In a previous post I argued that in the current environment, the Federal Reserve could buy up the entire stock of government bonds without triggering any incremental inflation. The argument for the ineffectiveness of conventional QE is fairly simple. Government bonds are already safe collateral both in the shadow banking system as well as with the central bank itself. The liquidity preference argument is redundant in differentiating between deposits and an asset that qualifies as safe collateral. Broad money supply is therefore unaffected when such an asset is purchased.

The monetarist objection to this argument is that QE increases the stock of high-powered money and increases the price level to the extent that this increase is perceived as permanent. But in an environment where interest is paid on reserves or deposits with the central bank, the very concept of high-powered money is meaningless and there is no hot potato effect to speak of. Some monetarists argue that we need to enforce a penalty rate on reserves to get rid of excess reserves but small negative rates make little difference to safe-haven flows and large negative rates will lead to people hoarding bank notes.

The other objection is as follows: if the central bank can buy up all the debt then why don’t we do just that and retire all that debt and make the state debt-free? Surely that can’t be right - isn’t such debt monetisation the road to Zimbabwe-like hyperinflation? Intuitively, many commentators interpret QE as a step on the slippery slope of fiscal deficit monetisation but this line of thought is fatally flawed. Inflation comes about from the expected and current monetisation of fiscal deficits, not from the central bank’s purchase of the stock of government debt that has arisen from past fiscal deficits. The persistent high inflation that many emerging market economies are so used to arises from money-printed deficits that are expected to continue well into the future.

So why do the present and future expected fiscal deficits in the US economy not trigger inflation today? One, the present deficits come at a time when the shadow money supply is still contracting. And two, the impact of expected future deficits in the future is muddied thanks to the status of the US Dollar as the reserve currency of the world, a status that has been embellished since the 90s thanks to reserves being used as capital flight and IMF-avoidance insurance by many EM countries (This post by Brett Fiebiger is an excellent explanation of the privileged status enjoyed by the US Dollar). The expectations channel has to deal with too much uncertainty and there are too many scenarios in which the USD may hold its value despite large deficits, especially if the global economy continues to be depressed and demand for safe assets remains elevated. There are no such uncertainties in the case of peripheral economy fiat currencies (e.g. Hungary). To the extent that there is any safe asset demand, it is mostly local and the fact that other global safe assets exist means that the fiscal leeway that peripheral economies possess is limited. In other words, the absence of inflation is not just a matter of the market trusting the US government to take care of its long-term structural deficit problems - uncertainty and the “safe asset” status of the USD greatly diminish the efficacy of the expectations channel.

Amidst the fog of uncertainty and imperfect commitments, concrete steps matter and they matter especially in the midst of a financial crisis. Monetary policy can almost always prevent deflation in the face of a contraction in shadow money supply via the central banks’ lender-of-last-resort facilities. In an economy like 2008-2009, no amount of open-market operations, asset purchases and monetary target commitments can prevent a sharp deflationary contraction in the private shadow money supply unless the lender-of-last-resort facility is utilised. Once the system is stabilised and the possibility of a deflationary contraction has been avoided, monetary policy has very little leeway to create incremental inflation in the absence of fiscal profligacy and shadow banking/private credit expansion except via essentially fiscal actions such as buying private assets, credit guarantees etc. In the present situation where the private household economy is excessively indebted and the private business economy suffers from a savings glut and a persistent investment deficit due to structural malformation, fiscal profligacy is the only short-term option. Correspondingly, no amount of monetary stimulus can prevent a sharp fiscal contraction from causing deflation in the current economic state.

Monetary policy is also not all-powerful in its contractionary role - it has significant but not unlimited leeway to tighten policy in the face of fiscal profligacy or shadow banking expansion. The Indian economy in 1995-1996 illustrates how the Reserve Bank of India (RBI) could control inflation in the face of fiscal profligacy only by crippling the private sector economy. The real rates faced by the private sector shot up and spending ground to a halt. The dilemma faced by the RBI today mirror the problems it faced then - if fiscal indiscipline by the Indian government persists, the RBI cannot possibly bring down inflation to acceptable levels without causing the private sector economy to keel over.

