Why the Fed’s policy won’t lead to high inflation

Stephen Williamson has an excellent observation about the Fed’s new commitment to hold rates near zero for 2 years:

Further, it seems the outcome the Fed would hope for is one where inflation increases, the interest rate on reserves increases commensurately, and the Fed proceeds to sell off assets so as to normalize the state of its balance sheet, with zero excess reserves. Committing to IROR = 0.25 for two years risks two outcomes that seem equally bad (if we believe that 2% inflation is optimal). One is the too-high-inflation outcome: People anticipate high inflation, reserves start to look much less desirable, and the high inflation is self-fulfilling. The other is too-low-inflation: People anticipate low inflation, the reserves look more desirable, and low inflation is self-fulfilling. The first scenario is something that I have been worried about. The second scenario was a concern of Jim Bullard, and Narayana Kocherlakota.I think both are possibilities, i.e. there are multiple equilibria.

Fed officials like to talk about “anchoring expectations.” In this circumstance, the kind of FOMC statement that would anchor expectations would be something like: “We anticipate raising the fed funds rate target (actually the IROR target, but what the heck) as observed and anticipated inflation warrants. Currently, we think we are on a path on which inflation will increase.”

George Selgin made some similar criticisms in the comment section of this post and this post (where Nick Rowe also makes comments.).  I completely accept their analysis.  Interest rate pegging is a really bad idea.  But I am not particularly worried that the high inflation outcome will occur, for two reasons:

1.  Consider Stephen’s comment “Currently, we think we are on a path on which inflation will increase.”  You would think that is the view of the Fed.  That would certainly be their view if Lars Svensson (of targeting the forecast fame) were running the place.  But alas, Svensson is in Sweden, the land of negative IOR (and the only western European country expected to achieve rapid growth during 2009-12.)  The Fed probably expects core inflation to slow a bit over the next year.  Why don’t they adjust one of their policy levers?  Why not more QE, or lower IOR?  Your guess is as good as mine.

2.  The Fed still has plenty of anti-inflation credibility.  And thus it’s widely understood that if inflation exceeded the Fed’s comfort zone, they’d slam on the brakes in mid-2013.  But what about the period before mid-2013?  It turns out that many New Keynesian models suggest that current NGDP is strongly affected by future expected NGDP.  Although I’m not exactly a NK economist, my intuition tells me they are correct on this point.

Consider the following analogy.  Suppose the Fed said it would let the dollar/euro exchange rate float for two years, and then peg it at 1.40.  Also suppose this announcement was credible.  In practice, the spot rate would show very little variation over the next two years, even though the Fed was taking no explicit actions to stabilize rates (until mid-2013.)  The same intuition applies to NGDP.

Keynes understood this at an intuitive level, which is why he always talked about the importance of business “confidence.”  Whenever reading Keynes, just substitute the term “expected NGDP growth” for “confidence” and the meaning will be much clearer.  Of course other factors such as regulation can also affect business confidence, but Keynes focused on AD.

So although I agree with the criticism of Williamson and Selgin, as a practical matter I focus on the fact that the Fed’s action is almost certainly going to be too little, not too much.  (And obviously the 3 year T-note market agrees.)  I hope I’m wrong, as I’d much rather see the Fed trying to rein in 4% inflation in 2013, than trying to boost up 0% inflation in 2013

Selgin and Williamson are also correct that what the Fed really needs to do is commit to a nominal target, and let interest rates move as necessary to hit that target.  Because they failed to do so, a two year interest rate commitment is likely to be meaningless.



27 Responses to “Why the Fed’s policy won’t lead to high inflation”

  1. Gravatar of William J McKibbin William J McKibbin
    11. August 2011 at 07:48

    Let’s face it, the bankers at the Federal Reserve have devoted their lives to holding inflation to as close to zero as possible — bankers’ concerns about growth or employment are way down the list of their priorities — the Federal Reserve is delighted now with their success over the past several years with holding inflation at almost zero — they go home and pat each other on the back and tell their spouses that everything is going really well for the Fed right now — oh, and don’t forget that those at the Fed are all well-paid — reality is that the Federal Reserve is all about holding inflation as close to zero as possible, and that’s how the Fed measures its success — that’s life folks…

  2. Gravatar of David Pearson David Pearson
    11. August 2011 at 08:26


    I think a bigger picture view is more appropriate. Much as you don’t like it, the U.S. will have chronically high fiscal deficits for the next decade (or more). This is a (consensus) prediction, not a judgement about what should happen. The real danger of high inflation comes from markets’ perception that the Fed will allow the government to finance itself at negative real rates more or less permanently. (This was the case in most high inflation Latin American countries.) In other words, persistent deficit monetization.

