Inflation Expectations and Trepidation

The theoretically correct approach to most flavors of the liquidity trap is not fiscal stimulus.  Nor is it, unless the economy is in an abnormally depressed equilibrium requiring a face slap, quantitative or qualitative monetary policy.  The foolproof solution is to explicitly commit to inflation, prove that you're serious through aggressive action, and demonstrate that you know what to do once you've succeeded.

This is the Fed's playbook, and they are playing by it, coming through both verbally and in action.  The populace is listening, as consumers expect 3.0% annual inflation over the coming 5 years, although down from 5.2% in May.  But Japanese households expected 7% domestic inflation in June, and we know how that worked out.

Those surly bond vigilantes are giving less creed to the Fed's efforts, expecting zero inflation over the same period.  Some inflation expectations are a little less anchored in the blogosphere, to put it gently.

A Better Fool

The world has a way of humbling theories, particularly the foolproof ones.  So far, the operations of the Treasury and Fed have done little to resuscitate market and economic activity or create inflation.  The braggadocio Fed has had precious little traction, though theory would predict immediate and significant impact on market pricing.

The limited impact thus far might not surprise readers.  What good are inflationary expectations in an environment where inflation is not possible?  Regardless of the intent of the US government, the successful reflation of our economy rests not in its hands, but instead in the hands of those who peg their currencies to the dollar, unless and until the US takes some aggressive international actions with significant associated drawbacks.

International investors in the US have myriad strong reasons to resist this reflation.  They expect, for some reason that's beyond me, to be paid back for their extensive reinvestment in the US economy.  They would not enjoy the severe and destabilizing domestic inflation required for US reflation without revaluation.  They also don't want the partial default and export collapse resulting from a revaluation of their currency upwards.

The inertia is powerful, and domestic inflation expectations can't trump this global reality.  But let's assume these inflationary threats do impact the expectations and actions of some actors in the US economy.  What might we expect as a result?

Trepidation

Investors and lenders, who generally receive a fixed coupon on their investment, would naturally demand a higher interest rate to compensate for this expected reflation.  Borrowers expecting similar reflation might be tolerant of that expectation, or they might look at the realistic returns and competition facing their investment and be reluctant to accede to those terms.

Regardless, it's the increased uncertainty about the trajectory of future inflation that causes the most trouble.  The wider the divergence between present reality, natural expectations, and imposed expectations, and the more variability in all these rates, the higher the term premium embedded in a longer loan.  This will put an upward pressure on long real interest rates, which is precisely the opposite of what we wanted to accomplish in the first place.

So much for expectations.  But the supporting action of the US' credibly crazy government for inflation, economic growth, or bust might similarly do harm.  Such dramatic expansion of the Fed's balance sheet, sporadic intervention in myriad markets, and massive deficit spending would seem to me to decrease the confidence in the dollar as a medium of exchange and a store of value.  That should cause the private sector to seek a higher return to justify this additional risk, leading to a negative impact on economic activity.  Who knows who gets sprung next, and what the effect will be on your investment?

Some economic models and empirical work view concerted government intervention positively, even during crisis.  If we had an organized, consistent, and scoped response to this crisis, I would find that outcome plausible.  

We, however, are playing financial Calvinball.  This is never good, as initial assessments reveal.

In short, I think the focus on inflation expectations and the associated, requisite demonstrated willingness to intervene whenever and wherever necessary are self-defeating at best, and quite likely deleterious in our current world.