A recent op-ed in the WSJ posits the following claim:
A few critics of quantitative easing (QE) and the zero interest rate (ZIRP) have correctly pointed out that these policies weaken the dollar and thereby reduce the purchasing power of American paychecks. They increase the risk of future inflation, obscure the true cost of the unsustainable fiscal policy the federal government is running, and transfer wealth from savers to debtors.
But QE and ZIRP also reduce long-term economic growth by punishing savers, reducing saving and investment over the long run. They encourage the misallocation of resources that at a minimum is preventing the natural rebalancing of our economy and could sow the seeds of another painful boom-bust.
There is a lot going on in these statements. Also, I don’t like thinking about monetary policy in terms of interest rates. Nonetheless, here are my main points of rebuttal:
(a) Does the Fed control real interest rates in the long run? In other words, the author seems to think that by having the Fed target a federal funds rate near zero that this effects savings and investment (i.e. lower interest rates lead to lower savings and since savings=investment this means lower investment and lower growth). But don’t people make savings and investment decisions based on real interest rates whereas the Fed is targeting a nominal interest rate? Consider an example to illustrate my point. Suppose that the Fed came out tomorrow and said that they wanted to promote savings and investment and therefore were raising their target of the federal funds to 5%. Holding inflation expectations constant, the Fisher equation implies that the real interest rate would rise substantially. However, we cannot hold inflation expectations constant in this example because that policy would necessarily have an effect on inflation expectations. In fact, it is very likely that this policy would induce expectations of deflation. The policy would do nothing to raise real interest rates.
(b) The use of “boom-bust” is clearly a reference to the Wicksell-Hayek business cycle model. However, in that model the boom (which leads to a subsequent bust) is caused by malinvestment due to the fact that the market rate of interest is set below the natural rate of interest. Assuming that this view is empirically valide, what is the current natural rate of interest? One empirically testable hypothesis from this view is that when the market rate of interest is held below the natural interest rate, this results in ever-accelerating inflation. Do we observe ever-accelerating inflation? Do we at least observe rapidly growing productivity in the face of stable inflation? I think that the answer to those questions is no.
(c) Does inflation reduce the purchasing power of American paychecks? First, this depends on how we measure things and the time horizon. If American paychecks have less purchasing power, then we would expect to see real compensation declining. We don’t. Perhaps the author is referring to the purchasing power relative to other currencies. Have we seen a marked depreciation in the USD relative to the Euro or the Pound sterling? No.
Do not mistake this analysis for downplaying the costs of inflation. The costs associated with inflation can be significant. However, just because something costs more in nominal or real terms does not necessarily mean that individuals are worse off. For example, we have seen a large increase in the price level since 1970. Nevertheless, given that an 18 cubic foot refrigerator cost about $400 in 1971 and the same size refrigerator costs about $450 today, the average worker in 1971 would have had to work about 107 hours to purchase that refrigerator (based on average wages) whereas the worker in 2011 would only have had to work about 23 hours.
Rising prices aren’t a cost of inflation, they are the definition of inflation.
(The costs of inflation are the things that would have been avoided in the absence of inflation. For example, the inflation tax on money holdings, “shoe leather” costs, costs associated with shorter contract durations and negotiation, etc. Read Axel Leijonhufvud, for example.)
(d) Inflation reallocates wealth from savers to borrowers only when it is unexpected. Has inflation been higher than expected?