By suddenly sounding the alarm about our ballooning deficits in his Congressional testimony yesterday, the Fed chief tried to seem to vigilant and responsible.
Bernanke wants to reassure everybody that the economy will not get out of control on his watch. But paradoxically, this may actually hold back the recovery. The best way for Bernanke to boost consumer and business activity NOW would be to persuade people that he will destroy the value of the dollar through inflation. I’ll explain.
Let’s start with the conventional wisdom. Writing in the FT earlier this week, Martin Wolf argued:
People need to believe that the extraordinarily aggressive monetary and fiscal policies of today will be reversed. If they do not believe this, there could well be a big upsurge in inflationary expectations long before the world economy has recovered. If that were to happen, policymakers would be caught in a painful squeeze and the world might indeed end up in 1970s-style stagflation.
At first blush, this seems unobjectionable—clearly we don’t want 1970s-style stagflation. But if we are still facing a material risk of a protracted deflationary slump, then Wolf’s argument runs counter to the views of many economists—notably Paul Krugman, Lars Svensson (deputy governor of Sweden’s central bank), and Gauti Eggertsson (of the New York Fed)—who have studied how monetary and fiscal policy can most effectively combat deflation.
What makes Japanese-type deflation so worrying is that real interest rates remain too high even when nominal rates have reached zero. Conventional monetary policy runs out of ammunition. Expecting deflation, consumers rationally save more, and their increased savings are not translated into investment.
But what if, ask Krugman, Svensson, and Eggertsson, consumers and businesses expected significant inflation, say 5% a year forever? Consumers would immediately spend more, reasoning that money in the bank earning next-to-nothing interest would rapidly depreciate. And businesses would invest more, since borrowing would suddenly look cheap in real terms. Voilá, no more deflation.
However, this only works if consumers and businesses expect sustained inflation. An expectation of brief inflation won’t have much effect on behaviour. The implication is that the Fed has to persuade people that it won’t fight inflation once the economy recovers, the opposite of what Martin Wolf wants people to believe. As Krugman has put it, a central bank needs to “credibly promise to be irresponsible.”
If Bernanke is using quantitative easing to boost inflation expectations, then I think we need to seriously address the likely ineffectiveness of any such policy when Fed officials repeatedly promise to shrink the balance sheet in the future. In other words, they are explicitly committing to a temporary increase in the money supply. There is no reason to believe this will meaningfully impact inflation expectations.
Of course, we don’t really want Bernanke to be irresponsible. We just want him to convince us that he will be.