Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Friday, April 29, 2011

Krugman and Carney on the Fed

Here are a couple of interesting interpretations of what's going on in the mind's of Fed officials. The first is by Paul Krugman (via Mark Thoma); see: The Intimidated Fed. The second is by John Carney; see: Why Won't the Fed Do More to Fight Unemployment?

I'm not sure about Krugman's claim about Bernanke being "bullied" by the "inflationistas." I think that John Carney has it just about right here.

27 comments:

  1. I'm pretty sure Krugman would argue that creating inflation expectations would be a good thing. He sees it as reducing the expected real interest rate, potentially below zero if the nominal interest rate is low enough. So people will spend their money instead of watching its real value decline as it sits in their bank accounts.

    I've never been completely convinced by that, and there may be something in Carney's argument about the effect of inflation expectation on wage demands.

    Real people are way less rational than the "agents" of economics models. They don't like inflation, even if their wages rise at the same rate as prices. I just don't know what the overall effect of increased inflation expectations would be.

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  2. we have negative real yields on 5y TIPS and fairly low real yields on 10y TIPS, so one could argue the Fed has done a good job in reducing real rates via inflation expectations...right?

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  3. Paul, I'm sure you are correct about Krugman. According to Krugman (and many others), the problem right now is that the nominal interest rate is at zero (never mind that this is not even approximately true for longer dated treasuries). The idea is to create an expected inflation so as to drive down real interest rates, thereby stimulating consumer and investment demand.

    There are many theoretical models that support this proposition. Indeed, the Tobin effect argues that inflation will cause asset substitution (away from cash into capital) and therefore stimulate output (not necessarily in a welfare improving manner, however).

    For me, the issue is mainly a quantitative one. Not sure that the mechanism is very strong at low rates of inflation. And one has to be careful not to play around with inflation expectations. It's probably best, as a long run strategy, to keep inflation expectations as firmly anchored as possible.

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  4. Anonymous...could you point us to the data you are drawing on? Thanks.

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  5. Mr. Carney gives Brazil's 75% inflation as a single example of what might happen in the US, but is there any evidence that future inflation expectations in the US are getting anywhere near this extreme?

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  6. Anonymous,

    Think of it this way. Inflation depends, in part, on expectations of future inflation. And expectations, in turn, can depend on all sorts of things, including the expected future conduct of monetary policy. Expectations can change very rapidly, even capriciously, if purely psychological factors are involved. Hence the stress by central bankers to keep inflation expectations "anchored." An unloosened anchor may whip around uncontrollably. That's the basic idea.

    So, it is not essential to this argument that inflation is as high as Brazil's. The evidence most people have in mind is what happened to the U.S. in the 1970s.

    You might find the following paper of some interest (The Expectations Trap Hypothesis, by Christiano and Gust):

    http://faculty.wcas.northwestern.edu/~lchrist/research/ep00/epfinal.pdf

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  7. Thanks David, will save and peruse.

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  8. from anon @ 1027:

    From the St Louis Fed - I believe you might know them. ;)

    Link: http://research.stlouisfed.org/fred2/graph/?id=DFII10,DFII5,

    You can see the real yield on 5y TIPS is (still) negative (I have -50.6bp as of Friday's close for the real yield of the on-the-run 5y, which is not the same thing as the constant maturity 5y that FRED2 lists).

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  9. So Carney is basically arguing that people have a model of the economy that is biased with respect to the impact of additional Fed action. That is, additional Fed action would affect expected inflation more than it affects actual inflation. (If this weren't the case, then it would unambiguously tend to reduce unemployment.) It seems a little strange to be basing Fed policy on such a blatant violation of rational expectations. And it's not like there's a well-defined theory of (non-rational) expectations formation here. One could imagine that expectations are adaptive, for example, but what is being posited here is more like the opposite of adaptive expectations: there is no observed change in the inflation rate, and an unbiased forecast would not call for a change, and yet expectations change. Maybe that's what Bernanke's worried about, but it seems like a pretty flimsy theory on the face of it.

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  10. Andy:

    The takeaway from my post is that I agree with Carney (and disagree with Krugman) as to why the Fed is not likely to pursue another round of QE. Krugman argues that the Fed is intimidated by the inflation hawks; Carney argues that the Fed just doesn't believe it will have any positive effects.

    Now, I did not say that Carney had it all right; I said he had it just about right. You are, in my view, absolutely correct to criticize the specific argument he makes as to why the Fed believes additional QE will not have positive effects.

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  11. Andy is right. Carney's analysis is weak. And David, in the comments you seem to back Carney's fears about inflation expectations. Is there a single historical example of inflation expectations being higher than the actual experience of inflation? I get that Brazil, expected an inflation rate of +70% after a period of experiencing that, but has had a country ever had inflation expectations of 10% after only experiencing rates of half that?

    And, given the current labor market, were to be concerned about employees demanding higher wages because they are afraid of future inflation? That's laughable.

    This is a bogus argument against QEIII. It cannot explain the Feds inaction.

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  12. "Is there a single historical example of inflation expectations being higher than the actual experience of inflation?"

    Yes: the US.

