The cutting of interest rates to near zero in the wake of the recent financial crisis is not an attempt by the Fed to create an inflationary bubble, it is an attempt by the Fed (a successful one as it turns out) to prevent the US, and indeed world, economy from sliding into a recession on the scale of the Great Depression. To explain this properly however, is not easy without recourse to some fairly complicated macroeconomics. I’ll quickly set out a basic model of the economy which, if you accept the basic assumptions, will show that the Fed is doing the right thing, and that the term “inflationary bubble” is a misleading and not particularly useful phrase to use in this context.
A definition of inflation is a good point of departure: as any economics textbook will tell you, inflation is a sustained increase in the average price level in an economy. This means that the price of goods is on average increasing. It is highly unlikely that the price of all goods will be increasing, but the effect of those that are increasing outweighs those that are decreasing.
Studies have shown that the average man on the street considers inflation to be a serious problem, whilst the average economist will tell you that, with qualifications, it is not dangerous at all. This is because most people see inflation as making them poorer – they have to pay more for the goods they are buying. But one man’s expenditure is another man’s income, and one of the main reasons that there is inflation is because workers demand higher wages year on year. As such inflation and wages tend to move up together and thus there is little effect on a person’s standard of living. If inflation goes up 10% but wages go up 10% as well then nothing has actually changed.
The problem with inflation is that does not occur evenly – so some people will be affected more than others. Also it is difficult to make rational decisions about what to buy if the prices keep changing. And high inflation tends to be volatile, creating a risk of higher wage demands feeding higher inflation which could then spiral into hyperinflation.
You might think therefore that zero inflation is the way forwards, but the difficulty with this is that the level of inflation is controlled by the central bank’s base interest rate (set in the US by the Fed). A higher interest rate will mean that you are benefiting more from leaving your money in the bank rather than spending it now, which will have the effect of dampening current demand. A low interest rate will mean that you could even be making a loss by putting money in the bank, so it makes sense to spend now which boosts demand. There are two problems with this.
Firstly workers do not like wage cuts, but a low level of inflation allows the real wage to decline without a firm having to cut the nominal wage, thus avoiding unemployment. Second if there is a weakening of aggregate demand such as the one seen in the global recession, central banks will want to cut base rates to near zero to stimulate demand. If inflation is negative then this still implies a positive real interest rate (because prices are falling so it makes sense to delay consumption), and so you may become stuck in a deflation trap where spending is desperately required but cannot be encouraged by the monetary policy instruments available to the Fed. This occurred in Japan in the 90s and during the Great Depression.
So, now we have a basic framework for how inflation works, why is the term “inflationary bubble” misleading? Well, as I have already shown, inflation is not a problem if it is occurring evenly. A bubble can only form if a good is overvalued, but if everything is moving together, nothing will become overvalued. Thus there could be a bubble in, say, the housing market (as there was before the recession) where house price inflation was moving much faster than prices in the rest of the economy without the actual value that people placed on the houses in question changing. As such the bubble had to pop eventually with a sudden fall in house prices. This was the case towards the start of the global recession. However the Fed has no specific control over such bubbles, because they control only the whole economy – they can try to prevent them occurring by increasing interest rates, but these will hit the whole economy and may cause disproportionate damage to sectors where prices are increasing more moderately.
The question is still not answered properly however, and now we must turn our attention to just what the Fed is doing. They may not be creating bubbles as such, but they could still be ‘overheating’ the economy by encouraging too much inflation. If we look at the indicators though it is blindingly obvious that this is not the case – in 2009 the Consumer Prices Index (CPI), which is the most common international measure of inflation, actually fell in the US by 0.4%. Overall in the past year inflation has been 0.1%, reflecting the change in GDP from -2.5% in 2009 to a projected +3.0% in 2010 (based on The Economist Intelligence Unit Estimate, Feb 13th 2010). Central banks would only start to become worried if inflation crossed the 5% mark or so, and would only be seriously worried if it was above 10%.
So what exactly is the Fed trying to achieve? Well, clearly they are attempting to get the economy back on track, with a comfortably controlled inflation rate of 2-3% and positive GDP growth. How does this work? Well, for that I’ll need to quickly set out a very basic Keynesian model of the economy.
A recession occurs because of a weakness in spending. If people do not spend money, then they cannot receive income. If there is not enough money circulating in the economy, then there cannot be an expansion of output – businesses will not grow, income levels will not increase, standards of living will fall and unemployment will increase. As such it is very much desirable for people to keep spending (although a low savings rate is dangerous too as these savings are used to fund investment which is also a determinant of growth).
The classical model of the economy is simple: in a recession prices will fall, people will see that current consumption is becoming more desirable, and they will spend more. Recession over. John Maynard Keynes watched governments following this logic during the Great Depression, saw how it clearly was not working, and then set about building a model of the economy that far better describes what occurs during a recession. Crucially Keynes argued that far from being self correcting, a recession will persist and even worsen if action is not taken to boost demand. Indeed the Great Depression was only properly ended by the most enormous bout of government spending in the 20th Century, otherwise known as the Second World War.
The basis of the Keynesian model is the argument that prices are sticky in the short run – it is difficult for firms to quickly change prices to respond to changes in demand, mainly because workers get so upset if you tell them they must accept a wage cut. Worryingly the upshot of this is that firms change the only other variable they have control over, which is output. How do you reduce output? Well, you fire workers.
An unemployed worker is a worker who is in serious financial trouble, and who is therefore not going to be particularly keen on spending money. This in turn leads to demand falling further, more unemployment, and a persistent and worsening recession. The economy will not self correct because wages cannot fall to correct for the unemployment. As such someone needs to step in, and that someone is the government (using fiscal policy), and more recently the central bank (using monetary policy).
Keynes did not have much faith in the ability of monetary policy to get a country out of a recession, precisely because of the problem of the deflationary trap set out above, and he was right that in the case of the Great Depression and indeed the current recession that it would take more than that to solve the problem. However the Fed does not control fiscal policy (that is the remit of Obama’s stimulus package or FDR’s New Deal) so all they can do is slash interest rates in the hope that it will encourage people to spend their money rather than put it in the bank, for the reasons explained above.
They are not trying to stimulate inflation by doing this; they are trying to stimulate demand which pretty much inevitably will cause some inflation. The point is that inflation is only of importance if it gets out of hand – if it is moderately under control it is far more important to ensure that the economy is growing so that you do not end up with a large number of persistently unemployed who lose their skills and cause further economic problems. The Fed is therefore not attempting to create an inflationary bubble. As the year progresses and the economy returns to normal, they will not maintain interest rates of 0.15%; they will steadily increase them to facilitate a gentle and careful return to normality.