Federal Reserve Admits Inability to Control Inflationary Expectations

Another solid post by Izabella Kaminska at FT Alphaville on The unintended consequences of QE. This one offers observations from a Federal Reserve Bank of Dallas working paper, by William White, about “Ultra Easy Monetary Policy and the Law of Unintended Consequences“. Here is one section worth highlighting:

A further concern is that the reductions in real rates seen to date, associated with lower nominal borrowing rates and seemingly stable inflationary expectations, might at some point be offset by falling inflationary expectations. In the limit, expectations of deflation could not be ruled out. This in fact was an important part of the debt/ deflation process first described by Irving Fisher in 1936. The conventional counterargument is that such tendencies can be offset by articulation of explicit inflation targets to stabilize inflationary expectations. Even more powerful, a central bank could commit to a price level target, implying that any price declines would have subsequently to be offset by price increases.

However, there are at least two difficulties with such targeting proposals. The first is making the target credible when the monetary authorities’ room for maneuver has already been constrained by the zero lower bound problem (ZLB). The second objection is even more fundamental; namely, the possibility that inflationary expectations are not based primarily on central banker’s statements of good intent. Historical performance concerning inflation, changing perceptions about the central banks capacity and willingness to act, and other considerations could all play a role. The empirical evidence on this issue is not compelling in either direction.

Repeating a key statement there, contrary to the hopes and dreams of market monetarists, the Fed surprisingly admits that:

inflationary expectations are not based primarily on central banker’s statements of good intent.

Moving on, another portion of the paper expresses concern that low rates will hurt margins in various means of financial intermediation. Japan remains a good example in this matter as low interest rates and a flattening curve have drastically reduced net interest margins, almost entirely wiping out profitability among the banks. Separately, we should heed the lesson from Denmark that negative rates (which reduce margins) can pressure banks to compensate by charging higher rates on loans.

All of this gets back to an issue previously discussed by Ryan Avent, Steve Roth and others, which is the asymmetric nature of monetary policy. In short, the Fed’s ability to fight inflation is far greater than its ability to create it.

In conclusion, Kaminska and White are spot on:

Yet herein lies the irony. For, if it’s clear that low-yield policies and QE buy time, and only time, this inevitably puts the onus on governments, not central banks, to steer the economy out of the path of the unintended consequences of monetary policy.

Indeed, as White concludes:

If governments do not use this time wisely, then the ongoing economic and financial crisis can only worsen as the unintended consequences of current monetary policies increasingly materialize.

Monetary policy provides a bridge to an expected future outcome, but cannot ensure the structure (economy) on the other side is built high enough. Governments, through fiscal policy, must provide institutions and incentives to support (or at least not hinder) growth. The US government has performed far better than those in Europe, but has still fallen short. As we approach the end of the monetary bridge, it appears there may be a steep drop ahead.