Inflation Targets and Psychology

Tyler Cowen has an excellent write-up over at the New York Times about the Fed's reluctance to announce an explicit inflation target. In sum, it asks why, when our monetary policy is clearly inflationary, our monetary authorities aren't forthcoming in that. I think the question is important, because, as Tyler notes, "if [the Fed] could just convince Americans that it was committed to monetary expansion and economic growth, it would help the economy pick up speed."

The Federal Reserve, even at its most proactive, still needs to be seen as proactive in order to implement effective policy. Let's think about why that is. Say the Fed starts aggressively ratcheting up QE tomorrow. We'd get all this new money flooding our economy and basic Econ 101 tells that our preexisting dollars should lose value. But here's the wrinkle: that inflation isn't a macroeconomic given–we expect it because we acknowledge that inflation, like any aggregate trend, is closely related to certain microeconomic processes. The microeconomic process that does all the legwork here is a demand shift responding to a supply hike. It's weird to think of a world in which, say, an influx of bargain-basement iPods wouldn't discount prices across the board. Retailers selling at the pre-glut prices would be forced to run sales even if it meant taking a loss: anything's better than cannibalising the full purchase price of unsold inventory. Well, QE works on the same principle: the central bank infuses the money supply with bargain-basement dollars, and we expect to see prices react. Money should become cheap, and we should need more of it to buy bread.

But we've spent the last two years pursuing aggressive QE, and money's still expensive! Why? Well, to use the iPod example above, imagine that same supply glut consisting in snow shovels. Now, no one really alters his buying habits of snow shovels too dramatically. And even when he does, it's not in response to price cues. No one reads the Sunday circular looking for a killer deal on a snow shovel. No one buys snow shovels in bulk when they happen upon such a deal anyway. All the retailers know this, so they don't fret over demand droughts because of bargain-basement alternatives elsewhere; we'll never find them; we'll never look. And ultimately, this means snow shovels exhibit a pretty high demand inelasticity relative to supply. We might change our consumption patterns, sure–but it's because of snowfall, season and weather.com. We could care less if we're not the utility-optimising paradigm of snow shovel consumer who'd pounce on a good deal in a heartbeat–frankly, there's more utility in not being snow shovel hypervigilant.

And right now, money is demand inelastic to supply too. Usually it isn't. Usually consumers are hypervigilant about the "price" of money, because usually they're quick to jump on a good loan opportunity. We all want that first house, or that sweet refinancing deal, or that business loan so we can finally jumpstart our entrepreneurial dream. But no one is looking. No one is keyed into the opportunities sitting there over there idle in the bargain-basement corner of the loan business. And as a result, we're stuck with snow shovels: there's no systemic adaptation to supply shift, there's no discounted dollar; there's no discounted dollar, so there's no increase in prices. There's no inflation!

The short-and-simple as to why this is happening is the liquidity trap. At least, that's the most likely contender. The liquidity trap says what I just said in a nutshell: there's no responsive lurch to increased money supply because no one's looking. But this defies conventional microeconomics. We should be looking. We should be out there shopping, because this is the epitome of buyer's market. And our spending and haggling and wheeling and dealing should be smoothing out the QE by spreading its effects across the entire breadth of our economy. But it's not, because, as the liquidity trap teaches us, we're in a weird microeconomic position: what consumers should be doing isn't what they are. And what consumers are doing is reeling from their former experience in acquiring debt. Consumers got a raw deal in their last run-ins with loans; they've learnt not to shop. Fool me once, right?

This is really the crux of Cowen's argument, even though he left it implicit. By stating a firm commitment to hiking inflation, the Fed would be caressing wary debtors. It'd be advertising a once-in-a-lifetime sale that you just can't miss. Think about it: if you score a loan at 3% interest and we ultimately spike inflation to 3 as well, you're taking on debt for free!

But what Cowen's article leaves me wondering is if, in addition to all his reasons the Fed's kept mum, there isn't another even-more-important one: not everyone takes on debt in anticipating inflation. Many others prepare for it by choosing high-yield investments, thereby keeping up current returns. And since high-yield investments also tend to be long-term ones, that means the Fed could inadvertently end up locking money out of the very economy it hoped to push more into.