How You Could Be Impacted if the Fed Initiates "Surprise Inflation"

Occasionally, BestCashCow likes to conduct thought exercises that explore various economic theories and topics. The article below explores the Barro Gordon concept of "surprise inflation" and how the Fed may want to turn to it should inflation rates and the economy remain depressed.

Since its rollout in 2008, Quantitative Easing, or QE as it’s known, has been met with mixed to negative reactions among the economic community. One goal of QE was to raise long term inflation expectations (increase inflation means an increase in interest rates to compensate), which happened initially but has tapered off in recent months. The Survey of Professional Forecasters shows inflationary expectations holding steady around 2%, but you have to take that with a grain of salt as it relates to extrapolating those expectations outwards onto the entire population. In either case, neither set of expectations displays the increase The Fed was hoping to achieve. This is quite extraordinary. Since the financial meltdown in 2008, despite all of its heroics, the Fed has not been able to successfully increase the inflation rate and is still in many ways battling with a deflationary environment.

In my last semester at Penn I took an economic theory course on money and banking where we took a model by Robert Barro and David Gordon on inflation and adapted it to talk about optimal debt levels and policy. The original 1983 Barro-Gordon Paper, “Rules, Discretion and Reputation in a Model of Monetary Policy,” deals with the government’s incentives and policy options as it pertains to manipulating the inflation rate. There’s a lot more to the model than I’ve included below, and it’s worth checking out if you’re interested, but I’ve tried to capture the flavor of the paper in a concise manner. The paper provides a theoretical framework for one way that the government can stimulate the economy.

If the government believes that distortions, from items such as income taxation and unemployment compensation, have lowered production and the amount of privately-chosen work below acceptable levels, the government may want to take action. By raising the inflation rate above expected levels (“surprise inflation”) the government can depress the value of real wages and theoretically stimulate economic growth. Additionally, surprise inflation lowers the government’s future real expenditures for interest and repayment of principal, essentially allowing it to “raise” money without having to resort to taxation. The tradeoff here is that in using surprise inflation, the government takes a hit to its reputation and receives “punishment” for a given length of time, resulting in a less than desirable and more costly equilibrium since people adjust their expectations. Which route the government chooses depends on a few different factors, namely the punishment interval they must endure before their reputation is restored, the last of which Barro-Gordon indicates in an optimal contract with the people, would be for finite amount of time.

The argument could be made that by using surprise inflation, they could, as the paper suggests, stimulate economic growth, lower debts in nominal terms, and increase long term inflationary expectations (one of their original goals). Whether they meant to or not they did induce a recession (they were not solely to blame, but their complacency played a large role) which lowered inflationary expectations, so the government has set itself up to “cash in” on their “investment”, or “biting the bullet” as Barro-Gordon refers to it. Obviously there are a lot of factors present here that aren’t included in the theoretical environment and the punishment interval as well as the benefit parameters are not clear.

One way or another, the Fed is going to have to find a way out of this monetary, low inflation ditch. The question is what the chances are that the government actually does initiate surprise inflation, and if they do how would they do it and how would it affect your savings? For starters, there doesn’t appear to me be a historical precedent for this type of operation, and it’s not as if the Fed would willingly admit they were looking to surprise the public. So, don't look for new Chairwoman Yellen to discuss surprise inflation.

As for how the government would increase inflation, there would be a few different ways they could go about it:

1. Hand out loans to member banks: This doesn't appear as feasible because most banks today have plenty of cash. They are not lending because of a lack of capital or deposits, but rather out of caution and fear of a weak economy, as well as weak loan demand.
2. Monetize government debt: The Fed is able to create money without printing a bill. They have the ability to buy Treasury Department issued bonds with a check, essentially flooding the economy with the dollar amount of the bond purchase. This is similar to QE, but instead of commercial and private lenders, the Fed is buying from another part of the government.
3. Lower the reserve requirement: A slightly more risky proposition, the Fed lowers the bank reserve requirement that banks must keep on deposits. Theoretically, this stimulates more lending. In the past, the reserve requirement has almost never changed because of the perceived fear of disrupting financial markets that can come with a change. Still, if stuck in a bind, the Fed may decide to try it.

Of the three, the government can most covertly initiate the second and third options. For savers, the increase in the inflation rate would dilute the value of savings and make investments in things that will provide a hedge against inflation i.e. derivatives (options, swaps), precious metals, and real estate wise choices. This has the potential to create a very explosive rising rate environment and those savers that have money locked in low rate, long term CDs would see the value of their investments eroded. In such an environment, it makes sense to stay liquid.

Borrowers with fixed, low interest loans would fare well but those in any variable rate loan would see significant rate and payment increases.

Will the Fed pursue such a policy to shock the economy? Most likely not. But as we've seen with the multiple QEs, the Fed is trying to stimulate the economy and increase the inflation rate. Whether it will take even bolder steps to do this in the future remains to be seen. In general, the more talk you hear talk of deflation or a lack of inflation, the better the chances the Fed will take unprecedented and surprise moves to shock inflation back to life.