The Fed’s Inability to Stimulate the Economy

The Fed's Inability to Stimulate the Economy

The Fed may have to blow up the economy to get inflation under control

Why the Fed may have to blow up the economy if it doesn’t get inflation under control

In a recent article, I suggested that inflation expectations are a major factor in the Fed’s apparent inability to stimulate the economy. I’ve received few responses to this.

In a new letter, William Dudley, the former head of the US Treasury and the current head of financial operations at the US Office of Management and Budget, makes a strong case for this.

His concerns have been echoed by several Fed officials (here and here for example), but he has not received the attention of many commentators.

This is perhaps due to the fact that, for whatever reason, much of the public’s focus is on what monetary policy is doing to the economy rather than that monetary policy is doing to inflation expectations. The Fed might therefore be more reluctant to criticize the expectations of inflation.

Nevertheless, on the issue of inflation expectations, the article in the latest issue of the FT makes it clear that inflation expectations are a very large factor in the Fed’s inability to stimulate the housing and auto sectors, without which a new housing bubble will grow out of control and the auto sector will collapse.

Mr Dudley points to three factors as being the major factors inhibiting the Fed’s ability to stimulate the economy at the moment: the expectations of inflation (in particular, the expectations of core inflation), an overly low level of liquidity (as expressed by the Fed’s discount rate) and a housing bubble.

The first two can be dealt with by improving monetary policy in the near term. The third can only be dealt with by doing away with the housing bubble.

Indeed, all of these factors are related. The higher the expectations of inflation, the lower the rate of effective bank reserve expansion (i.e. the expansion of bank equity) and thus the lower the level of monetary accommodation in the financial system.

Moreover, a bubble in the housing market makes it very difficult for the Fed to raise the effective discount rate, because the price level is so high that it is difficult to

Leave a Comment