QE Has Worked Before: My Reply to Paul Krugman

Paul Krugman appears to be responding to my previous post where I argued it was unfair of him to dismiss Milton Friedman's views based on what happened in Japan.  In his reply he continues to raise doubts about the efficacy of Friedman's monetary prescription for Japan in the 1990s and the United States in the early 1930s.  He then goes on to question those of us who have been calling on the Fed to target the level of aggregate spending through something like a nominal GDP target. Here is Krugman (my bold below):

I think it’s also important to note that Friedman was all wrong about Japan — and that you can argue that he was also wrong about the Great Depression, for the same reason. For what Friedman argued, both for Japan in the 1990s and America in the 1930s, was that all the central bank needed to do was more — push out those reserves into the banking system. This would raise the money supply, and a higher money supply would have the usual effects.

But the Bank of Japan tried that — and found that pushing more reserves into the banks didn’t even lead to rapid growth in the money supply, let alone end the problem of deflation... So, after 2000 the Bank of Japan engineered a huge increase in the monetary base; this was the original quantitative easing. And it didn’t even translate into a surge in the money supply! This is why I’m so skeptical of people who say that all the Fed has to do is target higher nominal GDP growth — in liquidity trap conditions, the Fed doesn’t even control money, so how can you blithely assume that it controls GDP?

Let me begin my response by encouraging Krugman and other monetary skeptics to have a little more faith in the power of monetary policy.  Here is why: QE has been done before in the United States and it worked incredibly well.  It was initiated in early 1934 when FDR and his treasury officials decided to (1) devalue the value of the dollar relative to gold and (2) quit sterilizing gold inflows.  Now this was a radical move at the time, much like QE2 is to many folks today.  The gold standard was viewed then almost as a sacred institution.  FDR was going to weaken it and allow prices to permanently increase.  How dare he! But that is exactly what was needed, a big permanent shock to inflation expectations that  served to stop the deflationary spiral, end the liquidity trap, and allow a recovery in aggregate demand.  Now this policy move was backed up with significant and permanent increases in the monetary base over time: it went from about $8 billion right before the policy change to about $24 billion by the end of the 1930s.  Below are two graphs that shows this remarkable QE program at work.  Here is the monetary base and M2 (Click on figure to enlarge.):

Note how the increase in the monetary base was followed by an similar increase in M2.  Monetary policy--in its unconventional form--was able to influence the money supply.  And note the slowdown in the monetary base in 1937 was followed by a slowdown in M2.  This is when the Fed decided to stall out FDR's QE program and in the process help create the recession of 1937-1938. (See Francois R. Velde for more on this recession.)  

What about total current dollar spending? Here too, FDR's QE program also served to stimulate aggregate spending as seen in nominal GNP:

Again we see that nominal GNP closely tracks the surge in the monetary base.  FDR's QE was a smashing success when it came to shoring up aggregate spending.  So those of us folks who want the Fed to increase and stabilize nominal GDP have a good reason to believe it is possible--it happened before.

So let's recap the highlights here:

(1) QE was tried before in the United States during a liquidity trap and worked incredibly well.

(2) QE not only worked well, but it did so in an economic environment far wore than that found in either Japan in the 1990s or the United States today.

(3) QE worked  because it (i) it reshaped inflation expectations and (ii) was backed up with meaningful increases in the monetary base.  

The Fed is more than able to do the same today.  It certainly can reshape inflation expectations.  Just look at what has happened to them over the last month or so when Fed officials started talking up QE2.  The Fed would be far more effective, though, at shaping inflation expectations by explicitly committing to some nominal target. Thus, the Fed needs to come out this week with more than an announcement that it is going to purchase say $500 billion assets going forward.  It also needs to shake up inflationary expectations and do so in a manner that creates certainty going forward.  The Fed, then, needs to (1) announce an explicit nominal target and (2) say it will do whatever is necessary to hit it (i.e. it will buy/sell as many assets as needed). I just hope it is a level target for total current dollar spending.

