Tuesday, July 21, 2009

Why Inflation Is Not The Threat Now

I've mentioned once before Economist Scott Sumner's blog. Sumner blogs on monetary issues. Like the popular New York Times columnist Paul Krugman, Sumner thinks that the main threat currently is deflation, not inflation. Unlike Krugman, Sumner argues that monetary policy is still effective and can address the current crisis alone, without government spending (fiscal policy).

Unlike almost all other economic commentators these days, Sumner argues that currently and last fall the Fed was pursuing a tight money strategy.

Two items from Sumner's FAQ section on his blog:

2. But weren’t interest rates cut to very low levels?

Interest rates are a very misleading indicator of monetary policy. Both in the early 1930s and late 2008, falling rates disguised a tight money policy. The rates were actually falling for two reasons. Expectation of recession led to less borrowing and thus lower real interest rates. And inflation expectations also fell sharply.

3. But didn’t the monetary base increase sharply?

Yes, but this is also misleading for two reasons. During periods of deflation and near-zero rates, there is a much higher demand for non-interest bearing cash and bank reserves. In addition, last October 6th the Fed began paying interest on reserves, which caused banks to hoard bank reserves.

So low interest rates don't necessarily indicate an a loose monetary policy and even if the Fed pursues a money creating strategy, increased demand for holding cash can thwart this.

The label contrarian gets thrown around so much these days it's lost most of its punch. But the notion that recent monetary policy has been tight seems to be one of the few current views truly worthy of the description. Fed Chairman Ben Bernanke however, is doing what he can to make the contrarian label outdated. Writing in a Wall Street Journal Op-Ed he notes:

When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

Bernanke goes on to argue that one way to control inflation, if and when it becomes the major threat, is through the payment of interest on bank reserves, encouraging them to hold cash rather than lend it out. The use of interest on reserves as a tool of monetary policy has been one of the major ideas of Sumner's blog.

But Bernanke is still talking as if we are in a period of loose monetary policy; for example he mentions, "[w]hen the time comes to tighten." When the time comes? We may be tightening now and not even realize it.

So if Sumner is right, not only is inflation not the current threat, but recovery could in fact be slowed or prevented outright. What if what looks like an expansionary monetary policy is, in fact, the exact opposite. It is difficult enough to determine the best policy approach to economic recovery; overcoming the fact that a policy may be doing the exact opposite of everything we think it is doing may be an insurmountable obstacle to recovery.

1 comment:

Scott Sumner said...

Thanks for the mention. Just to be clear, I do think we may get some kind of a recovery in the near future, but it will be much slower than it could be with optimal monetary policy (which I define as a monetary policy that the markets expect to produce on target inflation or NGDP growth---say 2% inflation.) The things that the Fed has done (Cutting rates to very low levels, and dramatically increasing the base) were also done in the early 1930s, and no one considers that monetary policy expansionary.