On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months.
Ferguson goes onto argue that this settled a debate between him and Paul Krugman where Ferguson has been arguing that the Federal deficits will have to be monetarized and the reason that nominal rates have increased is that inflationary expectations have jumped. The Federal Reserve is reporting that the long-term real interest rate currently was 1.8% on June 1, which means the 3.7% nominal rate represents expected inflation near 1.9%. Back on December 18, 2008, nominal and real interest rates on 10-year government bonds were about around 1.8% - that is, zero expected inflation.
Daniel Gross agrees with Krugman who writes:
Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices. But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all. Still, don’t such actions have to be inflationary sooner or later? No. The Bank of Japan, faced with economic difficulties not too different from those we face today, purchased debt on a huge scale between 1997 and 2003. What happened to consumer prices? They fell ... Some economists have argued for moderate inflation as a deliberate policy, as a way to encourage lending and reduce private debt burdens. I’m sympathetic to these arguments and made a similar case for Japan in the 1990s. But the case for inflation never made headway with Japanese policy makers then, and there’s no sign it’s getting traction with U.S. policy makers now.
Ferguson is basically arguing that we have seen a modest increase in expected inflation. Maybe so – but as long as we have only modest inflation, that may be a very good thing for the economy. After all – today’s labor market news is that the employment-population ratio fell to 59.7 percent. So why this silly worry that aggregate demand may be too strong?