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I’m headed off to a conference, but I just wanted to voice my disgust with Ben Bernanke quickly. Here is what I gathered from his speech in Jackson Hole:
1. The Fed has the tools to offset shocks to money demand, but only sees fit to use them in the event that the country is facing actual deflation.
2. The Fed is highly committed to memory-less inflation targeting, and is happy living with inflation below 2%.
3. The Fed will not offset contractionary fiscal policy, handing proponents of active demand management victory on a silver platter, though they don’t deserve it.
We will have to wait until the next Fed meeting to see Bernanke’s “real” intentions on monetary policy. Will he steer the committee into a more aggressive stance? The stock market is very slightly up on the speech, so maybe WAll Street knows something that I don’t…but I just can’t see how an aggressive policy move is in the cards.
I, for the life of me, can not understand where Stephen Williamson is coming from in the recent posts he’s done claiming that Quantitative Easing is ineffective, and that the Fed is completely out of tools which it can use to boost the economy. Here are the points he made from his most recent post, entitled “Mark, Brad, and Ben“:
- Accommodative monetary policy causes inflation, but with a lag. I think Brad’s inflation forecast is on the low side, as maybe Ben does as well. The policy rate has been at essentially zero since fall 2008. Sooner or later (and maybe Ben is thinking sooner) we’re going to see the higher inflation in core measures.
- Maybe Ben is more worried about headline inflation (as I think he should be) than he lets on.
- Maybe in his press conference Ben did not want to spend his time explaining why the Fed spends its time focusing on core inflation. What every consumer sees is headline inflation, and they are much more aware of the food and energy component than the rest of it.
- As with my comments on Thoma, there is really no current action that the Fed can take to increase the inflation rate. More quantitative easing won’t do anything, so the Fed is stuck with saying things about extended periods with zero nominal interest rates in order to have some influence through anticipated future inflation on inflation today.
Most of the list simply baffles me. First of all, accommodative monetary policy can cause inflation. And of course in the long run, a stable monetary policy only affects prices…but the blanket statement that monetary policy causes inflation is misleading, and highlights a problem with even talking about inflation. In a standard AS/AD model, the determinant of the composition of NGDP growth is the slope of the SRAS curve. In recessions, it is generally understood that the SRAS curve is relatively flat. In that case (arguably the case we are dealing with right now), an accommodative monetary policy which shifts the AD curve to the right would result in much higher output growth than inflation. As for the lag part, monetary policy has an almost immediate (< one quarter) impact on many markets; including interest rates, stock/commodity prices, inflation expectations, etc. Here is a chart of those market reactions to both QE's courtesy of Marcus Nunes:
[Click Image to Enlarge]
In each case, you can see that asset prices had a quite immediate response to quantitative easing. QE2 performing poorly doesn’t indicate that QE doesn’t work, it highlights problems with how the policy was implemented. Specifically, the Fed structured the policy around purchasing a specific quantity of Treasuries ($600bn) instead of setting a target level of nominal spending, or even a price level target, and then commit to purchases until that target has been reached.
Second, why would Ben Bernanke be worried about headline inflation when nearly every forecast from the Federal Reserve views the current rise in headline as temporary? Here is the SF Fed, which I posted earlier:
[Click Image to Enlarge]
Indeed, the FOMC’s own report states as much. Furthermore, we have a good idea of what is causing the bump in headline inflation, and that is the energy prices. We also have good reason to believe that this is due to rising demand in the briskly growing emerging markets, and the inability to ramp up supply. What in the world is monetary policy supposed to do about that? Is Williamson advocating tightening policy while NGDP is still FAR below trend, and we are not experiencing enough growth to catch up to the previous trend?
I don’t have many quibbles with the third point, but the fourth point is the one that floored me the most. I’ll outsource commentary to David Beckworth in a comment on Williamson’s post:
Steve,
Why do you keep saying there is nothing the Fed can do? You acknowledged in the comment section in your last post that the Fed could do something more via a price level or ngdp level target. By more forcefully shaping nominal expectations with such a rule the Fed could do a lot.
It is worth remembering that folks were saying the same thing about monetary policy in the early 1930s. They were certain there was nothing more the Fed could do and as a consequence of this consensus we get tight monetary policy and the Great Depression. Then FDR came along and change expectations by devaluing the gold content of the dollar and by not sterilizing gold inflows. His “unconventional” monetary policy packed quite a punch.
And here is my comment:
I’m with David on NGDP targeting. But even if the Fed didn’t do that, it has its interest on reserves policy, and the last I checked, it hasn’t set an explicit inflation level target, and there is ~$14 trillion in outstanding Treasury debt held by the public that the Fed does not yet own…something Andy Harless has pointed out on numerous occasions.
Jim Hamilton has another nice piece on Federal Reserve deposits. I have a couple of quibbles but mostly they are a matter of perspective. Hamilton says
I’ve been emphasizing that the U.S. Federal Reserve has not been printing money in the conventional sense of creating new dollar bills that have ended up in anybody’s wallets. Instead, the Fed has been creating new reserves by crediting the accounts that banks maintain with the Fed
This is probably a workable framework for people who think of printing money and inflation as being synonymous. Though its not how I think about it. I think of issuing reserves as printing money.
