Wednesday, August 21, 2013

Krugman Predicts Inflation :-)

Krugman has said that while interest rates are near zero we don't have to worry about inflation:

It’s true that printing money isn’t at all inflationary under current conditions — that is, with the economy depressed and interest rates up against the zero lower bound. But eventually these conditions will end. At that point, to prevent a sharp rise in inflation the Fed will want to pull back much of the monetary base it created in response to the crisis, which means selling off the Federal debt it bought. So even though right now that debt is just a claim by one more or less governmental agency on another governmental agency, it will eventually turn into debt held by the public.

We are living in weird economic times, where many of the usual rules don’t apply and there are big free lunches to be had. But not everything is a free lunch, even now. Sorry.
With a cleaner understanding of economics you don't need to say "the usual rules don't apply".    As interest rates go down the velocity of money goes down and with that you can increase the money supply without causing inflation.  But later, when interest rates start going up, inflation can get out of control.

The interest rate on 5 year bonds has about tripled in the last few months.  We are leaving Krugman's safe zone of "the zero lower bound".



Once the zero lower bound conditions have ended, what does Krugman say we must do again?

At that point, to prevent a sharp rise in inflation the Fed will want to pull back much of the monetary base it created in response to the crisis, which means selling off the Federal debt it bought.
If the Fed started to sell some of its trillions in bonds, then bond prices would crash and interest rates would go up more.  In particular the value of long term bonds would go way down.   The Fed could not sell them for anything near what it paid for them.  So it could not withdraw "much of the monetary base".

Hussman has shown that an increase from near zero interest rates to just 2% would require pulling back half of the monetary base to avoid inflation. The Fed would have to sell off half the bonds on its balance sheet, like $1.5 trillion worth.

However, the most the Fed can possibly imagine is a slight tapering of the $85 billion per month rate at which they are increasing the monetary base.   Even a hint of that caused the markets to freak, which caused the Fed to quickly backpedal on the whole tapering idea.   There is no chance of the Fed pulling back half of the monetary base.  It will not happen.

A comment on a previous crisis seems to hint that Krugman probably does not expect them to withdraw half the monetary base either:
But my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt.

The combination of rising interest rates, the impossibility of the Fed selling half their bonds, and  Krugman's explanation of things (or sound economic theory),  results in a prediction of a "sharp rise in inflation".

8 comments:

  1. Vincent, Krugman wrote that Jan 2. What inspired you to bring that up now?

    ReplyDelete
  2. Hussman has it completely backwards.

    The central bank lowers the base interest rate when the economy is in a recession, to try and increase demand. It normally lowers the base rate by expanding the monetary base, i.e. by increasing the quantity of bank reserves.

    So in a recession you have reduced GDP, an expansion of the monetary base by the CB in an attempt to increase demand, and as such a lower base interest rate.

    - So obviously money velocity goes down, it's just basic math. GDP down, money supply up, velocity DOWN.

    Similarly, the central bank raises the base rate to try and 'cool' the economy when either growth or inflation (overall or in particular sectors) is perceived to be too high. It normally raises the base rate by contracting the monetary base, i.e. by reducing the quantity of bank reserves.

    So in a boom you have increased GDP, a subsequent contraction of the monetary base by the CB in an attempt to reduce demand, and as such a higher base interest rate.

    - So obviously money velocity goes up. GDP up, money supply down, velocity UP.

    ReplyDelete
    Replies
    1. It has absolutely nothing to do with Hussman's theory of causation.

      Delete
  3. phil,

    Hussman isn't claiming causality, he's simply pointing out the magnitude of the problem. He shows how any FED attempt to contract the monetary base and 'cool' the economy would require them to sell a LOT of the debt on it's balance sheet (sell ~50% to raise short term rates by 2%).

    http://www.hussmanfunds.com/wmc/wmc130304.htm

    Given the size of the FED's balance sheet that would require finding people with enough money to buy nearly $2 Trillion without spooking the stock, bond markets, or tanking GDP. Probably not a likely event.

    Read Hussman's article on the matter (linked above). It's a very interesting read.

    ReplyDelete
    Replies
    1. What do you mean? I got $2T right here....

      Delete
    2. The Fed can raise the base interest rate by increase the interest paid on reserves. If it wanted to reduce the quantity of reserve balances and for some reason didn't have enough assets on its balance sheet to do that, it could, if it wanted to, swap reserve balances for term deposits at the Fed.

      http://www.federalreserve.gov/monetarypolicy/tdf.htm

      If you look at the bigger picture you could easily argue that Treasury securities are essentially term deposits at the Fed in everything but name.

      Delete
    3. Hussman does claim causality in the article linked to by Vince. He ignores the fact that the central bank simply creates bank reserve balances on its balance sheet, and decides the interest rate on reserve balances as a matter of policy.

      Delete

Looking for polite debate on ideas. Never attack a person. Be nice.