This has been bugging me (and therein you get a glimpse of how dull my mind is).

A day or two ago, Scott Sumner explained extremely well how you need a permanent increase in the money supply to generate inflation.  If the economy knows that it will be withdrawn in the next period, then money will be hoarded until that period.  Therefore nothing happens: it is not spent in the way it needs to be to get the price level up. Sumner puts it better:

Now consider the temporary currency injection.  We know that the long run price level doesn’t change.  Once the money supply returns to the original level (a year later) prices should also return to the original level.  At first you might assume that monetarists would claim that the price level would double, and then fall in half.  But consider the real interest rate.  Monetarists typically assume that real variables like the real interest rate aren’t much affected by monetary shocks.  But if prices doubled, and then were expected to fall in half, the expected real return on currency would be 100% in year two.  That is, the purchasing power of money would be expected to double in year two.  More likely, almost all of the temporary currency injection would be hoarded and prices would rise by just one or two percent—the risk free real rate of return

Many of you will notice that this is similar to what has happened in Japan (I think Krugman here is enlightening on that situation)

This is all very pertinent to QE, and our current situation.  In brief, our current authorities are so nervous about being called inflationists that they bend over backwards to insist on the temporary character of QE.  Observe the first question that Mervyn King fielded on this before Parliament:

Q7 Sir Peter Viggers: Quantitative easing. Why is buying assets better than printing money and throwing it out of a helicopter?

Mr King: Because we get the asset.

And you get to sell assets back. It may mean, as Duncan argued, that it may be failing.

Now, I am coming round to the idea that Japan, 1997 is such a bad place to be that a little extra inflation may be a least bad option.  But I remain sceptical that Tim Leunig’s idea of a five year burst of managed inflation can be actually achieved.  His idea is attractive because it retains some democratic accountability for what is, after all, a huge change: a massive redistribution from debtors to creditors (HT Buiter).  Sumner’s post helps elucidate why. Tim writes:

Since it takes about two years for central-bank policy fully to influence inflation, a sensible policy would be to target 4 per cent inflation for the five years from 2011, followed by 2 per cent thereafter. In Britain, the government would simply redefine the Bank of England’s inflation target . . . An increase in inflation by an extra 2 percentage points for a period of five years would have many benefits – for governments, companies, households and the banking system.

I have no doubt of the benefits.  What I doubt is whether in a world of forward-looking agents, hoardable-money (or investable in risk-free things), and a crucial role for expectations in setting real conditions, such a managed up-and-down can be done. After all, current spending is largely influenced by expectations of future inflation.  If in period 1, agents know that in period 2 inflation will drop suddenly, will they not change their behaviour in such a way that damages the simple quantity-price relationship in period 1?

Wolfie Munchau said it too:

Of course, it can be done, but only for as long as the commitment to higher inflation is credible. Inflation is not some lightbulb that a central bank can switch on and off. It works through expectations. If the Fed were to impose a long-term inflation target of, say, 6 per cent, then I am sure it would achieve that target eventually. People and markets might not find the new target credible at first but if the central bank were consistent, expectations would eventually adjust . . . If, however, a central bank were to pre-announce that it was targeting 6 per cent inflation in 2010 and 2011, and 2 per cent thereafter, the plan would probably not succeed. We know that monetary policy affects inflation with long and variable lags. Such a degree of fine-tuning does not work in practice.

And it’s obviously even harder when there’s a Crunch on . . . This graph is “expectations of rates on mortgages, bank loans and savings from the Bank:

NOP expectations

Despite the purpose of QE being partially “shock and awe” – “we’re doing everything we can” – only for ONE QUARTER of the past few years has the expectation ahead been of lower rates.  Some bazooka.

So, my wonkish question is this: Sumner is clearly correct about the (in)ability of a temporary change in Quantity of Money to change price levels, IMHO.  Is the reasoning also applicable for the first derivative of price levels?

UPDATE:  When people get more cash in their pockets, do they spend it?  Depends on their expectations and animal spirits (H/T, Keynes . . . ).  Currently, it looks like they are paying down equity in their houses (BOE figures)

ANOTHER UPDATE:   There seem to be few commentators out there willing to brave the complexity and confusion of monetary statistics.  Ambrose Evans-Pritchard seems to be one of them, linking to that MoneyMovesMarkets blog too. Where I really agree with him is:

What is clear is that zero rates are playing havoc with the indicators, so nobody really know what is going on — and that includes the central banks. You have to trust your instincts here. We are in the field of psychology and anthropology.

Yes – the only people you should doubt should be the people who seem certain


8 thoughts on “A wonkish question about Managed Inflation

  1. I go back to Bernanke’s big deflation speech (made in 2002 and very much the Fed ‘playbook’ throughout the crisis).

    He argues:
    “The claim that deflation can be ended by sufficiently strong action has no doubt led you to wonder, if that is the case, why has Japan not ended its deflation? The Japanese situation is a complex one that I cannot fully discuss today. I will just make two brief, general points.

