The Economist recently wrote:
“If a central bank is deploying QE over a long period of time, that means it has not paired QE with a commitment to higher future inflation.”
In other words, if a central bank wants inflation, it can’t go at it half-way. The central bank must demonstrate a real commitment to causing inflation. Mere “tweaking” of the economy will not suffice.
When the Federal Reserve aims at 2% inflation, everyone yawns. 2% is barely noticeable by the majority of people. If there’s only going to be 2% inflation, the public won’t “expect” any inflation at all. Inflation is built more on public expectations than mathematical “tweaking” of the economy by the Federal Reserve. Without the public “expectation” of inflation—of serious inflation; say, 10%, maybe more—there may not be much inflation.
In seeking to cause just 2% inflation (and complaining that the official rate of inflation—1.6%—is just a teensy bit too low) the Fed fails to inspire public expectation of inflation. After all, if the Fed only wants to actually increase inflation from 1.6% to 2.0%—less than one-half of a percent—who will notice? Who will care if the price of groceries rises by 0.4% over the next year? Who will complain? Who will expect inflation? Who will fear inflation?
It’s like telling your wife that you’re going to change the temperature on your home’s thermostat from 68⁰ to 67.5⁰. Your wife may not say so, but she’s probably wondering why you waste her time with such insignificant announcements.
The Economist article implies that, if the Fed wants to cause real inflation, it can’t rely on mathematics and economic formulae. Inflation is, to a large degree, psychological. The Fed can’t cause real inflation without scaring the public into “expecting” more and more inflation.
But once the public succumbs to fear (and possible panic), the Fed loses control of inflation and of the economy. If the Fed can cause the people to fear and expect 10% inflation, that emotional expectation could drive inflation up to 20% or even more. That public “expectation” might grow beyond the Fed’s capacity to control.
On the other hand, if the Fed truly aims to increase inflation by only 0.4%, no one will care and there’ll be no “emotional” support for more inflation.
Thus, the Fed is caught between the rock and the hard place.
On the one hand, if the Fed tries to cause just a little bit of inflation with mathematics and tweaking, the public won’t notice, care or become fearful. Without the emotional energy provided by some underlying public fear, the Fed probably can’t conjure up enough inflation to stimulate the economy.
On the other hand, if the Fed dares to inspire enough public fear to precipitate noticeable inflation, the Fed risks losing control of the economy as the over-emotional public stampedes one way or another.
The Economist article is suggesting that, so far, the Federal Reserve and other central banks have failed to stimulate their national economies because their Quantitative Easing (QE) strategies have been too tepid to inspire much public emotion. Without that public emotion, it’s at least difficult and perhaps impossible to cause enough inflation to stimulate the economy.
• More, the Economist implies that QE is not about causing inflation, per se, but rather about preventing deflation. In fact, the fundamental threat after (perhaps even before) the post-2008 crash, has been deflation. The Federal Reserve has used QE’s 1, 2 & 3 to offset and prevent deflation by trying to cause inflation.
Inflation was not the objective. Inflation was the means to achieve the real objective: preventing deflation.
But, so far, the Fed has only stabilized the economy and prevented it from falling headlong into an era of deflation. That stabilization is a kind of success, but it’s not evidence of the result the Fed wanted and needed to “stimulate” the economy: significant inflation.
Thus, the Economist implies that the facts of three separate doses of Quantitative Easing (QEs 1, 2 & 3) are evidence of that the Federal Reserve has failed to demonstrate a sufficient “commitment to higher future inflation”. The Fed wanted inflation, but they didn’t want it bad enough. Each subsequent episode of QE is not only evidence that the previous episodes failed, but also evidence that the Fed lacks the will and/or power to cause enough inflation to truly “stimulate” the economy.
If the public no longer believes that the Fed can cause significant inflation, can the Fed cause inflation? Have the Fed’s repeated but largely unsuccessful attempts to cause significant inflation caused it to assume the role of the “little boy who cried ‘wolf’?”
If the public no longer believes Fed can cause inflation, does that loss of “inflation expectation” increase the prospect of deflation?
• “Prolonged QE is effectively a signal that the central bank is unwilling to commit to higher inflation.”
The Economist implies that the Fed should’ve done more, immediately after the A.D. 2008 crash, to stop deflation by causing significant inflation. The Economist implies that the Fed “under-reacted” to the A.D. 2008 crash. If the Fed had done more—if it had combined the forces of QE 1 and 2 (and maybe even 3) into a single economic thunderbolt in A.D. 2008, it might’ve caused sufficient inflation to prevent deflation and “snap” us out of the recession/depression. But, by doing so, the Fed might also have a caused a panic sufficient to collapse the economy.