Both reserves and cash are what we think of as “high powered money.” High powered money is the ultimate base for all the assets that we use for buying stuff, such as our checking accounts. The more high powered money out there the more checking accounts there can be.
Issuing a new checking account is how a bank makes a loan and this increase in lending increases demand in the economy. So, printing more reserves would tend to increase demand. That was pretty much how things worked up until the Fed started paying interest on excess reserves.
Once a bank issues a new checking account the law says that you have to dedicate some of your reserves to backing that account. These reserves are required reserves. Required reserves do not get interest payments from the Fed.
Thus when a bank decides to make a loan it has to switch some of its interest paying excess reserves over to non-interest paying required reserves. The fact that they loose the interest payment is what discourages them from doing this.
My overarching point is that there will be some people who suspect that Hamilton is shifting definitions to hide the Fed “true printing of money.” Yet, even if you think of issuing reserves as printing money – which is the frame that I use – Hamilton’ logic still follows through. It follows because the interest on reserves policy breaks the traditional link between printing reserves and increasing demand in the economy.
Hamilton goes on
Many banks are still afraid to make any but the very safest of loans. In such a setting, the Fed could create all the reserves it wants, and it’s not clear that much if anything has to change as a result.
However, the situation is not going to stay like this forever. When banks do start to see something better to do with their funds, one could imagine the situation changing pretty quickly. The Fed’s plan when that starts to happen is to remove some of those reserves by selling off some its assets, and preserve the incentive for holding reserves by raising the interest rate paid on them.
So this is correct but one could easily confuse very wonky concerns with a breakdown in monetary policy.
So before all of this interest on reserves business the Fed managed the money supply by targeting the Fed Funds market. That is, the Fed kept the price at which banks loaned reserves constant.
Now suppose I am the manager at BigTime Bank. I decide for whatever reason that I want to make trillions of dollars in loans. To do this I need to acquire more reserves. I go into the Fed Funds market and start borrowing these reserves from other banks. This will tend to drive up the interest rate on reserves, which is the Fed Funds rate.
However, the Fed is targeting the Fed Funds rate. This means that in response to my action the Fed will increase the supply of reserves in order to push the interest rate right back down. The result is that the Fed automatically accommodated my desire to make a bunch of loans by increasing the supply of reserves.
So what stops me as the manager of BigTime Bank from flooding the market with new loans and driving up demand? What stops me is that I have to pay interest on all of these reserves. If the interest I am getting on loans is not competitive with the interest I have to pay to borrow all of these reserves then its not worth it for me to do this.
So, the ultimate control on how willing BigTime Bank is to make loans, is the Fed Funds rate. That’s why changes in the Fed Funds rate were historically a big deal.
Now, lets think about the current world. Here what is stopping BigTime Bank from making a bunch of loans? Its that by making a bunch of loans BigTime Bank has to move some of its reserves from excess to required and thereby lose the interest payment the Fed is offering on excess reserves.
From the BigTime Bank’s point of view this is the same cost. Issue more loans and either pay out more money from borrowing in the Fed Funds market or loose out on interest on reserves. In both cases it’s the interest rate that is holding the BigTime Bank back.
If the Fed wants to cool down the economy then, what it does under the current policy is to raise the interest rate on reserves. That will function just like raising the Fed Funds rate on the old policy.
So in terms of core monetary policy there is no real difference between regimes. There are a wonky concerns about making sure that the entire system functions without a hiccup since it hasn’t been done this way before.
There are also concerns about managing the Feds balance sheet. The Fed expanded the amount of excess reserves that banks had and then paid interest on those reserves. However, that wasn’t just a give away from the Fed to banks. In exchange the banks had to give the Fed some of their interest bearing assets including lots of Mortgage Backed Securities in the beginning and Treasury Bonds now.
The Mortgage Backed Securities and Treasury Bonds are both paying higher interest rates than the Fed is currently paying on reserves. So in terms of immediate cash flow the Fed is making more money now. However, Mortgage Backed Securities and Treasury Bonds are also “riskier” than reserves. They are risky because they pay a fixed interest rate, while the interest on reserves will theoretically fluctuate with the economy.
If economic growth picks up the Fed will be forced to raise the interest it pays on reserves. This is just like it would have to raise the Fed Funds rate in an overheating economy.
If the economy is growing fast enough then interest on reserves will have to be raised to a higher rate than the interest the Fed receives on Mortgage Backed Securities and Treasury Bonds. This would result in losses for the Fed. Its not exactly clear what “losses for the Fed” will mean, but for the sake of calm markets its best if we just don’t go there.
This means that the Fed will want to get out of the business of holding all of these securities at some point and its not clear how or when that might happen.
Jim Hamilton has a nice breakdown on all the positive signs for US growth. I even have a new presentation I am giving titled “Don’t Be Lulled into Fall Sense of Despair” that basically argues that if things go as planned the US economy will be growing steadily and so will profits and tax revenues.
