THE STASH MAY 29, 2009
Amid the speculation that inflation fears are driving up long-term interest rates, Paul Krugman spends today's column trying to defuse the anxieties. Krugman argues that the Fed isn't really expanding the money supply the way the inflation hawks allege, and that U.S. policymakers don't seem particularly keen on resorting to inflation to lower the government's debt burden. He blames much of the inflation fear-mongering on right-wing economists who oppose deficit-spending (but not deficit-creating tax cuts).
Krugman is probably right to see an ideological component in some of the inflation kibitzing. But is there a more objective case to be made?
One candidate comes care of University of Chicago economist John Cochrane. Cochrane is often lumped in with ideological economists from the monetarist school like Allan Meltzer and Milton Friedman. But, while sympathetic to this camp, some of his recent assessments have been more interesting and less dogmatic. (He was one of he first to note that the chief reason banks weren't lending post-recapitalization was the demise of the shadow banking system, not because banks were hoarding.)
The "credit crunch" is already over — short-term debt spreads have returned if not to normal, at least to functioning levels. The "flight to quality” will soon follow. Investors will wonder, “why should I earn two percent in treasuries when I can earn 6% - 10% in highly rated municipal and corporate debt?” In trying to buy the latter, we will see long term rates rise all on their own, with no change in short rates. In fact, as I write (May 2009) this seems to be happening: Long term rates have risen about a percentage point in the last few weeks, despite no change in short rates.
But while the current rise in long-term rates may not be signaling worries over inflation, Cochrane cautions that we're not out of the woods quite yet:
Now, while interest rates are rising and everyone else is selling Treasury bonds, the Fed has to sell another trillion or so to soak up extra money. It has to let short rates rise to meet the long rates. But we will still be in a serious recession. Many institutions will still be on the edge, including banks and other financial institutions tied to still-declining property values. And many of these institutions make a lot of money by borrowing low and short and lending long. Many Americans (and many registered voters) will still not have jobs. In this environment, can the Fed really have the will to engage in massive open- market operations, and start worrying about inflation?
In the end, Krugman and Cochrane disagree over when the Fed has to begin this "soaking up" process. Cochrane believes the extra money can be inflationary even when the economy is in recession (a stagflation scenario). Krugman believes that, as long as the economy is weak, banks will sit on the cash the Fed has poured into the system (rather than loan it out), so prices won't rise.
Maybe the point to keep in mind is that, as Krugman concedes, "big disagreements are especially likely in weird times like the present, when many of the normal rules no longer apply."