The simplest solution is to commit to buy T-bonds (and, if needed, Treasury-backed MBSs) until TIPS spreads show 4% expected inflation. At that high an inflation rate you don’t need much QE, because the public and banks don’t want to hold much base money.
My reply:
1. Central banks have tried many times to commit to pegging exchange rates, which in principle seems easier to do than pegging an inflation rate. These attempts have often failed, as the central bank finds itself overwhelmed by private speculators. This suggests to me that one should be skeptical of the effectiveness of open-mouth operations.
2. Suppose that the Fed backed up its commitment to 4 percent inflation with a lot of action. My belief is that it would take a great deal of action–an order of magnitude more than what we have seen.
3. By the time inflation reached its 4 percent target, there would be a great deal of “inflation consciousness” among investors and in the general public. We would get into a regime of high and variable inflation. You do not know whether inflation would tend toward 4 percent, 8 percent, or 12 percent.
4. In this regime of high and variable inflation, prices would lose some of their informational value, as people find it harder to sort out relative price changes from general inflation. This would be detrimental to economic activity. Scott and I both remember the 1970s, and from a macroeconomic perspective, they were not pretty.
5. So fairly soon, you would see a reversal of policy, with Scott complaining about the stupidity of the Fed overshooting its inflation target. The Fed would take dramatic action to undo what it did before.
6. After several painful years, we would be back to the regime of low and stable inflation.
This is right on every single bullet point.
Afaict, which isn’t far, you are the only person describing the problem, aside frome the tinker toy model crowd. Shouldn’t you write this up for a journal?
The market would be skeptical and it would take dramatic action to convince them but this same degree of action would persuade them of their power to reverse direction though with some uncertainty over how swift and forceful they would act not highly variable. The 70s were still better than the 80s though this was only realized in retrospect and they were much more variable. The risk would be seesawing with delays that potentially exacerbate swings but the moderation shows slowing inflation is not particularly difficult.
And let us ask: “Why is that level of inflation good? Why is getting more investment than we seem to have now good?”
The following may be colored by my ignorance.
It *seems* to me that the line of thinking is “if inflation is higher, the real cost of holding cash and equivalents will go up, so the relative cost of active investments will go down. People will therefore move cash to investment” with the implication that this investment will make us all richer in the future than we otherwise would be.
BUT
Does not all of that presume that there exists a very large pool of projects, visible to the relevant actors, with real rates of return such that they don’t make sense when cash is losing real value at 1.5% per year but do make sense when cash is losing value at 3.5% per year. A pool of projects big enough to matter in US macroeconomics, all good or bad on a 2% swing?
And isn’t the implication that these are projects that would lose more than 1.5% now? So they are to be encouraged by making them lose relatively less compared to cash, but one wonders if they would still be losers?
If the pool of projects to be activated by this strategy are all 2% losers (and hence worse than cash) but you make cash a 4% loser, how many people will pick the lower loss rate at the expense of liquidity?
WHAT IF
The reality is that the relevent actors (investors with money to commit) cannot see a large enough pool of investments with positive returns at all? What if any increase in investment will be malinvestment? It is easy to point to particular things where more investment could be socially or economically justified. But does the sum total of these things add up to a pool of projects large enough to matter in macro economic terms?
Bryan Willman:
Evidently, the “color” of your “ignorance” mirrors my own.
I would add the following WHAT IF to the list you’ve already correctly identified …
WHAT IF
All or most of the “new money” introduced by the “Increase Inflation Now” schemers doesn’t actually get deployed within the U.S. economy, but instead flows outside to further investment in proven growing economies, e.g., China?
The greatest fallacy underlying ALL of the Sumner/MM claims and “economic linkages” is that the U.S. is somehow a closed economy – particularly with regards its money/capital flows!
And I’m NOT in favor of “closing the borders” to capital flows just so Sumner and his ilk can get to be “right” in their musings.
I will note that the same issues apply to government. Government entities are under spectacular pressure to spend on all manner of “public goods” (and sometimes “public bads”) – and at least in my observation pursue as much revenue as possible to do this.
Does this not imply that any projects left undone have simply not persuaded a political majority, or public majority, that they are worthwhile? What economic or political theory gives us confidence that society as a whole is wrong about that on the whole?
Yes, there may be some pothole in my street that really ought to be filled. But does that really mean government is underspending at macro economically meaningful levels?
Has any hard-ish money country had stable inflation rates 5% or higher, for any good length of time? I can’t recall ever seeing it.
Theoretically any stable, predictable rate is supposed to be as good as any other, but something of psychological origin seems to indicate that only low rates are tolerated without flipping to a very different social equilibrium in attitudes about the stability of the value of money.
Frogs notice if you raise the temperature of the water too rapidly.
Total quantitative easing thus far was about $3.5 trillion. If it took $35 trillion in QE to make this point we’d have monetized the entire government debt with $18 trillion to spare. If we could do that, plus have all this money left over to say shore up federal entitlements, variable and higher inflation would seem a low cost to bear.
The US debt won’t be forgiven in this way unless the Fed holds onto the bonds until they expire without taking payment for them. If they try to do that how are they fighting the higher inflation that Arnold predicts?
Excellent post. For it is not enough to trust the Federal Reserve can change expectations. One must also trust the Federal Reserve can CONTROL this change in expectations. For while traders in financial markets respond quickly to changes in monetary policy – and adjust their pricing accordingly – consumers do not. The inflation of the 1970s became embedded in the culture and the expectation of inflation persisted for a generation and distorted the interpretation of economic data.
I think #6 is a dubious conclusion. We shouldn’t expect that the market will react the same way to fed policy if 1-5 came to pass.
What do you mean? I read it as we’d end up back where we started precisely because we aren’t choosing to be here in the first place.