Feldstein argues that the Fed's QE program will inevitably lead to inflationary pressures in the future, because when the new money finds its way into the real economy it will lead to a spending splurge. Frankly, at the moment a spending splurge would be a very good thing. The economic trend throughout the world is deflationary, everyone is cutting back spending, banks aren't lending and the velocity of money is dropping like a stone. The Bank of England (which Feldstein doesn't mention), which has done far more QE in relation to the size of the UK economy than the Fed in relation to the US, says that the primary purpose of QE is to maintain inflation near its 2% target and counteract DEFLATIONARY pressures. Many might dispute this, since the UK's CPI has been and remains well above target, but the BoE's quarterly inflation report shows a downwards trend and there is evidence of significant retail deflation which is not being picked up in the CPI measure because it is occurring through discounting from published prices, coupons, special offers and sales.
Many might also dispute the effectiveness of QE as a counter to deflation - by extension this also implies disputing its inflationary effect, although those who both complain about the ineffectiveness of QE and predict runaway inflation arising from it don't seem concerned by logical inconsistency. Stella and Singh argued that as QE is simply an asset swap, it has no effect on inflation. Others have noted that as most money in circulation is created through bank lending, and banks are currently restricting lending, all QE does is increase bank reserves without any great benefit to the wider economy. Conversely, the Bank of England (not surprisingly) argued recently that the UK would be in deeper recession without QE. My own view is that QE is at best a very weak stimulus and you would have to do an awful lot of it to achieve the same effect as a 50 bps cut in interest rates.
However, Feldstein is not describing an immediate inflation risk. He is looking ahead into the future when (we hope) the economy starts growing again. At that point the money created through QE would indeed be likely to create inflationary pressures in the economy, and it is the Fed's job to nip those in the bud through interest rate rises and other measures.
Feldstein believes the Fed will be unable to tighten monetary policy enough to counter the inflationary effect of QE. He notes that high unemployment rates persist throughout the Western world, and suggests that hysteresis will prevent unemployment falling to levels acceptable to politicians. Politicians will then apply pressure to prevent the Fed raising interest rates to the level needed to choke off inflation. This is really quite unfair to the Fed, which has maintained generally good control of retail price inflation for the last twenty years. The Fed does have two mandates - price stability and low unemployment - and the two might come into conflict, but that is certainly not a reason to suppose that the Fed would abandon any attempt to control inflation if unemployment remained high. Rising inflation is a disincentive to saving and investment, and in the longer run that destroys jobs. Controlling inflation is therefore an essential part of the Fed's low unemployment mandate.
There are calls for the Fed and other central banks to be brought under political control. Feldstein rightly in my view identifies this as a risk. Politicians by definition have a short-term view - their goal is always re-election - so they generally prefer policies that give short-term electoral gains at the expense of longer-term economic benefits. But in what way would preventing the Fed from controlling inflation improve their electoral chances? Well-off Americans are as terrified of inflation as the Germans, and the powerful "grey voters" have lived through a period of high inflation and remember its effects all too well. At present the political pressure is clearly in the opposite direction. The American right is arguing for tightening of both monetary and fiscal policy, ostensibly to choke off inflation that is not happening and will not happen any time soon, but I suspect actually to improve returns on capital and enable taxes to be cut for the well-off. And Feldstein is providing ammunition to their campaign. Political pressure doesn't always come from politicians.
The fact that the combination of tight monetary and fiscal policy prevents people spending and investing, and therefore inhibits growth, appears nowhere in Feldstein's analysis. Yet he clearly believes that growth would still happen if policy were tighter. I find it worrying that a Harvard professor of economics apparently believes in magic.
And growth in the absence of adequate money supply is not the only Feldstein magical belief. Feldstein argues that the recent rise in the gold price and rising price of agricultural land in Iowa and Illinois indicate flight to hard assets, and that this suggests that investors fear inflation. But if that is their fear, why are yields on non-indexed highly-rated government securities in negative territory? Why is there a global shortage of USTs? In short, why are investors still buying these securities if they believe the value of those investments is about to be catastrophically eroded by runaway inflation? And is there really a noticeable flight to hard assets anyway?
