In a new piece up at Project Syndicate, economist Ken Rogoff argues that the Fed can make the coming deleveraging process easier by creating an inflation burst.
While America is facing the limits of fiscal policy, monetary policy can do more, as Federal Reserve Chairman Ben Bernanke detailed in a recent speech in Jackson Hole, Wyoming. With credit markets impaired, the Fed could buy more government bonds or private-sector debt. Bernanke also noted the possibility of temporarily raising the Fed’s medium-term inflation target (a policy that I suggested in this column in December 2008).
Given the massive deleveraging of public- and private-sector debt that lies ahead, and my continuing cynicism about the US political and legal system’s capacity to facilitate workouts, two or three years of slightly elevated inflation strikes me as the best of many very bad options, and far preferable to deflation. While the Fed is still reluctant to compromise its long-term independence, I suspect that before this is over it will use most, if not all, of the tools outlined by Bernanke.
That’s all well and fine, says Paul Krugman, but there’s another problem: how?
Just saying “monetary policy” doesn’t cut it. Yes, the Fed has tools available even though short-term rates are up against the zero lower bound, and it should be using them to the max. But their effect is highly uncertain; I don’t think anyone can count on the Fed to deliver, on cue, Rogoff’s “two or three years of slightly elevated inflation”. In fact, the whole logic of the liquidity trap suggests that if central banks can gain any leverage at all, it’s only by credibly committing to inflation over a fairly sustained period.
This is basically what Bernanke outlined in his recent Jackson Hole speech. There’s just no obvious way of getting newly-printed dollars into the economy, when banks aren’t lending and Congress isn’t spending (more).
In the end, Krugman is forced to note that WWII is what ultimately created the post-Depression inflation. Let’s hope it doesn’t come to that.