Update I: Josh Hendrickson reminds us that QE seems to be working rather well in the U.K.
Update II: The M2 and monetary base data come from Friedman and Schwartz (1963) while the nominal GNP data come from Balke and Gordon (1986).

What the GDP Report is Screaming to the Fed

There is a loud and clear message coming from today's BEA report on the U.S. economy:  it is time for the Fed to adopt an level target for total current dollar spending.  The report showed that final sales of domestic product grew at an annualized rate of only 2.4%.  This is far too weak of a growth rate in aggregate demand for there to be a robust recovery.  Moreover, it means that  that total current dollar spending is falling further below its long-run trend.   This can be seen in the figure below: (Click on figure to enlarge.)

The fitted trend puts final sales at about $16.5 trillion.  Actual final sales is around $14.6 trillion, a whopping $1.9 trillion shortfall.   That the Fed can let aggregate demand fall this far below trend is mind-boggling.  It is even more staggering when one considers that there were forward-looking indicators all along that were telling the Fed it was passively tightening monetary policy by allowing this development to happen.  This need for an aggregate demand target is further supported by the following two figures.  The first one shows the year-on-year growth rate of final sales of domestic product over the most of the postwar period.  It  shows how far aggregate demand has to go just to get back to a normal growth rate of about 5%. (Click on figure to enlarge.)

The next figure shows the key reason--other than the Fed's failure to act aggressively enough--why total current dollar spending is so depressed.  This figure shows that money demand, as measured by velocity, is still relatively high (note: velocity and money demand are inversely related). There is still a monetary disequilibrium problem out there: there is excess demand for highly liquid assets and the Fed has failed to offset it.This is a point made repeatedly by the us Quasi-Monetarists  (Click on figure to enlarge.)

Is it really that hard to get total current dollar spending back on path?  I think not, all that is needed is for the Fed to (1) announce an explicit nominal spending target and (2) then say it will do whatever is necessary to hit it (i.e. it will buy/sell as many assets as needed). Thus, I think calls for "shock and awe" by the Fed--such as Goldman Sachs claim that the Fed needs $4 trillion to be effective--are wrong. The Fed simply needs to convince the public it is committed to an explicit target and most of the heavy lifting will occur on its own in the market.  We see glimpses of this with the uptick in expected inflation associated with all the Fed chatter about QE2.  In this case, the Fed has done nothing official yet l the market is already pushing expected inflation up.  Just think how much more effective it would be if the Fed was explicit and publicly commit to a nominal anchor. Shaping expectations is key to the Fed's success here.

The question then comes back to why an aggregate spending target?  I have talked about this policy goal before, so let me draw from it:

[Though I want higher inflation now] I have never been enthusiastic about stabilizing inflation as an end in itself.  The reason being is straightforward: inflation is a symptom, not an underlying cause.  More generally,  the percentage change in the price level could be the result of shocks to  aggregate demand (AD), aggregate supply (AS), or both.  Currently, it seems clear that the drop in inflation expectations and the drop in core inflation are reflecting faltering aggregate demand.  Thus, it makes sense to talk about the need to arrest these drops.  However, it need not always be the case--low inflation could also be the symptom of a positive AS shock (e.g. productivity boom).   Imagine, for example, aliens land and give us new technology that makes our computers faster, gives us clean energy, and allows us to travel to  distant galaxies.  Such an alien encounter would create mother of all productivity booms.  Among other things, this productivity boom would imply a higher neutral interest rate, lower inflation rate, and robust AD growth (given  the increase in expected future income).  In such a case a rigid inflation target of say 4%, as some have proposed, would not make  sense here.  Most likely it would be too high an inflation rate to keep AD stable.   

Another way of saying all of this is that monetary policy should focus only on that over which it has meaningful control:  total current dollar spending or AD.  It should ignore AS shocks, both the good and the bad, because all it can do by responding to such shocks is to make matters worse  as alluded to above.   Focusing too narrowly on an inflation target--which assumes every shock is an AD one--can cause a central bank to make this very mistake.  I made this case before in  more detail in this post which got some play time in the economics blogosphere (e.g. Mark Thoma reposted it here).  My hope was that this post would help folks see that the stabilization of AD rather than inflation targeting should be the key  objective of monetary policy.   