All that having been said my worry is that this will cause the Fed to back off of its aggressive stimulus policy. The Fed should stay the course with QE2 and consider QE3.
As I have mentioned before, we are conditioned to think of 3 – 4% growth as strong. However, that is in a world where there are few slack resources. This is not our world. Our world has plenty of idle resources.
6% growth is not unrealistic. I urge the Fed to push towards that goal. High profits and growing government revenues are great but we need to put people back to work.
The Mankiw Rule for example doesn’t call for raising the funds rate above zero until the (unemployment rate – core inflation) rate drops below 6. Right now we are still above 7.5
Indeed here is what the Mankiw Rule says the Fed Funds rate should be
We are still deep into negative territory meaning that we need additional monetary stimulus above and beyond a zero interest rate.
As a side note, I would love to claim that QE2 is behind this increased growth but that is premature. The timing is right on, but we need more evidence before we can claim intellectual victory.
Karl posted something that he should have titled “Stream of Consciousness” instead of “Unsubstantiated Claims” where he thought out loud. One of those thoughts landed on the Fisher effect.
My sloppy writing makes it sound as if I am saying Reihan should read up on the Fisher effect. What I mean to say is that Reihan brought up the fact that people fear inflation eroding savings. These fears are common. I have had many a Facebook debate over them. Indeed, Ron Paul has repeatedly pointed to this has his main reason for fearing debasement of the currency.
I believe that the Fisher effect is controversial among Austrians, and Keynes didn’t believe in the relationship at all, except under hyperinflation. Using price inflation in the Fisher equation makes a lot of things confusing, because the composition of output under recession circumstances (less than full employment — or a flat SRAS) is that raising inflation expectations to, say, 3% from 2% will likely cause an increase in real output, leaving inflation at it’s long-run target. Indeed, the Fed isn’t even interested in boosting inflation expectations past its set 2%, and has made that very clear. What the Fed wants is higher NGDP…but unfortunately it operates under a target for nominal interest rates.
Scott Sumner has a post about how inflation is, counterintuitively, good for savers. The thrust of it is that raising NGDP expectations will raise the Wicksellian real interest rate. People will spend more on investment (maybe not consumption, but probably), and we will get far more output, while trend inflation remains intact (and if it doesn’t, then the Fed can act as necessary). This is a boon to savers, as it raises not only the interest rate on savings accounts, CD’s, and the yield on bonds…it raises other asset prices as well, like stocks, real estate, commodities, etc. All are vehicles for saving, and a higher level of NGDP causes every type of investment to increase its yield.
This is the fundamental reason inflation is confusing. People think a lot about cash, but not many people save in cash (as in safes) under a normal positive trend inflation rate — criminals mostly. I think that price inflation is just muddying the debate here, and is completely useless.
A little late, I know, but Happy Thanksgiving everyone!
Remarks from Ben Bernanke indicate that the Fed is shooting itself in the foot:
“I have rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy,” [Bernanke] said.
In fact, the Fed should engage in level targeting, as I have been pushing in the last few posts. It should commit to a higher target for nominal expenditure in order to return to the previous trajectory from the Great Moderation. That requires a higher level of NGDP growth than is “normal” in order to catch up. One way to do this under the current monetary regime is to create higher inflation expectations. Do they need to be much higher? I don’t think so, but it’s not entirely unreasonable to disagree.
So we know that most members of the FOMC view 2% as the preferred inflation target. We now also know that the Fed is holding true to that target, come hell or high water. 2% is better than 1%, but a temporarily higher target would produce a much more robust recovery. Arguably, the Fed is in the business of providing stable NGDP growth consistent with high employment and low inflation. It allowed NGDP to plummet and now they should be trying to make up that lost ground as quickly as possible. This statement is clearly against that goal.
We’re in for a rocky road if our monetary authority sees it fit to tie its hands.
In a Times article a few days ago is this interesting quote from Laurence Meyer, a former Fed governor:
It was this impending gridlock that might have pushed Mr. Bernanke to move, said Laurence H. Meyer, a former Fed governor. “Bernanke has said that fiscal stimulus, accommodated by the Fed, is the single most powerful action the government can take for lowering the unemployment rate, when short-term rates are already at zero,” Mr. Meyer said. “He has nearly pleaded with Congress for fiscal stimulus, but he can’t count on it.”
I’m taking this as a explicit, and unshrouded nod to the concept of “money financed fiscal policy”. Or, what is lovingly referred to in the press as “monetizing debt”. This is a situation where the government draws up a plan to distribute money, whether through direct transfers or increases in government consumption/investment, has the Treasury issue debt in the amount decided upon Congressionally, which the Fed then purchases with newly-coined money (and for hysterics, this money is created “out of thin air”!).
As Karl has noted, and as concurred upon by commenter Jazzbumpa, a program such as this would inevitably “work”. And by work, I mean it would raise inflation expectations such that businesses would be induced out of cash and into consumption and capital goods. This, of course, is something that the ARRA failed to do. This is true, but it is optimal policy?
