Posted Tuesday, July 3, 2012, at 9:29 AM
One continuing source of confusion on monetary matters stems from the existence of a number of well-known models in which strange "liquidity trap" scenarios might arise, and it could be very difficult for a central bank to elevate inflation expectations. I'm no modeler of esoteric scenarios, but I'm here to tell you that in the real world, we're not in one of them:
The Federal Reserve's massive balance sheet hasn’t sparked an inflation surge, nor is it likely to, a top central bank official said Monday.
“In a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and, ultimately, inflation are no longer valid,” Federal Reserve Bank of San Francisco President John Williams said in the text of a speech prepared for delivery before the Western Economic Association International, in San Francisco.
Suppose that instead of saying that, Williams had said:
Inflation will probably go up over the next few years as we try to bring unemployment down, but as long as it stays below 5 percent, I'm not going to worry until we reach full employment. If the economy needs more demand, we could always stop paying interest on excess bank reserves or even turn them negative. The point is that we want to see convergence toward the trend level of demand, rapid reductions in unemployment, and if that means 3 or 4 percent inflation for a year or two, it's a small price to pay.
Now suppose that was followed up by a bunch of Fed governors saying, "Yeah, that's about right—we have a dual mandate after all." Some commentators might freak out, but equity markets would soar, and I say you'd see a surge in investment and durable goods purchases. The point isn't that some crazy model might apply to some country at some time. But right now we're in the time where Fed officials fan out around the country to reassure people that even if a miraculous economic boom arises, the central bank will make sure to nip it in the bud with IOR in order to keep gasoline cheap and wages low.