Wednesday, April 15, 2009

Uncertainty as defined by Larry Summers (or just another example of a two-handed economist?)

In an interview last week, Larry Summers said that "there are risks of both deflation and inflation", so anything is possible... In defense of Larry Summers' lack of commitment when it comes to forecasting inflation, there is indeed an outgoing debate between those who are afraid that advanced economies are heading into deflation and those who believe that the aggressiveness of monetary policy (and the expansion in the central banks' balance sheets) will soon produce a large and persistent increase in inflation rates. 

To some this might sound like the standard two-handed approach of economists but I think that in this case the debate is also reflecting an unusual amount of uncertainty as we are dealing with an episode that is different from what we have seen before (of course, as an economist, I have to defend the profession...). 

There are two reasons for why uncertainty can be so high. First, this is the deepest recession for many advanced economies after WWII. While there are some historical episodes of even deeper downturns (such as the Great Depression), they took place in a very different economic, political and institutional environment. In addition, some of the monetary policy actions that central banks around the world are taking can be seen as an experiment (out of desperation). Traditional monetary policy actions are not enough so they need to try unorthodox measures. Yes, we have a sense on the consequences that these actions will have but we do not have previous historical experiences to produce a good quantitative estimate. If you want to look at how this uncertainty is reflected in differences in inflation forecasts, here is an interesting entry from the macroblog at the Altlanta Fed on the current state of inflation expectations and uncertainty.

The deflation scenario is one that is supported by the data. Today, the U.S. Bureau of Economic Analysis released the CPI estimate for March and on an annual basis, inflation was -0.4%, the first time this measure is negative since 1955. This combined with a weak economy and an unresolved financial crisis could in theory lead to a deflationary spiral. However, one has to be careful reading too much into the figure that was released today. If one looks at the details, the only category where we had deflation was in "transportation", which is driven by the decrease in oil prices over the last 12 months. Falling oil prices is, if any, good news for the US economy. Other items display inflation rates that were clearly above zero on an annual basis (Food and Beverages at 4.3%, Education at 3.2% and Other Goods and Services at 5.7%). The trend looks somehow more worrisome as on a month to month basis we see negative inflation rates across more categories in some of the most recent months, but it is fair to conclude that we are still far from the type of persistent deflation that can cause major damage to the economy.

The inflation scenario is driven by the massive increase in the balance sheets of many central banks (including the Federal Reserve that has probably been the most aggressive of all). We know that this increase in the balance sheets has not translated into a one-to-one increase in the money supply (see earlier entry about the money multiplier), but there is still the risk of inflation if central banks do not react faster and withdraw the additional liquidity when the economy recovers. Simon Johnson has recently written an article in the Washington Post summarizing the inflationary risks of the current monetary policy "experiment". Theoretically, the Fed has the ability to do what it needs to be done to avoid inflation (see, for example, this article by Woodward and Hall on the potential use of the interest rate paid on reserves). 

So what will it be, inflation or deflation? If central banks are good at what they do and they quickly react to the different potential scenarios ahead, we should not see any of the two (i.e. we should see an inflation rate that remains positive but around or below what is considered to be the -explicit or implicit- medium target for central banks). 

Under which conditions can central banks fail? On the deflation scenario, the failure would be one of anticipation. As long as central bank are ahead of the curve and provide the necessary liquidity using whatever means are necessary (including the "helicopter money drop"), they should be able to keep their economies from falling into persistent deflation. On the other side (the inflation scenario), there are potentially two risks: a technical one and a political one. From a technical point of view, central banks also need to anticipate changes in inflation expectations and move as fast as they can to avoid any sustained increase in those expectations. The second risk is more of a political nature. One can envision scenarios where the central bank could be under enormous pressure to give up and let inflation increase above its normal level. If the economy recovery is slow but still fast enough to get inflation expectations increasing, undoing the monetary expansion could have a large impact on the interest rate. An increase in the interest rate will impose a serious cost to governments who are currently accumulating debt at a very fast pace because of large deficits. And if growth is not strong enough to bring the necessary tax revenues, governments will feel the need of either raising taxes or cutting spending, none of which are easy from a political point of view. No doubt that this will be an interesting test of the independence of central banks. We have already seen in recent months central banks deciding on actions that "they did not want to take" but it was necessary because of the "special circumstances". If inflation expectations come back too early, the trade off between inflation and growth (and interest rates) will be very strong. Would it also be considered a special circumstance that requires unusual actions by central banks? Let's hope we do not get there and we do not need to test the independence of central bankers.

Antonio Fatás
on April 15, 2009 |   Edit