I say no. I don’t think that fiscal policy need ever enter the picture. I think that the Federal Reserve should announce an explicit target to get the growth path of nominal expenditure to the previous level from the Great Moderation, and then continue to level target a stable growth path from there. In doing so, the Fed should immediately stop sterilizing its own open market operations by paying interest on excess reserves (indeed, the interest in reserves should be slightly negative, reflecting real rates). The Fed could then move down the yield curve, and buy Treasury debt that currently resides on the balance sheets of banks, businesses, and individuals; moving the price up while moving the yield down to zero. I suspect that there is enough debt out there that it would not run out of things to buy before hitting its nominal target. However, if it does, then it can move on to other assets.
The key thing here is that there are many interest rates in the economy, and not all of them are pegged at zero. My point is that far from needing to bring fiscal policy into the picture, monetary policy could go it alone. If the SRAS curve is relatively flat, which is a prediction of macro models, then the resultant inflation expectations would produce much more real output than inflation (lets ballpark and say 5% real growth, 2% inflation), up until full employment is reached — at which point, the Fed would revert to its normal level target. I do not think that Bernanke is “pleading with Congress” for fiscal policy. Why would he? If he identifies that aggregate demand is low relative to the Fed’s own target, then by all means, he should be taking steps to move aggregate demand to where the Fed is most likely to hit their target goals.
To those who say that it is unrealistic that the Fed would do this, is it any more unrealistic than hoping for money-financed fiscal policy?
Inflation is confusing. The concept makes crazy people crazier. And even worse, it makes otherwise sober people disagree with eachother. Reading through the accounts of QE2 on the internet the past few days have solidified my view that inflation is a thorny enough concept that we should rid it from popular vernacular. Is inflation important? Sure…but what measure of inflation is correct? CPI-U? GDP Deflator? Your crazy uncle’s index? Does inflation help or hurt savers in the current landscape?
If there is anything that gets turned on it’s head when an AD recession hits, it is the concept of inflation. During normal times (full employment and capacity utilization), inflation is harmful as it drives up interest rates, discourages saving, and encourages misallocation of capital. However, none of those things apply to the current situation in which we find ourselves with a large output gap and high unemployment. Thus, we need higher inflation in order to close the output gap (the difference in money expenditures between where we are currently, and the trend rate from the Great Moderation…currently about -13%), but that turns everything that everyone knows about inflation backward. All of a sudden inflation is good for savers, good for the unemployed, and good for economic growth. Well, stable inflation expectations are key…but it’s hard to steer a ship, and it’s hard to get a non-confusing answer out of pundits and other commentators.
In order to square this circle, I propose we forget about inflation. And not just forget about talking about it, but forget about its use in the setting of monetary policy. Instead, we should target nominal expenditure at a steady growth rate (3% a la Woolsey, or 5% a la Sumner, Beckworth, etc.) with level targeting. What advantages does targeting nominal expenditure have? Well…
- Targeting nominal expenditure (NGDP for short) allows monetary policy to better address recessions which arise from both aggregate supply and aggregate demand shocks. David Beckworth has an excellent discussion of this point.
- NGDP is a better indicator of monetary shocks than inflation indicators like CPI. Because prices are sticky, and because measures of inflation are so problematic, a fall in NGDP won’t immediately show up in inflation numbers. Also, if there is a large price shock in something like oil, this will raise the money price of all goods and services, causing anyone focusing on inflation to miss the underlying weak economy…and thus potentially set monetary policy to be too contractionary (sound familiar?).
- NGDP allows us to broaden our focus to aggregates like MZM, asset prices, yields, excess reserves etc. We’ll relinquish our inane focus on interest rates, which are a very problematic indicator of the stance of monetary policy, and have a much better picture of the health of the economy.
- NGDP sounds better. People have an innate fear of inflation. Inflation destroys savings, after all…and we all know frugal people are virtuous. Well, how about, in the event of a recession, instead of economists clamoring against the crowd that we need inflation, they say that we want aggregate expenditures (and thus nominal income) to be at some level higher than it currently is? Money illusion is a powerful motivator. Who would argue with that?
Targeting nominal expenditure would be a beneficial step from both an economic theory perspective, and a public relations perspective. Lets take the confusing concept of price inflation out of our discourse, so that we can see the world more clearly.
P.S. We are currently 13% below the target path from the Great Moderation, and are where we were at before the crash of Sept/Oct 2008. To make that up by 2011:Q3, the Fed would have to target NGDP at $17.6bn (to continue on a 5% NGDP growth path). However, Bill Woolsey favors a 3% growth path for money expenditures, which means that the Fed would only have to target a 13.8% increase by 2011:Q3 (or $16.4bn), and then continue on with 3% growth, level targeting, from then.
Update: Found the link to Beckworth’s article!
I was going to write up a post on my exasperation at the Fed’s recent meeting statement, but Ezra Klein got to it before me and did a good job, so you should go read what he has to say. One point that I want to highlight, because I have made the point that the dual mandate is mostly just an insiders joke:
Paragraph two: We admit everything is terrible. In fact, it’s so terrible that it means we’re failing our mandate. “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.”
