Essay: Monetary Policy Tough Love: Should the Fed

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Monetary Policy

Tough Love: Should the Fed Stop Worrying and Learn to Love Inflation?

Given the depth of the recent economic contraction and the credit market dislocations that accompanied it, Harvard economist Kenneth Rogoff -- a former head of the International Monetary Fund's research team -- has repeatedly warned that a conventional monetary policy framework will be unable to repair the underlying damage. Specifically, he suggests that the world's central bankers may be well served by relaxing their traditionally hawkish stances to instead embrace inflation.

In ordinary economic environments, the Federal Reserve and other monetary authorities have been extremely reluctant to tolerate inflationary pressures beyond a "comfort zone" of around 1% to 3%. Beyond that level, inflation can generate self-perpetuating distortions in consumption, production, and investment psychology as well as redistributing relative wealth in what is effectively a "regressive consumption tax" (Erosa and Ventura 2-4).

As Rogoff points out in his 2008 essay "Inflation Is Now the Lesser Evil," significant inflation also discourages lending by discounting the value of debt in real terms. Having borrowed money in the past, debtors can now repay it with debased currency, which may leave the lender with a smaller inflation-adjusted return or even an outright loss. This is normally viewed as another negative effect of inflation, but Rogoff argues that it may be the only way to let global consumers and governments work out massive debt overhangs that would otherwise be difficult to service much less retire.

Two years of 6% annualized inflation, for example, would erode the buying power of the outstanding principal on non-inflation-indexed long-term debt by roughly 11% and would depress the real value of interest payments on the same basis. While Rogoff admits that this is "unfair" to lenders, he is willing to accept the inequity if it is the only way to lower the aggregate debt burden in real terms.

Reducing the real debt burden is central to Rogoff's pro-inflationary argument because his research has demonstrated a link between high public indebtedness and slower economic growth. Over the last two centuries, Rogoff discovered, public indebtedness over 90% of gross domestic product (GDP) translated into a median drag of 1 percentage point of economic growth per year for developed economies, or 2 percentage points a year for less mature economies that accumulate debt over 60% of GDP (Reinhart and Rogoff 2).

Figure 1: U.S. Public Debt and GDP, 1995-present

Source: White House Office of Management and Budget

As it happens, the cost of the TARP program and other recession-motivated spending has pushed the U.S. federal government dangerously close to that 90% threshold. While the economy appears to be growing again, at last report the total outstanding federal debt had swelled to $12.6 trillion on annualized GDP of $14.4 trillion for a debt ratio of 87.5% (White House Office of Management and Budget 133-4). Thus, if Rogoff's observations about high debt and low growth apply to the current situation, an inflationary period could help to keep the real costs of existing federal debt from swamping a still-fragile economic recovery -- or at least, as he says, "significantly ameliorate the problems" by giving monetary policy makers more room to maneuver.

Naturally, inflation would also be a boon to retail borrowers who are currently struggling to cope with massive housing and related debt on assets that are in many cases significantly deflated, overleveraged, or both. Before the true extent of recession-oriented government spending became clear, this was initially Rogoff's primary strategic reason for advocating inflation:

In addition to tempering debt problems, a short burst of moderate inflation would reduce the real (inflation-adjusted) value of residential real estate, making it easier for that market to stabilize. Absent significant inflation, nominal house prices probably need to fall another 15%. […] If inflation rises, nominal house prices don't need to fall as much (Rogoff, "Inflation" 2).

As his later work suggests (Reinhart and Rogoff 21), while private debt also acts as a drag on macroeconomic growth, the impact of each dollar of consumer debt is likely to be more diffuse. In a recessionary period, public debt tends to increase while consumers deleverage; reinflating housing markets in particular would assist this overall deleveraging process by lowering the real cost of mortgage debt in constant dollars while creating equity.

