Fed needs spark greater expectations for inflationJESSICA RINALDI/Reuters
We are days away from a new Cleveland Fed estimate of U.S. inflation expectations, and market data indicate the bank will be reducing its inflation expectations further.
Over the short to medium term, both inflation and economic growth are expected to stay flat. Despite having a dual mandate of 2 per cent inflation and unemployment between 5 and 6 per cent, the Federal Reserve is expected to miss these by considerable margins. The Fed must act, and act quickly, to stimulate growth in the U.S. economy through looser monetary policy.
A common objection to looser monetary policy in the United States is that banks and financial institutions will just sit on the money, keeping it from entering the broader economy. This concern is unwarranted; if it were literally true, then the Federal Reserve could monetize the entire debt without consequence.
It is not literally true, of course. It overlooks the role of expectations in macroeconomics. There is no depreciation cost to banks holding onto cash since inflation expectations are so low – a dollar five years from now will be worth a dollar today.
If the Fed, however, announced an increase in the money supply through some mechanism (such as quantitative easing) so that inflation expectations rise to, and stay at, a given level, this would no longer hold true. A bank or financial institution would face negative real returns by holding onto cash.
If inflation is expected to be higher in the future, then the real cost of holding cash rises. As such, financial institutions will seek alternative venues for their funds, pushing that money into the broader economy and creating a hot potato effect. That money then circulates through the economy, raising both the rate of inflation and the rate of economic growth.
By creating those expectations, the Federal Reserve may not actually have to increase the money supply at all. The sheer indication that it will hit its inflation target no matter what, will move markets, so long as the threat is seen as credible.
Expectations are important in economics. By creating inflation expectations, the Federal Reserve can ensure that money reaches the broader economy.
Mike Moffatt is an Assistant Professor in the Business, Economics and Public Policy (BEPP) group at the Richard Ivey School of Business – Western University