The Power Of Expectations

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Doug Henwood returns to our basic disagreement about monetary policy:

I really don’t know what he expected the Fed to do. Just before the Lehman crisis, the Fed held about $900 billion in assets. (See first column, here.) Within weeks, it held over $2 trillion. Now, it’s close to $3 trillion. They bought all kinds of stuff, guaranteed trillions more. They cut interest rates to zero and made it clear they’d stay there for a long time. They did it in a secretive and unaccountable way, but they can hardly be accused of passivity. Would it have made a big difference if they’d said, “Gosh, we wish inflation would rise to 3%”?

My claim is that, yes, it would have made a difference if the Fed said, “We’re happy to let inflation run 3-4 percent for several years until we get back down to something like full employment.” At the margin, the higher inflation rate would have inspired cash-rich firms to expand operations rather than sit on the money. At the margin, the higher inflation rate would have inspired cash-rich individuals to buy stuff rather than sit on the money. At the margin, the higher inflation rate would have speeded the process by which indebted working- and middle-class Americans discharge their mortgage debts.

It’s important to recall that it’s not just me saying this. According to Ben Bernanke, a 3 percent inflation target would produce jobs and increase real ouput, but he doesn’t want to adopt one because “[t]he anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted.” That, to me, is a terrible reason for millions of people to be languishing in unemployment.

Now conversely, imagine that the Fed is happy with the level of inflation that we have right now, but by some miracle, the Congress decides to spend a huge sum of money on a giant program of public investment. Well, if it’s well designed, the stimulative impact will mostly be mobilizing idle resources. But there’s no way you could design a program of that kind that exclusively mobilizes idle resources. With income higher, there’s bound to be some increase in demand for scarce resources — oil and gasoline, most notably, some other commodities, maybe a few forms of specialist labor, etc. That’s going to lead to higher prices. Except that since the Fed doesn’t want to allow higher prices, they’ll tighten the money supply to counteract the impact of fiscal policy. Now we’re getting nowhere. The fiscal expansion can’t work unless the monetary authorities in some sense want to cooperate with it.