Research Paper on "Dynamic Inconsistency of Low Inflation Monetary Policy"

Research Paper 11 pages (3020 words) Sources: 1+

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Dynamic Inconsistency of Low-Inflation Monetary Policy

The lingering effects of the Great Recession of 2008 are still being felt in substantive ways across the global economy, and many observers are questioning the efficacy of the various stimulus methods that have been used by the Federal Reserve to mitigate these effects. Recently, the Federal Reserve has used the devices it has available on several occasions to control the money supply in an effort to pump more money into the economy. While these economic stimulus initiatives have succeeded in freeing up additional money that might have otherwise been used to purchase federal securities, banks remain cautious about the future and the economy faces stagnated economic growth unless these stimulus initiatives can be fine-tuned and directed at areas that provide the framework for recovery while minimizing inflationary trends. This paper provides a review of the relevant peer-reviewed and scholarly literature concerning the dynamic inconsistency of low-inflation monetary policy. For this purposes of this analysis, it will be assumed that the Federal Reserve will continue to use the devices that it has available to control the nation's monetary policy, that inflation will continue to be viewed as an undesirable concomitant of economic growth and that policymakers will remain reluctant to implement needed long-term solutions that may be politically unpopular in the short-term. Following a review of the literature, a discussion concerning the dynamic-inconsistency problem will be presented. A summary of the research and important findings are provided in the study's conclusion.

Review and Discussion

Monetary Policy and Its Effect on Inflation

The term "monetary policy" is used by economists to refer to "a deliberate exercise of the Federal Reserve's power to induce changes in the money supply in order to achieve price stability to help smooth out business cycles and to bring the economy's employment and output to desired levels" (Shim and Siegel 295). The monetary policy that is in place at any given point in time is primarily directed at regulating the economy's credit availability, the overall money supply, and to a lesser extent, the level of interest rates by the Federal Reserve system (Shim and Siegel 295). In the United States, the Federal Reserve system has three major ways that it controls the money supply as follows:

1. Changes in the required reserve ratio;

2. Changes in the discount rate; and,

3. Open-market operations, such as purchase and sale of government securities (Shim and Siegel 295).

According to Lim, Park and Harcourt, the monetary policies that have been used in the United States in recent years were focused on maintaining economic growth with inflation being a necessary evil in the process. For instance, Lim and his associates note that, "Contrary to conventional opinion, which focuses solely on low inflation, monetary policy in the developed world has been rather expansionary. In Japan and Europe this has reflected largely unsuccessful attempts to revive lagging growth; in the U.S. It has reflected [the Federal Reserve's] concern to keep the good times rolling" (274). In recent months, the Federal Reserve (hereinafter alternatively the "Fed") has used a series of so-called quantitative easings, or QEs, to pump additional money into the economy through the purchase of long-term securities. In this regard, Lenzer notes that, "No doubt about it, Fed Chairman Ben Bernanke's use of well over $2 trillion in Fed funds did help push higher the price of many securities, especially those in natural resource or commodity businesses -- increasing the paper wealth of the investing class. A related goal was to buttress the rate of inflation and defeat the fear of a deflationary spiral, a double dip in economic activity" (1). The utility of these massive stimulus packages is at the core of the debate over whether governments can truly affect the inflation rate in meaningful ways through the mechanisms it has available to control monetary policy. In this regard, Eggertsson asks, "Can the government lose control over the general price level so that no matter how much money it prints, its actions have no effect on inflation or output?" (283). According to a recent report from Draper (June 14, 2011), an economic analyst with the Denver Business Journal, opinions concerning the effect of the quantitative easings to date remain mixed, but the goal of these initiatives was clear: "The Fed has launched two significant economic efforts -- called quantitative easing -- since the recession began in early 2008, purchasing outstanding Treasury obligations so fresh capital would be infused into the financial system. The aim was to increase U.S. economic growth and reduce unemployment" (Draper 2).

