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. . . the appropriate policy is not “Keynesian.” The appropriate policy is to exit the Keynesian world. How do we know we are in a Keynesian world? Just think back to the 1930s:

1. Lots of talk about how millions of workers will be permanently unemployment by technological progress. (Sound familiar?) In the 1930s this actually was slightly excusable, as productivity growth was fast. Now we have very slow productivity growth (Great Stagnation), so the technological unemployment argument is just silly—made by people who don’t understand AD shocks.

2. Ultra-low long term interest rates.

3. Lots of worry about inflation even though inflation is the lowest in decades.

4. Worry that companies need to be bailed out, or else unemployment will rise.

5. Calls for fiscal stimulus to generate jobs.

6. Claims that monetary policy is ineffective because rates are near zero.

Note that none of those things occurred during the 1990s, despite even higher inflation, and even higher productivity growth. It’s all about misdiagnosis.

What conservatives don’t realize is that the solution to being in a Keynesian world is to return to the classical world ASAP. Was QE3 intended to do that? Bernanke probably hopes so, but it’s quite possible that the Fed as a whole is merely treading water. Why are people like Kocherlakota now more sympathetic to stimulus? Why did the Fed “move” more than expected a few weeks back? Perhaps because they are simply trying to maintain the status quo. Not Bernanke, who probably really does want to do more, but the institution a a whole.

It’s likely that with the recession in Europe, sharply slower growth in developing countries, and the oncoming fiscal cliff, there would have been a slowdown in 2013 without QE3, which would have put the Fed in a really difficult spot. Here’s Jan Hatzius:

We are surprised that neither party has seriously challenged the case for near-term fiscal retrenchment. In particular, the expiration of the $126bn payroll tax cut (1% of disposable income) is almost universally accepted. This expiration alone is likely to shave 0.6 percentage point from 2012 growth on a Q4/Q4 basis””the same order of magnitude as the estimated boost from QE3″”at a time when investors are lining up to finance US government expenditure at a real 10-year yield of -0.8%. While we agree that the US government will ultimately need to tighten its belt, a big move in a restrictive direction still looks decidedly premature to us.

Bernanke explicitly indicated that the Fed had to take fiscal policy into account when deciding how best to hit their targets. That’s fiscal offset, which reduces the fiscal multiplier. Of course the Fed doesn’t know exactly what Congress will do, so my hunch is the Fed is reacting to the most likely scenario. Hatzius seems to feel they provided just enough to offset the most like fiscal retrenchment.

Don’t get me wrong, I think the Fed would have done some sort of QE3 even without the fiscal cliff, but I also believe this looming cliff helps explain why the move was more aggressive than forecast. NGDP growth dropped to 2.77% in the second quarter, and it seems like the Fed wants to get it back up over 4%. Eventually they’ll succeed, but it will be a limited “success.” We’ll still be in a Keynesian world for many years. And we’ll react to that fact not by getting out of the Keynesian world, as we should, but rather by continuing to run big deficits and bailing out firms that are failing.

As far as I know there have been only two previous zero interest rate policies, the US during 1932-51, and Japan since the mid-1990s (and still counting.) There’s no reason to believe that rates are going to rise anytime soon. The Fed still needs a higher NGDP target. A few weeks ago they took some baby steps in the right direction. Now it’s time to follow-up with even more specificity. Where exactly does the Fed want to go? And how badly do they want to get there?

I won’t sleep comfortably until the 10 year T-bond yield is back up over 3% (or the Fed abandons interest rate targeting.)

Which means I might not sleep well for the rest of my life . . .

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This entry was posted on October 11th, 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.



