Paul Krugman writes,
The idea here is that by indicating its willingness to let the economy rip for a while, the Fed can encourage more private-sector spending right away. Potential home buyers will be encouraged by the prospect of moderately higher inflation that will make their debt easier to repay; corporations will be encouraged by the prospect of higher future sales; stocks will rise, increasing wealth, and the dollar will fall, making U.S. exports more competitive.
It sounds so easy. Is there any sense that the third round of QE layered on top of an extend operation twist will really do all of these things?
In addition to extending QE the Fed has used more aggressive language, extended the period for which zero rates are likely and has assured us that once growth starts up it will not be quick to raise rates Krugman calls this letting the economy rip. I was not aware that the Fed was trying to prevent the economy from ‘ripping.’
I don’t see the magic. This is the third round of QE. The other changes being made by the Fed may be significant but they are still relatively minor and conjectural, and distant in their potential impact or so it seems to me. Will strong Fed language be so important? Does another six months of ZIRP really matter? Is the assurance on raising rates so crucial (or even believable)?
What Krugman does in this column Click here is to assume that this plan will create inflation. This is one of the first questions Bernanke dodged at his press conference. But is that how it works?
What is also so very interesting is that before Bernanke both Volcker and Greenspan had taken a completely different view, that the dual mandate could be collapsed into one policy objective. Under Volcker the Fed began to argue that the Fed does what it can to boost long term sustainable growth when it produces price stability. Under Bernanke these two objectives (roughly, growth and inflation) have been separated and now they come into conflict. Not only that but now price stability has become the enemy of growth, as inflation below the Fed’s preferred 2% mark is considered ‘too low.’ Under Greenspan a number of testimonies were given by the Fed Chairman arguing that true zero inflation should be the goal of monetary policy. Volcker was a ‘low inflation guy’ too.
If you did not realize it, we are now in a complexly different land under Bernanke that we were under with Volcker and Greenspan. Suddenly there seem to be a Phillips curve. Suddenly a strong form of Keynesianism is being endorsed that stimulus is safe with a large GDP gap (do we really have one of those?). But since nothing is really specified we really don’t know the model that is etched in the Fed’s brain as it heads down this path…Does Bernanke think that the GDP gap will prevent inflation but does Krugman believe in the Phillips curve and in the ‘saving grace’ of inflation? Are they on the same page? It’s really too confusing to make sense of since the Fed won’t tell us what its real plan is or how it works. So much for transparency…
The first order of business should be to look at what the Fed is doing to discern the impact. So far QE has been marginal despite the Fed’s estimates of its impact. It takes a lot of securities buying to have any economic impact. So far two separate QE programs have not boosted the economy to stronger growth and the Fed’s balance sheet has grown enormously. What makes this one different?
Extending the period for rates to be zero has not does any wonders and some argue it is counter-productive so what should another six months of ‘guarantee’ make any difference?
Here it is not the extension of the language but the pledge to not raise rates quickly when growth picks up that may matter most. Still, the Fed does not see appreciably strong growth until 2014 or 2015. So this pledge is for the future. And any attempt to pin Bernanke down on what this pledge really means met with frustration at the press conference. It is hard for me to see how such a pledge can effectively boost markets. Assume that this vague pledge is believed and the day comes when growth picks up and the Fed does nothing. Does anyone think market rates will stand pat with a near zero Fed funds rate and 3.4% GDP growth? What is the Fed’s pledge really worth? Is the Fed promising to get behind the curve? Will that be healthy? In its forecast it is behind the ‘excessive growth curve’ for two years in arrow at 3.4% and inflation does not even budge. This does not seem like Krugman’s world.
If the idea is to boost home prices and to increase future sales and to reduce the burden of debt how much inflation are we talking about and for how long? The fly in this ointment is that the degree to which inflation has these boosting influences is directly proportional to how much inflation we create and for how long we tolerate it. Is the Chairman hoping for 2.5% inflation? 3% inflation? 4% inflation? What is he aiming at? We really don’t know. And I’ll remind you that he dodged the question on letting inflation go higher and it is NOT represented in the FOMC’s own just offered ‘projections.’ The Fed appeard to live in a GDP-gap world. For now it’s Krugman that is embracing the Phillips curve world.
What gets the ball rolling? Do we really think this QE will boost the mortgage markets by cutting interest rates significantly further? Is possible to do that? An article in the FT today asserts that the mortgage pipeline is so full that there can be no rate impact because the process is already jammed with transactors.
Will this QE finally work by getting investors to buy those riskier assets they have been shunning?
While both Krugman and the Fed Chairman mentioned the positive impact sought on stocks and on housing the mechanism for this is unclear. Possibly it’s just the stronger message from the Fed that will elicit a response in markets? Will that be enough to get people over their fear of a crumbling Europe, of a fiscal cliff and of a stuck economy?
How does any of this boost housing prices without the proper microeconomic foundations (a fiscal fix)? There is a huge stock of foreclosures still waiting to happen and with banks still so careful about making loans and requiring such high credit scores how does housing get this boost? How does the housing market punch through that barrier and how does house price inflation get started? What are the mechanics of Krugman’s inflation assumption? Can the Fed get to this result on $40bln per month of mortgage backed bond buying? Is there enough spark here to light Krugman’s fire?
And isn’t it dangerous to try inciting the stock market on low interest rates instead of exciting investors through improved earnings? Isn’t this backwards and dangerous?
Of course, another objective will be to raise wages but wages are constrained by competition overseas. So to get any wage inflation going the dollar would have to fall significantly. We have seen some dollar weakness but China pegs to the dollar and Europe has so many of its own problems it’s hard to see the dollar getting very strong Vs the euro!
The last problem is that the kind of inflation QE inspired last time around was not the stimulative sort that Mr. Krugman wants. It boosted oil prices and commodity prices and the dollar did weaken a bit, giving rise to protests from abroad that the US was targeting a weaker dollar. Higher oil prices cut into and undermined consumer spending.
And, of course Bernanke has not even admitted that he is actually seeking higher inflation. Maybe he does think he can’t say it. But if he does not have a specific plan in front of the public then when/if inflation percolates it will look like a policy mistake and markets will not react to it very well. Moreover if inflation is in the plan why isn’t it in the Fed’s ‘projections?’
We know firemen sometimes set back-fires to create a burn barrier that they hope the main conflagration cannot cross. But if you did not know the strategy, wouldn’t you think that it sounds crazy for firefighters to set a fire to limit a fire? Similarly a Fed Chairman who is supposed to protect against inflation had better have a very clear plan if he is going to use higher inflation as part of his monetary plan.
I don’t think Bernanke is there yet; by ‘there’ I mean ready for public disclosure, true transparency. I fear that Krugman’s scenario is what the Chairman has in mind. And if so, exactly HOW MUCH inflation for HOW LONG is the Chairman ‘targeting? Is the whole FOMC on board for this or is this part of a secret plan or one that features some denial as its keystone? And is THAT why the future inflation outlook is so nice and stable despite stronger growth?
For these reason I am skeptical of the new plan. I am not a Bernanke hater as Krugman seems to suggest of anyone that disagrees with the Chairman. I just don’t see why we should add stagflation to our list of problems. What we need is fiscal medicine and arguably making people think that the Fed can solve our problems without the right fiscal fix may even be counter-productive.