Although opinions concerning the actual effect of these stimulus efforts remain divided, some of the outcomes are well-known. For instance, following the Fed Chairman's announcement on August 27, 2009 wherein Bernanke assured central bankers that the Fed would "do all that it can to ensure continuation of the economic recovery," the Fed engaged in the purchase of additional longer-term securities, an initiative that followed the Fed's injection of $1.5 trillion on in mortgage-backed securities in the first quantitative easing in 2009; this initiative allowed mortgage sellers the opportunity to purchase these securities, thereby driving the price of securities up modestly while reducing their corresponding yields in a process that also encouraged other investors to purchase equities (Lenzer 3). Based on his analysis of the effects of the quantitative easing initiatives, Lezner notes that, "

On balance, we have to admit the nation is better off" (3). Some salient effects of QE1and QE2 to date include:

1. U.S. real gross domestic product (GDP) grew by 3.7% in the first quarter of 2010, in between QE1 and QE2;

2. The ISM Manufacturing Index, which measures the health of the U.S. manufacturing sector, was at 57.8 for the three months prior to QE2 and is now at 53.5;

3. The ISM Non-Manufacturing Index was at 54.6 prior to QE2 and is now at 52.8;

4. The S&P/Case-Shiller index, which measures housing values, was at 156.2 prior to QE2 and is now at 151.7.

5. U.S. unemployment rate was 9.8% in 2010, and is now at 9.1%.

6. Core CPI inflation had increased by 0.5% on an annualized rate for the three months prior to QE2 and is now growing at an annualized rate of 2.1% (Draper 3).

Other recent economic indicators include the following:

1. The food index rose 0.4% in May 2011, the same increase as in April 2011; the food at home index increased 0.5% and has risen 3.7% since December 2010.

2. Among major grocery store food groups, the index for meats, poultry, fish, and eggs rose 1.5% and the cereals and bakery products index increased 1.0% and the dairy and related products index and the index for other food at home posted smaller increases.

3. The energy index declined 1.0% in May ending a series of ten consecutive advances. After a series of several sharp increases, the gasoline index declined 2.0% in May 2011; prior to seasonal adjustment, gasoline prices rose 3.6% in May.)

4. Despite the May decline, the gasoline index has increased 23.7% over the 6-month period ending May 2011.

5. The index for all items less food and energy rose 0.3% in May 2011 after increasing 0.1% in March 2011 and 0.2% in April 2011.

6. The shelter index rose 0.2% in May 2011 after increasing 0.1% in each of the seven previous months.

7. Both rent and owners' equivalent rent rose 0.1%; the acceleration in shelter was due to the index for lodging away from home, which rose 2.9% in May 2011 after being unchanged in April 2011.

8. The apparel index increased in May 2011, rising 1.2% after a 0.2% increase in April 2011.

9. The index for new vehicles rose 1.1% in May 2011 after increasing 0.7% in April 2011; the index for used cars and trucks also rose 1.1%.

10. The index for recreation, which was unchanged in April 2011, rose 0.3% in May 2011.

11. The medical care index rose 0.2%, with the index for medical care commodities unchanged and the index for medical care services up 0.3%.

12. The Consumer Price Index for All Urban Consumers (CPI-U) increased 3.6% during the 12-month period ending May 2011.

13. The Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) increased 4.1% for the 12-month period ending May 2011.

14. The Chained Consumer Price Index for All Urban Consumers (C-CPI-U) increased 3.3% for the 12-month period ending May 2011 (Consumer Price Index 3).

Therefore, based on the foregoing trends and indicators, Draper concludes that, "If the idea was to lower unemployment at the expense of increasing inflation, QE2 was a success" (4). The costs involved in achieving this modest reduction in unemployment, though, are staggering. According to Draper, "If QE2 cost $600 billion, and in that time, the labor force increased by 1.028 million jobs, one could say that one job was created for every $583,657 the Fed purchased in Treasury notes. Given this data, the Fed would need… READ MORE

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