The Fed Has Not Done Enough and it Has Not Fired Most of its Ammunition

These are difficult times. The sudden collapse of stock prices is not creating panic so much as despair, a despair voiced by Joseph Stiglitz in his column in the Financial Times today in which he correctly observes:

The Fed’s announcement that it will keep the target federal funds rate near zero for the next two years does convey its sense of despair about the economy. But, even if it succeeds in stopping the slide in equity prices, it won’t provide the basis of recovery: it is not high interest rates that have been keeping the economy down.

Joseph Stiglitz is a brilliant economist, richly deserving the Nobel Prize he won in 2001, but it is shocking that he would assert that monetary policy can promote recovery only by reducing interest rates. Evidently, that idea has been repeated so often and with such conviction that even an economist of Professor Stiglitz’s stature can unthinkingly parrot it without embarrassment.

Does Professor Stiglitz believe that if US monetary authorities decided to buy foreign exchange with dollars driving down the value of the dollar against other currencies, dollar prices would not rise? And if foreign governments responded by purchasing dollars with their own currencies does he believe that prices in terms of those currencies would not rise? Competitive devaluations would require no reduction in interest rates to be effective and would produce an immediate increase in money supplies and prices. So it is clearly within the power of central banks, if they had the will to do so, to achieve any desired increase in the price level. That the Fed and other central banks have not done so means only that they have not tried.

Stiglitz continues:

Corporations are awash with cash, but banks have not been lending to the small and medium-sized companies that are the source of job creation. The Fed and Treasury have failed to get this lending restarted, which would do more to rekindle growth than extending low interest rates though 2015

He is right that the Fed and Treasury have failed to get lending restarted, but fails to mention the primary reason: banks are being rewarded for holding reserves with a higher interest rate than they could earn by holding short-term Treasuries. Returning to a zero-interest-rate policy on reserves or even imposing a tax on excess reserves would certainly change banks incentives, inducing them to reduce their holdings of reserves and to seek alternative ways, like lending to businesses and consumers, to generate income.

A similar sense of futility, though reflecting a profoundly different economic outlook from that of Professor Stiglitz is evidenced in The Wall Street Journal in its August 9 editorial on the FOMC’s announcement.

This is what a central bank does when it wants to appear to do something to help the economy but has already fire most of its ammunition.

But within two paragraphs, the Journal sharply pivots in its characterization of the Fed’s statement. After noting the dissents of three FOMC members, regional bank presidents not appointed by President Obama, the Journal conjectures that:

the policy statement may have been a compromise, and that others on the committee would have gone further, perhaps so far as to start a third round of quantitative easing.

So the Journal itself seems to imply that the Fed’s statement ought to have been characterized as follows: This is what a central bank does when it can’t agree to use the ammunition that it has.

The Journal, like Professor Stiglitz, pronounces the Fed’s quantitative easing a failure because all it accomplished was to “[push] investors into riskier assets (stocks and commodities). But the prices of those assets have since fallen back down to what investors think they’re worth.” It is almost surprising to read that the Journal believes that the Fed has power to push investors into anything, but readers of the Journal editorial page are no longer so easily surprised. Investors make judgments, which may or may not be correct, on their own based on the policy signals emitted by the Fed. If asset prices rose as a result of the Fed’s policy, it was because that was what investors, given the information they then had, felt the assets were worth. If the assets fell in price later, that was because investors revised their expectations, presumably in light of new information, including new information about the Fed’s policy intentions, as well as the intentions of other relevant policy makers.

The Journal presumes that QE2 was intended to produce wealth effects that would increase consumer spending. In this presumption, the Journal actually has some support from unfortunately inaccurate explanations of how the program would work by Mr. Bernanke himself. But such wealth effects were, in the Journal’s view, offset by the negative “income effects” occasioned by the commodity-price bubble induced by QE2.

Economic growth has decelerated over the past year despite QE2, so we wonder what good Mr. Bernanke thinks it did. We’re hard pressed to see what good QE3 would do as well.

We know that QE2 was intended to prevent inflation expectations from falling to dangerously low, even negative, levels, as they seemed about to do last summer. And in this it was successful. The deceleration in growth was associated with a series of unfortunate one-off events: severe winter weather, a spike in oil prices as a result of the Libyan uprising against Colonel Ghaddafi, and the tsunami and nuclear disaster in Japan. But rather than accommodate these supply shocks by allowing prices to rise as would be natural in the face of a supply shock, pressure built to tighten monetary policy to counter the supply-driven rise in prices, with results that are now becoming all too evident: rapidly falling inflation expectations and real interest rates.

