A monetary policy pop quiz by Noah Smith

Andy Harless comments:

Problem 1. People now expect near 2% inflation. Presumably they will keep expecting this until something happens to change their mind. What might happen, and how would it change their mind? 

Most likely, I think: the adult population keeps growing (as it will for the next 15 years with near 100% probability) and eventually the rising demand for housing causes rising rents and home prices and a boom in construction, as well as consumption via mortgage equity withdrawal, along with the associated multiplier effects. Eventually the associated increase in aggregate demand uses up all easily available labor and starts to bid up prices. People notice that the Fed is not raising rates despite an increase in the inflation rate. As more and more people realize that the Fed is not going to raise rates, they come to expect a higher inflation rate, and you get Friedman-Phelps-Lucas effects. So the inflation rate just keeps rising. Eventually people realize that the Fed is never, ever going to raise rates, and you get hyperinflation.

Another possibility: Profit margins are very high right now, on average. Maybe firms will start competing aggressively and prices will fall. And since there's high unemployment, once they compete away those profits, maybe they will start cutting wages. So you get deflation. This raises the real interest rate and makes investment less attractive, which reduces demand, which accelerates the deflation, so you get a deflationary spiral. Note however, that this deflationary spiral would happen no matter what the Fed does with interest rates. Also note that it seems intuitively kind of implausible that we could have a bubble in the value of money that never pops. So if I had to choose, I think that my first possibility is much more likely -- at least it's more likely to be the eventual endgame, although you could get some temporary deflation along the way.

Problem 2. Given the Fed's current asset base, the only way it could keep the interest rate at 50% is by paying 50% interest on reserves. That would effectively suck nearly all the money out of the economy, because banks would stop lending and start bidding aggressively for deposits. But it would all be funny money, because the Fed's net worth would go ever deeper into negative territory. (It's assets are mostly longer duration assets that would lose most of their value if the 50% interest rates were expected to persist.) It's hard to say what the endgame would be. Maybe extreme deflation and increasing use of alternative means of payment. Or maybe not, maybe people would lose confidence in money -- these credits the Fed would be making without anything to back them up -- and we would get inflation instead.