Why hasn’t the Fed been targeting two or three percent inflation?

by on December 29, 2009 at 7:19 am in Economics, Political Science | Permalink

I've been thinking about this question more and I've come up with a speculative possibility.  Right now banks are earning their way back into profitability by playing the spread.  They're paying close to zero on deposits and earning fair sums on long-term loans.  Perhaps this term structure is sustainable because people are expecting little inflation in the short run but moderate inflation in the longer run, plus there is some risk on the loans.  (These inflationary expectations may be changing; if you wish pretend I am writing this six months or a year ago.)

So let's say we move from zero expected short-term inflation to three percent short-term expected inflation.  The nominal short rate rises to three percent and the real short rate remains more or less constant.  Long rates would go up a bit but not much, since beyond the short run there is already an expectation of moderate inflation.  In sum, the spread between short and long rates might narrow.

Here is the key point: from the bank's point of view, what is the correct measure of the real rate of interest?  Is it defined by the nominal rate relative to the expected growth in the CPI?  I doubt it.  When you're near the bankruptcy or nationalization constraint, it's often nominal profits that matter (relative to fixed nominal liabilities, accounting standards, capital standards, etc.), not "real profits" defined relative to the CPI.

In sum, maybe three percent expected inflation conflicts with the desire to rapidly recapitalize banks through maintaining a wide interest rate spread.  Maybe we need that zero nominal short rate or at least the Fed thinks we do.

I don't wish to push too hard on this hypothesis, it is speculative rather than confirmed by evidence.  And propositions about the term structure of interest rates do not always run the way you think they will or should.  I'm aware of other problems.  What kind of zero profit condition is imposed on the banks?  Given the odd objective function of the banks, how exactly does the Fisher effect work in the short run?  Or is it imposed from without by competition from non-bank lenders?  I'm not sure on these questions and they suggest possible holes in the above speculation.

I also regard this as a somewhat gruesome hypothesis.  It means that "Main Street" is paying for "Wall Street" (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one's savings.  Risk on the Fed balance sheet is also paying some big part of the bill, since presumably that is helping to maintain the interest rate spread.

The term structure also implies that the market is expecting rising short rates, so if the bank mess isn't cleaned up soon, heaven forbid.  The spread, as a means of restoring bank profitability, won't last forever.

E. Barandiaran December 29, 2009 at 8:14 am

Trying to make sense of your post, I conclude that your answer to the question of why the Fed is not now committing to a low-inflation policy is becasue the Fed has to deal with the fragility of the banking system. As usual, and regardless of what many economists think about the convenience of the Fed targeting some inflation rate, the Fed faces a tradeoff–today it is between its commitment to low inflation and its commitment to preserve the soundness of the banking system.

Tom December 29, 2009 at 9:36 am

One thing is “confirmed by evidence”. Main Street, particularly retirees and prudent savers, is paying for Wall Street. This is no hypothesis. We need more people pushing hard on this point.

Marc Roston December 29, 2009 at 10:11 am

Commitment to “moderate” inflation is too hard, especially given the US fiscal position right now. The risk is that any shift in short term inflation expectations feeds back into the concerns held by those who finance our consumption. Triggers serious dollar problem.

Sure, you could say the Japanese and Chinese already hold this risk. However, they are extremely concerned over perceptions and where this goes longer term. It’s obvious to me that the fastest way to bailout “Main Street” is inflation, at the expense of “Wall Street” and the lenders to the US.

Philo December 29, 2009 at 10:37 am

“. . . plus there is some risk on the loans.” I suspect this is a major factor in the banks’ current profitability (their apparent profitability as an accounting matter, that is). People became more averse to risk a year and a half ago. The banks low-interest offers to depositors are attractive enough because they are maximally safe–government-guaranteed; meanwhile the banks can charge relatively high interest on commercial loans because they are (perceived as) quite risky. Besides profiting by playing the temporal yield curve–borrowing short-term and lending long-term–banks profit by playing the *risk* yield curve–borrowing “safe” and lending “risky.” Of course, the government is really bearing much of this excess risk.

FE December 29, 2009 at 11:14 am

We had a crisis caused, in no small part, by excessive debt. The official response has been to subsidize borrowing (cash for clunkers, homebuyer’s credit) and penalize saving (by driving rates to zero). Someone please explain to me how this is supposed to end well.

Yancey Ward December 29, 2009 at 11:53 am

What has the CPI done in the last 11 months?

