Consulting by RPM || Free Advice Blog

Yet Another Krugman Kontradiction

[UPDATE below.]

I think I may have to christen a “YAKK” category on Free Advice.

On October 26, in a post entitled “Do Investors Expect Too Much From Bernanke?”, Krugman had a chart showing how inflation expectations had risen substantially since August, when the market began expecting QE2. This is Krugman’s commentary:

Financial markets seem convinced that quantitative easing will be highly effective at solving at least one problem: inflation running well below the Fed’s 2-percent-or-so target. The chart above shows the difference between interest rates on 5-year inflation-protected bonds (which are now negative) and rates on unprotected bonds; implicitly, the market forecast of inflation over the next five years has risen half a point.

But I really don’t understand this. Granted that QE2 will probably have some positive effect, hopefully bigger than analysis based on the debt-maturity equivalence suggests. Still, the prospect remains that we’ll face multiple years of high unemployment — or, if you prefer, a protracted large output gap (PLOG). And history is clear on what that means: declining inflation…

My guess, then, is that the markets are overreacting; they’re thinking, “The Fed is printing money!”, while forgetting that this ultimately matters, even for inflation, only to the extent that it seriously reduces unemployment.

Everyone got that? The market’s expectations responded just the way Scott Sumner hoped, and so QE2 was “working” on that account. But Krugman was a stick in the mud, saying markets were wrong and that the Fed really wasn’t doing enough.

OK, today (November 23) Krugman writes in a post entitled “Sabotaging QE”:

When short-term interest rates are up against the zero lower bound, whatever power the Fed has to influence the economy comes largely from its ability to affect expectations. This is true even for Bernanke-style quantitative easing: you can’t really push down longer-term yields unless the market believes that you’re going to keep buying until the rates are where you want them. It’s even more true when it comes to credibly raising expected rates of inflation.

So if a large political faction begins yelling and screaming as the Fed attempts QE, this will have the effect of undermining the policy’s effectiveness. And so it’s proving.

The free ride’s over, Paul. A new sheriff is in town. I’ll see you in the ring.

UPDATE: I know this is futile, but let me try to allay one set of objections. I understand that Krugman would say he is being consistent. Why, he was pooh-poohing the expectations of higher inflation, by arguing that his saltwater model said Bernanke wasn’t doing enough.

In contrast, Krugman could continue, the moral reprobates that were “sabotaging QE” were pooh-poohing the expectations of higher inflation by saying that their freshwater models said that Bernanke was doing too much.

So you can see why Krugman is a hero, and the latter group are moral monsters. No contradiction at all.