Tuesday, October 11, 2011

Do you believe in magic? Ryan Avent does!

Avent joins the crew attributing untapped magical powers to the Federal Reserve:


"Losing its credibility as an inflation-fighter, some of it anyway, is precisely what the Fed needs to accomplish. As Paul Krugman has put it, the Fed needs to promise to be irresponsible at some future point, thereby raising expectations of future inflation. That, in turn, will boost current inflation. Consumers will want to spend their money in the period before its value erodes, and through that mechanism future inflation becomes current inflation.

So the question then becomes: can the Fed convince markets that it will be irresponsible in the future? The answer, quite obviously, is yes. The Onion helpfully suggested one way in which this might be accomplished. At a recent dinner, colleagues of mine joked about other ways to solve the problem. One suggested that Ben Bernanke might ask to have his salary indexed to gold or the Swiss franc. Another said the chairman should take to the podium to tell Americans they'd better start spending their dough soon before it's worthless, lighting a cigar with a $100 bill all the while. More practically, Mr Bernanke could raise his desired inflation target or simply declare that the Fed won't touch rates for a certain period, no matter what happens in the broader economy."


People, if the Fed has credibility as an inflation fighter it is for the Rogoffian reason that we have appointed inflation adverse central bankers. That is, people whose preference is for low inflation.

Please repeat after me:

THE FED HAS NO MECHANISM TO BIND ITSELF TO LIVE UP TO ANY ARBITRARY PROMISES IT MAY MAKE TODAY ABOUT THE FUTURE!!!

Promises to act against one's preferences in the future that are made without any commitment mechanism are simply cheap talk and are extremely unlikely to shape agent's expectations or actions.

We could appoint a central banker whose preference was for high inflation. In that case any promises to create low inflation or deflation in the future would be incredible and ineffective for exactly the same reason today's conservative central bankers' promises to create future inflation would be incredible and ineffective.

This is not a Tinkerbell situation folks; believing in magic is not going to get us through the crisis.

6 comments:

Jo VB said...

I guess the way to increase inflation (or raise expectations of future inflation) is to replace Bernanke with Krugman. Clearly, we can rationally expect the new chairman to do anything in his power to stimulate the money supply and some of it might stick.

Nomination would be tricky of course, as the GOP does not seem to want inflation. Which brings us back to square one. "We" will only get inflation if "we" want it.

Tom said...

"Can the Fed convince markets that it will be irresponsible in the future?" Of COURSE it can! All it has to do is act irresponsible in the ten years leading up to now.

Done!

John Thacker said...

I realize that measures like M2 show that a lot of money has been created. OTOH, it also seems like inflation is still low.

I find it impossible to believe that the central bank couldn't create inflation if it really wanted to.

Pretending that the central bank could just promise instead of actually doing, and get the same effect, seems bizarre, though.

Richard said...

Suppose the Fed announced that it would conduct monetary policy in such a way that the 5yr TIPS spread would be, say, 2.3% (+-0.1%). Scott Sumner, Ryan Avent et al. would all say this is a significant improvement over the current scenario when it comes to shaping expectations (even if it's not an NGDP target). Surely the Fed can commit to maintaining the kind of inflation expectations that in fact prevailed for most of the last decade... no?

Jon P said...

Now I'm going to picture winged fairies with beards and blazers for the rest of the night. Thanks, Angus.

James said...

I think you are obviously wrong on this one. The Fed makes believable commitments every day, saying it will pay its employees and meet at certain times. Its commitment mechanism is the fact that a reputation is a valuable durable good