I hope this is my last attack on conservative opposition to QE2, as I am getting sick of the topic.  I’ll try to summarize all their arguments here, to see if any are even slightly defensible:

1.  Inflation only seems low because the Fed ignores food and energy.

The core rate is only 0.6%, but even the overall CPI is only running 1.2%.  So that argument is flat out wrong.  Yet it doesn’t stop some people from making it.

2.  History shows that when central banks print lots of money, high inflation results.

Actually no.  History shows that when central banks print lots of money at the zero rate bound, one generally doesn’t get much inflation.  Japan has been printing lots of money for years, and has also run big budget deficits—thus they’ve been monetizing the debt.  And their price level is lower than in 1994.

3.  Japan is different.  When the Fed has printed lots of money we’ve had high inflation.

Actually no.  Again, when at the zero rate bound, printing money is not necessarily inflationary.  The Fed printed lots of money in the 1930s, indeed the monetary base nearly tripled.  Yet the price level fell during the 1930s.

4.  The gold market shows that high inflation is just around the corner.

Actually no, for reasons discussed in this earlier post.  Every direct indicator we have of inflation expectations shows very low inflation in the years ahead.  CPI futures markets, 5-year TIPS spreads, the consensus economic forecast, they all point to low inflation.

5.  OK, in the past printing money didn’t produce high inflation at the zero rate bound, and we don’t have high inflation now, and both forecasters and markets tell us not to expect high inflation in the future.  But I just can’t believe we can print that much money without eventually suffering from high inflation.  Monetarist theory tells us . . .

Monetarist theory has nothing to do with the current policy environment.  Monetarist theory is all about the impact of printing non-interest bearing money–aka “high-powered money.”  The reason it’s called high-powered is because it lacks interest, and thus is a sort of “hot potato,” an asset that everyone tries to get rid of, and the in process drives up prices.  Milton Friedman and Karl Brunner would be rolling over in their graves if they knew people were claiming monetarist theory meant than the issuance of reserves paying interest at rates higher than earned on T-bills was some sort of “high-powered money.”

6.  If the policy does raise NGDP, interest rates will also rise, causing the Fed to suffer capital losses on its large bond portfolio.

Conservatives presumably believe in efficient markets, and thus the expected loss is approximately zero.  The term structure of interest rates has already priced in the expected increase in rates that will occur as the economy recovers.  Yes, there is some risk, but far less than people think.  The Fed is mostly buying medium terms bonds, for which the price risk is rather low.  And if the recovery is much stronger than expected, the gains to the Treasury would far exceed the losses to the Fed.  This is NOT an argument for leaving millions of workers unemployed.  Especially given that the Fed took far greater risks to save the big banks.

7.  Yes, they are paying interest in reserves, and that prevents inflation right now, but when the economy recovers there will be tremendous pressure on the Fed to avoid raising the interest rate on reserves, and they will spill out into the economy. 

Even distinguished economists such as Becker and Posner are making this argument, but I find it the most perplexing and feeblest argument of all.

Right now the Fed is under tremendous pressure not to do more monetary stimulus, despite 9.8% unemployment and below target inflation.  There is little pressure on the Fed to do more.  Yet somehow we are to believe that when the economy recovers somewhat and inflation is much higher, and unemployment is lower than today, there will be tremendous pressure on the Fed to not raise rates?  And all this despite the fact that the Fed is almost universally blamed for holding rates too low for too long, and inflating the housing bubble?  That makes no sense.

Even worse, we need easier money to reduce that part of unemployment that is not structural; almost certainly a substantial share of the 8 million jobs lost in the recent recession was cyclical.  NGDP is not now growing fast enough to rapidly reduce unemployment.  I don’t expect the 11% NGDP growth we saw in the first 6 quarters of the (low inflation) Volcker recovery of 1983-84, but surely we can at least raise NGDP growth a bit higher than the current path?  How can we in good conscience tell the Fed not to do the right thing, and ease the enormous suffering caused by unemployment, solely because we fear they might do the wrong thing in the future?  Especially given that there is little political pressure on them to inflate now, when you’d think the political benefit of easy money would be greatest?  Obama didn’t even nominate three people for empty Fed seats for 15 months, which shows how little the liberal establishment cares about monetary policy.  And we are to believe that in the near future when the need for monetary stimulus is far less, Obama will suddenly morph into a latter day William Jennings Bryan and start pressuring the Fed?

