Sunday, October 17, 2010

Ben’s new rabbit: Inflation expectations

Once again, we find ourselves holding our breath for a new fluffy rabbit coming out of Ben’s hat on November 2nd (the day of the next FOMC meeting). In previous pieces I have discussed the limitations of unconventional measures (QE in particular) in stimulating aggregate demand. Here, I want to revisit this discussion in light of Bernanke’s new magic trick: that of managing inflation expectations.

The starting point is the two principal factors restraining aggregate demand currently: First, the ongoing balance-sheet repair by a certain segment of households, corporates and banks; and second, the fact that economic agents that are cash-rich maintain a strong preference for liquidity. Put differently, those with little cash and lots of debt can’t spend; and those with lots of cash and little debt won’t spend.

So the question is: What tools does the Fed have available for addressing these two problems? Pre-empting my conclusion, Large-Scale Asset Purchases (or LSAPs) of US Treasuries are an ineffective—indeed, a counterproductive—tool for addressing any of the two problems above; the kind of LSAPs that would work are *not* available to the Fed in the current political climate. But there is certainly hope in the Fed’s intention to manage inflation expectations. The issue there is where exactly inflation expectations should be guided towards, and how best to achieve that.

Starting with balance-sheet repair... I have argued before that the Fed’s LSAPs of mortgage-backed securities (MBS) and US Treasuries (ie "QE 1.0") have not been an effective tool for tackling the problem. This is because, by design, they fail to target those segments of the economy undergoing balance sheet repair.

As an example, the drop in mortgage rates that followed the Fed’s MBS purchases helped prompt an increase in mortgage refinance activity. But the cash boon from lower mortgage payments only benefited people who could afford to refinance—ie those with jobs, income and positive equity in their home, instead of the cash-strapped households facing foreclosure. Meanwhile, foreclosures kept on rising as recently as September 2010.

Ditto for corporates: Large firms with access to capital markets benefited from higher investor demand for “safer” fixed-income assets such as high-grade corporate bonds (arguably triggered by the LSAPs). But small firms with no capital market access continue to face tight lending standards.

Against this backdrop, for any new LSAPs to work, the Fed would have to be far more adventurous in terms of the assets it purchases (for more on this see here and the comments on that piece). Unfortunately, in the current US political climate such an “adventurous” LSAP program is not an available policy tool—esp. since it would require the cooperation of the Treasury. So what’s left?

Come out the new rabbit—the guidance of inflation expectations. There are two issues here: First, how does the management of inflation expectations help stimulate aggregate demand? Second, what should “managing inflation expectations” mean at this juncture and how can the Fed best achieve it?

Starting from the first question, there are two ways in which the guidance of inflation expectations can help aggregate demand at this juncture. First, by preventing real interest rates from increasing to undesirable levels: with nominal interest rates at record lows, sustained declines in inflation expectations would translate into rising real interest rates—a rise that the Fed would be unable to “fight” by cutting the nominal interest rate further. Hence the need to work on the inflation-expectations front.

But the *appropriate* management of inflation expectations can go further in my view. It can help address the second problem I mentioned in the beginning—agents’ preference for liquidity.

Currently, with inflation (and inflation expectations) at low levels, holding cash is “cheap” because of the low opportunity cost. But an increase in inflation expectations would make holding cash expensive, provided it is accompanied by a Fed commitment to keep nominal short-term rates low even if inflation eventually exceeds the Fed’s medium-term “target”. Note that in the absence of such a commitment, agents would expect the Fed to raise short-term rates as inflation moves higher. This which would in turn preserve their real return on cash, eliminating the incentive to switch into less liquid investment instruments, consumption and/or hiring (in the case of corporates).

Put simply, in order to facilitate a switch away from cash, the Fed has to commit to allowing inflation to go above its medium-term projection. Now, before you accuse me of pushing the Fed into some treacherous territory, check out what Ben said on Friday:

Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate.

Repeat: “mandate-consistent.”

Later in that the same speech, Bernanke added that

“The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below.”

Now that’s for the “longer-run”—i.e. beyond 2012. In my view (and that’s just *my* view), the “mandate-consistent” inflation in the nearer-term is above that level, precisely for the reason I mentioned above: Economic agents with lots of cash at hand need an incentive to part with their cash.

So much about the economic rationale. How about implementation? In my view, hints of such an approach were given by Bernanke on Friday:

A step the Committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low for longer than markets expect [my emphasis]. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.

The problem with Ben’s specification however is that “longer than markets expect” does not condition the period of low rates on the inflationary path. As such, it falls short of achieving the liquidity-preference objective I mentioned above.

But there is also a second problem (read “systemic risk”) with the Fed’s overall policy framework—one that brings me back to reiterating (for the nth time) my aversion to the LSAPs. This is the inconsistency between the Fed’s attempts to “force down” long-term yields to levels that are misaligned from the Fed’s own medium-term targets for inflation and growth!

Basically, it’s one thing to intervene in order to correct a misalignment of asset prices from fundamentals (like the Fed did with its liquidity interventions in 2008). It’s another thing to intervene in order to engineer a misalignment of asset prices away from fundamentals—the very fundamentals you (Fed) are trying hard to achieve! This latter is not only non-credible; it is also dangerous, as it creates bond-market bubbles that can unwind with potentially disruptive effects for the financial system (it’s no accident that the hot topic at the IMF meetings last weekend was when will the bond bubble burst).

So with all that in mind, my call to Ben would be “a little more inflation and a little less LSAPs please”. LSAPs of Treasuries or MBS have little power to stimulate aggregate demand but carry too many risks for the financial system. Instead, the FOMC should find the language to convince the world that a little more inflation in the near-term is the way to go.

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