PIMCO: Fed needs to 'be irresponsible' if deflation appears

To borrow a phrases from the late, great Jimi Hendrix, wrap your mind around this one: would you root for an "irresponsible" Fed?

PIMCO's Managing Director Paul McCulley is doing exactly that. McCulley, in a PIMCO commentary, said that, if the U.S. economic recovery does not begin as expected in Q3/Q4, the Federal Reserve should push inflation above its long-term target to encourage U.S. consumers to spend money.

"The way to make monetary policy effective is for the central bank to promise to be irresponsible," McCulley wrote, citing a 1998 paper written by Nobel Prize-winning Princeton University economist and New York Times (NYT) columnist Paul Krugman.

McCulley, applying Krugman's doctrine, argues that a "radically" different central bank policy may be needed if the United States' wage and price structure starts to resemble Japan's infamous "lost decade" era of deflation.

Market economy's No. 1 enemy: deflation

Deflation -- a protracted, systematic decline in prices and wages -- occurs in pronounced recessions and other conditions in which demand is weak. Robbing companies of the ability to increase revenue, it handicaps the economy's ability to grow. If it takes hold, deflation can lead to the dreaded "deflationary spiral," in which price cuts lead to lower corporate revenue, prompting more lay-offs, leading to further consumer spending declines, prompt more price cuts, and so on.

Krugman argued that the key to inspiring consumer expenditures lies in convincing the public that printed money will remain printed; in so doing, the central bank can shift deflation expectations to inflation expectations. In 1998, Krugman wrote that "The way to make monetary policy effective is for the central bank to credibly promise to be irresponsible – to make a persuasive case that it will permit inflation to occur, thereby producing the negative real interest rates the economy needs."

In other words, central banks, such as the Bank of Japan -- and, if need be, the Fed -- should not so much act irresponsibly, as act irresponsibly relative to orthodox, conventional thinking.

Comment: McCulley is in agreement with Krugman that a little contrived "irresponsibility" by a central bank can be a good thing and useful. Without getting too wonkish, here's how it would work:

Businesses and consumers, expecting prices to decline, would put off capital investments and spending, because they expect to pay lower prices later, due to low inflation rate target and a likely exit strategy for the quantitative easing policy at the Fed. The Fed, however, would inform them that the credible inflation target is actually considerably higher, and it's not ending the quantitative easing so soon. The logical conclusion would be that businesses and consumers who are putting off investing and spending will end up paying a higher price later.

This approach, Krugman argues -- and McCulley agrees -- will change expectations of falling prices/wages to expectations of rising prices/wages, encourage investment and spending, and avert a deflation disaster. Central bank policy can then revert to normal inflation targets once deflation has been prevented.

Monetary and Economic Analysis: Of course, supply side theorists, Art Laffer among them, will argue that the Fed's quantitative easing policy, combined with fiscal stimulus by the Congress, will lead to rampant, runaway inflation. Wrong again, as Krugman incisively analyzed: it's very hard to have rampant inflation when you're in a liquidity trap.

Finally, for those investors who have the time and are inclined to do so, I encourage you read Krugman's excellent analysis of the Japan case study.
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