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Commenter 123 sent me the following list of questions by David Altig, of the Atlanta Fed:

The questions about the costs and benefits of any particular policy intervention are abundant, and for virtually every potential pro there is a potential con. Here is my personal, certainly incomplete list of pros/cons or benefits/costs associated with another round of large-scale asset purchases: Pro: Lower interest rates (and perhaps a lower dollar) will on balance spur spending. Con: The expectation of low interest rates for a longer period of time will reduce the urgency to borrow and spend. Pro: Expanded asset purchases and lower rates will preserve needed liquidity in financial markets. Con: Expanded asset purchases and lower rates will create or exacerbate financial market distortions. Pro: More monetary stimulus reduces the probability of an undesirable disinflation in the near term. Con: More monetary stimulus increases the probability of undesirable inflationary pressures in the longer term. Pro: Lower Treasury and MBS rates will induce an appetite for risk taking that is needed to get productive resources “off the sidelines.” Con: Lower Treasury and MBS rates will induce an appetite for risk taking that sets us up for the next bubble. Pro: Monetary policy is the only channel of support for the economy, absent new fiscal policies. Con: Monetary policy support is relieving the pressure to make needed fiscal reforms that would be much more effective than monetary stimulus. Pro: With additional monetary stimulus, GDP growth will be higher and unemployment lower than they would otherwise be, and outcomes may be more consistent with the FOMC’s mandate to promote maximum employment. Con: With additional monetary stimulus, the exit from monetary stimulus once the economy improves will be more difficult than it would otherwise be, and outcomes may be inconsistent with the FOMC’s mandate to achieve price stability. Pro: The performance of the economy has not been consistent with the FOMC’s mandated objectives. Con: The economy is slowly moving in the direction of the FOMC’s mandated objectives, and the Fed should “keep its powder dry” in case of further deterioration of the economy.

[Note: The rest of this post is aimed at the Fed as a whole, not at Altig personally.]

I am not going to answer Altig’s specific questions. Instead I’d like to suggest that the Fed as a whole is thinking about the entire issue in the wrong way. Let’s start with the term ‘intervention,’ which Altig uses in his opening paragraph. Suppose you went up to the front of the Greyhound bus, and started chatting with the driver. Suddenly he asked whether you’d like him to continue “intervening” with the direction of the bus. Most people would be taken aback, indeed that sort of “intervention” is pretty much the be-all-and-end-all of being a bus driver. You steer the bus.

The Fed essentially steers the nominal economy. But it has a very ambiguous attitude toward this responsibility. In real time, it sees movements in NGDP as being caused by factors beyond its control. Thus banking panics and hoarding caused NGDP to fall in half during the early 1930s, not the Fed. A private sector wage/price spiral drove NGDP up at an 11% rate from 1972 to 1981, creating high inflation. And (the BOJ) argued that the bursting of a credit bubble and banking distress drove NGDP lower in the late 1990s. And of course the Fed argues that banking distress and a bursting housing bubble drove NGDP 10% below trend in the 2007-2010 period.

On the other hand when things go well, as when NGDP grew at relatively stable rates from the mid-1980s to 2007, the Fed takes credit for the resulting “Great Moderation.” It attributes these gains to technical improvements such as the Taylor Principle. So it doesn’t entirely deny that it drives the nominal economy, rather it only denies responsibility when things go poorly.

Academics see things very differently. Milton Friedman (and later Ben Bernanke) argued that the Fed caused the collapse in NGDP in 1929-33, and that the Fed was responsible for the Great Inflation. And they both argued that the BOJ was responsible for the fall in Japanese NGDP in the late 1990s.

And although Fed officials won’t take the blame for contemporaneous policy failures, they are happy to blame their predecessors, as it makes their current actions seem more enlightened. Thus the semi-official Fed view is now that Friedman and Bernanke were right, that the Fed did cause the Great Contraction, and that the Fed did cause the Great Inflation.

But this creates a problem, as the arguments used by Friedman, Bernanke, et al, in blaming the Fed for previous errors, also would suggest that they are to blame for the 2007-2010 plunge in NGDP growth. Consider two important Bernanke arguments from the early 2000s:

1. Financial distress is no excuse; the BOJ had the resources to boost NGDP growth, it failed to show “Rooseveltian resolve.”

