Today (October 27, 2013), the New York Times has an excellent page 1 story by Binyamin Applebaum indicating that more and more economists favor the encouragement of inflation as a way to fight the persistent stagnation that the U.S. economy has been suffering from since the Big Financial Flop of 2008 and the resulting Great Recession. As Paul Krugman notes in his blog, this policy is what he's been advocating for awhile. This pro-inflation company includes even Kenneth
Rogoff, the Chicken Little of government debt.
One argument against this view is that of economists who "warn that the Fed could lose control of price as the economy recovers." The idea is that inflation will accelerate (speed up) in a way that gets us back to the conditions that the U.S. last saw during the 1970s.The problem with this "Back to the 1970s" perspective is a key fact that was left out of the news story.
What's left out is the fact that the official (U3) unemployment rate is currently at 7.2%, which is significantly higher than almost all estimates of the inflation-barrier unemployment rate, also known as the NAIRU. (The initials stand for the Non-Accelerating Inflation Rate of Unemployment. This rate is known to ignorami as the "natural" rate of unemployment.) Worse, the ratio of paid employment to the potentially working population has stayed distressingly low since the Great Recession (even when corrected for the population's changing age profile). It's true that the official unemployment rate has edged downward, but this is largely an illusion: as unemployed people stop looking for jobs (discouraged by the bad job situation), the statisticians count them as having dropped out of the labor force and therefore as no longer unemployed. If all of those workers who left the labor force were counted as "unemployed," the unemployment rate would be much higher. Heidi Shierholz of the Economic Policy Institute has shown this by looking at real-world data.
Anyway, the point is that the NAIRU concept cuts both ways. In happier times, conservative economists could point to this minimum and use it to argue against people who want full employment. They'd say that "we can't go there because there be monsters," where of course the monsters are worsening inflation rates. If the Fed encourages inflation, people will begin to expect inflation and will act to protect the real purchasing power of their incomes (or to buy now, before prices go up). This means that inflation becomes built into the economy's normal behavior. If the unemployment rate stays below the NAIRU, the inflation gets worse and worse.
But nowadays, the U.S. economy has unemployment significantly above this threshold. In the current situation, the inflation rate should be falling and it is doing that, as Appelbaum's graph shows. Except for the usual barriers against cutting wages and prices (some of which were mentioned in the article), it could easily become negative, so that we would see deflation (as actually seen in Japan). People would expect falling prices, which would then lead to behavior that causes prices to fall further. In this case, we would see a vicious cycle that encourages depression.
That is, the "Back to the 1970s" scenario might have applied in 2006, when the job situation was significantly better, but it cannot apply now. Any inflationary surge that the Federal Reserve and the federal government engineer would be canceling out the current deflationary tendency. It wouldn't actually cause rising inflation.
Putting it a different way, those who are always shouting "inflation!" are assuming that the economy is operating at the NAIRU, or what used to be called the "inflation barrier" or full employment.
The 64 thousand ruble question -- also not addressed by Appelbaum -- is how the Fed and the federal government are ever going to cause an inflationary surge. The Fed's stimulus as mostly created a lot of excess reserves in the banks' coffers rather than stimulating the economy and the inflation rate. The federal government has been going in the opposite direction, joining most of the state and local governments to encourage deflation. -- Jim Devine
One argument against this view is that of economists who "warn that the Fed could lose control of price as the economy recovers." The idea is that inflation will accelerate (speed up) in a way that gets us back to the conditions that the U.S. last saw during the 1970s.The problem with this "Back to the 1970s" perspective is a key fact that was left out of the news story.
What's left out is the fact that the official (U3) unemployment rate is currently at 7.2%, which is significantly higher than almost all estimates of the inflation-barrier unemployment rate, also known as the NAIRU. (The initials stand for the Non-Accelerating Inflation Rate of Unemployment. This rate is known to ignorami as the "natural" rate of unemployment.) Worse, the ratio of paid employment to the potentially working population has stayed distressingly low since the Great Recession (even when corrected for the population's changing age profile). It's true that the official unemployment rate has edged downward, but this is largely an illusion: as unemployed people stop looking for jobs (discouraged by the bad job situation), the statisticians count them as having dropped out of the labor force and therefore as no longer unemployed. If all of those workers who left the labor force were counted as "unemployed," the unemployment rate would be much higher. Heidi Shierholz of the Economic Policy Institute has shown this by looking at real-world data.
Anyway, the point is that the NAIRU concept cuts both ways. In happier times, conservative economists could point to this minimum and use it to argue against people who want full employment. They'd say that "we can't go there because there be monsters," where of course the monsters are worsening inflation rates. If the Fed encourages inflation, people will begin to expect inflation and will act to protect the real purchasing power of their incomes (or to buy now, before prices go up). This means that inflation becomes built into the economy's normal behavior. If the unemployment rate stays below the NAIRU, the inflation gets worse and worse.