The current privileged status of the US Dollar and the low interest rates and inflation does not imply that long-term fiscal discipline is unimportant. Currently, the demand for safety reduces inflation and the low inflation renders the asset safer - this virtuous positive-feedback cycle can turn vicious if expectation of monetisation is sufficiently large and the mutual-feedback nature of the process means that any such transition will almost certainly be rapid. It is not even clear that the United States is better off than say Hungary in the long run. The United States has much leeway and flexibility than Hungary but if it abuses this privilege, any eventual break will be that much more violent. Borrowing from an old adage, give an economy too much rope and it will hang itself.



Bang on post, Ashwin. [cross commenting from Miles Kimball...] In case there was any doubt whether buying duration is good or not... The Fed announced operation twist at 12:32. At that moment: 1) The 10-year bond rallied from 1.66% to 1.63, the 30 from 2.77% to 2.72% 2) The SPX fell from 1354 to 1348, or 0.4% The rally in treasuries means the announcement was a surprise. The drop in the SPX means that it wasn't desirable. We are now two for two. Both times they've announced an expansion of operation twist, stocks have dropped. Someday I suppose they'll get the picture. Who knows.


K - Thanks. I agree - at least when rates were a lot higher the effect from say mortgage refinancing benefits could exceed the portfolio risk effect. But now when rates are as low as they are, I can't see how the Fed thinks that buying T-bonds helps the economy.


How about a nominal devaluation? Of a basket of developed economy currencies (which don't have a BoP issue) vs. a basket of EM currencies. Can it be achieved by coordinated central bank action without a local debauchment of currency?


Ritwik - if the EM CBs agree, this can obviously be achieved. Essentially this idea tries to undo some of the impact of the post-90s reserve accumulation strategy. I would just question what this basket of EM countries would be which would not have a problem with effectively appreciating their currencies. India, Brazil maybe but surely not enough to counteract the slowdown in the entire developed world. China probably needs to be in it as well but given the Chinese slowdown I'm skeptical that the free-float value of the RMB implies an appreciation.

diego espinosa

An interesting question is why BOJ QE combined with large expected deficits did not create inflation expectations in Japan. One answer is that the deficits only offset contraction in private credit, so no net reserve demand was created. I suppose the other answer is that the BOJ showed itself more willing to generate positive real rates by reversing QE (something Bernanke would never entertain). In Japan, the EZ and the U.S., the promise of QE-financed future deficits is lurking in the background. What would pull it front and center? What is the dynamic that will convince markets that this situation will persist indefinitely? That would make an interesting post.


Diego - Part of the explanation in Japan is similar to the US. Reserve currency, safe asset demand etc. This demand is even higher given that Japan has positive real rates to offer. The problem is that the dynamic is currently self-fulfilling - high demand for safe assets leads to low inflation, low inflation makes asset safer and also depresses global economy which increases safe asset demand. How do you transition to the 2-3% per annum inflation level on a sustainable basis without destabilising the system and risking overshooting? The answer is not clear to me but I'd rather that they try via direct transfers to households. In that case if we have inflation at least it comes about via a shoring up of household balance sheets rather than lining the pockets of some corporate crony capitalist.

Diego Espinosa

Ashwin, I agree -- an incomes-based fiscal policy is far superior than our current asset price-based one. We had a chance in 2007 to restructure the banking system (a la Chile or the Nordic countries) along with a larger social safety net. This would have been money well spent. Its possible, though, that its now too late to carry out that kind of solution. The issue is that inflation expectations in the face of this safe asset/monetization dichotomy are arguably highly non-linear and potentially unstable. This is ironic, of course, because inflation expectations have been highly stable. This is why its hard to convince anyone that a danger exists.


Diego - I tend to agree that it may be too late. The reorganisation would have been best done in the eye of the storm but instead we stabilised the ship. That was the point of an earlier post where I argued that the collapse in shadow money supply that would have happened if we'd bailed in bank creditors should have been seen as an opportunity to pursue a transfer policy. On the instability, again Minsky understood this completely - he always claimed that the end point of the stabilised system was a system that was simultaneously on the edge of a deflationary collapse and high,unstable inflation regime. Elaborating on this is the topic of my next post!