[Image Courtesy of David Beckworth]
How many of you wish that you had a job where you could consistently fail at the very time when it is clutch that you deliver in a big way? How many of you would like to say, “Well, I have a model of the economy that says we won’t be hitting any of our own targets…but oh well”? The Federal Reserve is in the exact position in the economy where they can act quickly and decisively and actually make a large impact on nominal spending. I would even go as far as to say that they can do so without “long and variable lags”, as markets should price in actions by the Fed nearly immediately, and indeed they have been.
Contrary to the popular narrative, I believe that it is this very passivity by the Fed that brought us to the brink in the fall of 2008, when every indicator of economic activity (industrial output, consumer spending, business confidence, NGDP expectations, etc.) were found to be in sudden free-fall mode. At that time, interest rates were in the 1.5%-2% range, and the Fed’s target was still 2% until October 2008!
And here we are, fully two years later, and we still cannot get the Fed to act…nor can we get the executive branch of government to take the problem seriously! This inaction belies an institution that either is ill-equipped to respond when necessary, or is structured in a way that prevents decisive action. Since I believe that the Fed has all the tools it needs (it being a monetary superpower), I would place the blame on the structure of the network.
There is nothing more important on the Fed’s plate right now than bringing nominal spending back in line with the previous trajectory of NGDP. Not only to assist 50 million people who are currently unemployed, and help numerous others rebuild their balance sheets…but to save our economy from the whims of populist sentiment that will likely take hold if our economic malaise continues for very much longer. That means rounds and rounds of fiscal stimulus. That means the development of an entire class of freeters who never reach full potential. And most importantly, that means the loss of real goods and services that could otherwise be produced in our economy — which translates into a lower real standard of living for everyone.
At this point I would do anything for a little more monetary stimulus.
Another chart to steal from Real Time Economics, this time provided by Justin Lahart.
The classic hydraulic macro story would imply that someone is hoarding cash. It would be really nice then if we could look around and see some cash being hoarded. Indeed, we do.
A point I want to make is that none of these pieces of evidence is in-and-of itself conclusive: The small business survey, the flow of funds, inflation expectations, etc.
There could be explanations for all of them that involve something other than the traditional liquidity demand story: that is that recessions are caused by excess demand in the market for cash/bonds/safety.
However, the liquidity demand story suggests that certain things should all be happening at the same time: a decline in the demand for labor, a decline in the purchase of durables, a decline in consumer prices and business’s pricing power, a decline in asset prices, a decline in inflation expectations, an increase in cash holdings, an increase in the ease of finding workers, etc.
And, all of those things are happening.
I like to focus on inflation because I think just about all of us have agreed that inflation is primarily controlled by actions at the Fed. Thus close patterns between inflation and other variables should suggest that they are also controlled by the Fed.
Here is fraction of income spent on durables and inflation.
Ed Leamer likes to say that its all durables and housing. I think there is more going on in housing than money creation but lets check the Leamer story versus inflation.
Looking at durables only suggests that inflation might flatten out soon. Looking at durables and new houses suggests that deflation will be upon us for sure. It will be interesting to see what happens.
Note, however, that this is not saying that a reduction in income spent on durables and housing will cause a decline in inflation. Its saying the Fed has already taken certain actions. The immediate result of those actions is a decline the fraction of income spent on durables and new houses. The future impact of those same actions will be a decline in inflation.
In other words the inflation decline is already baked in. What we have to ask ourselves now is whether we want to take actions that would raise inflation expectations for the medium future.
Update: I probably should have put “during the recession” in the title. Unfortunately it’s gone to press.
Chevelle, at Models and Agents, explains why the previous round of “quantitative easing” performed by the Fed did not have a [sufficient] expansionary effect:
By that metric, the Fed’s past LSAPs have probably fallen short. Clearly, measuring the counterfactual is impossible, but there are reasons to believe that the impact on aggregate demand was small. Why? First, because the reduction in mortgage rates boosted refinancings only by people who could refinance—i.e. people with jobs and some positive equity in their home. Not exactly the most cash-strapped ones who would have spent the extra cash.
Second, the portfolio-balance effect of the LSAPs on the prices of assets like corporate bonds or equities is at best weak, if not counterproductive. The reason (which I explained in detail here) has to do with the fact that US Treasuries and MBS are not “similar in nature” to corporate debt and equities. Unlike the latter, Treasuries/MBS have more of a “safe haven” nature—so that removing them from investors’ portfolios create demand for more “safe” assets, rather than boosting the prices of equities, high yield bonds, etc.
Luckily, one Benjamin S. Bernanke explained how to perform private asset purchases that would, in fact, have an expansionary effect:
If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.
If you see that guy around, tell him to talk to the Federal Reserve. I remember hearing a podcast with Scott Sumner a while back where he floated the idea of the Fed buying bonds off of the public (i.e. You and I), and paying for them with cash. Lets get to it!
