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Can a Central Bank Always Create Inflation?

Ambrose Evans-Pritchard got a Paul Krugman lashing over the weekend thanks to some comments about the power of Central Banks when the economy is stuck at the zero lower bound.  Evans-Pritchard had argued that increasing the money supply is still a relevant strategy for increasing inflation and Paul Krugman didn’t agree based on the evidence of the last 5 years which has put king sized holes in the idea that “money printing” QE can create inflation.

Ambrose responded today making some rather strong claims that I don’t think are exactly right. This isn’t the first time I’ve been critical of his commentary. Back in 2009 Ambrose wrote a piece about a potential bubble in US government bonds and I responded with a lengthy piece citing the many reasons why I didn’t think US Interest rates would rise, why bonds weren’t in a bubble, why there was no risk of US solvency, why we weren’t like Greece, why there was no hyperinflation coming and why high inflation certainly wasn’t coming. All of this led me to believe that there was most certainly not a bond bubble in US government bonds and that view has been undeniably correct.

It’s important to be precise in these discussions because the details are what help us understand cause and effect. I start from a very in-depth understanding of the monetary system and its institutions and apply specific monetary environments to my thinking. It’s by no means perfect, but it’s generated some fairly good results over the last 5 years.

Anyhow, Ambrose says in his piece:

“Central banks can always create inflation if they try hard enough. As Milton Friedman said, they can print bundles of notes and drop from them helicopters. The modern variant might be a $100,000 electronic transfer into the bank account of every citizen. That would most assuredly create inflation.”

Central Banks are not omnipotent independent entities.  They are essentially just normal banks with loose legal constraints and a central infrastructure. But they are still constrained by the laws in the system in which they operate. For instance, the Federal Reserve is not legally allowed to just transfer $100,000 in the bank account of every citizen. The Fed must operate within the laws that constrain their actions as outlined in the Federal Reserve Act. And the Fed “transfers” money into private bank accounts by buying other private sector assets. This is the key weakness in QE’s inflationary transmission mechanism. As I’ve described tirelessly, QE swaps private sector financial assets. It does not create more net financial assets. It’s madness to think that swapping a checking account for a savings account will lead to higher inflation. So Ambrose is not describing a realistic transmission mechanism.

Ambrose then goes on to argue that monetary policy that “finances” the deficit could be inflationary. I don’t necessarily disagree with this, but that is not monetary policy. The size of the Federal deficit is not determined by the Federal Reserve so they can “finance” the deficit as much as they want, but they are merely playing second fiddle to the US Congress.  Again, the Fed is not the institution in control there.

He later argues that the key to QE being inflationary is to buy assets from non-banks.  That’s been happening in droves in the USA with no inflationary effects. Again, this was a mere asset swap of privately held T-bonds for deposits with the banks acting as middlemen. I described this in some detail here. But he goes on to say:

“The relevant monetarist prescription is to buy assets from non-banks. The authorities do not have to purchase state bonds (though to do so is convenient, politically neutral, and easily reversible). They could equally create and inject money by buying land, or herds of Texas Longhorn cattle. Central banks can buy anything they want, and it should be obvious that the effects of buying cattle do not work through the rate of interest.”

Again, the Federal Reserve has no authority to purchase cattle or land. But yes, if they did this would most certainly be inflationary. I’ve referred to this idea as “Roche’s Bags-O-Dirt” in the past. That is, if the Fed could buy worthless bags of dirt from the private sector at $100,000 a pop that would most certainly cause inflation for obvious reasons. But again, we have to understand the world for what it is and not what our monetary theories want it to be. And buying bags of dirt, cattle or land just isn’t on the legally mandated list of assets that the Fed can (or will) buy.

If we fail to understand our monetary system for what it is, as opposed to what economic myths say it is, then we come to all sorts of generalized, vague and erroneous conclusions. Of course, all Central Banks are somewhat different in how they’re structured and so the details matter in terms of how powerful they really are within a certain economy, country and legal structure, but in the developed world economies there are important constraints on these entities that limit exactly how powerful they are.  I hate to pile on here, but I think Krugman is generally right – given the limited policy tools that Central Banks have and their unwillingness to utilize more controversial tools I just don’t see how there’s a currently relevant transmission mechanism by which Central Banks can be relied upon to carry the policy burden.  So while economic theory is correct that a Central Bank can always create inflation, the reality is generally much more complex.