Jun 26, 2012

A Central Bank Always Has Iron Control Over Inflation

Naked Capitalism has an uncharacteristically sloppy and obnoxious post up by Stephanie Kelton, some econ professor, lambasting the chorus of econ bloggers who have been calling on the Federal Reserve to fix the economy. The obnoxious part is at the beginning, where she postulates a conspiracy trying to shift blame away from the president and onto the Fed. Let's set that aside. Here's the meat of her argument:
And so instead of building a powerful, unrelenting case for further fiscal easing, mainstream progressives are focused on the Fed, demanding that it do just as much to promote growth and employment as it does to promote price stability. How? By following Krugman’s advice and “credibly committing to a higher inflation target,” which, it is argued, will stimulate spending by lowering the real rate of interest. It’s a policy recommendation that only an economist (or someone with enough credit hours to be dangerous) could conjure up. I almost hope the Fed tries it so that we can banish this proposal to the wasteland of failed policy recommendations (along with QE1, QE2 and Operation Twist). But millions of Americans are suffering and so I really do not want to see us pursue a losing policy just because the alternative looks like a political nonstarter.
The zero bound isn’t the problem. Brazil’s central bank has cut its policy rate by 400 basis points since August 2011. That’s 4 percentage points in under a year! Meanwhile, growth continues to slow and inflation is falling. Why? Brazil isn’t up against the zero bound (far from it, rates are at 8.5 percent). The problem is that monetary policy is a blunt instrument (at best). Committing to a higher inflation target isn’t going to pull us out of the economic doldrums.
Spotted the error? Kelton says an inflation target won't work, and cites Brazil, which did not adopt an inflation target. Instead, they cut rates. I agree, that's a blunt instrument, but it's nothing at all like adopting an inflation target.

Let's step back a second. A central bank has absolute, unquestioned control over the supply of currency. They can create arbitrary quantities of it at nearly zero cost. If they commit themselves in public to inflating that currency by some percent, and take serious steps to start up the presses, you'd have to be insane to bet against that inflation. Or, consider this analogy:
Imagine a situation in which you are the only person in the world who’s capable of producing diamonds. But you also have the ability to produce arbitrary quantities of diamonds, at any time, instantly, and at zero cost. Now why on earth would anyone worry that you might be unable to reduce the price of diamonds? I think that if someone in that position said, “I want to make diamonds 25 percent cheaper and intend to do whatever it takes to make that happen” that the price of diamonds would fall more or less immediately by roughly 25 percent. After all, the magical diamond man has promised he’s going to make this happen. You probably wouldn’t need to do anything at all. To be sure, just to show the world that you’re not a jerk and to maintain your credibility for the future it would probably be wise to follow-up the crash in the diamond futures market with the production of some actual new diamonds. So instead of diamonds, say you had the ability to produce arbitrary quantities of dollars….
For how a bit more inflation might help the recovery, see here. Krugman's case is stronger than Kelton says, and she doesn't address how inflation helps erode the real value of debt, while strangely insisting that fiscal stimulus (more government spending) is the way to...help households deleverage.

Finally, Kelton also doesn't address what is probably the most effective action the Fed could take: namely, printing money and giving it out to everyone (or just electronically adding $10,000 or whatever to everyone's bank account). If we're still lagging in aggregate demand—meaning we don't have enough spending throughout the economy—then handing out money is about the most straightforward way to get some. It sounds crazy, which is probably why it's so politically implausible, but the economics are ironclad.

UPDATE: I should clarify that I'm not against fiscal stimulus either, just that monetary policy is also important, and does work. These are two great tastes that taste great together. Furthermore, there is a real danger than any economic recovery kicked off by fiscal stimulus would be strangled in a the crib by a Fed fanatically committed to 2 percent inflation uber alles.


  1. the diamonds in your example would be analogous to govt deficit spending which adds that many net financial assets.

    The CB can't add net financial assets.


  2. No, it wouldn't. Fiat currency means it's not backed by anything. The Fed can print as many dollars as it likes.

    1. The only way the cb could add net financial assets is if it bought no financial assets.

      Dollars are financial assets, as are tsy securities, mtgs, corporate bonds, stocks, etc.

      So when the CB buys financial assets the economy no longer is holding the financial assets the CB bought, but instead is holding the dollars the CB used to pay for its purchase.

      That means QE, for example, is an exchange of financial assets, with the net financial assets held by the economy remaining unchanged.

      If, however, the CB, for example, bought a real asset, like an airplane, the dollars spend would be adding net financial assets to the economy as a real assets, the plane, was moved from the private to the public sector. But that's usually called 'deficit spending' and is done by the tsy, not the cb

  3. President and Fed both needs to take Action. While Gov. needs massive fiscal deficits to rebuild America and put nation back to work. The Fed needs to work in conjunction of Gov. Instead of obsession about balancing the budget and giving advice to Gov. about fiscal discipline. The Fed. should be 100% committed in financing Fiscal deficits. No questions asked. And in the process of deficit spending, Fed. should raise its inflation targets because massive deficit spending will cause some inflation which needs some room.

    The bottom line is, Fed with its tight inflation targets and Gov. with psychosis of Balancing Budget and fiscal discipline during this recession will crash the economy badly. The lever of growth and inflation/deflation has too much tilted onto concerns of inflation. Time to balance the lever and focus on growth.

    Both Fed and Gov. needs to act.

  4. You missed Mosler's point. You argued that the Fed could print money and give it to people. It can't do that--that's a fiscal deficit since that's raising income of the non-government sector. The Fed can only legally buy certain financial assets, which is very different. It's the difference between receiving 100k in a Christmas bonus and having 100k from your retirement portfolio converted to cash. Hopefully it's obvious that the rational response to the two must be difference in terms of spending. And anyone who undrestands the Fed's operations knows that it can only do the latter, not the former, even as you just argued they could do the former.

    Scott Fullwiler

  5. I say the Fed has more leeway than that. Their statues forbid abject money printing, but they have in fact dramatically expanded the monetary base through a lot of shady stuff. If they were actually so constrained by accounting rules, then all that means is that the Fed is not a real central bank. If they can't just print money and give it to people, then that's the fault of dumb laws, not evidence against the thesis.

    In any case, this is all an aside to the main point that the Fed could control inflation if they 1) announced a target and 2) engaged in some kind of open market operations to that end. They have a ton of credibility on this point, and that's what matters.