Scott Sumner routinely forgets my name when listing people who thought money was tight, and favored unconventional monetary responses to the recession…but that’s okay. I wasn’t blogging that much in late 2008. In any case, I would like to provide a concise answer to a question Scott raises on his blog today:
The very fact that Congress and the President are ignoring this issue (confirming FRB nominations), pretty much tells me that they are clueless on monetary policy. On the other hand, both groups do favor more AD, so their “heart” is in the right place. And of course I’m a big believer in democracy. So who do I favor making the decisions; the clueless or the heartless? I’m tempted to say “Whoever agrees with me; first tell me the target Congress would set.” But of course that’s cheating. The honest answer is that I don’t know. But it is becoming increasingly clear that we won’t get good policy until this dilemma is resolved.
In my mind, the myth of an independent central bank has pretty much been shattered (Karl’s as well). Every time the theory of why we have an independent central bank has been put to the test in a big way, the Fed has failed miserably.
But maybe the answer is more nuanced than that. Perhaps the Federal Reserve itself is simply a proximate cause. If you take the view that the actions of the Fed represent the consensus of the economics profession, then perhaps it is the economics profession who are the underlying cause.
In either case, it is clear that there should be hard rules in place that the Fed must abide by. At the same time, I think that the Fed should have maximum room to act independent of politics when it really needs to. Our current “dual mandate” provides nothing but an excuse for the Fed to shirk its duties. Thus, I believe that the Federal Reserve Charter should be rewritten to state that it is the Fed’s contractual duty to set an explicit nominal target, level targeting, and do everything in their power to hit that target. If you ask me I favor NGDP, but some people favor price level, and some favor inflation…if you really want to pin the Fed down, write which nominal target the Fed needs to hit into the charter. NGDP will still be here 100 years from now.
However, and this is important, that is the end of Congress’ power. Once they have arbitrated as to what the Fed needs to do, Congress gets out of the way and lets the Fed act. The only point at which Congress should have the authority to intervene is if the Fed is off-target, in which case Congress should have the power to remove the current board (or specific members) and appoint a new one. But, and this should be written into the charter as well, the only circumstances in which Congress can do so is if the Fed is missing its target (or criminal behavior, or other things that don’t have to do with monetary policymaking).
Separating politics from policymaking is definitely a good thing (I even came around on TARP), especially in monetary policymaking. However, having a monetary authority that is gallivanting around, allowing NGDP expectations to plummet 8% with zero recourse is unacceptable.
That is the title of today’s Wall Street Journal Symposium [Gated]. And the overwhelming answer from preeminent monetary economists? Nothing.
Not that they didn’t answer the question. Most of the panelists’ answers amount to the Fed remaining passive. Here is John Talyor:
To establish Fed policy going forward, the best place to start is to consider what has worked in the past. During the two decades before the recent financial crisis, the Fed employed a reasonably rule-based strategy for adjusting the money supply and the interest rate. The interest rate rose by predictable amounts when inflation increased, and it fell by predictable amounts during recessions.
Fairly predictable. John Taylor has made this point numerous times, and is a very hard rules-based guy. I’m a rules-based guy as well…but I don’t see the inherent virtue in the Taylor rule, however defined. Essentially Taylor seems to want the Fed to stabilize NGDP growth around a Taylor rule at the current (reduced) output level, which puts us permanently behind the previous trend rate of output. As far as I can tell, he doesn’t care to make up the slack…which of course means elevated unemployment for an extended period of time.
Richard Fisher, who is a predictable hawk, lived up to expectations as well:
One might assume that with more than $1 trillion in excess bank reserves and significant amounts of cash held by businesses, the gas tank of those who have the capacity to hire is reasonably full. One might also conclude that the Fed, having cut the cost of interbank overnight lending to near zero and used quantitative easing to coax the entire yield curve downward, has driven the cost of gas to virtually nil for businesses that are creditworthy. And yet businesses still aren’t hiring.
This is a mind-bogglingly insane statement. When suffering an immediate deficiency of aggregate demand, supply-side factors are second order. Yes, we should streamline regulatory hurdles…but that has nothing to do with why firms aren’t hiring. Fisher must have missed a lot of economics, and apparently doesn’t understand that demand for safe assets (which in developed countries equates to cash) drives most recessions (especially during a time where there is a lack of supply of safe [private] assets), and that the Fed decided to pay banks to hoard cash…and so they did. I’m having a hard time figuring out how Fisher landed his current position.
On to the most depressing, Frederic Mishkin:
Purchasing long-term Treasurys might suggest that the Fed is accommodating the fiscal authorities by monetizing the debt—thereby weakening the government’s incentives to come to grips with our long-term fiscal problems. In addition, major holdings of long-term securities expose the Fed’s balance sheet to potentially large losses if interest rates rise.
Such losses would result in severe criticism of the Fed and a weakening of its independence. Both the weakening of its independence and the perception that the Fed is willing to monetize the debt could lead to increased expectations for inflation sometime in the future. That would make it much harder for the Fed to contain inflation and promote a healthy economy.
Expanding the Fed’s balance sheet through large-scale asset purchases can be necessary in extraordinary circumstances, such as during the depths of the recent financial crisis. But in relatively normal times, the costs of using this tool are sufficiently high that it should not be used lightly.