So what kind of monetary policy would serve to consistently stabilize AD?  The answer is one that directly targets a stable growth path for AD. This could be a NGDP target or a final sales of domestic output target or any measure that directly aims to stabilize the growth of total current dollar spending.  Scott Sumner outlines its advantages in a recent post, but let me add a few thoughts.  First, an AD target is easy to implement.  All it requires is a measure of the current dollar value of the economy.  It does not require debates over the proper inflation measure, inflation target, output gap measure, and coefficient weights that plagued inflation targeting and the Taylor Rule.  Second, it can easily be made into a forward-looking rule by having the Fed targeting the market's forecast of AD.  This would require some innovations such as  NGDP futures market, but it is within the realm of possibilities as shown by Scott Sumner.  Finally, it could be easily communicated to and understood by the public by labeling it along the line of a "total cash spending target."

So FOMC officials take note: the BEA report is screaming to you it is time to get serious about stabilizing total current dollar spending.

Update: Yes, NGDP grew at about twice the rate of final sales in Q3.  But that is because there was a sizable buildup in inventories (i.e. NGDP - final sales = change in inventories).  For this reason, final sales is a better measure of actual aggregate demand than NGDP.  With that said, I would be delighted if the Fed started targeting the level of NGDP.  Any aggregate spending target would a big improvement in my view.

Milton Friedman, Nominal Income, and Paul Krugman

David Wessel has an article in the Wall Street Journal today where he considers what Milton Friedman would do now.  He comes to same conclusion Will Ruger and I did last week in our Investor Business Daily piece (PDF version here): Milton Friedman would support some form of QE2.  Though we reach the same conclusion, let me elaborate on two points raised by Wessel.  First, he notes that Friedman would want nominal income to be stabilized:

[Milton Friedman] would look at growth in income. "He considered stable nominal [unadjusted for inflation] income growth desirable because sudden swings in it (and thus in spending) cause huge macroeconomic disturbances when wages and prices fail to adjust quickly," says economist David Beckworth of Texas State University. Income is growing well below historical norms. POINT: For QE.

Will and I made this point in our Op-Ed and provide some discussion of it here.  The clincher for me, though, is this figure of  the growth rate of final sales of domestic product, a measure of aggregate demand (AD) (Click on figure to enlarge.):

The data in this figure runs through 2010:Q2.  It reveals that AD has a long ways to go before being stabilized. Milton Friedman wouldn't be please with the results shown in the above figure.  Because of this AD shortfall and other reasons, I personally would like to see the Fed target some measure of aggregate spending such as a NGDP level target.  Though probably low on the list of nominal anchors the Fed is likely to adopt, the FOMC actually discussed the possibility of a NGDP level target in its last meeting.

The second point I want to elaborate on is that Friedman would argue the Fed is not out of ammunition.  Here is Wessel:

Friedman would have scoffed at the notion that the Fed is out of ammunition. He believed in the potency of "quantitative easing," or QE—printing money to buy bonds. "The Bank of Japan can buy government bonds on the open market…" he wrote in 1998. "Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand…loans and open-market purchases. But whether they do so or not, the money supply will increase…. Higher money supply growth would have the same effect as always..."

Nowhere in this quote does Friedman say a temporary increase in the money  growth rate is the goal.  He says a higher money supply growth rate, period.  That is why I think Paul Krugman's comments on this piece are off.  Krugman says that Friedman's call for Japan to increase the monetary base in the above quote were insufficient because Japan tried it and it didn't work.  No, Japan did not try what Friedman suggested.  Rather, Japan only added temporary injections of montary base that were pulled out once price level stability was reached.  Thus, to argue Friedman's prescriptions for Japan were wrong one has to argue that he called only for  temporary increases in the monetary base. But he did not make that call.  Here is Scott Sumner on  Japan's approach to monetary policy:

What happened in Japan is precisely what proponents of QE in the US (such as Krugman and I) predict would happen. The BOJ adopted a policy of raising rates and reducing the money supply any time inflation rose above zero. (Bernanke mentioned this aspect of the BOJ's policy in his Jackson Hole speech.) This sort of policy will not result in inflation, because the monetary injections will be viewed as temporary. And indeed they were, the BOJ reduced the monetary base by about 20% in 2006, just as inflation was rising above zero. This prevented an outbreak of inflation. In Japan the CPI is still at 1993 levels, which is of course consistent with the BOJ's announced target--stable prices. By this standard the BOJ has been the most successful central bank in world history. Whether a stable CPI is good for the Japanese people is an entirely different matter.

