Knowing and Making

...and why the Bank of England and Fed are right to have done so already. I'm not talking about whether the European Central Bank should directly buy eurozone government bonds. This causes a moral hazard problem - it might encourage governments to be profligate and reduce incentives for structural reform. It's, at the very least, debatable. I'm talking about a more general question: why should central banks print money in a recession? This post won't have much new to say to macroeconomists, but it attempts to address a concern of many non-economists - won't printing money just cause more inflation? First, let's run a thought experiment. Imagine that your national government has decided that profligate use of fossil fuels is a problem. Probably because of the risk of climate change. Instead of using a carbon tax, the government decides to restrict the supply of oil coming into the country. It could allow more oil in if necessary - in fact it has a large res...

Turns out quantitative easing is  deflationary - at least the Federal Reserve thinks so. Today the Fed announced that the interest and capital repayments from the bonds it bought last year will not be retired from the system (which would reduce the money supply). Instead, they will use them to buy new Treasury bonds. Via Mark Thoma: ...the Fed will keep “securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities” Now I hate to say I told you so, but I told you so ... There is, however, a point more important than my self-satisfaction: whether this policy will work. Unfortunately this policy adjustment appears to reveal a basic uncertainty in the Fed's goals. By making ad hoc adjustments like this, the Fed keeps the rest of us off balance - we don't know what it will do next because its signals are too vague. In some cases this kind of policy is desirable - regulators and...

Mervyn King said today that the UK economy might go back into recession and that the recovery is weaker than hoped. So, Mervyn, what possessed you to stop quantitative easing  less than a week ago? Scott must be so disappointed. Unless you can come up with a solid rationale for why QE can't work , this is bizarre and inexplicable. p.s. to be fair, he has also said today it's ' far too soon ' to assume there will be no more QE. David Wighton in The Times points out that this behaviour looks ' downright peculiar '.

In the leader column of City AM today, Allister Heath argues that quantitative easing should be stopped because it will lead to inflation. Set aside for a moment the fact that this is the whole point of it. Is he right that it will actually succeed in causing inflation? Scott Sumner (consistent with mainstream monetary theory) points out that an increase in the money supply is only inflationary if it is expected to be permanent. And is QE a permanent increase? Not necessarily. On the contrary: QE in isolation makes the money supply smaller . Under QE, the Bank of England has issued £200 billion of new currency and used it to buy bonds (mostly gilts) in the private market. (The Federal Reserve has done something similar, with a higher proportion of corporate and mortgage-backed bonds.) So there's now £200 billion more sterling than there used to be - it's fair to say the money supply is bigger. What will happen next year - or in five years time, or thirty years when all the ...

How interesting. The Bank of England, whose notional target is a 2% inflation rate (CPI), is now looking at cash GDP in deciding its quantitative easing policy. That's according to Stephanie Flanders, who has an intelligent writeup of the Bank's considerations in deciding whether to print another £25 billion to purchase government and corporate bonds. Scott Sumner will surely be pleased to hear it: he has been advocating for a while that central banks should target nominal GDP . What's more, they are looking not at the rate of change, but at: ...the Bank's expected path for cash GDP in the next year or two... implying that the target is an absolute level, so if there's a shortfall this year they may even try to make it up next year. Now there's some way to go from using NGDP as one of the considerations in guiding this month's policy, to setting a formal rising path at 5% a year, trading a futures index and giving up inflation targets altogether. But this i...

I'm guesting at missmarketcrash this week, so half my postings will be over there. But my loyal readers needn't miss out, because I'll come up with some slightly more theoretical musings here. Then again, if you prefer what I write on her blog, please say so, as it will be a bit more whimsical (if you don't count my Apprentice postings) and a bit less rigorous than here. Today's posting over there is about Michael Savage - kind of - but more about the uniqueness of names and whether that's an economic commodity. I think the £50 billion intervention of the Bank of England today deserves note, so that's what I'll discuss at home. It wasn't expected, and indeed the BBC reported it at face value: "Bank of England provides £50 billion boost to economy" evidently before letting their economics editors loose on it. Once Stephanie Flanders had her say, it was translated into "a QE surprise". Quantitative easing, as it's called, was ...

Robert Peston is a bit torn today as to whether the markets are being rational or irrational - are they taking into account a future potential fall in gilt prices in this week's trading, or are they focusing only on a short-term rise in demand and ignoring the future? My take is that they are following a plausible model of bounded rationality: being rational within the reasonable scope of the foreseeable consequences of their actions, but not beyond. Traders can see a certain distance into the future with reasonable certainty. They can see the immediate consequences of the Bank of England's policy: that a fair proportion of available bonds are going to be bought up, and thus the price should increase in the short term. There are basic reasons that people need to buy government bonds (e.g. pension funds selling annuities) and so regardless of long-term returns, a temporary shortage can push up prices. They can also foresee the likely short-term effects for the economy of additi...

Well, it's (almost) official. The Bank of England today is likely to start a formal policy of quantitative easing, buying British government bonds from the private sector in order to increase the money supply. Stephanie Flanders has a useful post outlining the issues and questions, in which she references (but does not really answer) the most important question: what effect will it have on behaviour? This is a question that can be considered using three theory bases: macroeconomic models microeconomic incentives psychology, behavioural theory and cognitive biases The macroeconomic models in the current situation give a direction but not a magnitude: QE should increase the money supply and stimulate demand. We are so far outside normal conditions that it's impossible to gauge from the models how strong the boost will be. Understanding the microeconomic incentives also gets us only so far. More money will be in private actors' accounts; it won't be earning any real retur...