There is a fallacy of composition in Feldstein's assertion about agricultural land: since when has the price of land in Iowa and Illinois been a reliable indicator of the global price of agricultural land? Are there really no local effects? And his argument about gold doesn't make too much sense either. The underlying trend in gold prices has been downwards from a peak of nearly 1900 in September 2011 (change the settings on the link to see the 1 year, 2 year and 30-day charts). Yes, in the last ten days there has been a bit of a positive spike. But a ten-day spike is not sufficient to indicate a change in the underlying trend. The gold price is traditionally volatile, and there are many possible reasons for that spike. Central banks have been buying gold for reasons that are not entirely clear: Izabella Kaminska argues that central banks are propping up the gold price, which would otherwise be falling off a cliff. Cullen Roche recently changed his investor advice for gold to "buy", because the long-term price and the risks to the economy had in his view changed sufficiently to make gold a reasonable investment choice within a diversified portfolio. Gold was recently reclassified as a zero-risk asset for the purposes of bank capital adequacy requirements, which would encourage banks to buy gold. And there might also be some investors buying physical gold as an inflation hedge, as Feldstein thinks - the inflation fear-mongers and goldbugs no doubt have some effect, and the FOMC's suggestion that more QE will be needed soon will have spooked some investors. But the effect doesn't exactly seem large, and it is really too soon to tell whether the gold price trend is reversing. Feldstein doesn't seem to have much evidence to support his claim that financial markets generally fear inflation.
Inflation is not the only risk to capital. Default is also a risk if your assets consist of someone else's debt, as most do. One thing I learned from my extensive debates with Freegolders recently is how frightened they are of counterparty risk - the risk that the borrower will simply walk off with your money, leaving you with nothing. The fact that investors are currently prepared to accept negative real returns on investments they regard as "safe" - USTs, German bunds, FDIC-insured deposit accounts - suggests that fear of counterparty default is not limited to the Freegold hyperinflationistas, but is widespread among investors. Better to suffer a small amount of capital destruction than risk losing everything for a positive return, it seems. The shadow of Lehman lies long over the American financial markets, and the Eurozone debt crisis looms large in the European markets.
On Twitter, the Berkeley economist Brad Delong asked me whether investors really fear inflation, since they don't seem to be hedging against it:
And in his own post on this matter, Delong notes that if investors really feared inflation they would be investing in index-linked securities, but there is no evidence of a flight to TIPS from other US government securities. Admittedly if the prevalent investor fear is hyperinflation, not inflation, then TIPS would not be regarded as adequate protection so would not be preferred over hard assets. But as I've already noted, there doesn't seem to be any evidence of a flight to hard assets from other "safe" investments, either.
@frances_coppola Re: Feldstein: Can you tell me how financial investors can fear something if they take no steps to hedge against it?
— J. Bradford DeLong (@delong) August 30, 2012
Investors are indeed afraid - but not of inflation. In a debt-laden and deflationary economic environment, fear of default is quite sufficient to explain investor flight to "safe" assets - including, of course, gold and land, though the fact that at present there isn't a noticeable movement of funds from highly-rated government debt to hard assets suggests that investors in general still believe that their money is safe with government.
Feldstein's article is written entirely from an American perspective. So his mention of the ECB is somewhat strange. It is also very wrong. The Eurozone economy is dominated by Germany, which does not have high unemployment - but does have a paranoid fear of inflation. Unlike the Fed, the ECB has only one mandate, namely price stability (it has no mandate to control unemployment). Monetary policy in the Eurozone since 2008 has been tighter than anywhere else: it is the only major central bank that has not done QE, although its two LTROs amounted to much the same, and until recently it maintained interest rates well above the zero lower bound. And it has the Bundesbank breathing down its neck. Every time the ECB does anything slightly unconventional to loosen monetary policy, someone from the Bundesbank complains. And it is only a year since the ECB raised interest rates because of inflationary pressures in Germany, despite the mounting evidence of catastrophic deflation in the periphery. The ECB has also continually resisted attempts from the distressed peripheral countries (and France) to persuade it to finance sovereigns and recapitalise banks in contravention of its mandate: the little bond-buying and bank financing it has done has been only just sufficient to prevent deflationary collapse and protect the Euro. So Feldstein's suggestion either that the ECB would suddenly cave in to political pressure, when it has not done so throughout the debt crisis, or that Germany would suddenly choose low unemployment over inflation control, when it did not do so throughout German reunification, is yet more magical thinking on his part.
Inflation is not the main risk at the moment, and it is not what investors fear most. Feldstein is not only wrong, he is - because of his influence - dangerously wrong. The US has tightened monetary policy in a deflationary environment before. The result was the Depression.