    Now, you might argue that if the Fed stimulates we won’t have high fiscal deficits because real tax revenues will grow. Maybe. We have two likely scenarios: in one inflation spirals higher due to debt monetization; in the other the Fed wins the day and sparks a robust real recovery. The question is whether markets (not economists) will perceive the second or first as more likely.

    FWIW, here is Paul Krugman’s take on the concept of inflation and debt monetization:


  3. Gravatar of Morgan Warstler Morgan Warstler
    11. August 2011 at 08:29

    Whenever reading Keynes, just substitute the term “expected NGDP growth” for “confidence” and the meaning will be much clearer. Of course other factors such as regulation can also affect business confidence, but Keynes focused on AD.

    Which is WHY Keynes was wrong.

    This is indeed the PERFECT turn of the phrase.

    We will ONLY let NGDP “confidence” happen when we are SURE the regulatory system is FORCED into efficient operation.

    Anything else place Government on equal footing with the market, and that is unacceptable.

  4. Gravatar of Morgan Warstler Morgan Warstler
    11. August 2011 at 08:31

    McKibbin, mine is the more nuanced explanation for what you are saying.

  5. Gravatar of George Selgin George Selgin
    11. August 2011 at 08:54

    My argument, Scott, isn’t that inflation is for the near future more likely than deflation. I only wished to point to the risk of inflation at some future date inherent in the Fed’s commitment to pegging (or trying to peg) the nominal FFR for a very long period. If natural rates eventually rise, sticking to the commitment must either result in inflation (the case if the Fed’s operating rule boils down to something like, “whenever the FFR rises above the fixed target, engage in more aggressive open-market purchases”) or in deflation (the case in which the Fed realizes that the only way to stick to its commitment without risking hyperinflation is to tighten money enough to keep the natural nominal FFR down despite a higher real FFR).

    Personally I can’t see the Fed resorting to the second course, despite the fact that it is the only one consistent with actually achieving the pegged rate commitment (and therefore the one that our “modern macro” types prefer to harp upon. But neither do I imagine that hyperinflation will be tolerated. The more likely outcome of a substantial increase in the real FFR prior to the expiration of the two-year commitment is that Bernanke will be forced to swallow his words and raise the target. Just what rate of P change would emerge in this case I don’t venture to guess.

  6. Gravatar of Benjamin Cole Benjamin Cole
    11. August 2011 at 10:17

    Anybody anticipating inflation now is deeply mistaken. In fact, the hysteria around inflation in completely baffling. Does anyone looks that the numbers?

    Despite Fed actions of the last two years, there is no inflation. Does anyone look at BLS stats? Or does that get in the way of hysteria and fetishes?

    The CPI-U was at 225.722 in June and at 219.964 in July 2008. That is a 2.62 percent increase in three years. About 0.8 percent a year. Come July CPI figures that rate of inflation will probably drop, as headline inflation is going down. July will likely be the second month in a row that headline inflation drops.

    Moreover, many right-wing economists used to note that the CPI overstates inflation, as consumer and businesses always migrate to best products and services. I use a cell phone today instead of three land lines, and my savings are $100 a month.

    Inflation? You mean except for real estate, stocks, unit labor costs, and all manufactured goods?

    Moreover, the one inflation that visible–gasoline–reflects a cartelized and unreliable oil sector (unreliable due to thug states that control the global oil supply), rife with speculation. Oi prices on the NYMEX can go or down by $50 depending on what? The Fed? Hoo-haw.

    If going to zero-bound results in inflation, please explain Japan.

  7. Gravatar of Rob Rob
    11. August 2011 at 10:32

    Leading aside the specific issue of the inflation risks around the Feds 2 year commitment I have a question about the inflation-risks around NGDP targeting itself

    I can see this policy would likely address the monetary disequilibrium we find ourselves in. However, as quite a large expansion to the monetary base may be needed to actually achieve the targeted NGDP level , what confidence (based on theory or precedence) do we have that the Fed has the right tools to reverse this increase in the money-supply when market conditions change and inflation becomes a risk ?

  8. Gravatar of flow5 flow5
    11. August 2011 at 11:28

    Lending by the CBs is inflationary (it expands both the volume & velocity of new money). Lending by the non-banks is not inflationary (it results in the turnover of existing money).