It is unfair to attribute to Friedman the Bank of Japan's policy goals.  Krugman's claim that Friedman called for  "just printing notes" and nothing more like shaping expectations ignores the fact that Friedman actually understood the value of shaping inflation expectations.  It was Friedman, after all, that called for the Fed in the early 1990s to target the expected inflation rate implied by the spread between the nominal yield on Treasuries and the the real yield on TIPs.  Friedman knew the importance of managing inflation expectations.

Structural Problems Need QE2 Too

One argument against further easing by the Fed is that the main source of U.S. economic problems is structural in nature and cannot be addressed by monetary policy.  In particular, the balance sheets of households have collapsed and require a significant amount of painful deleveraging.   More monetary stimulus cannot  change that fact.  QE2, therefore, ultimately will be an exercise in futility.  This critique has been thrown at me a lot lately and so let me address it here.  

First, I agree that there are big structural problems with the household sector and that they are driving much of the problems elsewhere.  Households spent the past decade leveraging up and now they are having to reverse this buildup of debt given the collapse of the asset side of their balance sheets.  This household balance sheet problem in turn got  transferred to the government balance sheet and is also currently influencing aggregate spending choices. So yes, this is a structural problem and requires some radical structural solutions like swapping the underwater portion of mortgages for equity. Felix Salmon suggests some other structural solutions.

Now just because this is a structural problem it does not follow that monetary policy cannot contribute in a productive manner to the deleveraging.  In fact, monetary policy can actually make this structural adjustment easier to do.  How so?  There are two ways.  First, monetary authorities could push the price level back up to trend and reduce the real debt burden facing Americans.  During the past recession the price level actually fell and this deflation made it more costly to service existing nominal debt.  In other  words, the drop in dollar incomes  along with the drop in the dollar price of assets were not matched by similar drop in household dollar debt.  Moreover, this price level decline never returned to its (unofficial) 2% trend path and according to the FOMC's forecast is not headed back to it anytime soon.  Chicago Fed president Charles Evans made this point in a recent speech with this figure:

QE2, then, could help houesholds better cope with the deleveraging by pushing up dollar incomes and dollar prices of assets. 

The second way QE2 would provide support to deleveraging households is that it would increase total current dollar spending.  This development, in turn, would in the presence of sticky wages and prices increase real economic activity and boost the real income of households. For those who doubt the ability of the Fed to increase aggregate spending should look to the pick up in expected inflation coming from treasury bonds.   This increase in expected inflation is ultimately a signal that the bond market believes aggregate spending--the underlying cause of inflation assuming no big changes in aggregate supply--will pick up in the future.  And if aggregate spending and inflation are expected to pick up in the future this belief in turn will affect current spending choices. With higher real incomes, households will be better able to service their debts and deleverage their balance sheets.  Thus, QE2 by pushing the price level back to trend and increasing real incomes will provide much needed support to main structural problem facing the U.S. economy.   

P.S. I am not arguing we return asset prices to bubble levels, but that we simply return overall prices or the price level to the 2% trend.  This would imply some increase for asset prices too. 

P.S.S.  I would rather have QE2 return aggregate spending to its trend level rather than return the price level to its trend for reasons laid out here.  For now, though, I will settle for a price level target.

In Case Fed Officials Needed More Evidence...

