A Platonic Dialogue About Quantitative Easing, or, Summoning the Inflation Expectations Imp
Glaukon: Let us talk about the Inflation Expectations Imp.
Daedalos: The Inflation Expectations Imp?
Glaukon: That is what Robert Waldmann calls him. He is a cousin of the Confidence Fairy.
Glaukon: As you know, if the fiscal authority finally gets its house in order, adopts a sustainable long-term fiscal plan, and demonstrates its commitment to that plan by immediately undertaking politically and economically painful austerity measures, the Austerity Confidence Fairy appears and touches business investment committees with her magic wand, and they begin to spend, and the economy recovers!
Glaukon: When the central bank commits to a program of quantitative easing that is sufficiently large, people's fears that this program of quantitative easing signals higher future inflation leads them to start dumping nominal assets for currently-produced goods and services: that and that alone then generates the higher inflation that they feared, and so the economy recovers!
Kurush: You are, I presume, saying that there is a certain formal symmetry between these two arguments?
Kurush: There is a difference, however. The impact effect of austerity is to reduce government purchases, which means it's non-expectational effect is to put downward pressure on aggregate demand.
Glaukon: But that downward pressure is trivial compared the mighty force of the wand of the Confidence Fairy!
Kurush: And the impact affect of quantitative easing is to take risks off of private sector balance sheets, leaving them with underused risk bearing capacity that can then support additional loan-financed spending. Its non-expectational effect is to put upward pressure on aggregate demand.
Glaukon: Trivial compared to the much larger stimulus to spending caused by the mighty force of the Inflation Expectations Imp!
Kurush: Excuse me. The point is that there is no expectations tatonnment process that would lead one to anticipate that the Austerity Confidence Fairy would be effective. If you start from the assumption that people do not anticipate any Confidence Fairy expectational effect, then news of austerity makes them depressed--and then when they factor that depression into their models they become even more depressed, and the thing spirals downward. by contrast, if you start from the assumption that people do not anticipate any Inflation Expectations Imp expectational effect, the fact that the Federal Reserve has taken risk onto its balance sheet leads people to think that there is now unused risk-bearing capacity to support a higher level of investment, and when they factor that anticipation into their models they become even more optimistic, and the thing spirals upward.
Glaukon: Clever. But important enough to be worth taking into account? I mean, photon pressure on a thrown pitch tends to push it downward and could turn a high ball into a strike.
Kurush: This is why Gagnon, Evans, Hatzius, Romer, and company want open-ended policies: why they want the Federal Reserve to engage in open-ended Quantitative Easing III expanded without limit until the chosen expected price level or current interest rate target is hit.
Glaukon: So you are saying that they have already taken my critique of relying on the Expected Inflation Imp into account in designing their desired policy?
Glaukon: But there is no such thing as "unlimited"--at some point if the bond purchases are failing to affect prices the policy is reversed. So I think I can suppose we restrict ourselves to limited Quantitative Easing III--to purchases by the Federal Reserve of less than $1T of long-term bonds. Is there any better reason to think that that would summon the Inflation Expectations Imp than to think that a long-term entitlements Grand Bargain supported by a discretionary Federal spending freeze would summon the Confidence Fairy?
Klio: Now you are just being mean to Tim Geithner and Barack Obama…
Kassandra: I must protest this assumption you are all making that a policy of unlimited Quantitative Easing III is even conceivable. Suppose the Federal Reserve starts buying. And it pushes long-term bond prices above what people regard as their fundamentals. And so people sell their bonds for cash--and then they take their cash and leave it as reserve deposits at the Fed, thinking that sooner or later the Fed will have to sell off its bonds for less and then they will have their profit. At some point the Federal Reserve then turns into the London Whale and abandons its purchases and unwinds its position.
Klio: The Fed does not have to turn into the London Whale. It could just hold the bonds to maturity.
Kassandra: Ben Bernanke is not Chair-of-the-Federal-Reserve-for-Life. Barack Obama has shown no sign of wishing to appoint Federal Reserve Governors who would pursue a more aggressive and expansionary monetary policy than Ben Bernanke has. Rather the reverse: the aggressive wing of the Fed is made up of bank presidents like Evans, Rosengren, Williams. Mitt Romney does not know much about monetary policy. Paul Ryan does not know much either--but he thinks he does, and what he thinks he knows calls for a much tighter monetary policy than Bernanke has pursued.