So there you are.  The conservatives do not have a single good argument against QE2.  Every argument is based on bad logic, bad economics, a lack of understanding of history, or a lack of understanding of our political system.   There must be some reason why the conservative establishment hardly raised a peep when the Fed would cut rates when inflation was running 3% or 4% when Reagan was president, or when Bush was president, and yet are now up in arms over monetary stimulus when we have 1% inflation and 17 million people out of work.  There must be some reason.  But for the life of me, I can’t figure out what it is.

OK, I’ll get off this topic, and wait for conservatives to explain to me what’s going on.

And when we figure that out, then we can work on the even more bizarre opposition from certain voices on the left.  But perhaps I should leave it to Krugman to figure out what’s going on in the mind of that other outspoken, prickly, left-wing pundit and Nobel laureate.  Joe Stiglitz.

I usually agree with just about everything David Beckworth posts, but I can’t quite buy the argument he makes here.  David argues that low interest rates fed the 2001-06 housing boom.  And not just low interest rates, but a Fed policy of low interest rates (which I see as a completely different argument.)

When the tech bubble burst, business investment plummeted.   How should the economy react to that shock?  In a classical world interest rates should fall sharply (regardless of whether a Fed even exists) and other types of output, such as residential investment, consumer goods, and exports, should pick up the slack.  And that’s about what happened.

In my view interest rates are a very poor indicator of the stance of monetary policy.  Both David and I favor roughly 5% NGDP growth targeting.  As long as NGDP is growing at about 5%, monetary policy is on target, regardless of whether interest rates are 1% or 100%.  And if you look at NGDP growth during the Great Moderation, it was in fact pretty close to 5%, on average.

During 2001 and 2002 NGDP growth fell a bit below 5%, and that’s why the Fed cut rates to 1%.  In the subsequent expansion NGDP growth rose a bit over 5%, and the Fed reacted by raising rates sharply.  I can see how someone would have thought money was a bit too easy during mid-2003 to 2006, when NGDP growth was above 5%, but I can’t see any catastrophic failures that could account for the spectacular sub-prime fiasco.  We had even faster NGDP growth in the 1960s, 70s, 80s and 90s, none of which had a destructive housing bubble.

Update, 12/5/10:  Marcus Nunes sent me the following:

–

–

–

–

–

–

–

–

–

–

–

–

Having said all this, if I could go back in a time machine and run the Fed, I’d have raised rates faster in the 2003-04 period.  But that’s not because I would have expected a much superior NGDP performance, but rather as a second best policy to address a catastrophic failure in our regulation of banking.

There is a widespread view that economists on the right favor “deregulation,” and economists on left favor increased regulation of banking.  And the events of 2007-08 allegedly showed the left was right and the right was wrong.  And I can understand why many people feel that way.  Some right-wing economists did in fact offer poor policy advice–touting places like Iceland and Ireland as models of deregulation.  But I think that’s the wrong way to think about regulation, I’d argue that places like Canada and Denmark are the true models of deregulation.

The problem is that people tend to think of the term ‘regulation’ as meaning something like ‘restraint’ whereas in the left/right debate over the role of government it means something closer to ‘intervention.’  Consider the advent of zero money down, no income verification mortgages.  Does allowing banks to make those mortgages constitute “deregulation?”  Not in my book.  As I taxpayer I have always strenuously opposed all the federal interventions that make it easy to borrow money to buy a house–Fannie and Freddie, FDIC, FHA, etc.

Consider FDIC.   Despite the fiction that banks pay the cost of FDIC insurance (about as likely as assuming gas stations pick up the cost of the federal excise tax on gasoline), FDIC insurance is a burden on us taxpayers.  In a perfect world we’d have NGDP futures targeting and there’d be no need for FDIC.  But in the world we live in deposit insurance is unavoidable intervention into the free market.  I’d like to limit its reach as much as possible.  I resent my tax money insuring banks that make sub-prime mortgage loans, or risky construction loans.  I’d like to ban FDIC-insured banks from making housing loans with less than at least 20% down.  I am not opposed to allowing sub-prime loans, just not with FDIC-insured money.  If some unregulated financial intermediary wants to make such loans, that’s fine with me.  I am no expert on this area, there might be alternative regulatory fixes that involve substantial private mortgage insurance, or some mix of insurance and equity.  The point is that any and all acts that reduce the ability of banks to make FDIC-insured loans is “deregulation” in my book— it reduces the size and scope of the inefficient FDIC.  For instance, I consider the Bush administration’s attempt to regulate the GSEs more tightly (opposed by my Congressman, Barney Frank) to represent deregulation.

There are actually two Republican parties in America.  One wants to do real deregulation, to actually reduce the role of the government in the economy.  The other Republican party (which I fear is the more powerful one) wants to do “deregulation,” to remove all constraints on business, banking, the medical industrial complex, energy, for-profit colleges, etc, so that they can systematically loot the taxpayers by taking advantage of the enormous moral hazard that has seeped into almost all aspects of our modern regulated economy.

