The Signal of Inflation Expectations and the Noise of Everything Else

ROBERT MURPHY'S BET THAT INFLATION WAS JUST AROUND THE CORNER HAS GONE ABSOLUTELY HORRIBLY WRONG by DeLong

During the housing bubble, inflation was under control. What was needed (and will be needed) were anti-bubble-blowing policies on taxes and regulations. Bernanke contends that the Fed didn't blow the bubble, but as Dean Baker and others point out they could have talked it down.

Questions for Joe Gagnon: What is Quantitative Easing, Does it Work, and Should We Do QE3? by Mike Konczal (June 14,2011)

MK: So did QE2 work? And if so, how can you tell? 

JG: It did work. I think QE2 had two elements. One element was of moderate importance, one element was of minor importance. The moderate one is that QE2 convinced markets that the Federal Reserve would not allow deflation or a double dip recession to happen. This is good because it inspired confidence and kept inflation expectations from falling any further. That was the most important step, because it convinced financial markets that the United States wouldn't turn into Japan, which they were worried about. The element of minor importance was that it lowered long-term bond rates a little bit. It takes a lot of purchases to move these interest rates even a little bit, and QE2 wasn't big enough to move them dramatically. It's not nothing, but it is small in the scheme of things.

...
MK: So how do you know that QE has worked? What kind of studies are conducted, and how do they draw their conclusions? 

JG: I have a paper that looked at two things. When the Fed made announcements on QE1, what happened to bond yields? Yields on the things the Fed was buying went way down, but yields on things the Fed wasn't buying also went down. All yields went down. So that was one piece of evidence. As for the other piece of evidence, we looked back thirty years and ran a regression of how the government's net supply of long-term bonds affects bond yields. We found when the government issues more long-term bonds, bond yields increase. When the government buys back long-term bonds, bond yields go down. QE, really, is like the Treasury buying back long-term bonds and issuing short-term bonds. There's a long history of this, including in non-crisis times. So for both pieces of evidence, when the government buys long-term bonds and issues short-term bills, it can push down the yield curve. 

MK: So QE2 helped with the job growth of the past year? 

JG: It definitely contributed by relieving businesses' fears of a double-dip recession and deflation. This helped with some growth in the economy. But really, not enough. The Fed has not been aggressive enough, it has been too timid.

Can't find the article on inflation expectations at Konczal's blog so will have to look in my archives where I know I linked to it. Did find this nice quote of DeLong's on Jim Grant:

Or take Brad Delong's six minute debate about QE with Jim Grant from last year.  As Delong summarized it (my bold):

I found it depressing because the major unfairness Grant focused on is that, because of the Federal Reserve, investors in money market funds can get only one basis point of interest. The 9% unemployed: they are not the victims. Those who cannot sell their houses because of the foreclosure overhang: they are not the victims. Those whose businesses crash because of slack aggregate demand call they are not the victims. The real victims are the rentiers who have a right to a nice solid well above inflation safe return, and from whom the Federal Reserve is stealing that right.

And I found what I could gauge of Jim Grant's worldview depressing as well. He seemed to be selling rentier-populist ressentiment. Grant's world is full of "takers"--and the Federal Reserve is helping them. And the biggest takers in Jim Grant's mind are the hedge fund operators of Greenwich, Connecticut. Why are they the biggest takers? Because they can borrow cheap, at low interest rates, and put the money they borrow to work making fortunes. If only the Federal Reserve would shrink the money stock and raise interest rates! Then the hedge funds would have to pay healthy interest rates for their cash! Then the profits would flow to the truly worthy: the rentier coupon-clippers now suffering with their one basis point yields.

Never mind what a policy of monetary restraint to "normalize" interest rates would do to the unemployed...

You can read that in the recent statement by Mohamed A. El-Erian of Pimco, who, as Karl Smith noted, wants the Federal Reserve to focus on microeconomic goals instead of the macroeconomic problem of full employment.  This isn't new.  As Keynes noted, "the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners."

The implicit argument is that the interest rate compatible with full employment is too low for financial investors to accept.  Do we then just accept mass unemployment and the subsequent hysteresis-induced slowing of growth and human potential so Jim Grant and Pimco can make a profit they feel is worthy of their financial talents?  Of course not.