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  13. http://www.frbsf.org/publications/economics/letter/2011/el2011-16.html

    See Fig1 re "Is there a single historical example of inflation expectations being higher than the actual experience of inflation?"

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  14. Inflation is what happens when the Fed turns on the "printing press" and dilutes the value of dollars that already exist. It takes money out of your pocket and gives it, typically, to bankers. The bankers then create more dollars out of thin air using that "high-powered" new Fed money, pocketing the profit on what is, at its core, counterfeiting and fraud.

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  15. I heard a bizarre story on NPR last week. It was talking about the "tragedy" deflation in Japan. It made the particular point that people are paying less for food now.

    The Japanese deflation item was followed by a story about how food prices were going up in the US due to inflation, which was somehow a good thing.

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  16. Anonymous @ May 23, 2011 9:51 AM --

    That's only because the US is able to export its inflation so that devalued dollars are held by foreigners, making it look less like there is an oversupply of dollars. The CPI also doesn't include food or energy, arguably the tow most important items to most households. Hiding inflation in those markets from the official measure of inflation allows the official numbers to be lower than reality. Officials can put on their rose-colored glasses and announce on the news that "inflation is only at 1%, historically very low" while at the same time printing several trillion more dollars.

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  17. Anon @8.31 Sounds like you are machine reciting from a bible. Think, man. Think for yourself.

    Anon @8.35 Can't speak on behalf of NPR. I personally do not see anything wrong with an anticipated moderate deflation. But am also not going to go nuts over 2-3% inflation.

    Anon @ 9.51 If the US is able to export its "inflation" then how can you say there is an "oversupply" of dollars? Clearly, there is a world demand for dollars. And the CPI does include food and energy. You should check your facts before spouting your views.

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  18. What would it be called if I created more Federal Reserve Notes in my garage?

    What would it be called if I decided I was a bank, I had $10, and I used that to credit someone's account $50?

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  19. What would it be called if I created more Federal Reserve Notes in my garage?

    It would depend on what you planned to do with them. Hang them on your wall? Or use them to purchase goods and services (something the Fed is not allowed to do, btw)? In this latter case, I would call your action counterfeiting. You do not have the legal right to print Fed notes. Don't you know that? If you don't like it, then have Congress change the FR Act. You may, of course, print your own "money" in the form of private equity and debt.

    What would it be called if I decided I was a bank, I had $10, and I used that to credit someone's account $50?

    Again, it would depend what that person put up as collateral. If he/she put up a house worth $50, I would call it "liquidity creation."

    I understand what you are trying to say. But I don't think you understand how little you know.

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  20. What does the Fed put up as collateral?

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  21. You are mixed up. It is the Treasury that puts up the collateral (bonds), which the Fed transforms into money. Or, more recently, the Fed has "monetized" (accepted as collateral) a large amount of high-grade MBS (that is generating close to 5% risk-free yield).

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  22. Ah. "Monetizing the debt", right?

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  23. I said cpi, but I meant "core inflation" -- "the inflation rate that strips out the food and energy components of the consumption basket", to quote some handsome devil.

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  24. "It is the Treasury that puts up the collateral (bonds), "

    and these "bonds" are promises to gang rape taxpayers in taxpayer funded prisons if we don't give enough money.

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  25. So if the Fed now thinks QE3 won't help...have they learned something new from when they started TRAP, QE2 and QE1? becuase I thought it was the Fed's position that the prior interventions have been awesome... saving us from a living hell that the earth would become if AIG couldn't pay off all the Credit Default Swaps to Goldman Sachs and JP Morgan. Now that those guys are saved I guess there is no reason to intervene any more?

    Bailouts for the oligarchy, austerity for everyone else is the policy. You guys are just the specialized PR guys who are supposed to defend the policy.

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  26. It is pretty clear that David and Carney are saying Bernanke needs to crash the market to change inflation expectations. Then when people are begging, he can inflate the crap out of the market. So I advise everyone to go short until more people are begging for QE3 and then you should expect QE3 to be disguised with some new euphemism so when Quantitative Euphimism 3 is more on the radar then go triple long commodities.

    The economy is in a bad shitstom now, you can only hope to profit from the semi-predictable movements as we circle the toilet bowl.

    Who brought us here? the same folks who said that it was impossible to create a bubble as they blew them up serially, the same people who said real estate prices in this country could never fall in any real way, the same people who said we needed to strat wars in 6 countries simultaneuosly and that war was good for the economy. The same people are now advocating tax increases and bigger government. The same folks who think the 40 year drug war has been a good move. The same people who see no problem with having 2 million americans locked up in prison(more than the USSR or Red China. The same people who wrote textbooks telling us that we would be out of oil in 2000 and that the USSR would have a bigger economy than America. The same olks who think a carbon tax will be good for the economy now.

    When this ruling oligarchy is eliminated then we can have real economic growth again.

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  27. sadly these threads are getting noisier and therefore less useful.

    if you want to post, please do your homework first. e.g. to the poster who claimed food and energy are "arguably the tow [sic] most important items to most households", look at the CPI weightings and you'll realize "shelter" has a much higher weight than either food or energy (probably roughly what food AND energy are together).

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