In any event, as he notes (Reinhart and Rogoff 9, 11), both high levels of public debt (above 90%) and dramatic inflation (often above 5.5% on an annualized basis) have always accompanied periods of negative U.S. economic growth. Elsewhere ("Financial Crisis"), he has pointed to the inflation of the 1970s and the effective devaluation of the dollar in the 1930s as examples; other economists (Aizenman and Marion) would add the 1946-1955 period, in which average inflation of 4.2% eroded a massive federal debt burden of 108% of GDP by roughly 40% in under a decade.

Even if Ben Bernanke and his colleagues at the Federal Reserve did not have this historical precedent of tolerance toward inflation, Rogoff argues that an aggressively anti-inflationary posture may be a luxury that the Fed can't afford:

It will take every tool in the box to fix today's once-in-a-century financial crisis. Fear of inflation, when viewed in the context of a possible global depression, is like worrying about getting the measles when one is in danger of getting the plague ("Inflation" 2).

As it is, the magnitude of the "once-a-century" simultaneous collapse of housing, credit, and investment markets seems beyond the power of conventional monetary policy tools to repair.

Figure 2: FOMC Funds Target, 2005-present

Source: Federal Reserve

In fact, the Fed has already pushed those conventional policy instruments to the historical limit. Most publicly, from August 2007, when it became clear that problems in the subprime mortgage industry were becoming a systemic threat, the Open Market Committee guided overnight interest rates down from 5.25% to near zero in steps that were often both unscheduled and "extraordinarily rapid" (Federal Reserve Bank). The motivation here was to buffer the banking system from debt defaults while keeping cheap capital flowing through an economy that was otherwise at risk of freezing over.

Likewise, the Fed broadened its activities in the bond markets to an equally unprecedented degree in order to enforce its rate targets (through artificially augmenting demand for Treasury debt and thus depressing the long end of the yield curve) and, more immediately, to flood the world with dollars. By early 2010, the Fed had created over $1.5 trillion through its open market actions; while these extraordinary purchasing programs wound down through late 2009, they still represented a massive fiat expansion of the overall monetary supply over the course of their existence.

Figure 3: The Federal Reserve Balance Sheet, 2Q 2007-present

Source: Federal Reserve Bank

Between these monetary policy activities and the parallel expansion of government deficit spending on active economic stimulus, conditions would ordinarily be perfect for substantial inflation. However, while Rogoff acknowledges that "all central banks need to do [to create inflation] is to keep printing money to buy up government debt" ("Inflation" 2), this has not yet materialized. After flirting with technical deflation for much of 2009, consumer inflation is now positive -- 2.4% on an annualized basis -- but far from the elevated level that advocates of pro-inflationary policy would like to see.

Figure 4: MZM Money Stock, 2006-present

Source: Federal Reserve Bank of St. Louis

This absence of more widespread inflation during this period has often been commented on, but Rogoff would likely attribute it to the extent of the deflationary forces generated by the worst economic contraction in at least a generation. Indeed, to borrow his phrase, it appears that the Fed has been hard-pressed so far to do much more than successfully avoid sustained deflation. With 28% more dollars in circulation than there were in March 2007 (Federal Reserve Bank of St. Louis, MZM), nominal prices would logically have to expand on a similar basis over the past three years, but instead, the CPI is up 5.8%. Even after more than a year of effective zero-interest rate policy, consumer prices are still only increasing at a slighly lower-than-average pace.

U.S. central bankers have repeatedly acknowledged the unusual parameters of the situation, most recently conceding that "substantial resource slack continu[es] to restrain cost pressures" and that in fact "inflation is likely to be subdued for some time" (Federal Open Market Committee). This, in turn, has given the Fed unusual latitude to keep its rate targets practically at zero even though this would ordinarily feed inflationary pressure once economic activity revives.

More robust inflation would not only help defray the real cost of servicing government and private debt. Research suggests that a somewhat elevated inflation environment boosts seigniorage revenue -- the theoretical "inflation tax" or profit that the government derives from creating money -- by roughly 62% (Neumann 39). Extrapolating from 2000 figures (U.S. Senate Banking Committee) and the subsequent 326% expansion of paper currency (U.S. Bureau of Printing and Engraving), seigniorage may currently translate into an… [END OF PREVIEW]

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