Some economists have said that the best way to deal with deflation is for the central bank to flood the economy with money in order to persuade the public that inflation will rise in the future, thereby reducing expected real long-term interest rates. That advice would lead central banks to keep expanding the money supply and bank reserves even after doing so no longer lowers interest rates. In fact, the Federal Reserve, the Bank of England, and the Bank of Japan are doing just that under the name of “quantitative easing.”
Not surprisingly, central bankers who are committed to a formal or informal inflation target of about 2 percent per year are unwilling to abandon their mandates openly and to assert that they are pursuing a high rate of inflation. Nevertheless, their expansionary actions have helped to raise long-term inflation expectations toward the target levels.
In the US, the interest rate on government bonds now rises from 1.80 percent at five years to 2.86 percent for 10-year bonds and 3.70 percent for 30-year bonds. Comparing these interest rates with the yields on government inflation-protected bonds shows that the corresponding implied inflation rates are 0.9 percent for five years, 1.3 percent for 10 years and 1.7 percent for 30 years.
Ironically, although central banks are now focused on the problem of deflation, the more serious risk for the longer term is that inflation will rise rapidly as their economies recover and banks use the large volumes of recently accumulated reserves to create loans that expand spending and demand.
Martin Feldstein, a professor of economics at Harvard, was formerly chairman of US president Ronald Reagan’s Council of Economic Advisors and president of the National Bureau for Economic Research.Copyright: Project Syndicate
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