A few people asked me a while back how we would know that Quantitative Easing was working. I said inflation expectations will rise. Most were unsatisfied with that and I think wanted a clearer positive mechanism – small business credit might ease, mortgage rates fall, etc. The problem with those measures, however, is that they are confounded.  In particular think about mortgage rates. In the process of spuring economic growth the Fed tries to drive down interest rates. However, if people believe that it will be successful then expectations of inflation will rise which will tend to drive up interest rates.  So you can’t just look at interest rates to tell if its working.

Inflation expectations, however, are fairly decent gage of whether we are achieving what we hope to be achieving. Raising the rate of inflation is important is because there is a short-run tradeoff between inflation and growth. Indeed, we can see that as inflation expectations have risen, initial claims for unemployment insurance have fallen

Here is the are the initial claims for unemployment graphed against the Cleveland Fed’s estimate of one-year inflation expectations (inverted)



 

Initial claims shot upwards as inflation expectations collapsed in late 2008. There is a little rise (showing as a dip because the axis is inverted) when investors wrongly thought that we were out of the woods. It quickly reversed itself, however. One might be tempted to say that what this really shows is that inflation expectations are driven by the state of the economy. When the economy is doing well people expect businesses to try to raise prices. When the economy is doing poorly people expect business to lower prices. That’s fine as a shortcut way of thinking but as long as you believe that ultimately inflation is controlled by the Fed, then you must believe that proximately the Fed controls the state of business.  That is, if inflation is driven by the Fed, but inflation expectations are controlled by the state of business, then people must be expecting that the Fed is controls the state of business.

Also as a side note, it seems that the professional forecasting community is using the Tax Cut deal as an excuse to upgrade its forecasts. Which is to say that they didn’t have  the faith in theory to upgrade on QEII itself. I thought the deal was good. I was especially for the payroll tax cut but still the driver here is QEII.  Cutting taxes just serves as a way to smooth out the diffusion mechanism. Rather than waiting for financial prices to work their way through the economy you just cut checks.

Lastly, we need not stop here. Faster growth is good but even faster growth would be better. This is especially true because as the recession drags on long-term unemployment will turn into structural unemployment. Again we don’t really know why. I know its tempting to say its because people loose skills etc. Maybe that’s true. Its sounds plausible to me. However, we don’t know its true. All we know is that the data suggests that hysteresis is real and the longer we wait the worse it gets.

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