They should look no further than the Macroeconomic Adviser's monthly nominal GDP series.  This is a monthly indicator of total current dollar spending or aggregate demand in the United States.  It shows for August that aggregate spending declined at an annualized rate of decline of  1.69%.  More worrying, though, is that there is a downward trend in aggregate spending over the entire year. This downward trend is consistent with the quarterly forecasts of the Survey of Professional Forecasters that show a drop in the NGDP forecast. Here is monthly NGDP (click to enlarge): 

 

Now these numbers only go through August.  I suspect all the recent QE2 talk--and its effect on   nominal expectations and thus on current spending--may have to some extent arrested  this downward trend in NGDP.  Still the Fed should not let its guard down come the November FOMC meeting.

What Would Milton Friedman Say About Monetary Policy Today?

That is a question William Ruger and I address in an article at Investor's Business Daily. William is a colleague of mine and has just finished a scholarly biography of Milton Friedman. Here is the introduction to our piece :

Four years after his death, Milton Friedman's thoughts on monetary policy remain as relevant today as they were 30 years ago. Even Fed Chairman "Helicopter Ben" Bernanke (whose nickname comes from Friedman's famous "helicopter drop" idea for overcoming deflation) has referenced the Chicago don as an inspiration for his actions.

However, Friedman's views may not be well understood even by those who would claim him as their intellectual fountainhead — which could be problematic for policy-making. So what would Milton Friedman say about our current monetary policy?

We make the case that Milton Friedman would be supportive of more aggressive monetary action at this time. We note that Milton Friedman argued (1) low interest rates do not necessarily mean monetary policy is accommodative, (2) the Fed should target expected inflation, (3) the Fed should do what is necessary to stabilize nominal income, and (4) the Fed is not out of ammunition. Points (1) and (4) are made by Friedman in this article.  Point (2) is outlined in Friedman's book Monetary Mishief.  Point (3) is pervasive throughout Friedman's writings, but here is a recent example.  Our article also draws from Scott Sumner who has made similar arguments  before  about Milton Friedman.  

Lessons from the 1930s

Doug Irwin has a great article and podcast on the gold standard during the Great Depression.   Among other things, he notes that the countries that left the gold standard the earliest--a radical policy move at the time--were the first ones to experience economic recovery.  The whole discussion of how the gold standard contributed to the Great Depression is an interesting one and is instructive for today's economic issues.   I wish folks like Stephen Gandel, Tyler Durden, and David Rosenberg who see the Fed's QE2 not only as ill-conceived but as also having the potential to incite civil unrest would look to this period before making such claims.  If they did they would see how monetary experiments far more radical than QE2 actually ended the Great Depression.  They would also see that had such programs been implemented sooner  it is possible World War II may have been avoided.  Although a world war  is not imminent, there is the rising threat of a trade war.  And yes, there are lessons from the Great Depression even for this development. Here is Doug Irwin and Barry Eichengreen:

Today, the United States is in the position of the gold-standard countries in the 1930’s. It can’t unilaterally adjust the level of the dollar against the Chinese renminbi. Employment growth continues to disappoint, and fears of deflation will not go away. Lacking other instruments with which to address these problems, the pressure for a protectionist response is growing. 

So what can be done to address the situation without getting into a beggar-thy-neighbor, retaliatory free-for-all? In the deflationary 1930’s, the most important way that countries could subdue protectionist pressure was to use monetary policy actively to push up the price level and stimulate economic recovery. The same is true today. If fears of deflation were to recede, and if output and employment were to grow more vigorously, the pressure for a protectionist response would dissipate.

The villain of the piece, then, is not China, but the US Federal Reserve Board, which has been reluctant to use all the tools at its disposal to vanquish deflation and jump-start employment growth. Doing so would help to relieve the pressure in Congress to blame someone, anyone – in this case China – for America’s jobless recovery. Where the Bank of Japan has now led, the Fed should follow.

QE2 would get exported to China and other economies that peg to the dollar.  Obviously, this presents  problems for China and it may resist QE2, as we saw with their interest rate increase yesterday. In the long run, though, QE2 going to China and other places should provide added global stimulus and may even help rebalance the world economy.

