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Kevin Drum has a post discussing whether the Fed could achieve a 4% inflation target. The post discusses some of Brad DeLong's idea, and then concludes as follows:

So if I'm reading DeLong right, it's not clear that the Fed could engineer 4 percent inflation at all right now. Maybe Scott Sumner has a bright idea about how we could do this.
This is always a difficult question to answer. Not because the solution is difficult---it's incredibly easy---rather because it's difficult to explain the solution to others, as most people think about policy in terms of cause and effect, not needed effect and implied cause. The simplest solution is to commit to buy T-bonds (and, if needed, Treasury-backed MBSs) until TIPS spreads show 4% expected inflation. At that high an inflation rate you don't need much QE, because the public and banks don't want to hold much base money.

But most people don't see things that way. They want to know how the policy can work assuming the public expects it to fail. I don't see why the public would expect it to fail if the TIPS market expected it to succeed, but let's put that aside. The fear is that even if the Fed bought all $20 trillion in T-bonds and Treasury backed MBSs, we still wouldn't get 4% inflation. If they adopted a 4% inflation target, I actually don't think the Fed would need to buy even one dollar more in debt, just refrain from raising rates for a few more years and stop paying interest on reserves. But let's say I'm wrong. What then?

Then you put a negative 2.75% interest rate on bank excess reserves, including vault cash holdings above a certain minimum threshold. That dramatically reduces the amount of QE required, as all the base injections go out as cash held by the public (and of course some of that goes back into safety deposit boxes, which is not the same thing as vault cash.)

I very much doubt that this hypothetical would ever come into play, but the thought experiment shows the Fed hasn't even done 10% of what it could do, so no one should ever be pessimistic about the ability to hit a 4% inflation target based on actual central bank policies in recent years---they haven't even come close to testing that ability.

Of course anything is theoretically possible, and if I'm completely wrong then the government would face a choice, either undershoot the 4% target, or let the Fed buy things they currently are not allowed to buy. But I would strongly encourage Kevin Drum to rethink his pessimism on this issue. The passivity of real world central banks should not lead us to doubt what a really determined monopoly producer of intrinsically worthless fiat money can do, if sufficiently determined. They can debase their currency, if they wish to. As James Hamilton once said (not exact words) "If the Fed doesn't know how to create inflation, then put me in charge."

That's how I feel too. Fortunately there is no need to---the Fed insists it could do much more stimulus if it wanted to.

HT: Rob Fightmaster


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COMMENTS (21 to date)
Emerson writes:

As Prof. Sumner says, the Fed could easily create inflation.

So why doesn't the Fed at least hit its implied 2% target?

My impression is that the public , and Congress, are more anti inflation than they are anti slow growth. And so any degree of inflation would be met with a political backlash.

The Fed is a political organization after all, and it wants to shield itself from the political heat that would come from inflation

J Mann writes:

I've said this before, but if your *worst* case scenario is that the Fed prints enough money to retire the entire government debut and for the government to declare a 100% tax holiday and stimulus 2.0 and we STILL don't reach 4% inflation, then let's go ahead and try that!

baconbacon writes:

There is a lot of re-framing going on here. The question isn't "can the Fed produce more inflation?"- its "can the Fed hit an inflation target of 4% consistently?".

B Cole writes:

So, if the Fed says it is targeting 2% inflation and conducts $10 trillion dollars of QE, what is the probable result?

Scott Sumner writes:

Emerson, I strongly disagree. Prior to 2008, inflation was running slightly above 2%, and people viewed Greenspan as some sort of genius. He was lauded by Congress and by the press.

JMann, Good point.

Bacon, If they do get to 4% inflation then there would no longer be any zero bound problem. In that case there is no reason that they could not go back to the policies of 1990-2007, which were very effective at keeping inflation close to the target.

Recall that Kevin Drum was skeptical that they could even reach the target at all---that's what I was responding to.

Ben, Right now? More than 2% inflation is the "probable result".

Kevin Erdmann writes:

Scott, I don't think you're being fair to Emerson. There has been a clear shift in sentiment since the 1990s because of the housing debacle. There is near unanimous agreement that the Fed was very loose in the 2000s despite NGDP growth that was lower than any other period in modern experience and inflation that tended to fluctuate closely around the 2% range. There is strong public sentiment now against neutral monetary policy.

baconbacon writes:

Scott-

That is an enormous leap. The ZLB isn't the only difference between the current situation and today. Large excess reserves still exist which could well make the process of adjusting the Fed funds rate via expanding/contracting reserves difficult and possibly impossible. Additionally publicly held debt (as a % of GDP) is much larger than it was during the 80s/90s, and demographics have also changed. Assuming that policies that worked somewhat well during a different would definitely work well again is a dubious assumption.

Ricardo writes:

Way too complicated. A much simpler solution is to get out those Whip Inflation Now buttons and put them on upside-down.

MikeP writes:

A much simpler solution is to get out those Whip Inflation Now buttons and put them on upside-down.