The Dems are more likely to want to try to tame the beast, but then keep passing laws that make the economy even more riddled with moral hazard.  Not much of a choice these days.

As far as I know there is really only one respectable argument that inflation expectations are approaching dangerous levels in the US.  We know that 5 year TIPS spreads are low, and we know that the near to medium term consensus inflation forecast is low.  We know actual inflation is low and falling.  But then there are those gold prices.

I’ve never been convinced that the high gold prices were signaling US inflation fears.  One problem is that gold prices are set in a global market, so it’s not clear why we should assume they are forecasting high inflation in the US, rather than the eurozone, Japan, India or China.  India has generally been the world’s largest buyer of gold.  Furthermore, most other metals prices have also been soaring, presumably due to rising demand in the developing world.

First let’s look at the supply side of the equation.  We can’t directly observe supply curves, only equilibrium points.  But nonetheless the recent price and quantity data suggests that supply may be falling.  We know that gold prices have soared in terms of all major currencies, and yet gold output continues to decline rapidly:

Note that production peaked at 2600 tons, and fell to 2260 tons in the latest year available (2008.)  I’ve read articles suggesting that most of the world has now been thoroughly explored, and it is felt that most of the major goldfields have already been discovered.  Producers are having to concentrate on less high quality ores.

Set against that bleak supply picture, we have the following news from the FT about gold demand in China:

Those Chinese consumption estimates are rather large when set against a world production total of 2260, and falling.  I seem to recall someone pointing out that Asian gold demand couldn’t be the problem, because the totals were fairly stable.  But that confuses shifts in demand with movements along a demand curve.  When world output is falling, it is necessarily true that total quantity demand will also fall.  If you confuse demand and quantity demanded, it will never look like higher demand is pushing up prices when output is declining.  For instance, consider the following scenario:

1.  The world supply of gold is shifting to the left, and is expected to continue doing so.

2.  Chinese demand is rapidly shifting to the right, and is expected to continue shifting right as Chinese wealth rises dramatically.

3.  Indian demand is shifting right, but much more slowly.

Here’s what I would expect.  Global gold prices would be expected to rise strongly over the next few decades.  If markets are efficient and nominal interest rates are very low, the expected future rise should also raise current gold prices.  The intertemporalarbitrage necessary to make this happen would be provided by gold speculators who buy up lots of gold, driving current prices much higher.  Because Indian demand is increasing only modestly, yet remains the world’s largest, the higher price causes India to slide up and to the left along their demand curve, to a higher price and a lower quantity demanded.  People might wrongly assume that Indian demand had declined, whereas in fact Indian demand was still increasing (due to income growth) but the price was increasing so fast that quantity demanded declined.

The fact that Chinese quantity demanded increased rapidly despite a huge rise in gold prices suggests that the Chinese demand curve is moving to the right at a truly explosive rate.  Indeed in this model it would be possible for future expected Chinese demand to explain 100% of the world’s recent gold price rise, even if the current quantity demanded were falling slightly.  Speculators might be holding gold stocks in readiness for future expected Chinese demand.  But of course Chinese consumption (Qd) is rising fast despite the high prices.

The real price of gold is still much lower than in 1980, a time when China was not a factor in the world gold market, and also a time when lots of new gold fields were yet to be discovered.  I can easily understand how savvy hedge fund managers could see the China boom as being very bullish for gold:

The surge in gold imports to China bodes well for some of the world’s biggest hedge fund managers, including David Einhorn of Greenlight Capital and John Paulson of Paulson & Co, who have invested heavily in bullion, and top miners Barrick Gold of Canada, US-based Newmont Mining and AngloGold Ashanti of South Africa.  [Also from the FT article.]

Again, I don’t doubt that there are individual investors fooled by news stories of massive monetary base increases and huge deficits, who think that high inflation is just around the corner.  Not many average investors know that the same thing happened 15 years earlier in Japan, with no inflationary consequences.  But I believe the best point estimate of the market’s consensus inflation forecast comes from the CPI futures market, as well as the TIPS spreads in the T-bond market.

One interesting question is why Chinese inflation is rising sharply.  It’s clearly not due to any rise in US inflation; rather the most likely explanation is the Balassa-Samuelson effect.  I’ve been predicting a huge appreciation in the real value of the yuan for quite some time, and so far I’ve been right.  A recent article in The Economist pointed out the real yuan is up about 50% since 2005, with about half the increase being nominal appreciation and the rest representing higher inflation in China.

