The expectations bluff
“Mad. Mad. Mad. Bernanke’s gone totally MAD, I tell you!”
“What’s he thinking with QEternity? It’s so inflationary. AGHH!”
But what if, as Dario Perkins at Lombard Street Research wonders this week, that’s exactly the reaction Bernanke was hoping for?
You see, when a central bank’s normal tools run dry, all a bank’s really got left are Jedi mindtricks.
And that means manipulating people’s minds, on a nationwide (if not global) brainwashing basis.
You see, if the central bank can persuade the population to think differently about the future — despite rational instincts telling people otherwise – it can change the population’s behaviours today. It’s really very Paul Mckenna. It doesn’t matter if today’s reality is shouting excess capacity, no jobs, stagnant growth… featuring shelves packed high with products galore to boot. If people can be convinced that tomorrow the future will be different, that there won’t be enough to go round, they can be persuaded to act in a way that shifts the economy today. They can be persuaded to work harder, invest more — so as to cover would-be future shortages — and keep hoarding products and services today.
And because expectations shift forward curves, money can be made along the way.
Thus what Perkins is saying is… at this point, expectations are all Bernanke’s got.
As he notes:
Some investors are worried about Ben Bernanke’s latest effort to revive the US economy. In Milan last week, Italian clients described QE3 as ‘disturbing’, ‘dangerous’ and even ‘crazy’. There was lots of talk about the inflation it would create. If this reflects investor sentiment more widely, Mr Bernanke will be delighted. This is exactly the response he wanted. Faced with diminishing returns from QE, the Fed either had to give up on these policies (where we seemed to be drifting during the summer), or employ them more radically. Mr Bernanke’s response was emphatic – an open-ended promise to provide whatever level of QE is needed to get the unemployment rate down, plus the strong suggestion these policies will stay in place even when the economy recovers. During more than a decade of deflation, Japanese policymakers never got to this point. But in less than four years and despite an economy that is still growing, Mr Bernanke is there. He is deliberately behaving ‘irresponsibly’.
—–
The criticism of Japanese monetary policy in the 1990s was always that the BoJ simply wasn’t brave enough. US economists such as Paul Krugman, Michael Woodford and Ben Bernanke (remember he was an academic at the time) argued central banks could always end deflation if they were prepared to take big risks with inflation. The extreme example, of course, would be helicopter drops of money. But since central banks can’t simply hand out money to the general public and are usually constrained in terms of which assets they can buy, they’d need to adopt a more sophisticated variant of this approach. In particular, they should try to force up inflation expectations by promising to keep interest rates close to zero even after economic growth had returned and inflation was increasing. Rising inflation expectations should reduce real interest rates and stimulate spending.
In other words, let Zerohedge, Max Keiser, Ron Paul, Jim Rogers, and Paul Ryan fan inflation fears. They might actually be doing the world a propaganda favour.
After all, the problem isn’t with the propagation of inflation myths. It’s if and when people stop believing in the prospect of inflation, or when government starts fanning deflation expectations by accident instead (mainly, as a result of austerity measures).
As Perkins concludes:
The important question is whether this new approach will work. As unsatisfactory as it sounds, that will largely depend on what impact it has on sentiment and private-sector confidence. In the near term at least, there are reasons to be constructive. Investors were starting to wonder if Mr Bernanke and his colleagues had run out of ideas, so this latest stimulus sends an important signal. Regardless of what happens in Europe or China, or domestically with the fiscal cliff, markets can rely on the Bernanke Fed to continue to provide aggressive policy support. The ‘will they/wont they?’ debate is dead. They will. And the open-ended nature of this support should enhance its effectiveness, especially as it is tied to real improvements in the labour market.
That last point we think is important too. By introducing QEternity rather than QE3, Bernanke’s effectively quashed the market’s ability to demand yet more QE.
As Perkins notes, this could be because he’s chosen to go in all-guns blazing:
One of the problems with past QE is that financial institutions have been sitting on additional liquidity because they are too nervous to take risk. This is the ‘disaster premium’ in global markets, which has compounded banks’ capital and funding constraints. Investors are prepared to invest at very low yields in safe assets, despite the losses this involves in real terms, because they are hoping to avoid much larger losses in the future. Expectations of higher inflation and nominal spending would punish such liquidity hoarding, forcing investors to take more risk – with higher inflation, those real losses accumulate more rapidly.
… but we think it could also be a strategy designed to show up the diminishing returns of QE itself.
After all, if the market knows it can’t ask for more QE, it will have no choice but to ask for fiscal spending next time round.
So, buck moved very nicely to the Treasury instead.
As Perkins reminds there is, after all, a fine line between madness and genius, and it’s not at all clear which party is currently the mad one:
Madman policies are undeniable risky and hard to predict, but I welcome them. Bernanke has shown he is brave, but he is not genuinely mad. The truly crazy policymakers are sitting in Europe – those are the guys who have effectively given up on growth and yet seem to believe they can keep their jobs even as everyone around them loses theirs. Current German macroeconomic policy is more dangerous than anything Mr Bernanke can come up with.
So shhhh… best not tell anyone QEternity might not be as inflationary as some imply.
Related links:
A time of hoarding and inflation fears, 1930s edition – FT Alphaville
MOST: “The reflation trade may not have long legs” – FT Alphaville
Jedi Economics - FT Alphaville
