The Fed can generate inflation. Perhaps that seems obvious. After all, the Fed can create money at essentially zero marginal cost. But the point has been disputed. Several decades ago, a generation of Keynesians held firm to the belief that inflation was not a problem if the economy was not at full employment. In a world where inflation expectations lag behind actual inflation, expansionary monetary policy boosts aggregate demand, increasing the level of real output (productivity). Only when the economy is at full employment does an increase in the level of total expenditures translate entirely to an increase in the price level associated with inflation.
However, we learned from the stagflation of the 1970s that inflation is always and everywhere a monetary phenomenon. Increasing the quantity of circulating currency will eventually generate inflation. We seem to have forgotten this lesson. The Federal Reserve has convinced investors that a massive expansion of its balance sheet will not lead to inflation. Some believe that the Federal Reserve will be unable to meet the new average inflation target.
Rest assured: we will soon be shaken from our complacency. Over the last several months, inflation expectations implied by the TIPS spread have noticeably risen. Some might conclude from the post-announcement pullback in inflation expectations that the Fed’s new policy will be ineffective. The recent pullback in stocks and U.S. Treasuries have reversed some. Expected and actual inflation exceeds the 2 percent mark. And the rates on U.S. Treasuries, especially of longer maturities, will rise with these inflation measures.
I believe those who see the pullback in inflation expectations as a sign of the ineffectiveness of Fed policy on the post-announcement movements in rates on sovereign debt. Changes that occur soon after an event should be interpreted in light of context. The announcement was no surprise. Many had been expecting the change in policy. The FOMC did not hide it from the public.
Yet, the TIPS spread has not risen above 2 percent. Perhaps investors are not fully convinced by the Fed’s new policy. The market is a process. Every investor knows that the expectations game is a tug-of-war between the bears and the bulls. Even a market that is fundamentally ready to take off has to overcome the pessimism of the bears. For now, the position of the bears is supported by the continued transmission of Covid-19 in the U.S. and Europe and the return of restrictions on the freedom to assemble.
I think their pessimism is misplaced. The Federal Reserve has signalled strongly that it will provide support in the face of a drop in the level of total expenditures. It swiftly responded to the Covid-19 crisis. And, as a result, deflationary pressure was limited compared to the 2008 recession. We had only a brief crash in inflation expectations. Inflationary expectations never fell into negative territory and they quickly recovered to pre-crisis levels. Investors expected that the Fed was committed to maintain growth in the level of expenditures. They were convinced of this before the Fed’s announcement of its commitment.
The preannouncement increase in inflation expectations remains intact. I expect that the Federal Reserve is committed to and will effectively implement an average inflation target. If I am right, investors will account for this in time. Of course, I might be wrong. But I would be surprised if a central bank, the entity that can literally create money, were unable to generate inflation despite its intention to do so.
Those who believe that the Federal Reserve will be unable to lift inflation expectations suppose that the zero-lower-bound problem will prevent effective policy implementation. Absent a negative rate regime, interest rates reach a floor at zero percent. If inflation expectations don’t increase, nominal interest rates will be too low to allow the Federal Reserve to lower interest rates. The Fed has not shown a willingness to move rates into negative territory, making a negative interest rate policy unlikely. Hence, the central bank fails to stimulate economic growth in this view because it is unable or unwilling to lower rates.
Others believe that the Federal Reserve will fail to generate a higher rate of interest due to its payment of interest on excess reserves. If correct, it is unclear why there has been any inflation since the Federal Reserve began paying interest on excess reserves.
Yet, the Federal Reserve has many options to increase the rate of inflation. One way or another, the Fed will meet its new target.
The Fed could cease removing funds from the overnight lending market, a policy which has resumed since the start of the Covid-19 policy crisis. Or, the Fed can expand its domain of operation to find new borrowers, as it did with its Main Street Lending Program in the last year.
Finally, as Bernanke famously noted, the Fed could expand the quantity of money in circulation by supporting fiscal expansion or dropping money from helicopters. While I am not calling for either policy, I am confident that policymakers have enough motivation and creativity to find a way to generate inflation. Indeed, Steve Mnuchin’s recent call for the central bank to support fiscal expansion suggests that policymakers are already thinking in these terms.
A lack of concern for fiscal discipline by both the U.S. Treasury Secretary and a call for persistent, near zero rates by the Chairman of the Federal Reserve suggests that the Federal Reserve and the U.S. Treasury will act in concert to make the new inflation target a reality. It is not a question of whether the inflation rate will pass 2 percent, but when.