On Inflation Expectations and Central Bank Credibility

inflation rate since April 2012

I have to confess something: I’ve never quite understood the argument that in order to raise inflation expectations, the Federal Reserve would have to “credibly promise to be irresponsible” (to use Paul Krugman’s phrase). The reasoning goes that after the 1980s disinflation, the Fed has built up a reputation for being a “responsible” inflation-fighter, and to raise inflation expectations, it would have to somehow convince everyone that it was going to toss all that over the side. Thus you get half-joking suggestions for Bernanke to hold a press conference in a Hawaiian shirt holding a marijuana pipe.

I think part of my confusion is historical. Back in the day it was thought that monetary policy had an “inflationary bias”—that unless we had central banks placed mostly out of reach of normal politics, then politicians would inevitably reach for inflationary policies to keep unemployment low so they could win the next election, and it would eventually spiral out of control. Better to have nearly-unaccountable technocrats running things so they won’t be afraid of inducing a recession to keep inflation low.

Today, by contrast, that seems ridiculous. The Fed has been buying all kind of crap—Treasury bonds, asset-backed securities, shares in your cousin Jimmy’s hot dog stand—by the truckload and inflation keeps trending down. This isn’t a central bank worried about taking away the punchbowl just as the party gets started, it’s one that keeps pouring more and more expensive liquor in there and everyone just keeps staring glumly at the floor. (Maybe we should start handing out cups?)

In other words, we have a Fed that’s already being pretty damn irresponsible. (They look pretty good only compared to the sociopaths at the ECB.) They are commanded by law to try for full employment in the context of stable inflation, and they’re doing that halfheartedly at best. Inflation has been below-target for more than a year now (see graph above), and for some reason the gossip from the Fed is all about “tapering” their stimulus programs.

So I don’t think this about being irresponsible. I think the Fed has run into political and institutional barriers. They have no problem being irresponsible when it comes to unemployment because unemployed people have no power and the American power structure doesn’t care about them at all. Trying to boost inflation, on the other hand, means a direct threat to nominal creditors, i.e., rich people. To the extent that the expectations channel isn’t working, I doubt that this is about “credibility.” Instead people are rightly skeptical that the Fed could sustain even a mild burst of inflation in the face of what would be ferocious backlash from the creditor class.

Ryan Cooper

Ryan Cooper, a contributing editor of the Washington Monthly, is currently the Washington correspondent for The Week.