A Natural Experiment in the Making

Martin Wolf makes an interesting point today in his column.  He argues that the divergent policy paths of the United States and the United Kingdom are providing a natural experiment on the efficacy of "expansionary" fiscal austerity:

The US and UK have similarities that go beyond speaking the same language: both had huge expansions in household credit; both had to rescue their financial sectors; both have watched their central banks push interest rates close to zero and adopt “quantitative easing”; and both have experienced massive post-crisis increases in fiscal deficits. Yet a big policy divergence is on the way. The coalition government of the UK will on Wednesday announce details of their cuts in government spending. Nothing comparable is expected in the US...What we do know is that the UK has launched a remarkable policy experiment. The contrast with the US should at least be instructive.

While this will make for an interesting comparison going forward,  it will be difficult to disentangle the effects of monetary policy from that of fiscal policy.  Martin wolf cites an IMF study in his column that speaks to this issue.  This study shows that many of so called "expansionary" fiscal contractions  occurred because monetary policy was providing accommodation via lower interest rates and/or a currency depreciation.  Scott Sumner made a similar point a while back.  He argued it is nearly impossible to estimate the true size of the fiscal multiplier and thus the actual effect of fiscal stimulus because monetary policy will typically offset such actions.  Still, the diverging policy paths of the US and UK  will be interesting to watch. 

Bernanke's Speech

After all the excitement from the FOMC minutes released earlier this week, Bernanke's speech was a bit of let down.  The FOMC minutes showed a number of participants had discussed explicit inflation, price level, or NGDP level targets as a way to better shape nominal expectations.  I was hoping for a follow-up from Bernanke today.  Instead, all we got was an acknowledgment of the obvious.  Others share a similar disappointment.  For example, here is James Politi:

Ben Bernanke, Federal Reserve chairman, did not satisfy everyone’s desires for a decisive, comprehensive, statement on what the US central bank will be doing to address the sluggish recovery in his speech today in Boston.

For instance, he did not even touch some of the more radical moves to tackle inflation expectations that were mentioned in the minutes from the last FOMC meeting in September, such as a nominal gross domestic product target or a price level target.

And here is Brad DeLong:

I am still surprised at the Fed Chair we have. Where is the Fed Chair who was willing to try to get ahead of the problems in late 2008? Or the "Helicopter Ben" of 2003? Or the student of big downturns in Japan in the 1990s and the U.S. in the 1930s.

I hope Bernanke is simply holding his cards close to his chest as cautious central bankers tend to do.  If so, it still is far from optimal. If Bernanke plays his cards right in shaping nominal expectations, a dramatic expansion of the Fed's balance sheet may not be necessary.  All he and the rest of the Fed have to do is state an explicit nominal target and say that they will do whatever is necessary to maintain that target.  This would create far more certainty and better focus the market expectations than the current approach of trying to divine the Fed's true intentions.  We see glimpses of this possibility with the pick up in inflation expectations following all the QE 2 talk by Fed officials. So make it official Ben, announce an official NGDP level target!

P.S. Sorry, I couldn't resist putting in another plug for a NGDP level target in the last sentence. 

About That Bretton Woods 2 vs. QE 2 Showdown...

Apparently it was the topic de jour at the IMF annual meetings this past weekend.  Though framed as a "currency war" by some IMF participants, Martin Wolf explains it is really about two rebalancing acts in the global economy:

The first is internal rebalancing – a return to reliance on private demand in advanced countries and retrenchment of the fiscal deficits that opened in the crisis. The second is external rebalancing – greater reliance on net exports by the US and some other advanced countries and on domestic demand by some emerging countries, notably China.