9.5% unemployment, falling CPI and inflation expectations, and exploding national debt due to the political anxiety to “do something” is now ‘normal times’? This amounts to saying that the Fed has the tools, but shouldn’t use them unless we’re in the Great Depression. The Fed’s job is to keep us out of financial panics like the Great Depression, not make its job significantly harder by passively waiting until the depths of the abyss, and then acting. I don’t agree with that at all.
I don’t really know anything about Robert McKinnon, but he is worried about international currency flows, asset bubbles in China, and thinks that the Fed should mediate interbank lending to stabilize the yield curve at “normal interest rates”. I’m fairly confident that China can sterilize any dollar inflows that happen upon its shores…so I don’t see this as a problem that needs to be addressed by anyone but Chinese policymakers, and I happen to think that the Fed should be much more aggressive than stabilizing yield curves AAAAAND raising interest rates now is, of course, insane punditry. Apparently so does the Vincent Reinhart believes the Fed should be more aggressive as well:
As a consequence, the Fed has to be both aggressive and nimble. The Fed should promise to purchase government and mortgage-related securities between its regularly scheduled meetings as long as activity is forecast to be subpar and inflation is low or headed down. Purchases of, say, $100 billion every six-to-eight weeks would add up to a number worthy of shock and awe for those with a somber economic outlook.
All-in-all a very depressing symposium. They should have interviewed Scott Sumner, Bill Woolsey, David Beckworth, Nick Rowe, and Paul Krugman. Then, perhaps, the world could be saved.
Update: Beckworth seems to have beaten me to the punch, linking to Mark Thoma, who did as well…a
Karl has a post today arguing that Brian Wesbury is wrong for taking the view that fiscal stimulus is not effective (indeed harmful!) for two reasons: 1) that it pushes up interest rates through government borrowing (crowding out), and 2) people will expect future taxes to pay for the stimulus.
Unfortunately these are annoying arguments that get conservatives in a lot of trouble with smart commentators on the other side, and then tend to discredit their entire enterprise. Paul Krugman has made a cottage industry out of sniping these crude arguments from otherwise distinguished economists (see Robert Barro via flexible-price models).
However, while Googling Mr. Wesbury, I came across an article that I want to dredge up from February 2008. I want to do this not to point out that Wesbury has no credibility (like some commentators *ahem*), but to show how thinking in terms of interest rates screws people up, and how uncertainty is very dangerous to reputations. The title of the article is “Brian Wesbury Sees No Recession Ahead“.
Q: You say we are not in a recession and we are not even headed for one, right?
A (Wesbury): That is correct. Every single recession in the United States for the last 80 years has been preceded by a tight Federal Reserve policy — in other words, excessively high interest rates. And we clearly don’t have that today. Recessions are also preceded frequently by tax hikes or protectionism. So I would say that today we have very low interest rates, we have low tax rates, and we are not moving in a protectionist direction. As a result, those conditions that have led to recessions in the past don’t exist. One last point: I know of no point in history where we have ever scared ourselves into a recession. It just has never happened before and I don’t think it will happen this time, either.
This is a bombshell of a quote. My main point is that given the events that had happened up until then, saying that we won’t experience a terrible-horrible recession was not an unreasonable position to take. The problem is equating the setting of interest rates with the stance of monetary policy. I also know of no correlation between taxes and recession, and I’m sure he had in mind Smoot-Hawley when he was talking about protectionism…but that tariff was a drop in the bucket of what the actual problem was (then and today): falling NGDP.
By late 2008, in hindsight, Wesbury looks like a fool…but how would he have possibly known that the Fed would let NGDP fall at the fastest rate since 1938 later in the year? As a counterfactual, had the Fed kept up expectations that it would hit its 5% NGDP growth target, Wesbury’s statement wouldn’t look so bad today.
Arthur Laffer was (YouTube) famously in the same boat while talking with Peter Schiff, and of course made to look like a moron. My first piece of advice would be to not attempt to make public predictions. Since that is impossible, my second piece of advice would be to err on the side of caution when making predictions based on models (that is also true with NK multiplier models)…especially when facing strong headwinds.
P.S: I’m happy about the “Babble” tag.
There has been a lot of chatter around the blogosphere about Narayana Kocherlakota’s speech in Michigan last week, and seeing as I am trying to catch up on news, I think that is a good a place as any to start. First, here is the whole speech, so that you can read it if you would like.
The big focus, especially among left-leaning commentators, has of course been Kocherlakota’s comments on the unemployment situation. The only troubling thing to me about a monetary policymaking body discussing unemployment is the fact that it is happening at all. I don’t believe that there is anything “special” that monetary policy can do to alleviate unemployment — even in a booming economy. The capacity of monetary policy to act is to keep nominal GDP growing at a constant rate, year over year, and to tighten a little when it overshoots and loosen a little when it undershoots — such that the trend path of NGDP is a constant upward slope. I’m not an expert on the welfare-maximizing trend rate of NGDP…but people who are much smarter than me on average advocate 5% NGDP growth.
In any case, in the speech, Kocherlakota breaks down how Fed meetings operate, and then breaks down his “forecast speech” that he gave to the FOMC. Along those lines, he has three points: GDP (real), inflation, and unemployment. On those three points, he has this to say:
Typically, real GDP per person grows between 1.5 and 2 percent per year. If the economy had actually grown at that rate over the past two and a half years, we would have between 7 and 8.2 percent more output per person than we do right now. My forecast is such that we will not make up that 7-8.2 percent lost output anytime soon.