I cannot think of anybody on Wall Street today who would be willing to bet that bonds bought in the next six months as a result of Quantitative Easing would be held to maturity.
I can think of many for whom the obvious play if the Fed engages in Quantitative Easing is to sell your bonds to the Fed now, bank the cash, and wait until two or three or four years from now when the Federal Reserve decides to unwind its position as the political logic of Washington changes--and then price pressure works against the Fed, and gets you a very good price on your bonds, and a very good nearly-riskless profit on the round trip.
Glaukon: Then you are saying…
Kassandra: If stabilizing speculators believe that Quantitative Easing III will be ineffective and will be unwound in three years, they will bet that Quantitative Easing III will be unwound in three years, and that bet will make Quantitative Easing III ineffective, and because it is ineffective it will be unwound in three years. A self-consistent bad expectational equilibrium. It is out there. Scott Sumner's claims that the Fed can change the strategy space to one of pegging nominal GDP to its target rather than buying and selling fixed quantities of bonds and so eliminate the self-consistent bad expectational equilibrium work on the blackboard but may well fail in reality.
Glaukon: But Bernanke can promise that the bonds will be held to maturity…
Kassandra: And two years from now when Ryan is vice president and yammering about how bonds are in a bubble and the Fed is like the London Whale and demanding that the next Fed Chair unwind Bernanke's positions as a price of appointment and claims that the Fed is bankrupt because of all of Bernanke's trading losses--what good are Bernanke's promises now for what will hold then? He simply cannot commit. And without commitment, there is no reason to be confident that markets will respond to quantitative easing the way you think they should. And if they don't respond, Bernanke's successor certainly will not double down on a failed policy.
Glaukon: So what you are saying is…
Kassandra: That there is no way for the current Federal Reserve to commit not to unwind Quantitative Easing III. Thus if people believe in it, it works. And if people do not, it does not--and it is unwound in the next Federal Reserve Chair's term.
Kurush: So you are saying that there is exactly as much reason to be confident in the expectational equilibrium shift that you anticipate from summoning the Inflation Expectations Fairy as there was to be confident in the expectational equilibrium shift that Tim Geithner anticipated from summoning the Austerity Confidence Fairy?
Klio: Now you are just being mean.
Glaukon: But the Swiss National Bank changed the strategy space. It announced on September 6, 2011 that:
it would set a minimum exchange rate target of 1.20 francs to the euro and would enforce it by buying foreign currency in unlimited quantities.
And the Swiss franc fell by 9% in the next fifteen minutes without the SNB having to sell a centime:
In the absence of an upward inflationary spiral, why would anybody ever believe that Quantitative Easing III would be unwound?
Klio: Perhaps if they thought that the Federal Reserve had a 2%/year inflation ceiling, they would think it would be unwound whenever expectations of inflation started to rise above 2%/year, and thus if Quantitative Easing III began to have an effect on future price and inflation expectations the Federal Reserve would undo it.
Glaukon: Why should anybody think that the Federal Reserve has a 2%/year core inflation ceiling?
Klio: OK. A 2.2%/year inflation ceiling:
Daedalos: But suppose you could undertake some form of Quantitative Easing that cannot be unwound.
Daedalos: Suppose that the Federal Reserve printed money and used it to buy bridges, roads, biomedical knowledge, the human capital of twelve-year-olds, and so forth.
Glaukon: It would have to be the Treasury that was doing the buying…
Daedalos: Yes. That's the point. Money-printing financed fiscal expansion avoids the crowding-out risks of fiscal policy--no bonds are sold to crowd anything out--and the unwinding risks of Quantitative Easing--the transactions cannot be unwound.
Klio: So you would summon not the Austerity Confidence Fairy or the Inflation Expectations Imp but the Fiscal Policy Pooka?
Daedalos: Or, if not for Tim Geithner's keeping Ed DeMarco around, the Mortgage Valuation Valkyrie…