As noted by Wolf, it just so happens that both of these rebalancing acts can be addressed by one policy response: aggressive monetary easing by the Fed.  That now seems to be happening in the form of QE 2.   The Fed, though, is not purposely trying to tackle both  rebalancing acts.  Rather, it is simply trying to shore up aggregate demand (AD) in the U.S. economy and spur an economic recovery.  Doing so would solve the first rebalancing act.  Now because the Fed is a monetary superpower, its attempts to shore up U.S. AD will get exported to many other countries in the world, particularly those those dollar bloc countries that pegged in some form to the U.S. dollar and do so in a manner  that maintains external competitiveness.  It is these same countries that are a  key part of the second rebalancing act. They are not pleased by this development as it implies either (1) letting their currencies appreciate against the dollar and losing some external competitiveness or (2) intervening in foreign exchange markets to prevent this appreciation from happening and allowing a large expansion of their domestic money supplies. Either way, the second rebalancing act will occur: dollar block countries' currencies will appreciate or their domestic prices will increase.  

For the dollar block countries they see a "currency war" and want to fight back. For the Fed it sees weakening AD  and is determined to stabilize it.  So who will win this global economic showdown at the OK Corral?  Martin Wolf says there is no doubt to the eventual outcome of this exchange:

The US must win, since it has infinite ammunition: there is no limit to the dollars the Federal Reserve can create. What needs to be discussed is the terms of the world’s surrender: the needed changes in nominal exchange rates and domestic policies around the world.

For all the talk of the U.S. demise, this showdown looks to be one where the United States gets to show it is still a superpower.

A Bombshell in the FOMC Minutes

Contrary to what some observers are saying, the FOMC minutes released today reveal a big change in terms of policy options being discussed by the Fed.  For the first time the FOMC has discussed the possibility of targeting the level of NGDP.  Here is the key excerpt (my bold):

With short-term nominal interest rates constrained by the zero bound, a decline in short-term inflation expectations increases short term real interest rates (that is, the difference between nominal interest rates and expected inflation), thereby damping aggregate demand. Conversely, in such circumstances, an increase in inflation expectations lowers short-term real interest rates, stimulating the economy.Participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP.

This is huge.  The FOMC is now discussing a NGDP level target, a topic that has has been promoted in the economic blogosphere. For those of us who have been advocating this approach for some time (e.g. here and here) this is incredibly refreshing.  Maybe they are listening to us after all.  Lest you think I am reading too much into the above excerpt from the FOMC minutes, here is what David Pearson, a money manager who follows the FOMC closely, had to say about it:

[T]he Fed is careful in how it chooses its words in both the statements and minutes. Minority views are often referred to in the context of “a few participants noted…” or, “one participant commented that…” Today’s minutes tell us that, “Participants noted a number of possible strategies…” Notice the lack of a qualifier. That this was used to describe the discussion of both price and NGDP level targeting implies a surprising degree of consensus and openness around something never floated before in the minutes. Further, when someone pounds the table and says, “no way”, the minutes usually will say something like, “one participant expressed a concern that adopting such strategies might risk unanchoring expectations…” To do otherwise would be to pretend an strong objection was not raised.

So apparently they all sat around a table discussing that price and NGDP level targeting might be a good thing, and no one blew a gasket. This, I believe, is news.

Unfortunately, we will have to wait until the transcripts are released in six years to learn who actually was discussing NGDP level targeting.

Bretton Woods 2 vs. QE 2: Smackdown of the Decade?

My thinking on QE 2 has always been from a cyclical perspective. Thus, in my view calls for the Fed to do more to shore up aggregate spending and stabilize nominal expectations occur because these things had fallen off their long-term trend during the past recession.  I had not been envisioning QE 2 as ushering in a structural shift in the U.S. economy, let alone the global economy.  But according to both Ambrose Evans-Pritchard and Tim Duy I may be missing something here.  These two observers are making the case that QE 2 will turn out to be nothing less than a crude but effective assault on the Bretton Woods 2 system.  Here is Evans-Pritchard:

Asian investment in plant has run ahead of Western ability to consume. The debt-strapped households of Middle America, or Britain and Spain, can no longer hold up the dysfunctional edifice. Asians must take over, or it will come down on their own heads.

The countries actively intervening in exchange markets to suppress their currencies – China, Japan, Korea, Thailand, even Switzerland, to name a few – are all too often the same ones that have the biggest trade surpluses with the US...

