Fed Succeeding in Boosting Inflation Expectations

The thing you need to understand about the anomalous negative interest rates on inflation protected bonds is that this is the plan. Given the state of the economy we need negative real rates to produce growth. People have become extremely risk-averse, and we need to find out exactly how risk-averse they are. If the returns on risk-free investments are guaranteed to be negative, then suddenly riskier investments—i.e., investments in growing “real” economic activity—start looking better.

Meanwhile, I noted yesterday that I think Paul Krugman tends to overestimate how difficult it is for the central bank to generate inflation. And, indeed, today he says he’s puzzled by why markets are reacting so strongly to the QE2 talk and suggests they’re making a mistake.

Maybe they are, but I think what we’re basically seeing is the potency of the communications channel. In a case like this, if the markets converge on a higher expectation of inflation then that can easily become a self-fulfilling prophesy through the “bootstrap” mechanism described in his 1998 paper (PDF) “It’s Baaaack! Japan’s Slump and the Return of the Liquidity Trap.”

If the central bank can credibly commit itself to pursue inflation where possible, and ratify inflation when it comes, it should be able to increase inflationary expectations despite the absence of any direct traction on the economy via current monetary policy. Indeed, if one views monetary policy in terms of nominal interest rates, a credible commitment to inflation can seem to be a pure bootstrap policy: interest rates never actually need fall, all that is required is a promise not to raise them when the economy expands and prices begin to rise.

He then observes, correctly, that “How to actually create these expectations is in a sense something outside the usual boundaries of economics.”

This is an interesting research issue crossing over social psychology, political science, and economics that I think we don’t know very much about. But we should at least be open to the possibility that it’s very easy to generate these expectations as long as you actually want to. The key question now is will the powers that be try to “reassure” markets of their commitment to fighting inflation, or will they embrace an increasing price level as part of the solution to our problems.