Is raising inflation expectations a good idea, and will it work?

There have been several discussions about the viability of monetary policy right now, just when the economic authorities need to create demand while at the same time rates are at the zero bound*

Focusing on interest rates had always been what monetary authorities focused on. And for a long time, it seemed the effective and fiscally prudent policy choice. For as long as tweaking rates could increase or decrease economic activity, there was no sense in putting focus on extensive fiscal action. Fiscal policy determination is a politically-charged process, and very often ends up being directed at wasteful projects, and cutting the most fruitful activities in the worst possible way.

But for as long as the challenge is to simply reduce demand, increasing rates will do. If the challenge were to increase demand, as it is in the US right now, you also have to address several factors. I could list a few things other than rate/price that could influence, or put a limit on demand at the individual level.

Level of current income, level of current expenses, current level of indebtedness, capacity to service existing debt, capacity to borrow more-to financing more spending, confidence in stability of future income, expectations about future increases in fixed expenses, confidence in future value of purchasing power of current savings (if you have any), non-existence of any lender calling on their debt, confidence in future positive value of existing savings/investments/net worth, ease of liquidating current savings –to finance current spending, tax implications of using current income/net worth to spend now vs. later, confidence about over-all economy, and how it is being run… the list goes on further.

These can be addressed either directly, via fiscal policy action, or indirectly, via monetary policy action. When you are at the zero rate bound, the monetary policy tools to use (QE, etc) have the objective of increasing inflation expectations. If people expect heightened inflation, monetary authorities intend them to do several rational acts: buy stuff now that they would have postponed ‘til the future, and make investments in businesses, stocks, and others that rise in tandem with inflation.

Examples were made of buying a canoe now, buying a farm, buying oil and gas shares, as well as buying a restaurant meal now. The point was also made that rising inflation will spur people to borrow money, since the rising inflation will increase the value of physical assets, while inflating away the real cost of borrowing.

But rising inflation expectations cuts both ways. If a lender is going to lend to a borrower to buy his canoes now, it's now going to lend him at the rate that incorporates the higher inflation expectations for next year. So the higher borrowing rate effectively offsets the value of buying canoes now rather than buying it at a higher price next year and just borrowing less (or not at all). There's no way to get ahead if the other side also knows what one side knows.

And if Farm sellers and oil and gas shares owners know that inflation will be higher next year, they won't sell their farm now. Or they will sell their shares at a price that reflects the higher inflation. Intentional buyers may end up not wanting to buy anymore.

Having the restaurant meal now will likely be the best bet to get ahead, since the restaurant will likely still be selling at the price level that he already bought his cost inputs. But then, if one is worried about looming inflation, he may be less likely to eat out, too. For if people can be influenced that inflation can and will be increased by monetary authorities, they can also, and might be, influenced that inflation will get out of control (maybe because the currency is depreciating and higher imported input costs are wreaking havoc on the economy). In this sense, increasing inflation expectations may backfire, and cause demand destruction, the opposite of the intended effect. He may now be thinking that he needs to preserve his soon to be diminished purchasing power for basic necessities. He will trade down to less costly substitutes. He will ration his supplies. He will repair stuff rather than buy new ones. These are rational actions to make during runaway inflation.

It would be better yet, if the challenge were to increase demand, to just directly address the following: level of current income, level of current expenses, current level of indebtedness, capacity to service existing debt, capacity to borrow more-to financing more spending, confidence in stability of future income, expectations about future increases in fixed expenses, confidence in future value of purchasing power of current savings (if have any), non-existence of any lender calling on their debt, confidence in future positive value of existing savings/investments/net worth, ease of liquidating current savings –to finance current spending, tax implications of using current income/net worth to spend now vs. later, confidence about over-all economy, and how it is being run…..via fiscal policy action instead.

*This post flows from two unrelated comments I made in discussions elsewhere. It doesn't particularly react to the original post where those discussions arose.