Friday, February 13, 2009

More on What the Fed Can Do to End This Crisis

A few days ago I questioned whether the Fed's ability to lift the economy out of the current economic crisis truly has been exhausted as argued by some observers. In that discussion I failed to take note of the most important thing Fed can do in this crisis : change the deflationary expectations. Last November Jim Hamilton suggested the Fed start doing this with a 3% inflation target. As Hamilton notes, a key part of such a strategy would be to clearly communicate the new policy to the public and thus change expectations. More recently, Nick Rowe made the case that the Fed should change expectations by literally betting on a recovery. Here is how it would work:
Ben Bernanke should publicly bet $1 trillion dollars that the US economy will recover quickly from deflation and recession. He should make that bet on the Fed's behalf. The Treasury should publicly disavow all responsibility for bailing out the Fed if Bernanke loses the bet. If he loses the bet, it would be paid for by printing money.

This is how people would react to the bet.

If they expect deflation and recession to continue, so they expect Bernanke to lose the bet, they will expect the Fed to print an extra $1 trillion, which would be highly inflationary.....which is a contradiction.

If they expect the economy to recover quickly, so they expect Bernanke to win the bet, they expect the Fed will not print an extra $1 trillion, so they will not expect hyperinflation, just a normal recovery, which confirms their expectation.

By making such a bet, and making it publicly, the Fed creates the very expectations it wants to create: that deflation and recession will not continue, and that the economy will recover, and return to the normal rate of inflation.
There is more to Nick's strategy in his post, but the key point is that it would change the public's deflationary expectations. This ability to change expectations is something the Fed still can do to help end this economic crisis.

1 comment:

  1. Didn't Kydland and Prescott win a Nobel for work on the need for a consistent monetary policy framework? One thing markets could do with right now is a sense of what the Fed is doing. The suggestion of an inflation target would help. At the moment, macro policy, monetary policy and financial stability policy are all over the map. Markets have no clear idea of what is happening. Which is one reason why the Great Depression was so persistent.

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