Deflation Puzzle

Larry Summers writes an eloquent FT column "A world stumped by stubbornly low inflation"

Market measures of inflation expectations have been collapsing and on the Fed’s preferred inflation measure are now in the range of 1-1.25 per cent over the next decade.

Inflation expectations are even lower in Europe and Japan. Survey measures have shown sharp declines in recent months. Commodity prices are at multi-decade lows and the dollar has only risen as rapidly as in the past 18 months twice during the past 40 years when it has fluctuated widely

And the Fed is forecasting a return to its 2 per cent inflation target on the basis of models that are not convincing to most outside observers. 

Central bankers [at the G20 meeting] communicated a sense that there was relatively little left that they can do to strengthen growth or even to raise inflation. This message was reinforced by the highly negative market reaction to Japan’s move to negative interest rates.

So why is inflation slowly declining despite our central banks' best efforts? Here is a stab at an answer. I emphasize the central logical points with bullets.

• Interest rates have two effects on inflation: a short-run "liquidity" effect, and a long-run "expected inflation" or "Fisher" effect.  

In normal times, to raise interest rates, the central bank sells bonds, which soaks up money. Less money drives up interest rates as people bid to borrow a smaller supply, and less money also reduces "demand," which reduces inflation.  In the long run, higher inflation and higher interest rates go together, as they did in the 1980s.

However, we are now in a classic "liquidity trap." Interest rates have been zero since 2008. Money and bonds are perfect substitutes. The proof of that is in the pudding: the Fed massively increased excess reserves from less than $50 billion to almost $3,000 billion, and inflation keeps trundling down.

• In a liquidity trap, the liquidity effect is absent. 

The liquidity effect will remain absent as the Fed starts raising interest rates, and would remain absent if the Fed were to cut rates or reduce them below zero as other central banks are doing. You can't have more than perfect liquidity.

The Fed isn't even planning to try. It plans to keep the $3,000 billion of excess reserves outstanding and raise interest rates by raising the interest rate on reserves. There will be no open market operations, no "tightening" associated with this interest rate raise.  But even if it did, we're $2,950 billion of excess reserves away from any liquidity effect, so it wouldn't matter.

• When the liquidity effect is absent, the expected inflation effect is all that remains. Inflation must follow interest rates. 

Central banks thought they were raising inflation by lowering interest rates, following experience from the normal-times liquidity-effect correlation between lower interest rates and higher inflation. But that experience does not apply when its liquidity effect is turned off.

With no liquidity effect, lowering interest rates further below zero can only, slowly, lower inflation further. Central banks desiring inflation may have followed a classic pedal mis-application.

Do I "believe" this story? Belief has no place in science. It is the simplest coherent story that explains the last few years, not needing lots of frictions, irrationalities, and other assumptions. I have some equations to back it up. But we don't "believe" anything at least until it's published and has survived critical examination, replication and dissection. Still, I think it merits consideration.

Shh. I like zero inflation. If central banks have the wrong pedal but are driving the right speed anyway, why wake them up? Even Larry seems to have given up on the Phillips curve:

...suppose that officials were comfortable with current policy settings based on the argument that Phillips curve models predicted that inflation would revert over time to target due to the supposed relationship between unemployment and price increases.

There is no sign of the dreaded "deflation vortex," any more than there is any sign of dreaded monetary hyperinflation. We're drifting down to the Friedman rule. As Larry emphasizes, don't get excited over forecasts from models that rather spectacularly did not forecast where we are today. 
Central banks' desire for 2% inflation, and the Fed's rather puzzling interpretation of its "price stability" mandate to mean perpetual 2% inflation may also be relics of the bygone liquidity-effect regime. 

Appreciate the first half of the column which turns the signs around. It's a great bit of rhetoric.

I have to register mild disagreement with Larry's "solution" to the supposed "problem," 

In all likelihood the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates and, in extremis, further experimentation with unconventional monetary policies.

He doesn't say which monetary policies would work, given they have not done so yet. But these are topics for another day.

(Note: If quote and bullet formatting doesn't show up, come back to the original.)