Update:  Commenter David Pearson sent me the following information:

Demand and supply statistics

Gold Demand and Supply – Q2 2010

Outlook

The World Gold Council recently published the latest issue of Gold Demand Trends for Q2 2010, which suggests demand for gold for the rest of 2010 will be underpinned by the following market forces:

• India and China will continue to provide the main thrust of overall growth in demand for the remainder of 2010, particularly for gold jewellery.
• Retail investment will continue to be a substantial source of gold demand in Europe.
• Over the longer-term, demand for gold in China is expected to grow considerably. A report recently published by The People’s Bank of China and five other organisations to foster the development of the domestic gold market will add impetus to the growth in gold ownership among Chinese consumers.
• Electronics demand is likely to return to higher historic levels after the sector exhibited further signs of recovery, especially in the US and Japan.

Note that none of the major factors driving future gold demand is associated with inflation fears in the US.  The report also indicated that investment demand has risen strongly in 2010, but this is consistent with my argument that higher future Chinese demand, coupled with slow growing supply, would lead speculators to buy gold in anticipation of future price increases.

Here is another way of thinking about the problem.  Suppose that the Chinese yuan is expected to double in real terms over the next 25 years (which I think is quite likely.)  Also suppose that gold prices in dollars are expected to rise at the risk free interest rate (on T-bonds.) In that case gold prices in yuan terms might be expected to show little change over the next 25 years—which would lead to a much higher quantity demand as China becomes much richer.  That future expected Chinese demand (partly driven by the Balassa-Samuelson effect combined with Chinese exchange controls) could very easily be underpinning current investment demand in the US.

PS.  The article above links to “Gold Demand Trends,” which shows a wealth of detailed information about the gold market.  It seems gold ouput has risen a bit since the 2008 figures I got from Wikipedia.  But that doesn’t mean the supply curve is increasing.

One reason I like Matt Yglesias’s blog is because he is much less “tribal” than most other bloggers of the left and the right.  Here he takes a shot at liberals who insist it’s obvious that we need more government spending during the current recession, but somehow forgot to call for less government spending during the preceding boom:

Or at the state and local level, anyone who’s thinking seriously about the issue ought to see that the middle of a recession is a terrible time to implement major cutbacks in public spending. But at the same time, people who believe in good faith that state and local spending is above the optimal level will understandably agree with Rahm Emannuel that you don’t want to let a good crisis go to waste. After all, were center-left Keynesian economics bloggers issuing table-thumping condemnations of state and local spending increases in 2004-2007? Bemoaning the fact that we’d entered a new “dark age” of macroeconomic understanding where policymakers didn’t realize that under the circumstances states and municipalities ought to be trimming its workforce and accumulating huge surpluses? I think I missed that.

Like Yglesias, I don’t particularly care whether people on my side are offended by my opinions.  So I’ll keep attacking my friends and allies on the right whenever I don’t agree with their views on monetary policy.

Update 12/4/10:  When I woke up this morning I realized the preceding paragraph is all wrong.  It suggests I’m more courageous than other bloggers, which is both incorrect and kind of insulting.  My apologies.]

Here’s a question that puzzles me.  We know the right is up in arms over the Fed’s recent move toward monetary stimulus.  Yes, inflation is only 1.2% and core inflation is only 0.6%.  And yes, unemployment is 9.8% and rising.  But despite these dreary numbers it is viewed as an outrage that the Fed is trying to boost the growth rate of aggregate demand to a more normal level.

So this got me wondering about the right’s reaction to the Fed’s policy of easing during 2007.  As you may recall, the Fed cut rates several times during 2007.   I checked and found that the inflation rate during 2007 was 4.1%, more than double the Fed’s target.  Unemployment was below 5%.   So if the right was angry about monetary easing when inflation is half the Fed’s target and unemployment is double the natural rate, they must have been absolutely apoplectic about Fed easing when inflation was more than double the Fed’s target, and unemployment was below the natural rate.  After all we’re constantly being told that the Fed’s job is to produce price stability.  Period.  End of story.

Now I can imagine some apologist for the right arguing that the Fed needed to cut interest rates in 2007 because there was a banking crisis.  But haven’t we been told over and over again that the Fed should focus on targeting inflation, that it has no business targeting other variables?  So clearly that can’t be the explanation.

So what is the explanation?  Maybe there were a lot of complaints back in 2007 and I have just forgotten.  Were conservatives complaining that monetary stimulus would merely bail out the failed Bush administration fiscal policies, and allow him to put off the tax increases necessary to balance the budget?  I don’t recall reading that argument, but perhaps I forgot.

