Tuesday, March 24, 2009

Risks from the New Fed Policy

As I mentioned in my last post, the Fed's announcement that it will more aggressively expand the monetary base is a much needed development. Without it the dramatic collapse of U.S. nominal spending will only get worse and further destabilize the U.S. economy. This move can be viewed as an attempt to prevent the U.S. economy from overshooting on the downside, a policy objective that even Frederick Hayek supported. With all that said, there are risks associated with this policy move. First, Caroline Baum reports this new policy, which purposefully targets long-term Treasuries, may create big distortions in the market for Treasuries. Second, this aggressive monetary expansion will eventually have to be reversed to avoid a repeat of the 1970s-type inflation. This reversal, however, may not be politically popular if it involves some pain as noted by John Taylor:
Will the Fed be able to change course in time? To do so, it will have to undertake the politically difficult task of getting more than $3,000bn of government securities, private securities and loans off its balance sheet.
Given the short-run real effects of monetary policy, a reduction of the money supply of this size could be very disruptive. The reversal also may involve some quasi-fiscal costs as noted by Paul Krugman:
But here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent, where it was before the crisis. Then the price of those bonds will have dropped significantly.

And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created. So the Fed will have to sell additional assets; if the rise in interest rates is at all significant, it will have to get those assets from the Treasury. So the Fed is, implicitly, engaged in a deficit spending policy right now.In short, unwinding this aggressive expansion of the money supply may not be easy.
Given the possibility of these politically sensitive developments, one could question whether the Fed will actually be able to reverse itself in the future. This is a real concern, but as pointed out by Tim Duy the Fed and U.S. Treasury released a statement yesterday reconfirming the Fed's independence. Hopefully, this statement gives the Fed the freedom to take do what is needed to stabilize nominal spending presently without jeopardizing its independence in the future.


  1. Sounds like a very high tightrope act for Bernanke and Co. to have to follow...

    I wonder what this recession/depression will look like with the 15% interest rates of the early 80s? What could that do to the housing market?

    I grant you, as a guy with a significant mortgage I wouldnt mind seeing inflation as long as my salary goes up....
    but my parents, on a fixed income, with no debt will take it in the chops i fear....

    I sincerly hope we dont end up back in the late 1970s or alternatively in the early 1930s...
    by putting so much power in the hands of a small few, we can only hope Bernanke makes it all the way down the tightrope....
    he hasnt looked too nimble so far....

  2. A nice post that pulls together a number of themes. It also reminds me of a post you did a while back about Chris Sims's concerns about the future of the Fed balance sheet but I cant find it!
    And on another note: Given your concerns about the relevance of money & banking texts, what do you think of Ball's new text? At least its up-to-date!

  3. ECB: Look at the end of this post for Chris Sims's discussion of the Fed's balance sheet.

    Yes, I am impressed with Ball's new book. It looks like it could make a big splash in the market for money and banking textbooks. It will be interesting to see how the dominant Mishkin text fairs against it

  4. Right, that's the one. Sims links up nicely with Taylor's article.
    Ball is good for the first 12 chapters, but if you are not a fan of the New Keynesian approach to monetary analysis, you're not going to like the second half. Theories built on cashless economies without intermediation are unhelpful for understanding current events.

  5. ECB:

    Since you seem to know a lot, I have an issue to run by you that has has me perplexed. There seems to be many observers who continue to cite the interest rate conundrum of 2005-2006 as evidence that the Fed has little control over long-term rates and/or view it as the result of the saving glut. While I don't completely dismiss the saving glut--it could have affected the term premium--it seems to me that a more straightforward and consequential explanation for the flattening and then inversion of the treasury yield curve was that the bond market was pricing in a recession. They saw the imbalances building, expected a correction in the future, and thus they expected the Fed to lower short-term rates in the future.

    I have made this case several times on this blog, including this one that shows a figure with supporting evidence. Anyhow, this all seems so obvious to me, but for many observers apparently it is not so obvious. Why? I may be wrong here and would love to be pointed in the right direction if so. Any thoughts? Thanks.

  6. I wish I knew a lot more ! As far as the "conundrum", have you looked at
    John Cochrane's paper, "Decomposing the yield curve" http://faculty.chicagobooth.edu/john.cochrane/research/Papers/interest_rate_revised.pdf
    He address the period in question in Section 5.3 of the paper. Essentially he says its declining term premium. Long bonds became safer due to low inflation volatility. As well, long rates should fall in response to credible tightening. Patrick Kehoe gave a 1-hour "refresher" lecture on new research on term structure economics at the AEA meeting that is interesting. Its available as a video download. I think saying "savings glut" would invite stares of disbelief or derision among the finance people.