After three stages of quantitative easing (QE) since the crash of 2008 in an effort to increase liquidity and stimulate lending, the Federal Reserve, asexpected, has stopped buying long-dated bonds. Only history will give the experiment a verdict but while Paul Krugman and its disciples rejoiced at the fact that there is no more signs of inflation than Father Christmas, Allison Schrager in “the hidden inflation risk in ending the Fed’s bond-buying program”(Bloomberg business, 15 July, 2014) mentions that in a survey, 66 per cent of chief investment officers cited inflation as a source of worry in 2013.
Indeed, with this decision, we enter a period of uncertainty as we know little about the consequences of QE and even less of its ending. For a start, Emerging markets are worried as they have already experienced episodes of currency volatility as for instance Brazil, Turkey and India have seen weakness in their currencies as US investors go home in search of higher and safer returns. What about the EMU? Will the end of QE creates serious chaos for the unreformed large countries such as France. France had her budget accepted by the European Union despite her violation of the fiscal compact and the absence of credible fiscal tightening. To add to injury to countries such as Greece, Portugal and Spain which went to dramatic restructuring, France is making a farce of the EU by basing its “improved” budget plan on savings from a reduced contribution to EU budget along with “fighting tax evasion”!Against the background of the Eurozone’s self-imposed stagnation through its ideological attachment to a common currency, the only thing these countries have in common is their lack of political leadership, and meanwhile the pressure and expectations put on central banks to deliver prosperity has never been so great. In doing so, half a century of economic thought risk being forgotten starting with the lessons of the “Great Inflation” that spanned the late 1960s to early 1980s as explained in my book “Remembering inflation” published by Princeton last year.
Over the last years or so, the US economy has gone through remarkable positive economic changes which would make any EMU government leader envious: the US unemployment rate declined to 5.9 percent in September 2014 compared to 11.5 in August 2014 in the Eurozone, GDP grew by 3.5 percent in Q3 2014 compared to 0.1 percent in Q2 2014 in the Eurozone (and this is more than expected thanks to changes in the way GDP is now calculated); the US banking sector too underwent considerable reforms. Not to mention the U.S. shale revolution which has driven oil output to the highest in more than three decades, reducing US’s energy dependence from foreign countries and pushing oil prices down.
In his latest Wall Street Journal article “The Return of Volatility is Mainly about Monetary Policy” (WSJ, 10/26/2014), the Harvard historian Professor Niall Ferguson ( and CGR visiting fellow) cited some wise words from eminent monetary economists Tom Sargent (the 2011 Nobel laureate) and Marvin Goodfriend of Carnegie Mellon University. Writing with Paolo Surico in the American Economic Review, Sargent addressed the question of why there has been no sign of high inflation after the past several years of highly stimulatory monetary policy – a policy that looks set to remain exceptionally accommodative even after the expected decision of the Federal Open Markets Committee on 29th October to end its third and latest programme of ‘Quantitative Easing’ (QE).
Sargent and Surico contend that the real challenge will come when the relentless expansion of the monetary base (the mechanical effect of QE) eventually produces broad money growth. At that point, monetary policy will need to be tightened very sharply to prevent inflation spiralling out of control. Paul Volcker had the determination and courage to fight inflation whatever the short term costs in terms of jobs and output loss. His actions establish the Fed as a brand of credibility but who will be the next Paul Volcker?
In response to the financial market volatility in mid-October caused by concerns about weak global growth, central bankers in both the US (St Louis Federal Reserve Bank President James Bullard) and the UK (Deputy Governor of the Bank of England Andy Haldane) held out the prospect of yet more QE or at least waiting longer than expected before raising interest rates.
This type of reaction highlights the relevance of Marvin Goodfriend’s warning about the addictive qualities of current monetary policy both for investors (because QE drives up asset prices) and finance ministries (because QE finances budget deficits). That last point about fiscal policy is a core message of my book Remembering Inflation. As with any addiction, the longer it persists the more painful will be the ‘cold turkey’. The pain here will be felt in one or another form of higher tax – either the inflation tax used by governments as a way of reducing their huge debts, or abrupt fiscal adjustment forced by central banks’ moves to counter inflation by raising interest rates and ceasing to finance budget deficits.
As Niall Ferguson highlights, the problem with “unconventional” monetary policy is that it generates wrenching volatility and economic disruption. And as Schrager notes, what matters is not so much inflation but inflation risk because the uncertainty is far worse than the reality of inflation since uncertainty has negative effects on demand and investment. Hanging questions about whether to spend and invest now or later are the negative forces at work when there is no confidence or certainty about tomorrow: a firm cannot budget nor forecast how much to produce and therefore what capital and labour resources to employ in an uncertain environment. This is one of the very reasons why economists in the last 40 years came to the conclusion that confidence and certainty were keys to a prosperous economy.
Since Muth (1961) we know how important expectations are in the management of monetary policy, because future or expected inflation determines prices and in this sense, what matters is the risk of inflation rather than inflation itself. On this account, shouldn’t we be fully reassured given that since the 1980s inflation has followed the Fukuyama path of the end of history, inflation being ‘fully anchored’ at least it is what prominent economic commentators like Krugman and Paul Stiglitz would like us to believe.
But, given the history of inflation as told in my book, that view could be as wrong about inflation as Paul Krugman was about the internet when he famously discussed in 1998 in The Red Herring how most economists’ predictions are wrong. At the bottom of the article, Krugman made a list of prognostications, including
“The growth of the Internet will slow drastically, as the flaw in ‘Metcalfe’s law’–which states that the number of potential connections in a network is proportional to the square of the number of participants–becomes apparent: most people have nothing to say to each other! By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s.”
The danger of inflation may still seem remote for now. But responsible risk assessment and management must consider not only probabilities but also the seriousness of the consequences were the risk in question to materialize. In this case of inflation risk, if the Fed loses its brand – credibility – the journey to reestablish it may prove to be a long and extremely painful one.
Goodfriend, M. (2011). “Central banking in the credit turmoil: An assessment of Federal Reserve practice,” Journal of Monetary Economics, Elsevier, 58(1):1-12, January.
Muth, J. F. (1961). “Rational Expectations and the theory of price movements.” Econometrica 29: 315-335.
Sargent, T. J. and P. Surico. (2011). “Two Illustrations of the Quantity Theory of Money: Breakdowns and Revivals.” American Economic Review, 101(1): 109-28.