I’m not good at searching out old editorials; perhaps some commenters can help me.  But here is the Fed press release from the September 2007 rate cut:

Release Date: September 18, 2007

For immediate release

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent.

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally.  Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year.  However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook.  The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric Rosengren; and Kevin M. Warsh.

Not one vote against?  Thomas Hoenig could have voted against any rate cut.  He could have supported a quarter point rate cut and voted against the half point cut.  But he decided to vote for the full 50 basis point cut, which was more than markets expected and which set the stock market soaring.  And he did this at a time when unemployment was 4.7% and inflation was running at double the Fed’s target.  Interesting.

Another possibility is that conservatives think that right now money is really easy because the base has ballooned and rates are near zero.  Of course the same was true during the 1930s.  Come to think of it, conservatives also thought money was really easy during the 1930s, indeed they thought it was too easy.  Later Friedman and Schwartz showed conservatives how tragically mistaken they had been.  But perhaps they forgot.

It seems like lots of commenters are insisting that QE2 is failing because interest rates have risen since the November 3rd announcement.  If course most of the interest rate effect was already priced in by November 3rd.  But they are also missing a more important distinction—higher rates can be good news, or more specifically a reflection of good news.

Take yesterday’s big move in the bond markets.  Five year T-note yields jumped 17 basis points, from 1.47% to 1.64%.  But the yield on 5 year TIPS only rose by 10 basis points, from -0.22% to -0.12%. Thus 5 year inflation expectations rose 7 basis points, from 1.69% to 1.76%.  That’s good news folks.

Now some people might say; “Sumner, you can’t have it both ways.  The QE2 proponents have been arguing that the falling rates of September and October showed QE2 was working.”  Actually I can have it both ways.  In the months before QE2 was announced TIPS yields fell much more sharply than nominal yields and thus 5 year inflation expectations rose from about 1.2% to 1.7%.

Message to QE critics (and proponents); stop focusing on interest rates.  Here’s what Milton Friedman had to say in 1997:

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

The stock market understands that message; they brushed of the higher interest rates and rose 2% yesterday.  And stocks also rose when rates fell on earlier rumors of QE2.

Then there is the argument that the rising dollar (against the euro) shows QE2 isn’t working.  I admit to arguing that the strong dollar was a sign of tight money in the spring of 2010.  But I wasn’t basing that argument solely on the movements in the exchange rates, which are always an ambiguous signal.  A rising dollar can reflect tighter money here, or easier money in Europe.  In the spring it seemed to reflect tight money in the US, as other asset prices were confirming that signal.  And my initial reaction was that the same was occurring in response to renewed problems in the eurozone.  But a good macroeconomist will never fall in love with an explanation.  It seems like the eurozone troubles may be becoming so severe that the ECB will have to become more accommodative.  If there is anything the ECB hates more than easier money, it would be a crisis that ripped the eurozone apart.  Here’s a recent story hinting that ECB easing may be necessary to save the euro:

NEW YORK (AP) — U.S. stock futures are rising, building on gains overseas as the European Central Bank meets to discuss its plans to support the euro zone.

Investors are hoping that the bank will take additional steps to prevent the European financial crisis from spreading to Spain and Italy.

I’m not saying I have high confidence in this explanation, but rather that one must always remember to look at a wide variety of variables when analyzing a situation.  Even the very best macroeconomists can become a little too obsessed with one variable, Milton Friedman with the money supply, Robert Mundell with exchange rates.  But where they differ from their followers is that they generally knew when to look beyond that one variable, and which other variables were relevant to the problem at hand.

Yesterday a commenter named Leo made this interesting observation:

Readers should not (as I’m sure you don’t) confuse Hayekian pragmatism for Misesian logic.

I can’t comment on Mises, but I do consider myself a pragmatist.  In any given macroeconomic situation there are at least 10 models and variables that need to be considered.  Some people will ignore 9 of the 10, and then methodically apply Cartesian logic to the one variable that they consider “the real problem.”  That’s not my style.

PS.  What am I monomaniacally focused on?  NGDP expectations?

Update:  This article has a bit more info on the ECB:

LONDON (AP) — The European Central Bank stepped up efforts to contain the continent’s government debt crisis, as bank president Jean-Claude Trichet announced it would prolong measures to provide ready cash to banks and steady the financial system.

Markets were initially disappointed Thursday when Trichet did not say the bank would go even further and increase its purchases of government bonds. The euro sagged almost a cent during his news conference.

But it quickly bounced back, trading higher on the day on market chatter that the bank might in fact be quietly buying bonds of financially troubled eurozone countries — despite Trichet’s reticence on the issue.