From anti-inflation to pro-inflation

With the release of the Fed minutes yesterday, some commentators (such as Steve Goldstein of Marketwatch) came to the conclusion that the Fed is running out of bullets:

To put it differently: the Fed thinks the economy isn’t that great and there’s very little inflation to worry about, but its primary program to improve the economy doesn’t do very much.

It’s a clear admission the Fed is running out of gun powder. And that’s quite a shot it has fired to the markets.

A sea change in approaches to central banking
I emphatically disagree. In the last few years, we have seen a sea change in the approach to central banking. Gone are the days of Paul Volcker's adoption of Milton Friedman's monetary paradigm of PQ = MV. In a speech by (then) Governor Ben Bernanke on July 23, 2003 entitled An unwelcome fall in inflation?, he implicitly dismissed excessive money growth as a source of inflationary pressure [emphasis added]:

You may have noted that I did not include money growth in this list of inflation determinants. Ultimately, inflation is a monetary phenomenon, as suggested by Milton Friedman's famous dictum. However, no contradiction exists, as the expectational Phillips curve is fully consistent with inflation's being determined by monetary forces in the long run. This point, originally made by Friedman himself, has been demonstrated in many textbooks and so I will not discuss it further here. I only note that, as an empirical matter, instabilities in money demand, financial innovation, and many special factors affecting the monetary aggregates make them relatively poor predictors of inflation at medium-term horizons. For this reason, the role of the money supply remains implicit in this discussion.

In other words, PQ = MV doesn't work well in the short term because V, or monetary velocity, is not constant.

What's more, Bernanke has some very creative ideas of what to do when interest rates hit the zero bound. In a May 31, 2003 speech entitled Some Thoughts on Monetary Policy in Japan, he argued for monetary and fiscal authorities cooperation [emphasis added]:

Discussing the optimal objectives for Japanese monetary policy is all very well, but what of the argument, advanced by some officials, that the Bank of Japan lacks the tools to achieve these objectives? Without denying the many difficulties inherent in making monetary policy in the current environment in Japan, I believe that not all the possible methods for easing monetary policy in Japan have been fully exploited. One possible approach to ending deflation in Japan would be greater cooperation, for a limited time, between the monetary and the fiscal authorities. Specifically, the Bank of Japan should consider increasing still further its purchases of government debt, preferably in explicit conjunction with a program of tax cuts or other fiscal stimulus.

Wow! The government to spend and the BoJ to buy government bond in support (by printing money)? What happened to monetarism and the discipline of the markets? What happened to Reinhard and Rogoff's work on the sustainability of public debt? Bernanke addresses this issue:

Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.

Bernanke goes even further by stating that debt monetization could support public spending programs in order to generate a little inflation. Indeed, a little inflation isn't a bad thing to have under the circumstances [emphasis added]:

Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example. The BOJ's purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, BOJ purchases of government debt lower current deficits and interest burdens and thus the public's expectations of future tax obligations. Of course, one can never get something for nothing; from a public finance perspective, increased monetization of government debt simply amounts to replacing other forms of taxes with an inflation tax. But, in the context of deflation-ridden Japan, generating a little bit of positive inflation (and the associated increase in nominal spending) would help achieve the goals of promoting economic recovery and putting idle resources back to work, which in turn would boost tax revenue and improve the government's fiscal position.

That's what I meant by a sea change in the way that central bankers think. The thinking have gone from focusing on monetary growth targets (in order to control inflation), to monetary stimulus (to stimulate growth), quantitative easing, nominal GDP targeting and fiscal and monetary cooperation. Bernanke believes that fiscal and monetary cooperation is one more tool that the Fed has when interest rates hit the zero bound, as per his helicopter speech [emphasis added]:

As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

Is the Fed out of bullets? Definitely not. Once you recognize that Bernanke believes that the mission of the Federal Reserve has moved from primarily an anti-inflation mandate to a pro-inflation (anti-deflation) mandate, you understand how far Bernanke is willing to go.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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