2. Both interest rates (real and nominal) and the money supply are poor indicators of the stance of monetary policy. In the end only NGDP growth and inflation are reliable indicators of the stance of policy.

Of course if you average those two “reliable” indicators, since mid-2008 America’s had the slowest growth in AD, and hence the tightest money, since Herbert Hoover was president. How does Bernanke reconcile these views?

Bernanke claims money has been “extraordinarily accommodative,” based on the low interest rates and fast money supply growth. Thus he simply walks away from his 2003 definition of the stance of monetary policy. And no one in the press has called him on this inconsistency.

He has not walked away from his much more well known denial of “liquidity traps” as preventing monetary stimulus, as that would make him look like a fool. Instead he’s consistently argued that the Fed could do more, but is held back by certain unspecified “risks and costs” of further stimulus.

This approach to the problem is wrong on all sorts of levels. There are no costs and risks of keeping expected NGDP growing along a 5% track, level targeting, all the “costs and risks” come from missing the target. To take just one example, the ultra-slow NGDP growth after mid-2008 drove nominal rates to zero, and greatly boosted the demand for base money. This forced the Fed to buy lots of assets, exposing them (allegedly) to risk of capital losses on those assets. But that “risk” is caused by tight money, not monetary stimulus. Even worse, it’s not really a risk at all, as the Fed is part of the Federal government. Any losses to the Fed from falling T-bond prices are more than offset by gains to the Treasury. Indeed that’s why inflation has traditionally been viewed as a boon to government coffers.

But all this minutia about costs and risks misses the bigger picture. The Fed does not face a difficult choice about whether to intervene or not, it is already steering the bus, it just doesn’t understand that fact. The Fed needs to decide which direction it wants to take. There is no “non-intervention” policy by the Fed, as it has a monopoly on the supply of base money. Admittedly at zero rates there is a lot of slack in the market response to temporary currency injections, but the Fed also has the ability to steer expectations about its longer term goals for NGDP. I don’t know if Fed officials realize this, but the markets have basically decided that the Fed is happy with no return to the old NGDP trend line, and indeed a downshift to a lower rate of NGDP growth, probably about 4%. If the Fed doesn’t want that to happen, they need to use different language when talking about their longer term policy goals. Where will they push NGDP once they’ve exited the zero bound? Right now they are signalling 4% NGDP growth as far as the eye can see, which means a slow recovery.

I’m not arguing the Fed should “intervene” to “fix problems.” I oppose discretion. I want them to clearly set out a path for NGDP (or some other nominal indicator like a weighted average of inflation and output gaps) and set policy at a position where they expect to hit their target. Just as I’d want a bus driver to set the steering wheel at a position where he expected the bus to remain on the road.

Like Brad DeLong, I thought they had basically decided to do that in the decades before 2007, keeping NGDP growth close to 5%. And like Brad DeLong I was shocked to find out (in late 2008) that they had no such policy intention. That they were still like the old Fed of the 1930s, willing to blame the naughty market economy for any deviations of NGDP from a stable path.

I’m sure most readers are much less naive than I am, and understand that big institutions cannot accept blame (in real time) for costly mistakes that screw up the macroeconomy and cause millions to lose their jobs. Such as failing to cut the fed funds target much more aggressively in 2008, when rates were still 2%.

PS. Altig links to a John Cochrane piece that seems to take the view that monetary policy is ineffective when nominal rates are zero. How ironic would it be if Chicago became known as a “liquidity trap” school. Friedman must be spinning in his grave.

PPS. Several commenters sent me an excellent piece by James Pethokoukis. For the record I like Paul Ryan, but not as VP. Too ideological. And don’t worry about Romney, I assure you he has zero interest in gold. It’s all about getting the Ron Paul voters enthused. Readers from other countries should understand that in America these campaign promises mean nothing.

PPPS. Very said to hear that Arnold Kling has given up blogging. I disagreed with is views on macro, but was in awe of his skill in analyzing regulation and the interaction of government and markets. He was one of my favorite bloggers.

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This entry was posted on August 26th, 2012 and is filed under Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



