What if Another FED QE Causes Inflation Expectations To Jump?

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In a recent article, I wrote: “Don’t these inflationists realize that expectations can suddenly change, like a dam bursting? This is not in their models. They are the sorcerer’s apprentices. If they go too far in expanding the FED’s balance sheet, people are going to stop believing that they will ever exit. They will begin to expect endless inflation. The dam will break and a severe inflation will occur.

I’m not alone in saying this. I’ve run across an article in the Journal of Monetary Economics (2011) by Professor Lee E. Ohanian of UCLA. He has an explicit math model by which he reaches his conclusions (whereas my models and reasoning are usually verbal). He writes:

“Now suppose that inflation expectations increase. This could lead to possible cash flow problems for the Fed, which in turn could lead to a self-fulfilling inflation. To see this, note that in the absence of Treasury support, this cash flow problem may force the Fed to increase money creation to make it feasible for the Fed to pay interest on reserves…this is not a run on the Fed, which can print money. Instead, it is a run on the dollar based purely on expectations. This example suggests the possibility that inflation could become self-fulfilling…”

This idea is very well known and dates back at least to studies of money velocity in hyperinflations done by Philip Cagan.

Austrian economist Robert P. Murphy wrote about the related problem of interest on reserves back in 2009 (here, here and here). It’s good to see at least some mainstream economists catching on.

6:53 pm on August 24, 2012