Simon Kinahan December 29, 2009 at 2:08 pm

@Yancey – 11 months is an interesting choice of time period. In the last 11 months the CPI rose by a bit over 2%, which would normally be considered healthy, until you consider that in the previous 6 months it fell by nearly 4%, after rising quite rapidly in the first half of 2008, leaving the overall CPI down on its all-time peak and up only 2% over the last 23 months, which might explain why interest rates still reflect only near-zero inflation for the foreseeable future. The average to average number for 08-09 will be well under 1%, even though the December to December number will be over 2%.

Mike December 29, 2009 at 2:40 pm

Zero inflation allows the Fed to loan money to banks, which the banks can then loan to the U.S. Government. It’s a free 4% for the banks: http://www.businessinsider.com/henry-blodget-how-to-make-the-worlds-easiest-10-billion-2009-12

curmudgeonly troll December 29, 2009 at 8:03 pm

ummh, are we not aware that the Fed can peg the short rate at 0 regardless of short-term inflation expectations, by supplying the quantity of money demanded at that price?

the interesting question is why the bond-market vigilantes haven’t driven long rates higher yet, since bonds look like a sure loser at these rates, particular in foreign currency terms. (partial answer being Fed bond purchases plus ‘arbitraging the yield curve’ by borrowing short and buying Treasuries)

as for the conclusion that Main Street is getting screwed and Wall Street is being rewarded for previous depradations by further enrichment, I can only say … thank you for this blinding glimpse of the obvious

Simon Kinahan December 29, 2009 at 10:06 pm

@zbicyclist – So giving people money causes them to pay less for things they urgently need? Hmm. So that’s what the Fed has been doing wrong – we actually live in monetary bizzaro world where giving people more money causes them to not spend it!

@curmudgeonly troll – Actually the fed can only normally peg the short term rate at the expected rate of inflation over 30 days. The bond markets haven’t pushed rates higher precisely because they (on average) disagree with your inflation expectations.

Simon Kinahan December 30, 2009 at 2:03 am

@ct – The fed can peg real rates to below zero only by buying the entire stock of outstanding T-bills for the time interval of interest ie. by doing all the lending itself. Even then if everything is operating normally it won’t affect real rates for other loans. The reason being that profit-seeking investors always have the choice of holding actual cash instead. When the fed wants to increase the money supply, it can only do so by buying debt itself – it can’t force anyone else to pay the same prices its paying.

Negative real interest rates do happen, but they can’t arise from Fed policy contrary to what the bond market wants. They result from investors actively wanting to hold T-bills over cash, even though T-bills in and of themselves have lower returns. Basically its a sign something is badly messed up. One explanation I’ve heard for recent negative rates is that banks are trying to acquire T-bills right now to make their balance sheets look better at the end of the year – another way of putting this is that banks are currently extremely risk averse and there simply isn’t enough cash for them to hold as much as the actually want to make them look adequately capitalised.

I can’t don’t know much about the 1970s, but I’d imagine that either the banking system was similarly screwed up (inflation is bad for banks as I commented above), or inflation expectations were simply wrong. One plausible expectation I’ve heard is that at that time returns on T-bills were tax exempt, therefore carrying some benefit even if their returns were negative. Its much less likely that inflation expectations are simply wrong at present, since in the current environment of very low (albeit possibly accelerating) inflation over 1-6 months isn’t a serious risk.

Brian Macker December 30, 2009 at 9:00 am

Why? Simple, the goverment, the FED, and GSEs are populated by two classes of individuals the corrupt and the foolish.

Pedrosito December 30, 2009 at 9:09 am

Trust Ben, he only contributed to our current problems. He will see deflation even if the CPI is rising.

edh December 30, 2009 at 9:29 am

Mankiw has been blogging about a negative interest rate policy for some time.

http://gregmankiw.blogspot.com/search?q=negative+interest+rates

Paul December 30, 2009 at 10:17 am

Why did the ‘Big Banks’ need bailouts? They, supposedly, hired the tax subsidised products of our tax subsidised education industry. If anyone had the ‘best’ minds, with the best information, and the best systems it was them.

So, why should these ‘best and brightest’ not only be able to manage by themselves, but being all so PhD’, and Harvard, and MBA and Law Schooled why can they not even profit in these times with out the sheeple picking up the risk via the Fed?

Also, I can not blame ‘Wall Street’, since the Fed bailed out LTCM in ( 1999 ?), the big players knew that the Fed and Washington were their bitches, so it was bet away with no down side.

Naturally, with Turbo Tax Timmy now at beck and call and swiveling in the big Fed Chair( recently vacated by the Owl Clerk and I read Ayn Rand Greenspan ) the banks will continue to extort.

