Why No Inflation? Part II

In Part I, the fact that the US Federal Reserve was keeping interest rates at almost 0, which exported our inflation to other countries, and that this could not continue forever, was discussed.  Below are two points of view on what will happen when the Fed is forced to reverse course:

By Kenn Jacobine  September 23, 2013  PolicyMic.com

"Back in June, as the official unemployment rate continued to fall, Federal Reserve Chairman Ben Bernanke indicated to the public that the Fed might begin to scale back its easy-money policies sometime before the end of this year.  As the Fed met this past week, many economists and analysts expected it to announce that the central bank would indeed begin tapering its current $85-billion-per-month bond-buying scheme known as Quantitative Easing 3.

But these are also the same pundits who have been claiming for five years that the U.S. economy is in a state of recovery. They are either disingenuous or totally clueless

I had no doubt that Bernanke would not begin tapering QE3 now. In fact, QE3 may never end.

In the first place, for five years now the Fed has injected over $2 trillion into the economy through QE 1, 2, and 3, and the real unemployment rate is still north of 14%. More Americans are on food stamps than ever before. Middle class incomes are down and poverty is up. At this point, Bernanke’s largess is a life-support system for the economy. It will not cure the patient, just simply prolong the agony until the day of reckoning.

And the day of reckoning will come when long-term interest rates climb to the level where the current QE-induced housing and stock-market bubbles pop. The carnage from that, however, will be minor compared to the destruction left behind from the mother of all bubbles — Treasury Bills. The point is, in June when Bernanke simply mentioned the Fed might begin tapering, the stock market tanked 550 points and T-bill and mortgage interest rates instantly rose. Imagine the impact if the Fed really pulled the plug on the economy’s life support.  Additionally, because T-bill and mortgage interest rates have been rising that could mean Bernanke has lost control of long-term rates. The only tool he has for combating rising rates is more stimulus. Thus, instead of taper talk, analysts should be asking when the Fed will increase its amount of bond purchases per month.

Lastly, perhaps the biggest reason why the Fed may never be able to cut back on its monetary stimulus, is that to do so would accelerate the insolvency of Uncle Sam.  Realize that even though the current national debt is almost three times what it was in 1996, interest payments on the debt after adjusting for inflation are lower today than they were then. The difference is the rate of interest the federal government is charged. Bernanke has no choice but to keep printing. If he tapers, rates will go up, interest payments will become a bigger share of federal expenditures, and he will have to print even more to keep things going.  The hyperinflation that will result will finish off what’s left of the U.S. economy.

Many will say the above is nothing more than doom and gloom. But the above scenario is real. Bernanke has steered Fed policy down a dangerous path in 2008. Instead of allowing the market to liquidate the mal-investments from the preceding boom, he chose the politically correct path by attempting to re-inflate the bubble. Instead of letting those that were reckless and brought on the crisis lose their shirts, Bernanke launched a massive program of bailouts and bond purchases. He has printed himself (and us) into a corner and thrown away the key. To keep things from crashing he has no choice but to continue printing. Even then, the end will ultimately come and the devastation will be so much worse than 2008’s crisis."

And another, less-alarming view:

Ronald I. McKinnon October 22, 2013   Wall St Journal

On May 22, Mr. Bernanke broached the possibility that the Fed might begin tapering QE3. Although carefully hedged by suggesting that the Fed would wait to taper until the unemployment rate fell to 6.5%, his comments unsettled world financial markets. Over the next four days, long-term interest rates rose sharply, and foreign and domestic stock markets fell.

Subsequently, a chastened Fed chairman, and several presidents of Federal Reserve district banks—including William Dudley of the Federal Reserve Bank of New York—suggested that tapering would be deferred. On Sept. 18, the Federal Open Market Committee chose not to taper. After these disclaimers, the bond market partially recovered. However, long-term interest rates (now near 2.5% on 10-year Treasurys) remain higher than before the tapering speech—with volatility also substantially higher.

Yet there is no doubt that the U.S. needs to break out of its near-zero interest-rate trap in order to avoid perpetual stagnation, where real returns on new investments are also driven toward zero. But is there an efficient way out of the trap that the Fed has set for itself? I believe there is.

The Fed can start by raising short-term interest rates, currently near zero, while leaving QE3 on hold. Because the overnight policy rate is unambiguously under the Fed's control, the Fed should announce a schedule of slowly phasing in higher short-term rates that would end after two years, when rates reach some modest upper bound of, say, 2%.

The current constraint on the supply of loan finance, which arises when nominal rates are near zero, would then be relaxed. Commercial banks with huge excess reserves would start lending them out for a modest return. With short rates even moderately greater than zero, the near-moribund interbank market would spring back to life as a needed backstop for commercial banks' extending their credit lines to nonfinancial enterprises large and small. Money-market mutual funds would no longer fear "breaking the buck"—seeing their net asset value drop below $1 per share—when they accept short-term deposits.

After a year or so, when the new program achieves credibility, but before reaching the 2% end point, the Fed could return to the problem of tapering QE3. We now know that merely stopping the central bank's bond-buying program—as initially suggested in Mr. Bernanke's May 22 tapering speech—with future short-term interest rates being uncertain, leaves bondholders with no idea of what the equilibrium long-term bond rate will be. (I assume that simply leaving short rates at zero is not credible, if only because it does so much damage to the financial system.)

Ideally, however, if the new program of phasing in higher short rates capped at 2% becomes credible, this would anchor long-term interest-rate expectations. When QE3 is phased out altogether so that the government no longer tries to influence long rates directly, an efficient free market would then set long rates at the average of expected future short rates—plus a liquidity premium. The liquidity premium could vary a bit with the ebb and flow of nonmonetary forces, but the mean long-term interest rate would be effectively pinned down once the market knew what the central bank plans to do. It would be a good demonstration of the importance of transparency in a free market.

The major objection to this kind of policy change is that the "recovery" from the subprime mortgage crisis and economic slump of 2008 is so weak that the economy can't withstand any increase in interest rates. This general concern with economic weakness is what pushed the Federal Reserve into its near-zero interest-rate trap to begin with—followed by the Bank of England, the European Central Bank and the Bank of Japan.  All four central banks have fallen into similar traps and their economies remain sluggish.

What is at fault here is conventional macroeconomic theory. First, although reducing high interest rates to more moderate levels is stimulating for aggregate demand, going from moderate rates to near-zero rates has proved far less effective. Second, fine-tuning monetary policy to target a nonmonetary variable, such as the level of unemployment, has become an ill-advised fetish. What Milton Friedman taught us in his famous 1967 address to the American Economic Association, "The Role of Monetary Policy," is that central banks cannot (and should not) persistently target a nonmonetary objective—such as the level of unemployment, which is determined by too many other factors.

The most straightforward approach now is for the leading central banks—the Federal Reserve (perhaps with Ms. Yellen at the helm), the Bank of England, the Bank of Japan and the European Central Bank—to admit that they were wrong in driving interest rates too low in the pursuit of a nonmonetary objective such as the unemployment level.

They could then begin slowly increasing short-term interest rates in a coordinated way to some common, modest target level, such as the 2% suggested here. Coordination is crucial to minimize disruptions in exchange rates. Then our economic gang of four should, in a measured and transparent manner, phase out quantitative easing so that long-term interest rates once again can be determined by markets.

Mr. McKinnon, a professor at Stanford University and a senior fellow at the Stanford Institute for Policy Research, is the author of "The Unloved Dollar Standard: From Bretton Woods to the Rise of China (Oxford University Press, 2013)