Most Recent Stories

Central Banks Can’t Promise Permanent Monetary Base Expansion

I touched on this one earlier, but it’s worth reiterating. David Beckworth says that a Central Bank’s QE program will only be effective if it is believed to be permanent. In other words, he’s reiterating Nick Rowe’s point about expectations. David says:

“By  now you have probably noticed an inherent tension between these two underappreciated facts. On the one hand, the Fed never intended the expansion of the monetary base under the QE programs to be permanent. On the other hand, the monetary base injections needed to be permanent for the QE programs to really spur aggregate demand growth. And therein lies the Fed’s dirty little secret: the Fed’s QE programs were muted from the beginning. They never could on their own create the amount of catch-up aggregate demand growth needed to restore full employment. So despite all the Fed has said over the past six years, it made an explicit policy choice to avoid fully restoring aggregate nominal expenditures.”

This is a totally unrealistic belief. Central Banks cannot promise to make their monetary base expansions permanent. The reason why is simple – if promises of permanent monetary base expansions actually caused high inflation and high aggregate demand then the promise would have to be reversed at some point when the Central Bank inevitably responds to the problem it caused. In essence, they have to reverse what they did in the first place because the solution becomes the problem!  Private market participants realize this. They know that Central Bank policy isn’t a permanent one way trip. Eventually, something happens in the economy which requires a discretionary change in policy. It’s totally contradictory to argue that policy needs to be permanent to work because if the permanency of a policy actually worked it would have to be reversed in the future which means it obviously isn’t permanent.

All this talk about expectations is just textbook nonsense. It sounds great in theory, but in the real economy it makes no sense because no private actor would ever believe that Fed policies are permanent. They simply can’t be because the world is too dynamic to allow for such a static and linear policy approach.