Excellent!

It might even socialize the idea of a Nominal Inflation Market. The Fed could target that.

Shayne Cook writes:

Ricardo, I can't thank you enough. You not only provided me with an LOL for today, but also an LOL for every Sumner post in the foreseeable future.

Jeff writes:

[Comment removed. Please consult our comment policies and check your email for explanation.--Econlib Ed.]

Justin D writes:

--"That is an enormous leap. The ZLB isn't the only difference between the current situation and today. Large excess reserves still exist which could well make the process of adjusting the Fed funds rate via expanding/contracting reserves difficult and possibly impossible. Additionally publicly held debt (as a % of GDP) is much larger than it was during the 80s/90s, and demographics have also changed. Assuming that policies that worked somewhat well during a different would definitely work well again is a dubious assumption."--

I don't see how any of that is relevant is to whether the a central bank can generate a modest amount of inflation.

The Fed doesn't need to adjust the funds rate to create inflation. The Fed can communicate that it won't raise rates until core PCE inflation is above 4%, or engage in more QE purchases until such target is reached, or a combination.

baconbacon writes:

@ Justin D-

Reread what I was responding to

In that case there is no reason that they could not go back to the policies of 1990-2007

Your last few lines are simply an assertion that no central bank has ever successfully accomplished. Its efficacy is in doubt and is the basis for this discussion in the first place.

CMA writes:

"The simplest solution is to commit to buy T-bonds (and, if needed, Treasury-backed MBSs) until TIPS spreads show 4% expected inflation. At that high an inflation rate you don't need much QE"

Don't you need a lot of QE in the first place though to get the 4% inflation.

"I actually don't think the Fed would need to buy even one dollar more in debt, just refrain from raising rates"

To prevent rates from rising the fed would need to conduct OMP's.

TallDave writes:

Good explanation. And hey, if the Fed really can buy $20T in Treasuries with no inflation -- for gosh sakes do it right now! Then give the country a $1T/year tax cut with the interest. I mean, wow.

At any rate seems like we've been explaining this basic concept for years now. I've never seen any kind of effective rebuttal. Hopefully the Fed is listening to Lars and taking notes this week!

Justin D writes:

@baconbacon

--"Reread what I was responding to

In that case there is no reason that they could not go back to the policies of 1990-2007"--

If inflation was running at 4% a year, I don't see any reason why the Fed could not return to conducting monetary policy in the same manner as it had during that time.

--"Your last few lines are simply an assertion that no central bank has ever successfully accomplished. Its efficacy is in doubt and is the basis for this discussion in the first place."--

It is an assertion, but it's hard to imagine that a central bank in a fiat money economy could fail to increase inflation/NGDP growth if it were determined to do so.

I'm not sure that its efficacy is really in doubt, as opposed to the collective will of the FOMC.

Scott Sumner writes:

Kevin, I don't think the opposition is to 2% inflation, rather people are opposed to low interest rates. But higher inflation would actually give you higher interest rates, with a lag.

The difference between 1.5% and 2% inflation is hardly noticeable to the public.

Bacon, You've thrown a lot of ideas out there, but I don't see how any of them matter.

Why would the Debt/GDP ratio matter? And if I'm wrong, and it does matter, I thought bigger debts were more inflationary. But you suggest the opposite.

And why do excess reserves matter? The Fed can simply adjust the IOR to control reserve demand.

Ricardo, Bingo! BTW, I still have my WIN button from the 1970s.

CMA, You said:

"Don't you need a lot of QE in the first place though to get the 4% inflation."

I don't see why. A 4% inflation target would greatly reduce base money demand, and there is plenty of base money in circulation. If you prefer, it would sharply boost base velocity.

Yes, at some point they might need to use OMPs to prevent rates from rising, but by that time rates SHOULD be allowed to rise.

Justin D writes:

--"To prevent rates from rising the fed would need to conduct OMP's."--

Not when there is something like $2.6 trillion in excess reserves. More likely, the problem is the reverse: the Fed will need to drain those excess reserves prior to raising rates.

Elwailly writes:

I suspect the problem is no one believes the FED would ever be allowed to buy "all $20 trillion in T-bonds and Treasury backed MBSs".

Kevin's statement should have read "it's not clear that the Fed could engineer 4 percent inflation at all right now given the political environment it lives in"

It seems to me that no amount of will/determination from inside the FED can change that.

ThomasH writes:

The problem is that Kevin is a VSP hanger-on. He cannot believe that if getting 4% inflation is so easy it has not already been done. That's because no one has explained what the constraints have been on the Fed not having at least tried to keep the price level on its pre-crisis trend. This was the great failure of Bernanke's book; he did not explain why (the political constraints) it took any courage at all to act as he did.

Scott Sumner writes:

Elwailly, They wouldn't have to buy any more bonds to hit a 4% inflation target. I mean seriously, how much currency do you think the public wants to hold if TIPS spreads are 4%?

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