Is the Fed Using Maldistribution of Income to Control Inflation?

In his excellent article, "The Tale of Two Inflations," Steve Waldman, who sees matters much as I do, had this pithy comment:

Greenspan famously concluded that we can "mop up" asset price bubbles after they burst, rather than interfering with the dynamic whereby asset price inflation substitutes for consumer price inflation.

Bernanke pursues the same policy, Waldman implies.

The idea suggested arises from the fact that half of all income accrues to those who earn more than $85,000 a year and they have a lower marginal propensity to spend on consumer staples than those earning less who spend a higher percentage of their income on basic consumption items. The top half, on the other hand, instead spends much more on “investment” assets, such as stocks, bonds and other financial instruments. The argument is the Fed is playing on these facts to channel monetary purchasing power away from consumer goods and into asset bubbles to avoid the inflation of prices of consumer goods, while letting asset prices bubble up as a diversion. It is an interesting thought, but is it true?

Greenspan was very largely the architect of the housing bubble. Many, including Paul Krugman, argued for just such a bubble beforehand. The question in part is why. At that time, we were still recovering from the dot com bust and too we were in a bit of a recessionary dip. The idea was a housing boost would increase household net worth and would aid the economy which is so closely tied to housing. The wealth effect was expected to increase consumption and aggregate demand. The result is now clear to all. The housing bust injured almost everyone, rich and poorer alike. It led directly to the credit crunch and the Great Recession. While its results were clearly not anticipated, I have some serious doubts on whether it was intended as a diversion of purchasing power away from consumer goods. But that was then and now is now.

The Fed has adopted a near zero interest rate policy, which also has a strong propensity to induce financial asset bubbles for similar reasons. The policy likewise induces the carry trade to run off with dollars to be invested or used elsewhere after conversion into other currencies, mopping up loose liquidity and putting downward pressure on the U.S. dollar. Has the policy generated additional real investment in the U.S.? I believe not, on the whole. Certainly the banking system and its business customers see no great investment opportunities in the here and now. If we consider this policy in conjunction with the significant increases in the money supply, in part by the monetization of some on-going federal deficits, the Waldman suggestion takes on much greater plausibility.

However, the classical prescription for a recessionary malaise is lower interest rates, increases in the money supply to compensate for lower velocity of circulation and greater federal spending. So it is hard to tell what the Fed intends vs. what it has to put up with. What is clear is the effect of Fed policies currently, whether intended or not. They are to create asset price bubbles both here and elsewhere, too, via the carry trade. This may well be because of the maldistribution of income, not only here, but also to lesser extents elsewhere, too, but it is not clear that the Fed intends such bubbles or likes to deal with the aftermaths of those bubbles bursting. It seems as much the case that the orthodox and unorthodox monetary policies called for to fight recessions like ours have these untoward consequences, given the distribution of incomes.

Without searching through the comments of all Board members, whether the Fed is playing the situation now, after the housing bubble, is not clear to me.

What is your view?

Comments

[Luis de Agu...:]

According to the uncommon but supportive evidence from Wainwright Economics, inflation does not result from too much money in circulation, but from lack of confidence in a currency that causes its price in terms of gold and other real goods to depreciate.

Additionally and according to Wainwright’s experiential analysis parallel to its economics thinking, the Fed will move to tighten only when what it really cares about more than everything else in the world combined, i.e., the health of the banks over which it presides, appears safe. Result: near zero short-term interest rates until that condition appears en force.

And lastly, if short rates are near zero, long rates have to remain depressed. That’s virtually an arbitrage condition. However, as inflation and the government

Oct 29 10:34 AM

[Luis de Agu...:]

(re-post of complete comment below)

According to the uncommon but supportive evidence from Wainwright Economics, inflation does not result from too much money in circulation, but from lack of confidence in a currency that causes its price in terms of gold and other real goods to depreciate.

Additionally and according to Wainwright’s experiential analysis parallel to its economics thinking, the Fed will move to tighten only when what it really cares about more than everything else in the world combined, i.e., the health of the banks over which it presides, appears safe. Result: near zero short-term interest rates until that condition appears en force.

And lastly, if short rates are near zero, long rates have to remain depressed. That’s virtually an arbitrage condition. However, as inflation and the government's default risk both climb, an increasing disconnect between short and long rates will ensue.

Luis de Agustin

Oct 29 10:36 AM

[ryanclarke:]

The federal government has ... for the past nine years ... attempted and continues to attempt .... to transfer debt onto the books of the "little people" while relieving the debts of both the federal government and large companies which the government has determined are "vital" to the U.S. economy. The Fed will not succeed with this last attempt at blowing another bubble ... which obviously is brewing in energy ... because the only states which benefit from such an energy bubble are Texas, Alaska, and Louisiana ... and the majority of people living in these states will see little gains in wealth ... from paying $5 gallon for gasoline at the pump next summer.

Oct 29 04:02 PM

[bob adamson:]

Kimball, you continue to ask important questions that are very difficult to answer with satisfaction. The following covers old ground but is hopefully useful.

One assumption of Lord Keynes and several of his earlier followers in the 1940s was that there were dramatically different spending patterns within the different classes of society; collectively the working class essentially spent all their income as it was received because they needed to while the middle and upper classes collectively saved a significant portion of their income both because they had that option and because it provided to each a personal reserve to fund personal needs and opportunities that might later arise. The further assumption that when a recession struck the middle and upper classes horded more because of uncertainty for the future while the working class spent less simply because their incomes were cut was one of the foundations of his conclusion that the economy could stall in equilibrium at less than full employment. It also furnished the rational for the argument that, whatever the merits of tax cuts for the better off classes if the economy appeared to be in danger of softening, if there was a sharp downturn then direct government spending was necessary to return to equilibrium at full employment.

Whatever the merits of that analysis in the 1940s context, spending and savings patterns in North America have evolved considerably with the advent of increased incomes and availability of credit. The illusion that one can both consume and spend by acquiring a house because that house will increase in value over time induced many in all income levels to seize any opportunity to buy a house that, in terms of their income levels were very expensive. This and a policy of maintaining very low interest rates as long as consumer inflation was not evident fueled the real estate bubbles and the consequent secularized debt and derivative bubbles to a considerable extent prior to 2008.

Arguably both the residue of earlier excesses and the need to recover from the October 2008 to March 2009 meltdown are considerably complicated by the ingrained social assumptions (and the responses to those assumptions reflected in long held banking and governmental policies).

The difficulty now is to devise a chain of policy and practice that will over time but without undue delay lead the economy out of recession and also establish a sounder pattern of income distribution, savings and investment. The intellectual basis upon which to build that chain eludes us to date.

Oct 29 05:18 PM

[Graham and ...:]

"Bubble, bubble toil and trouble."

Oct 29 05:33 PM

[Ricard:]

I am betting on this outcome.


On Oct 29 10:36 AM Luis de Agustin wrote:

> Additionally and according to Wainwright’s experiential analysis
> parallel to its economics thinking, the Fed will move to tighten
> only when what it really cares about more than everything else in
> the world combined, i.e., the health of the banks over which it presides,
> appears safe. Result: near zero short-term interest rates until that
> condition appears en force.

Oct 31 01:56 PM