    The “tipping point” is determined by the relative growth rates of Reserve & Commercial bank financing, as compared to the growth rates of the financial intermediaries (non-bank lending sector).

    Only as monetary savings are routed thru the non-banks, rather than be impounded within the CB system, will payrolls rise sufficiently to erase the current “debt overhang”. IOeRs are the problem.

    I.e.,the 5 increases in REG Q ceilings(for the CBs only), beginning in 1957 & culminating in 1965, induced dis-intermediation in the MSBs & S&Ls (non-banks). It caused a housing crisis. The non-banks didn’t have any ceilings at that time. They were unregulated.

    The point is today, the remuneration rate (like Reg Q ceilings then), is high enough to cause dis-intermediation in the Shadow Banks (& other non-banks). I.e., IOeRs impound savings within the CB system.

  9. Gravatar of George Selgin George Selgin
    11. August 2011 at 11:32

    Benjamin, an FFR of zero is consistent with inflation, or deflation, or neither, depending on the state of the natural or neutral rate. If Scott Sumner has been trying to drive home anything, it’s that you cannot determine whether monetary policy is too tight or too easy or neither by simply observing where the funds rate is. That is why the same low rate that may be tight today might just as well turn out to be easy two years from now.

  10. Gravatar of flow5 flow5
    11. August 2011 at 12:54

    Under the influence of the Keynesian dogma, academicians have been trying for too long to analyze interest rates in terms of the supply of and demand for money.

    A “liquidity preference” curve is presumed to exist which represents the supply of money. In this system interest is the cost which must be paid, if lenders are to forgo the advantages of liquidity.

    All of this has little or nothing to do with the real world, a world in which interest is paid on demand deposits (July 21, 2011).

    Interest is the price of obtaining loan funds, not the price of money. The price of money is the inverse of the price level. If the price of goods and services rises, the “price” of money falls. Interest rates in any given market at any given time are the result of the interaction of all the forces operating through the supply of and the demand for, loan funds.

  11. Gravatar of amv amv
    11. August 2011 at 13:03


    I answered over here: http://coffeehouse-economics.blogspot.com/2011/08/kocherlakota-vs-selgin-amv.html

  12. Gravatar of George Selgin George Selgin
    11. August 2011 at 13:13

    Thanks amv. I’ll have a look.

  13. Gravatar of Steve Roth Steve Roth
    11. August 2011 at 13:15

    Is what you really mean “”never reason from a price change *alone*”?

    That you have to triangulate (at least)?

  14. Gravatar of Steve Roth Steve Roth
    11. August 2011 at 13:17

    Or: anytime anyone appears to be reasoning from a price change alone, they are actually engaged in implicit triangulation (at least)? The other point of the polygon being the unstated assumption(s)?

  15. Gravatar of George Selgin George Selgin
    11. August 2011 at 13:37

    At coffeehouse amv writes: “Thus, Wicksell’s concept of the spread between the real money rate and the natural rate breaks down if you substitute rational for adaptive expectations. … Note that Selgin applies Wicksell’s spread-concept to the case of frictionless RE models (see item (5) in his last comment here). As argued above, this is illegitimate.”

    I don’t think that this is a correct characterization of my argument. In “Two Hawks” at 06:33 I wrote, as part of a longer comment,

    “Now, my claim is that, even under these conditions, should real FFR* increase while the peg remains in effect, the result will be inflation that continues so long as the peg remains in effect.

    “How can this be the case, you will ask, if under the conditions described the Fed is incapable of making FFR and FFR* diverge persistently, and if the two can only remain equal by means of deflation sufficient to keep FFR*=0?

    “The key to the answer is that inflation results, not because the Fed is able under the conditions given to keep FFR below FFR*, but precisely because it it is seeking to do the impossible, that is, keep FFR down by means of easy money. The consequence isn’t an inflationary “equilibrium” in which FFR remains < FFR*, for no such equilibrium exists; but neither is it K's deflationary equilibrium, despite the fact that that equilibrium does indeed exist, because that equilibrium isn’t consistent with the Fed’s actual monetary policy stance. The inflation is, instead, a disequilibrium phenomenon that only comes to a halt if the Fed gives up the peg."

    I think I am in fact conceding here that there cannot be a spread. But it isn't the spread that causes P to rise. It is the Fed's futile effort to try and create a spread, that is, to try and keep the FFR at .25 when the FFR* is (say) .50, that must give rise to inflation. Admittedly, as I stated above, I am taking for granted an implicit Fed procedure for attempting to implement its peg. The procedure is: if FFR rises above .25, buy more bonds. If that doesn't work, buy more still, and so on. As I explain above, I don't imagine that the Fed would ever stick to such course as inflation mounted; at least, I hope it would not. But the argument that trying to maintain .25 would lead to inflation seems to me to remain valid.