I can’t blame them. If Washington wants to open it’s legs, a guy has to do what a guy has to do.

I wonder as this at the just beginning meltdown plays out, how foreign leaders are going to explain trashing their people’s wealth on a cowardly Washington that is fat, stupid, lazy and lying to their own people.

JMH December 30, 2009 at 12:36 pm

“…the Fed faces a tradeoff–today it is between its commitment to low inflation and its commitment to preserve the soundness of the banking system.”

And the problem there is that a set of existing banks is equated with “the banking system.” No sane person does this in any other part of the economy. Sears can go bankrupt without destabilizing “the retail system.” Airlines go into receivership without destabilizing “the airline system.” In every other industry, businesses come and go, scattering the wreckage of their failures across their partners, customers and suppliers who are hit with the inevitable unrecoverable losses and have to suck it up.

But when it comes to banking, oh, that’s far too important, we have to nationalize the risk. Frankly, this is exactly backwards. When a manufacturer goes out of business, valuable factories, machinery, and skilled engineers are idled while everything is sorted out. The economy takes a real hit. In banking, it’s all virtualized, no real productivity is lost if a bank goes under. Yes, yes, I know, the way the system is set up it can actually cause a great deal of damage. But it doesn’t have to be that way. Why is it that we allow an industry to operate in a fashion where poor business decisions by a handful of people in that industry can set of such a horrible chain reaction? In fact, not only “allow” but “mandate.”

Maybe the banking system we currently have is structurally unsound in the first place and needs to go away. Maybe all the efforts to prop it up are ultimately doomed and just making for a bigger mess when it finally falls over.

Jeff December 30, 2009 at 2:35 pm

“Gruesome hypothesis” or gruesome fact? I say fact.

Since it’s creation, the Fed has pursued boom-bust monetary policies. The Fed benefits people who can take advantage of first-use of inflated monies: big-spending politicians and Wall St. financial companies. The Fed harms everyday citizens by imposing the hidden tax of inflation.

The Federal Reserve Act specifies the goals of the Fed: “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Provably, the Fed promotes or creates unemployment, unstable prices, and immoderate interest rates. The Fed is in direct violation of the sprit and letter of the Federal Reserve Act.

The Fed must be abolished. It is opposed to the prosperity of the Americans. This was predicted at the start of the Republic.

“If a Central Bank is ever created in America- through inflation and deflation the ‘bankers’ will rob the Americans.” – Thomas Jefferson

Jay December 30, 2009 at 5:37 pm

“Right now banks are earning their way back into profitability by playing the spread. ”

Didn’t Bill Gross (of PIMCO) just make exactly this point a few days ago?

http://www.nytimes.com/2009/12/26/your-money/26rates.html

“What the average citizen doesn’t explicitly understand is that a significant part of the government’s plan to repair the financial system and the economy is to pay savers nothing and allow damaged financial institutions to earn a nice, guaranteed spread,† – William H. Gross

Paul December 30, 2009 at 8:31 pm

If this is true, why then is the Fed purchased billions in long term MBS and Treasury debt? This narrows the spread the banks could be profiting from.

curmudgeonly troll December 31, 2009 at 8:31 am

OK, if inflation expectations are 2% and you need cash next month, and you can own a T-bill that pays 1% or cash that pays 0: which one has a lower return, and which are you going to own?

Sure, in a model with assumptions about uniform expectations and automatic supply and market acceptance of an alternative, no one will own T-bills and the Fed can’t push short rates below inflation. In the real world it has, and the market hasn’t been cleared of T-bills.

You say it’s a sign that something is badly messed up with reality, but I would say it’s something that is badly messed up with your model.

babar December 31, 2009 at 4:12 pm

i don’t buy this. if we had inflation a lot of bad debt could get repaid in cheaper dollars.

postmodernprimate January 5, 2010 at 11:58 am

@theman – If its any comfort to you, Goldman isn’t having any easier a time finding real returns. – Posted by: Simon Kinahan at Dec 30, 2009 1:08:34 PM

It’s been so bad for Goldman there was actually a day last quarter where they didn’t book a profit. The horror.

mrktlr December 1, 2010 at 6:47 am

although actually the Fed does want you to save. They just want you to use your savings for something useful to earn a return. You’re not entitled to sit back and clip coupons at the expense of people who actually do useful work. If its any comfort to you, Goldman isn’t having any easier a time finding real returns.testking 642-983 certified professional
Mark Taylor

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