Inflated Wishful Thinking – Why Reflation Isn’t Going to Happen Any Time Soon
There has been a lot of chatter coming out of this past weekend’s meet of the American Economics Association in Chicago. Among the interesting reports is this one from Ryan Avent’s blog at The Economist.
In his post, Avent discusses a talk given by Stanford economist Robert Hall. Ryan summarizes Hall’s argument as follows:
“A little more inflation would have a hugely beneficial impact on labor markets, and a reasonable central bank would therefore generate more inflation, and the Federal Reserve as currently constituted is, in his estimation, very reasonable; therefore the Federal Reserve must not be able to influence the inflation rate.”
The reason for the lack of influence is variously attributable by some to either or both of (a) with interest rates at the zero lower bound and most (Keynesian) models indicating that we are in a liquidity trap, the Fed is unable to lower rates below zero and consequently is unable to increase expectations of inflation, and/or (b) the Fed is politically constrained in terms of additional quantitative easing (what Republicans call “printing money”).
Personally, I believe that Ben Bernanke, the Fed Board and the FOMC are still quite independent and hell-bent on doing anything within their means to fix the U.S. economy. In other words, I don’t buy the political stuff. In my opinion, it is beyond question that we are, and have been, experiencing a liquidity trap - and that pumping more liquidity into the system should have little or negative impact on its recovery. But it is equally true that when the Fed has resorted to quantitative measures, it has – in fact – increased inflation expectations.
The problem isn’t in generating expectations. The problem is in having those increased expectations generate actual, sustainable inflation that would have the effect of reversing the debt-deflationary pressures on the economy.
The problem is not in the liquidity trap alone, but rather comes from the exogenous (global), persistent excesses in the global supply of labor, capacity and capital – relative to the demand for all three.
This impacts the Fed’s ability to engineer a “corrective” higher inflation strategy that, even I would concede, would be entirely workable within a system closed to such exogenous forces. The problem isn’t with the theory of of the usefulness of induced negative real interest rates, it rests with nature of the universe within which that theory is being applied.
Here’s what is happening: efforts to ease and induce are not being transmitted into either actual, or ultimately expectations, of inflation because the excesses of supply effectively prevents inflated prices to transmit to wage inflation. Similarly, in an excess capacity environment, there is no need for additional investment – which would naturally be beneficial and inflationary as well.
With excess capital, money ultimately refuses to become more dear – which would be the desired result of heightened inflation expectations. Thus, until imbalances are otherwise resolved, excess liquidity merely flows to money substitutes (easily tradable oil, gold, equities) which has either a negative or neutral impact on consumption. The rising value of very liquid equities admittedly has some wealth effect – but it is lost when the increased price of commodities (gas for example) curtails consumer spending expansion in the absence of wage inflation. The cure then becomes worse than the disease.
Wage inflation, all other things being equal, does tend to lag price inflation even in the absence of the foregoing imbalances. But the Fed has been trying to reflate the economy for three years now – to no avail. Inflation has once again (since last summer) fallen steadily – to the point at which another bout of the deflation we saw during the peak of the financial crisis cannot be entirely unexpected.
I believe that the Fed is well aware of the dangers set forth above. They are not being timid. Bernanke is not swayed by nonsense coming from three guys whose initials are various combinations of R and P.* The Fed recognizes that they will be easing again – but the next time it will be to limit the degree of deflation, not to attempt to ignite a bonfire of reflation.
*aka Ron Paul, Rick Perry, Paul Ryan
One Response to “Inflated Wishful Thinking – Why Reflation Isn’t Going to Happen Any Time Soon”
I have been reading Mr. Albert's "The Way Forward" (co-authored with Hockett and Roubini at The New America Foundation). And I'm re-reading the Levy Economic Institute's Strategic Analysis. I am surprised at the business and economic community's refusal to acknowledge the efficacy of fiscal stimulus. The Strategic Analysis says "The Fed's recent pleas for additional stimulus legislation represent a real departure from that institution's usual fiscally cautious approach.. During the past 30 years has the Fed done nothing more frequently in Congressional hearings than urge legislators to cut fiscal deficits." (the author forgot the question mark). The discussion on reflation is secondary to demand, and this should not be forgotten. Non-financial corporations already have $2 trillion to resume hiring and investment.