Fed chairman Jerome Powell is significantly under fire for his apparently lack of ability to take inflation seriously or admit it may be more than “ transitory. ”
There’s been a lot talk of tapering the Fed’s enormous asset purchases, yet— as is typical for the Given, actual action remains scheduled for some nonspecific time in the near future. And if the economy weakens, as an increasing number of observers expect it to do , the Fed will surely poultry out on tapering and keep the cash spigots open.
Yet as lately as August the Given and its officials routinely cautioned that there wasn’t enough inflation and that the central bank must take the appropriate steps to get price inflation to the “ 2 percent” objective.
Indeed, for the past decade this concern over too little inflation has been a common narrative. Moreover, the 2 % inflation target is presented in the financial press as simply an assumed requirement. The inflation target can be treated as if it had been a timeless metric, plus (apparently) everyone agrees Given policy ought to be guided simply by this target. Moreover, it’s actual part of a dangerous package of policies including the payment of interest on reserves, and Fed purchases of long-maturity provides. The result is a chaotic economy heavily manipulated by Fed treatment.
Yet what’s so great about two percent inflation anyway? Exactly why do central bankers demand it’s so important? And possibly far more important is the bigger question: What effect could be the inflation target having on the particular boom-bust cycle and on economic prosperity?
The answers to these questions are explored and explained in Brendan Brown ‘s book The Case against 2 Per Cent Inflation: From Bad Interest Rates to a 21 st Centuries Gold Standard (Palgrave Macmillan, 2018). Brown comes to the topic along with considerable expertise. Currently Brown is a founding partner in Macro Hedge Advisors, and he’s the former head associated with economic research for Mitsubishi UFJ Financial Group.
At the core of Brown’s analysis is the fact that the world of the two percent target (TPT) is usually something new— and worse— than what came just before. It’s not just the same old financial policy but with slightly higher inflation targets. No, the era of the TPT is different, Brown explains, because it is portion of the fundamental shift to “ unconventional monetary policy. ”
Disregarding the Monetary Base
One of the key modifications inherent in the TPT is the fact central bankers moved away from managing the size of the monetary base, and have instead accepted targeting price inflation directly. That is, before the Great Recession— and especially before the reign associated with Alan Greenspan— central brokers used changes in the monetary base as the metric for just how much the money supply was to become inflated.
This particular distinction, Brown notes, is important because when the monetary base is the “ pivot” to get monetary policy, market mechanisms are still largely able to functionality. Under these conditions, you can find no attempts to directly manipulate interest rates and the thought of negative interest rates is something for the realm of fantasy.
Matters are quite different under a TPT standard. In the era of TPT, an arbitrary items price inflation rate gets to be the pivot for plan, and the central banks intervene directly to force up cost inflation and manipulate interest rates. This can be done through the new and novel method of spending interest on reserves (IOR) and through the central banks’ large-scale purchases of long-maturity government bonds.
The Fed Adopts New Tools to More Forcefully Manipulate Financial Markets
Why did the particular Fed need these brand new tools? As Brown displays, the Fed had lost faith in letting markets work with old-fashioned increases towards the monetary base. With the Fed engaging in unprecedented new models of monetizing debt, Fed officials surely feared rates of interest could rise without a lot more direct control. Dark brown writes how the new financial regime
was very different from an urgent situation increase in monetary base designed to pre-empt a contraction of the money supply which could intensify the economic downturn. Rather it had been a deliberate experiment to get new control over short- plus long-term interest rates, subjecting these types of to incessant manipulation, plus alongside the giant enlargement of the Fed’s balance page served key non-monetary purposes— including the subsidization of home loans.
This set the stage for tremendous money supply inflation made to prop up price inflation to the 2 percent target. But the Fed also kept failing to meet this particular 2 percent goal in the decade following a Great Recession. This was partially because at this time many causes of disinflation were at the office. Brown continues:
In seeking their target under the 2% inflation standard, central brokers and their political masters have experienced much frustration. The particular natural rhythm of prices has been downwards— reflecting quick globalization and digitalization. Central bankers have sought to suppress this (natural rhythm) and drive prices higher on a sustained basis. They have got encountered pushback from a mixture of circumstances…. They have doubled up, developing non-conventional monetary tools designed to increase the effectiveness of their policies aimed at “ breathing in inflation. ”
All of this, however , continues to be an experiment of large increases in money provide coupled with policy tools which are hardly tried and true. So , Brown warns:
These tools have carried serious side-effect. In particular, they destroyed the signalling mechanisms in the long-term interest rate market necessary to the well-functioning of a capitalist economy. While too early to find out what the eventual cost of this particular dysfunction will be, there are currently indications that the consequences are usually serious.
Messing Up Market Prices
The effects are serious indeed, because we’re at this point in a world where immediate rates are heavily controlled by the payment of interest upon reserves. Meanwhile, long-term rates are subject to the manipulation of Given asset purchases. Having wrenched interest rates further from the markets, the “ signalling mechanisms” no longer function and entrepreneurs interpret low interest rates as being a signal to pour additional money into longer-term projects. This reduces near-term investment in consumer products while the rising money supply at the same time encourages more spending on customer products. 1 Not surprisingly, price inflation in consumer goods will follow. This, of course , is exactly what the central bankers want in their pursuit of TPT, and all these false signals from interest rates can mean “ mission accomplished. ” But , as Brown notes, this comes with a price of “ dysfunction, ” as artificially low interest rates have led to immense amounts of malinvestment— which will eventually failure.
Fed economists likely know there is a big risk here, but politics realities likely won’t allow for any easy way out. This is for at least two reasons. The first is expectations. It is now assumed that any sign of “ deflation” or a worsening economy will bring even more stimulus, and as Brown notes,
In the bizarre and destabilizing world of the global 2% inflation standard…. [t]he presumption becomes that the central banking institutions will ease policy— meaning lower real rates than otherwise in the short plus medium term— in response to any kind of setback on the road to getting inflation back to 2% (from territory below). The consequences may well be a more intensification of asset pumpiing such as we witnessed via 2017.
This assumption is now built into Wall Street’s view of the central bank. The failure of the Fed to get involved in this fashion would likely provide bearish equity markets, and few incumbent politicians need that.
The particular Quest for Negative Interest Rates
But perhaps the greatest issue is the fact the particular Fed is desperate to get inflation rates up so that it has room to maneuver in case of a new recession or economic crisis. As it is, both real plus nominal interest rates are now as well close to zero for the Given to force down prices very far in the name of incitement. That is, the Fed desires to be able to push rates down a long way in order to stimulate the economic climate, but nominal prices can’t go much below zero. On the other hand, if the Given can get the inflation rate— and inflation expectations— upward to 2 percent or more, then the Fed can drive real rates down a lot further below zero. 2
Brown knows where all this leads. Indeed, we’re already there. One problem is a famine in interest income, along with a hunt for yield that gets ever more risky. The result is an increasingly fragile financial system. Other problems include mounting malinvestments and the inability of regular investors to save and spend money on any fruitful way. Increasing inequality, widespread defaults, and slowing economic growth are all outcomes we can expect.
Fortunately, Brown isn’t very content to just outline the problem. He provides a blueprint for any step-by-step return to relative normalcy. For him, the ideal is really a gold standard. But failing that, he allows for several other options in which cash would be relatively sound and reliable in contrast to today’s increasingly outlandish monetary experiments. Brown is nothing if not pragmatic and deeply steeped in the real-world workings of financial marketplaces. His book would be a very useful addition to the reading listing of any reader interested in to the specific details of monetary policy and the dangerous world the central bank has built.