The “But wouldn’t that cause hyperinflation?” conversation.

Try this–it works almost every time (except with knowledgeable macroeconomists):

Someone asks your opinion on the economy.  You say the solution is a more expansionary monetary policy to boost nominal GDP.  They reply “But rates have already been cut to zero, we’re in a liquidity trap, businesses aren’t investing, ‘the problem’ is the financial system, etc.”  You reply with a really aggressive scenario that has the Fed buy up almost every asset on planet earth.  Make it sound dramatic enough and almost every single time you’ll hear “But wouldn’t that cause hyperinflation?”

And it’s not just average people that do this.  The Bank of Japan has showed similar inconsistency, so did much of the conservative financial community in the Depression (ridiculing progressives who thought OMOs would do any good, but warning that “printing greenbacks” would lead to German-style hyperinflation.)  Even Keynes was all over the place on this question–I’ll discuss that in another post.  Why don’t people see an in between option?  How about 3% inflation?

Over the years my views on this have evolved.  Reflation must be harder than it looks, as Bernanke is no fool.  I now wonder if the Fed’s current operating procedure makes it difficult to find the happy medium of low inflation.  The Fed has almost doubled the base and yet prices are falling.  A large enough increase would cause expectations to turn around, but as soon as inflation expectations set in, that bloated monetary base would be reinforced with rising velocity.

The futures targeting approach that I discussed a couple of days ago would solve this problem, but even much less radical steps would help.  These include:

1.  Charge interest on excess reserves, in order to to get the demand for base money down to reasonable levels.

2.  Set a NGDP or CPI (level) target, and promise to make up for any under- or overshooting.

3.  Keep on eye on financial sector variables that are linked to the policy goals.  They provide early warning signs of inflation.

4.  Be much more aggressive in changing policy quickly when the inflation/recession risks threaten to become unbalanced.  In other words, don’t emulate the ECB.

BTW:  The preceding conversation won’t always happen the way I described it.  Conservative monetary economists will generally accept the assumption that monetary policy is effective at even zero interest rates, whereas Krugman will argue that the Fed is too responsible to create Zimbabwe-style hyperinflation, and this reputation will inhibit its ability to even generate mild inflation once rates hit zero.  Later I’ll describe why this view isn’t persuasive.

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This entry was posted on February 05th, 2009 and is filed under Level targeting, Liquidity trap, Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.