One of the big lessons of the recession for me is that inflation isn't so easy to create as the textbooks imply when the economy is mired in a severe recession. It's not a matter of just increasing bank reserves -- if the reserves sit idle in banks, even at extraordinarily low interest rates, then there increase in aggregate demand and no upward pressure on prices. Somehow, the idle reserves must get into the hands of people who will use them for consumption or investment (and government can fulfill this role as well), but we haven't been willing to pursue those polices.
Anyway, here's Paul Krugman arguing that if I'd just internalized the message in his 1998 paper, I wouldn't have been surprised at all!:
Hawks, Doves, and Ostriches, by Paul Krugman: More than four years ago Allan Meltzer issued a dire prediction: the Fed’s policy of expanding its balance sheet will lead to high inflation. We’re still waiting for that to happen. So it might behoove Meltzer to admit that he was wrong and ask where his analysis went wrong.
OK, you can stop laughing now. What Meltzer does, instead, is complain that the Fed has undermined his perfectly fine analysis. You see, those dastardly officials are paying interest on reserves – a hefty 0.25 percent – and this has led to something totally unexpected:
The US Federal Reserve Board has pumped out trillions of dollars of reserves, but never have so many reserves produced so little monetary growth. Neither the hawks nor the doves (nor anyone else) expected that.
So the money supply broadly defined hasn’t taken off – a complete surprise! – and hence no inflation.
Except that this isn’t at all a surprise; it’s exactly what those of us who had analyzed the liquidity trap predicted would happen when you expand the monetary base in an economy at the zero lower bound. ...
Nor was it just theory. Meltzer claims support from the lessons of history; but the relevant history is of other liquidity-trap episodes. Consider, in particular, the case of Japan’s quantitative easing in the early 2000s...
Unlike the Fed, the Bank of Japan didn’t pay interest on reserves. Nonetheless, a huge increase in the monetary base just sat there, mostly in the form of increased bank reserves – the same as what happened in America later.
We might add further that if the Fed can neutralize the supposedly awesome inflationary effect of quantitative easing by paying ¼ percent interest on reserves, it should be very easy to contain the inflationary threat in future.
Anyway, I do get kind of annoyed here. Some of us came into the global crisis with a well-worked-out theory of monetary and fiscal policy in a liquidity trap; the predictions of that theory have been completely consistent with actual experience. People like Meltzer chose to disregard all of that, insisting that terrible inflation (and high interest rates) were just around the corner. You almost never get that clear a test of rival economic views, and the results should be considered decisive.
Instead, the usual suspects stick their heads in the sand and pretend that they have been right all along. ...