    First, as you know, Japan’s economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.

    Second, and more important, I believe that, when all is said and done, the failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal. Rather, it is a byproduct of a longstanding political debate about how best to address Japan’s overall economic problems. As the Japanese certainly realize, both restoring banks and corporations to solvency and implementing significant structural change are necessary for Japan’s long-run economic health. But in the short run, comprehensive economic reform will likely impose large costs on many, for example, in the form of unemployment or bankruptcy. As a natural result, politicians, economists, businesspeople, and the general public in Japan have sharply disagreed about competing proposals for reform. In the resulting political deadlock, strong policy actions are discouraged, and cooperation among policymakers is difficult to achieve. ”

    So QE works…. unless there are “massive financial problems in the banking and corporate sectors” and political infighting. Hhhhmmm.

    Personally I think QE requires a credible threat of inflation, in this regard Liam Halligan’s constant warnings of hyper-inflation are helpful. Maybe raise the inflation target?

  2. I’ve had that speech permanently before me in writing this thing.

    I am looking into the idea that the Bank needs to boost its statutory mandate by adding in growth – an NGDP target. They seem to have an implicitone – in that, whenever there is economic slack, they say inflation will ultimately lag (e.g. latest minutes:

    “policy still had to besufficiently accommodative to close the output gap over a reasonable time frame, otherwise inflation would eventually fall well below the target.”

    The big problem with boosting the inflation target: politics. “Savers up in arms . . . why should I pay for the profligacy of those debtors . . . “. Letters to the FT and your MP. What a lot of fun.

  3. And there we go again… sensible economics not possible for ‘political reasons’. 😉

    I’m curious about a NGDP target, would require a big institutional shift at the BOE, it still has a fair few ‘inflation nutters’.

    Also, is it a more difficult target to measure, given we have monthly CPI figures but only quarterly GDP figs (which are then subject to much revision)?

  4. Yeah, I get the feeling the Bank feels very comfortable just where it is.

    We are not alone in having inflation nutters:

    I like this para:

    The experience of the 1970s is such a tired and faulted analogy. To generate a wage-price inflation spiral, you need to explain the mechanism by which rising inflation expectations (which don’t exist anyway) get translated into high wages. I do not see that current institutional arrangements in the US allow this; nor do we see it in the data:

    It WOULD be difficult to measure, though the point would be the future forecast, not the present. Also, I think it could be a rule of thumb – the statutory rule could still be CPI 2%, but the way of getting there at prsent would be to announce a determination to use all monetary means of gettingNDGP growth up to 5 pc

  5. The BoE can ask the govt to raise VAT is necessary if it fails to hit a 4% inflation target. The govt can agree. That way the 4% is credible.

    The BoE can do the same in reverse after 5 years. The govt can agree. That way the 2% is credible.

    Next problem?

  6. writing from mobile so pls don’t mistake brevity for disrespect.

    I don’t think what you propose would achieve anything like what your FT article calls for ie a reflation of the economy. it would be a massive drag on demand – elasticity wld mean you’d need a lot more than 4pc – raising 20-30bn from the incomes of businesses and households, and therefore depressing the economy.

    We know this – CEBR estimates VAT cut has boosted demand through large income effect. Retaill sales in july up 3.3% in a year with GDP down 5.5% suggests they’re right.

    What is needed is inflation caused by aboost in demand, not one stemming from the govt killing the supplyside with a big tax increase.

    Also – in the last years, the expected lowering of VAT by a massive amount will further depress demand. Just as the opposite is expected to happen thisAutumn.

    I could see how a preannounced VAT rise could achieve some inflation through people bringing purchases forward. But apart from being v good for govt coffers i fail to see how the ultimate aim of boosting private nominal incomes & making debt reduction easeier wld follow. Wages would not rise, nor wld profits.

  7. also – BOE normally accommodates Fiscal tightness with money looseness but how could it? rates 0, lquidity trap, problem we’re trying to solve.

    Sumner showed me where I’m wrong on his blog.

    Would be interested in what Duncan thinks

  8. The VAT change would be revenue neutral (sorry, I should have been explicit on that). I would wager that the demand side effect from raising VAT by a small amount and lowering some combination of council tax and income tax would be close to zero. Or everyone could be sent a cheque.

    As I say, I think that the Bank can get inflation up to 4% within two years from now – and those I speak to in the monetary policy world seem to think so. If the Bank do not think that they can do it, then we can delay the scheme a year until normal times return.

    I doubt this backstop would be needed, but it would work if necessary and add credibility if people don’t think inflation will rise.

    Next problem to solve?

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