10 years, much of the real value of the bond will be inflated away. For this to work, managers have to believe what the Fed says about monetary policy 3 to 10 years from now *and* they have to care. That is not the way in which managers manage (and they admit it). Larry Summers did a survey once. Many CEOs actually responded. The average response was something like

” to decide whether to make an investment we construct an estimate of the effect of the investment on accounting profits equal to sales plus net inventory investment minus spending on labor, materials and excise taxes, then we discount that flow at an annual rate of 30% and see if the number is positive. If the result is positive we invest”. 30% ! They said they had an extreme short term bias. They also care about accounting.

The inflation targeting proposal is that one should invest, even if one only cares about the short term, as one will gain as the value of debt rises less quickly than the calculated yield on debt. That one can write down the debt marking it to market. This does not work. Investors do not want shares of a firm which claims profits because its own debt has lost market value. The firm’s debt loses market value as the risk of bankruptcy increases. In this case, it is losing value (compared to a silly forecast) because of increasing expected inflation. However, the approach to accounting is one to avoid like the plague.

The firms will gain overt the life of the bond, but they won’t be able to tell investors this in the medium future. The policy should cause increased investment but, in the real world, I think it won’t.