    Now my question to amv is, how do you conceive of the Fed's procedure for implementing its peg? I have said that in my "model" (if you like), when the actual/natural FFR rises, the Fed buys more bonds, or buys bonds at a faster rate. What happens, whether at the open-market desk or elsewhere, in the model you have in mind?

  16. Gravatar of amv amv
    11. August 2011 at 13:48

    I’m sorry, if I misunderstood your position. Yet, whereas you indeed concede that there is no spread in the frictionless RE model (theory, if you wish ;-)), you still apply the monetary disequilibrium logic: but money cannot be a medium of exchange so that there can be no aggregate excess demand for goods (aggregate excess supply of money) on which your argument still rests.

  17. Gravatar of amv amv
    11. August 2011 at 13:49

    I altered my formulation to make that point clear.

  18. Gravatar of George Selgin George Selgin
    11. August 2011 at 14:11

    I’m not convinced that appeal to frictionless RE necessarily means jettisoning the concept of a medium of exchange (though if it does, all the worse for the model in question as a basis for assessing or choosing monetary policy). I understand frictionless price adjustment to be distinct from frictionless barter, at least in principle. That is, one can imagine a world in which traders (somehow) always set G.E. prices, yet “money buys goods and goods buy money but goods don’t buy goods.”

    If I’m wrong, on the other hand, then I must revert to a point I made earlier in our exchange, to wit: that if the model that tells us that a peg will prove deflationary as the natural real rate rises also implies that there cannot be such a thing as a monetary policy that results in an aggregate excess demand for/supply of goods, then we should either (1) agree that any monetary policy is as good as any other, so that it’s pointless to worry over the consequences of this or that policy; or (2) use another model, such as Wicksell’s original one.

    I understand that you may not disagree with me in saying that in this case we should chose option 2.

    One way or the other, I think we end up concluding that a peg means inflation if the natural rate rises.

  19. Gravatar of Benjamin Cole Benjamin Cole
    11. August 2011 at 14:28

    George Selgin:

    I am only pointing out that inflation is dead. In fact, one or two months of headline deflation–say from falling oil prices and real estate prices–might bring the CPI right back to July 2008 levels.

    Incredibly, no one is honking about this. Instead the carnival-barkers are braying about inflation and gold. You would think we are Zimbabwe.

    In fact. we are Japan.

  20. Gravatar of George Selgin George Selgin
    11. August 2011 at 14:38

    No argument about now, Benjamin. But the claim that you have to be nuts to “anticipate” inflation when the FFR is near zero is too sweeping. Anticipate when? I think it’s perfectly reasonable to anticipate a possible inflationary outcome of a commitment to keeping the FFR near zero for two years.

  21. Gravatar of flow5 flow5
    11. August 2011 at 14:42

    The effect of tying open market policy to a fed Funds rate is to supply additional & excessive legal reserves to the banking system when loan demand increases.

  22. Gravatar of amv amv
    11. August 2011 at 15:02


    I can live with (2).

  23. Gravatar of amv amv
    11. August 2011 at 15:02


    I can live with (2).

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  25. Gravatar of Scott Sumner Scott Sumner
    11. August 2011 at 17:41

    William, The Fed often cuts rates when inflation is well above zero.

    David Pearson, Yes, since tight money caused the big deficits, I most certainly will argue that easier money can shrink them. Inflation isn’t the issue–NGDP growth is.

    The sooner the Fed eases the sooner we can raise rates above zero.

    Morgan, Keynes was partly right and partly wrong.

    George. I didn’t mean to suggest you thought inflation was likely, just that by comparison I was less concerned about the risk of inflation that you and Stephen. Sorry if I misrepresented your view.

    I certainly agree with the rest of your analysis.

    Ben, I agree that our case is looking more like Japan every day.

    Rob, I don’t think a big increase in the base is necessary, but if so it can be quickly reversed through open market sales.

    Flow5: You said;

    “Under the influence of the Keynesian dogma, academicians have been trying for too long to analyze interest rates in terms of the supply of and demand for money.”

    Steve, I mean never say “oil prices went up therefore” or “interest rates went up therefore” or “the dollar depreciated therefore.” Always start by asking whether the price change is due to a supply shift or a demand shift.

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