But we can’t fault the Fed for under-reacting in A.D. 2008. I remember the idea that the government would provide $800 billion to the “too big to fail banks” was initially viewed as unprecedented, incredible, radical and shocking. In retrospect, we might view $800 billion as insignificant. At the time, however, $800 billion was monumental–but we probably needed $1 trillion. Maybe $2 trillion.
Even so, I doubt that the Federal Reserve and/or federal government could possibly have done more. No one “expected” that the economic recession would be so intransigent.
More, most people agree that even if the Fed and government failed to truly “stimulate” the economy in A.D. 2008, they did succeed in preventing an all-out economic crash.
• Unfortunately, QE is like welfare. You can receive welfare (or unemployment compensation) if you’re having a hard time, and no one minds or jumps to any conclusions. But, once you receive welfare (or QE) over a “prolonged” period, you may become “institutionalized” and come to believe that you can’t live without your QE subsidy.
Welfare recipients can become so addicted to welfare that they come to claim they’re “entitled” to receive it. Economies can become similarly addicted to QE and also argue that they’re “entitled” to QE. (“If you don’t give major banks and markets more QE, they’ll riot and burn Wall Street to the ground!”) Once addicted, corporations and markets don’t think they can survive without QE.
The world comes to believes they’re right.
Look at Janet Yellen. She recently said the Fed would exhibit “patience” before it cut the subsidy provided by low interest rates. The markets (addicted to Fed support) cheered and the Dow rose to record heights. So long as the markets can “expect” the Fed to provide the low-interest-rate subsidy, they’re happy and prone to set new records.
But the Fed had to be extremely cautious about cutting the QE3 of printing more money for the banks et al. The Fed wouldn’t dare cause the addicted markets to quit their addiction “cold turkey”. They had to “taper” the supply of easy money that supported the markets, and even then, the markets nearly rioted.
The Fed’s handling of QE is evidence that by receiving “prolonged” QE (the Wall Street equivalent to welfare), the recipient banks and markets are increasingly deemed to be too weak, ignorant and unintelligent to make it on their own.
Now, after prolonged and multiple doses of QE, no one really believes/expects that more QE (bank welfare) will make much difference. And so, when the Fed began QE3, nobody believed it would make much of a difference—and it didn’t. In the world’s eye, QE3 was just throwing good money after bad. QE3 wasn’t a solution. It wasn’t a remedy. It was just another episode of “kicking the can down the road.”
In a monetary system based on public confidence, once the public doubts that another dose of QE will make any difference, another dose of QE won’t make a difference. There’s little point to QE4 at this time because nobody “expects” it to make much difference. If QE4 is going to have any positive impact, it may have to wait another year or two—until after the public has forgotten that QEs 1, 2, and 3 didn’t really work.
• That’s where we are today: in a world where more QE won’t work because the last three installments of QE were ineffective. Therefore, the public doesn’t “expect” QE 4 to cause much inflation. Without that expectation, the Fed probably can’t cause much inflation.
This is not to say that there’ll be no inflation. Circumstances could change and we might find ourselves subject to significant or even hyper-inflation. But if we are subjected to hyper-inflation, it will be because of external circumstances or some “black swan” event. We won’t get hyper-inflation because it was caused by the Fed. If hyper-inflation occurs, it will happen despite the Fed’s best efforts to prevent it.
If so, what can the Fed do? If it can’t inspire more confidence (or more fear) in the pubic with more QE, does the Fed have any more “doggy treats” in its pockets to make us roll over and shake hands?
Yes, the Fed can continue to hold interest rates down near zero, but who does that help besides major corporations with impeccable credit ratings? In the context of a slow economy and low interest rates, banks that lend their capital to ordinary people assume great risk without much opportunity for profit (higher interest rates). Therefore, banks don’t want to lend money at irrationally-low interest rates to Joe Sixpack because they know that, in this economy, Joe has a high probability of defaulting on his loans.
What’ve the banks done? They’ve primarily loaned their currency to major corporations that have much less chance of going broke and defaulting on their loans. If the banks can’t be paid a rate of return (interest) that’s proportional to the risks they assume, they won’t make risky loans. That means fewer relatively high-risk loans for Joe Sixpack and more relatively low-risk loans to major corporations.
Major corporations are enriched by low interest rates, ordinary people tend toward poverty, and newspaper headlines warn of rising “income inequality”. (I wonder why, hmm?)
Worse, the consumer- (that is to say, “borrower-”) based economy tends to slow into recession or depression.
QEs 1, 2 & 3 tend to prove the Fed’s apparent inability to increase the “official” rate of inflation. As a result, the economy seems stagnant, the rich (those who have savings) are getting richer, and the poor and middle class (who have no savings) are getting poorer.
How long do your suppose that trend can continue?
What will happen when the poor and middle class are as broke as Lehman Brothers—and the federal government is too broke to bail them out?
We can “expect” poverty and economic decline for sure.
We might even “expect” a little chaos.