But nowadays, the U.S. economy has unemployment significantly above this threshold. In the current situation, the inflation rate should be falling and it is doing that, as Appelbaum's graph shows. Except for the usual barriers against cutting wages and prices (some of which were mentioned in the article), it could easily become negative, so that we would see deflation (as actually seen in Japan). People would expect falling prices, which would then lead to behavior that causes prices to fall further. In this case, we would see a vicious cycle that encourages depression.
That is, the "Back to the 1970s" scenario might have applied in 2006, when the job situation was significantly better, but it cannot apply now. Any inflationary surge that the Federal Reserve and the federal government engineer would be canceling out the current deflationary tendency. It wouldn't actually cause rising inflation.
Putting it a different way, those who are always shouting "inflation!" are assuming that the economy is operating at the NAIRU, or what used to be called the "inflation barrier" or full employment.
The 64 thousand ruble question -- also not addressed by Appelbaum -- is how the Fed and the federal government are ever going to cause an inflationary surge. The Fed's stimulus as mostly created a lot of excess reserves in the banks' coffers rather than stimulating the economy and the inflation rate. The federal government has been going in the opposite direction, joining most of the state and local governments to encourage deflation. -- Jim Devine
Hasn't QE contributed to the tanking of the USD? Isn't inflation linked to the devaluation of the currency? Isn't that what happened when Nixon closed the gold window and the price of petrol went through the roof?
ReplyDeleteMike, you're right to bring up exchange rates. Looking at the inflation-corrected "trade-weighted US dollar exchange rate" (with major trading partners), the US$ has gone down since 2003 or so. This started long before quantitative easing (QE). From the point of view of the US, that's a good thing, since it makes the US trade deficit smaller (and it's been quite large). The problem is that US major trading partners see their trade surpluses shrinking or trade deficits rising as a result. That hurts demand for their products and the availability of jobs in their countries.
ReplyDeleteIt's true that US inflation encourages depreciation of the US$, but depreciation has happened despite the fact that US inflation has been slowing. That's because how the US$ depreciates or appreciates doesn't just depend on US inflation: other countries' inflation is relevant, as are relative interest rates. If central banks around the world want to avoid the US$ depreciation that would result if the US Fed and federal government were to push for higher inflation, they need to encourage inflation in their countries, too. This would also help stimulate the world economy, so that the US and its major trading partners aren't fighting over the distribution of a pie with a fixed size. Unfortunately, this isn't likely at all, since the established politicians and bankers like austerity and hate inflation.
Nixon's devaluation was a sudden shock (going from a fixed exchange-rate system to a floating exchange-rate one) and had much bigger effects than the gradual process we're seeing now.
I just want to make sure that I see any other comments, so I'm checking "email follow-up comments to." For some reason, I couldn't to that with the original note.
ReplyDeleteI just wonder why fed pay interests on the excess reserve, especially when this rate is higher than those of trading between banks.
ReplyDeleteThe Fed pays banks on excess reserves because it is trying to keep the banks from being so nervous and scared. (It's related to the reason why the Fed has purchased a lot of "toxic" assets from banks.)The Fed itself says that it does this "to eliminate effectively the implicit tax that reserve requirements used to impose on depository institutions" but that doesn't address the question of why banks are holding so many excess reserves.
ReplyDeletePaying interest on reserves discourages very-short-term loans by banks to other banks, especially when the rate is higher that the fed funds (interbank) rate. That's true right now (0.25% vs. 0.1%) However, paying interest on reserves is not a major factor holding back bank lending to non-bank institutions, since they pay higher interest rates than those on "overnight" loans between banks.
The fed bought almost 30 persent of the bonds, certainly banks will hold excess reserves. The question here is when these money leak out of US into euro zone or other countries, so leading the devaluation of dollar, which might be good for US economy.
ReplyDeleteCash writes: > The question here is when these money leak out of US into euro zone or other countries, so leading the devaluation of dollar, which might be good for US economy.<
ReplyDeleteyes, as I said, that will likely happen, unless other central banks (especially the European Central Bank) also pump up the money supply.
ReplyDeleteBust always follows boom; in the new normal of authoritarianism, the sovereignty of regional economic fascism provides the seigniorage of diktat money. Now after five years of money market capitalism, with the Fed having lost control of the Benchmark Interest Rate, ^TNS, the tail risk of Global ZIRP, is economic deflation and economic recession; she is going to be a bad bitch. Regionalism is the singular dynamo of economic activity under authoritarianism, and is it attempts to deal with the derisking of liberalism’s debt trades and deleveraging out of currency carry trades.