This is a post more for posterity, really, and other selfish reasons. It’s a piece of analysis on the effect of the US Federal Reserve’s QE2 program on inflation expectations. This was my view at the time, but this question will be relevant for a very long time. With interest rates hitting the zero lower bound and monetary policy in unchartered waters, the normal transmission mechanism of monetary policy is broken. Thus, the effect of Federal Reserve policy on inflation and inflation expectations is a fascinating area to watch. This is definitely something to come back to at a later date.
QE2: Winning the battle of Inflation Expectations
Unconventional monetary policy is still monetary policy. This was the view from Fed Chairman Ben Bernanke in response to critics of the Feds programme of quantitative easing. Known as QE2, this latest round of monetary stimulus involves the Fed buying $600bn worth of long term US Treasuries. Given the unconventional nature of this programme, it is not surprising that it has had its critics. Criticisms have been heard from emerging markets, fearing an inflow of hot money, as well as Germany’s Finance Minister Wolfgang Schauble, claiming the results will be horrendous for the global economy. In the US, a prominent group of economists and analysts have published an open letter citing the debasement of the dollar and hyper-inflation as reasons to stop QE2 immediately. What is clear, however, is that deflation, rather than inflation was the major concern at the time when QE2 was launched. Standard economic analysis shows that the program was indeed necessary, as the US economy actually requires inflation to maintain the fragile recovery.
Ben Bernanke was right to explore unconventional methods of stimulating the US economy at this time as the short term rate on US bonds has been pushed to near zero. Despite these low rates, the US economy is still suffering from a large output gap – the difference between current output and potential output given the productive capacity of the economy – and unemployment of over 9%. Economists refer to this situation as a liquidity trap, as short term bonds and cash become almost equivalent assets. The strategy available to the Fed then becomes the unconventional one of buying long term bonds, in order to drive down long term rates and stimulate the economy. Lowering long term rates, however, is not the only goal of QE2.
The Fed now faces an ‘expectations’ issue regarding inflation. The concept of inflation expectations is crucial to the economic recovery. After establishing the necessary credibility regarding price stability, the fed could not allow the current downward trend in core inflation – CPI for all items excluding food and energy – to permanently unhinge the anchor of inflation expectations at around 2%. By engaging in QE2, the Fed is signalling that they are willing to do anything to maintain that anchor. This is precisely where concerns about hyper-inflation are misplaced. By signalling their willingness to maintain that expectational anchor, the Fed would do everything in its power to control rising inflation in the future if it did occur.
Deflation is the major concern
Deflation is a concern for consumption in normal times, but it becomes a major worry in an economy deleveraging from debt, as first discussed by Irving Fisher in the 1930s. For the purposes of exposition, consider two types of consumers: one that is heavily indebted and another that is debt free. For those consumers in the US that are heavily indebted, deflation would increase the real burden of their debt. These consumers become much worse off and decrease their spending further, creating another drag on the economy. For those US consumers who are debt free, deflation offers them the perfect reason to delay their consumption. This is where the anchor of inflation expectations becomes crucial. If the Fed allowed the current us disinflation to turn into expectations of deflation, these consumers would have no incentive to spend now. While deflation would increase the real value of their income, expectations of lower prices in the future could delay spending, especially on larger items. Consequently the economy needs inflation. If expectations of deflation set in, it would lead to a downward spiral that would be very difficult to reverse. In an economy where consumption comprises 70% of GDP, the debt deflation spiral would be very damaging indeed.
Mervyn King, Govenor of the Bank of England, has argued that deflations negative effect on aggregate spending can be amplified when consumption depends on the value of assets that are used as collateral for loans. Mr King relied on this notion to argue that debt deflation was the cause of the depth of the recessions in the US and UK in the early 1990s. In Mr King’s opinion, negative equity in housing can have a particularly severe effect on consumption. These sentiments were echoed for the current US climate in a letter from the Federal Reserve Bank of San Francisco. The analysis focused on the role of household debt and weakness in the recovery and found stark differences between US counties with high and low levels of household debt. Those counties that had built up high household debt during the boom are experiencing a more muted recovery in consumption and investment than those counties with lower household debt.
In a similar vein deflation would discourage investment. Like consumption investment depends on the real interest rate, not solely on the nominal. Again, expectations are key as the real interest rate is approximately the nominal rate minus expected inflation. Consequently, deflation expectations can turn a near zero nominal rate into a positive real rate. This simple relationship is needed to examine the prospects of investment in a situation of deflation expectations. Investment theory informs us that investment depends on both current and future profits. When calculating future profits, these must be discounted by future real interest rates. If firms believed that the current disinflation will turn into outright deflation, the real rate increases and future profits are discounted more heavily. The more they are discounted the less attractive the potential investment becomes. When inflation expectations are re-established and stabilised, it takes away one important area of uncertainty that may have been restraining private investment.
The impact of QE2 on Inflation Expectations
Inflation expectations can be difficult to measure accurately, but one measure commonly used to gauge expectations are inflation swaps. These are financial transactions where investors swap a fixed payment for payments based on the CPI. The first chart below shows the rate on the 5 year zero-coupon inflation swap. It is this downward trend from May to September, that when combined with the trend of actual inflation shown above, would have concerned the Fed. There is a clear uptick from September that one would assume owes a lot to QE2. Emphasising this effect, a more ‘pure’ measure of inflation expectations from the Cleveland Fed displays a similar trend. With measures such as inflation swaps, there is an ‘inflation risk premium’ that is embedded in this rate. Through removing this effect, the Cleveland Fed obtains this pure measure. Either way, inflation expectations have taken a significant turn upwards.
It can be common in economics to discuss the counter-factual, that is, alternate paths that an economy may face. Given the seriously damaging effects that deflation would have on the economy, it is easy to see why the Fed is so keen to avoid this alternate reality. In a recent appraisal of the program, Fed Vice-Chair Janet Yellen said that there will be 3 million more jobs and inflation is a percentage point higher because of this policy. It seems, to this point at least, that the Fed is also winning the battle on inflation expectations. This may prove to be the most crucial outcome of QE2. Some commentators, such as Lars Svensson, an academic specialist on monetary policy, believe the reason that Japans QE in the 1990s was not successful was because the authorities failed to re-establish inflation expectations. The Fed looks to have avoided this fate, so the natural question then arises, what does it do next? As inflation expectations are based on the expectations of future monetary policy, the Fed’s signals over their next move will be analysed very carefully.