Why so little inflation?
By Scott Sumner
Here’s Tyler Cowen:
Excess reserves held at the Fed are down from their peak of about $2.8 trillion, but still close to $2 trillion, massively higher than their long-run historical average.
Inflationary pressures are modestly higher than they had been, but still in the range of roughly two percent. . . .
Since the liquidity trap is gone, and inflation remains well under control, the liquidity trap does not seem to be the reason why inflation did not explode post-2008, following the Fed’s stabilization measures.
No one is admitting this simple reality, which is staring us in the face.
I’d point to two different policy regimes:
1. During the first 53 years of my life, the Fed controlled inflation by adjusting the quantity of base money, often with the intermediate objective of influencing the fed funds rate. During that period, short-term risk free rates were positive. Because base money paid no interest it was a very poor investment, except for currency hoarders trying to shield income from the authorities. When the Fed injected new base money it was a sort of hot potato. The economy got rid of excess cash balances by spending them, forcing prices higher. Banks held very few excess reserves.
2. Since 2008, the Fed has controlled inflation by adjusting both the supply and the demand for base money, but mostly the demand. Since 2008, the rate of interest on reserves has no longer been lower than risk-free market rates. Since 2008, base money is no longer much of a hot potato, and thus it’s possible to sharply increase the monetary base without creating much inflation.
Tyler’s right that we are no longer in a liquidity trap. And he’s right that this fact has often been ignored and that this ignorance is unfortunate. But he’s wrong about the specific problem. When you are in a liquidity trap, the reason big monetary injections are not highly inflationary is that the interest rate on base money is roughly equal to the interest rate on other risk-free assets. But that’s still true, even after 2015. So one would not expect the recent inflation outcome to be much different than what we saw under the 7-year long liquidity trap (December 2008 to December 2015.)
Here’s what Tyler should have said:
In December 2015, the US exited the liquidity trap. At that moment, all “old Keynesian” discussion of problems allegedly caused by the liquidity trap should have immediately ceased. These problems were no longer being caused by a liquidity trap. For instance, Keynesians had blamed the liquidity trap for the slow recovery, and the undershooting of the 2% inflation target. They argued that fiscal austerity was contractionary due to the liquidity trap. They argued that big trade surpluses in countries like China and Germany tended to reduce AD in the US, because of the liquidity trap. All of these are arguments that only apply in an actual liquidity trap, where the Fed cannot cut rates further. And even that ignores the possibility of negative IOR. Even if correct (I don’t think they were), these Keynesian arguments should have ended in December 2015, but they didn’t.
After December 2015, we were no longer at the zero bound. The Fed had control of interest rates and monetary offset was fully operative. The Fed was clearly in control of monetary policy. Yes, the decision to pay IOR made monetary policy somewhat ineffective, but that was the Fed’s choice, not a “trap”. That’s the reality that was starring us in the face after December 2015, and which many old Keynesians ignored.