[…]
The Fed’s price stability mandate is generally interpreted as maintaining an inflation rate of 2 percent, and 1 percent inflation is often considered to be too low relative to this stricture. I expect it to remain at about this level during the rest of this year. However, our Minneapolis forecasting model predicts that it will rise back into the more desirable 1.5-2 percent range in 2011.[1]
[…]
Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers. […] Given the structural problems in the labor market, I do not expect unemployment to decline rapidly. My own prediction is that unemployment will remain above 8 percent into 2012.
[1]5yr TIPS spread is at 1.43, 10yr @ 1.55.
Now, not making up the lost employment is partially a function of his previous point about per capita GDP remaining under trend for an extended period of time. This is the cyclical component of unemployment. Cyclical unemployment is created due to the relationship of the economy to the cycle of time. As such, the level of cyclical unemployment correlates well with the business cycle, seasonal factors, etc. I believe that most of the unemployment we are currently experiencing is of cyclical nature.
I think the error in Kocherlakota’s thinking stems from this quote:
Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.
This is wildly baffling. Not only does Kocherlakota make the forecast above — i.e. we will not be hitting any of our targets (nominal or otherwise) any time soon — he also states that he believes that money has been easy. That implies that monetary policy has zero effect on the economy, any time. He also identifies that low rates for an extended period of time are a sign of monetary failure, but does so in a future-orientation. While it is true that low rates can (and do) accompany* a deflationary “trap”, the policy prescription that follows is not to raise short-term rates regardless of the composition of employment. The proper policy response in that situation is to set a positive nominal target, level targeting and commit to move heaven and earth to hit that target.
That, rather than his statements about unemployment, is what I view as Kocherlakota’s underlying problem.
*H/T to Andy Harless in the comments. Also, read his post about Kocherlakota’s statements.
In a blog post today, Paul Krugman outlines a hypothetical situation that we could find ourselves in:
And this raises the specter what I think of as the price stability trap: suppose that it’s early 2012, the US unemployment rate is around 10 percent, and core inflation is running at 0.3 percent. The Fed should be moving heaven and earth to do something about the economy — but what you see instead is many people at the Fed, especially at the regional banks, saying “Look, we don’t have actual deflation, or anyway not much, so we’re achieving price stability. What’s the problem?”
I wonder if, on a particularly lazy day when Paul Krugman finds it difficult walk upstairs, he claims that he is in the “main floor trap”? But I digress. There is only one culprit in this situation: the dual mandate.
I’m not an expert on the history of the dual mandate, but I would venture a guess that it was the result of a grand bargain in which “price stability” came from the “hawkish” right, and “unemployment” came from the “dovish” left. The nature of the Fed’s dual mandate is such that it allows the central bank to wiggle out of nearly any situation if finds itself in with little consequence. Since the Fed is aiming at two diametrically opposed targets at once (price stability and full employment), it has large discretion upon which it can draw to justify its policy actions.
Is unemployment 9.5% with core CPI inflation falling below 1% and future expected inflation well below target as well? Well, that’s price stability!
How about persistent inflation rates bordering on double-digits while employment booms? Pat yourselves on the back guys!
In reality, and much to the chagrin of leftists everywhere, the modern Fed (1980’s+) has mostly erred on the side of price stability, which in the recent context has meant 5% NGDP growth with a rough average of 3% real growth and 2% inflation. This has allowed for a NAIRU of around 4-5% for the United States as a whole. Of course, that is a rate…and as long as the unemployed are continually in flux — that is, as long as hires outpaces quits and fires — that rate isn’t much of a problem. What is a problem is that the same dual mandate that was praised by some economists during the Great Moderation is now enabling the Fed to shirk its duties (and perhaps even worse, providing cover for “leveling down” with an implicit policy of opportunistic deflation…which is what Krugman implies above).
The Federal Reserve’s mandate is unique in the world. Most other central banks operate under a “hierarchical mandate” which generally stipulates an inflation target. It is hierarchical, because the central bank can set any target other targets it wants, and pursue them in order as long as they have hit their mandated target. The results of this kind of target vary from country to country.
In my opinion, Congress should scrap the Fed’s dual mandate, and instead mandate that the Federal Reserve set an explicit nominal target, and do everything in their power to hit that target (level targeting). If they’re feeling generous, they can give the Fed discretion as to which target they would like to set. If not, I would specify NGDP. I don’t think that the monetary policymaking body of the Federal Reserve should even look at a single unemployment number. They should focus like a laser on their keeping their nominal target in a very narrow range and leave the question of unemployment (which is a real variable) to other policymakers.
Stabilize monetary policy around a nominal aggregate, and I would wager that unemployment would find a way to work itself out with minimal intervention.
P.S. I kind of smile when I think about the Fed “moving heaven and earth to do something about the economy”. I suppose that is because 1) I think that monetary policy can do so and 2) I’m a huge nerd.
Modeled Behavior 