The correct explanation of how QE2 was supposed to work is that it would raise the cost of holding liquid assets that would lose value as prices rose. That is why, within a few months after QE2 was initiated interest rates actually rose along with stock prices, contrary to the Journal’s story about “pushing investors into riskier assets.” This would have induced business to shift some of their cash holdings into real investment rather than watch their idle cash lose value and to induce consumers to shift depreciating cash into consumer durables.

The notion that QE2 was undermined by a commodity price bubble is nothing but an urban legend. I apologize for being unable to reproduce the graph on the blog, but if you go to here, you will find the Dow-Jones/UBS commodity index and you will see that that at the peak of the so-called commodity price bubble in April 2011, the index was at the same level it was at in September 2005 and 20% less than it was in July 2008. The jump in food prices was largely the result of bad wheat harvests and US ethanol subsidies that have driven up the price of corn to unprecedented heights and caused farmers to shift production from other crops to corn.

The Journal then delivers the following piece of wisdom:

The larger error is to assume that monetary policy will save the economy from its current malaise. That’s the latest mantra from the same economists who told us that $1 trillion in spending stimulus was the answer in 2009. Since that has failed, we are now told the economy needs a bout of extended inflation to reduce our debt burden. Harvard’s Kenneth Rogoff says the Fed should allow “a sustained burst of moderate inflation, say 4-6% for several years.”

That may be the mantra of Keynesians, but it is also the policy advice that has consistently been given by monetary economists of various stripes who have warned since 2008 that an overly tight monetary policy would produce a recession and that Fed policy, because of its payment of interest on reserves, has not been the least bit expansive despite the rapid increase in the Fed’s balance sheet. Fiscal policy may have failed, but monetary policy has yet to be tried.

The Journal concedes that inflation can erode the value of money and debt, a truism too obvious for even the Journal to dispute. But the Journal counters with the withering observation that Argentina tries this every few years, as if Argentina were the model that Rogoff and others advocating a rapid but limited increase in the price level were offering for emulation.

“The middle class,” warns the Journal, “pays a huge price in a debased standard of living.” But the standard of living depends primarily on the real level of output and employment. And there are powerful theoretical reasons to expect that a substantial rise in prices would trigger a large increase in output and employment, restoring living standards to levels not seen in years. In addition, the historical example of FDR’s devaluation of the dollar in 1933 provides striking empirical evidence that for an economy with very widespread unemployment a period of rapidly rising prices can induce a substantial increase in output and employment. In the four months following FDR’s devaluation of the dollar, wholesale prices rose by 14 percent, and industrial output rose by 56%, while the Dow Jones average doubled, the fastest increase in output and employment in US history.

“Once you encourage more inflation, it’s hard to stop at 4%,” asserts the Journal as if it were laying down a law of nature. But there is no economic theory to support such a proposition. If the Fed announced a specific price level target, there is no reason why it could not reach the target, and, having reached the target, no reason why it could not remain there or revert back to a sustainable long-run price-level path.

“If monetary policy by itself could conjure growth, or compensate for bad fiscal and regulatory policy,” the Journal reasons, “we’d already be booming.” The Journal simply fails to grasp an elementary distinction: the difference between, on the one hand, the long-run potential rate of growth of an advanced economy, roughly 3% a year over long periods of time, a rate determined by real forces including the incentives provided for investment in the stock of human and physical capital, a stable legal system and efficient tax and regulatory policies, and, on the other, the job of restoring an economy to a long-run growth path from which it has lapsed. With the former, monetary policy, indeed, has little to do; for the latter, as F. A. Hayek recognized in The Road to Serfdom (p. 121) monetary policy is preeminently responsible.

There is, finally, the supremely important problem of combating general fluctuations of economic activity and the recurrent waves of large-scale unemployment which accompany them. This is, of course, one of the gravest and most pressing problems of our time. . . . Many economists hope, indeed, that the ultimate remedy may be found in the field of monetary policy, which would involve nothing incompatible even with nineteenth-century liberalism.