Yet this is an intolerable situation for the US. It should be no surprise that Washington has begun to retaliate in earnest...The atomic bomb, of course, is quantitative easing by the Federal Reserve. America has in effect issued an ultimatum to China and G20: either you stop this predatory behaviour and agree to some formula for global rebalancing, or we will deploy QE2 `a l’outrance’ to flood your economies with excess liquidity. We will cause you to overheat and drive up your wage costs. We will impose a de facto currency revaluation by more brutal and disruptive means, and there is little you can do to stop it. Pick your poison. 

Wow, QE 2 will be the atomic bomb that ends Bretton Woods 2.  Evans-Pritchard has always had a way with words. Tim Duy agrees and is concerned that international tensions could escalate:

The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder. The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next. Call me pessimistic, but right now I don't see how this situation gets anything but more ugly.

Note that this line of thinking recognizes the Fed as a monetary hegemon.  Its monetary policy get exported to the much of the world and thus, QE 2 will get exported as well.  Consequently, many countries will have to either (1) let their currency appreciate against the dollar and lose some external competitiveness or (2) intervene in foreign exchange markets to prevent this appreciation from happening.  The latter option, however, comes at the cost of an increase in their own money supply that will, as Evans-Pritchard notes, lead to a massive stimulus in their own economy. (They could sterilize this increase in the money supply, but it too  creates a quasi-fiscal cost.) Might this latter development become too much to bare and lead to the break-up of the Bretton Woods 2 system? Maybe, but given the scope and reach of  the U.S. dollar as a reserve currency this would be quite the feat.

What Do John Cochrane and Milton Friedman Have In Common?

Yes, they are both well-known economists from the University of Chicago, but there is more.   Milton Friedman in the early 1990s called for the Federal Reserve to start targeting the expected inflation rate implied by the difference between the nominal treasury yield and the real TIPs yield.  He made this call in his book Monetary Mishief.* Now John Cochrane is advocating this approach too:

[T]he Fed can target the thing it cares about – expected CPI inflation – rather than the price of gold.  To do it, the Fed can target the spread between TIPS (Treasury Inflation Protected Securities) and regular Treasurys, or CPI futures prices.  Here’s a simple example. Investors buy a CPI-linked security from the Fed for $10.  If inflation comes out to the Fed’s target, they get their money back with interest,  $10.10 at 1% interest. If inflation is 2 percent below target, the Fed pays $2 extra -- $12.10.  This pumps new money into the economy, with no offsetting decline in government debt, just like the helicopter drop. If inflation is 2 percent above target, investors only get back $8.10 – the Fed sucks $2 out of the economy at the end of the year.  If investors think inflation will be below the Fed’s target, they buy a lot of these securities, and the Fed will print up a lot of money, and vice versa.

I am thrilled to see a prominent economist like John Cochrane promoting this forward-looking approach to monetary policy. Had the Fed had such a target in place in 2008 it would have seen a drop in inflationary expectations well before Lehman's crash.  But it did not and, as result, it sat passively by and allowed an effective tightening of monetary policy during 2008. 

Of course, I would like the Fed to do one better and adopt a forward-looking NGDP target.  A foward-looking NGDP target would be more effective because the NGDP target focuses on that which the Fed has influence: nominal spending.  A forward looking inflation target may at times lead the Fed to respond to more than just nominal spending shocks.  This is because movements in inflation can reflect both aggregate demand and aggregate supply shocks. Macroeconomic stability requires the Fed only respond to former and ignore the latter.  With that said, I am happy to see John Cochrane pushing this debate in the right direction.  

(Hat Tip: Scott Sumner)

*The idea for targeting the expected inflation rate implied by TIPs originated with Robert Hetzel.  Interestingly, he too is a product of the University of Chicago.

Is This Really It?

I want to believe but will wait for further confirmation that the uptick in expected inflation--a proxy for  expected aggregate demand--is truly a change from the downward trend of January-September 2010.  For now, though, it does seems all the chatter coming from William Dudley, Brian Sack, Eric Rosengreen, Charles Evans, and other Fed officials on QE2 is doing a great job in changing inflation expectations.  Here is the expected inflation rate on the five-year treasury up through October 5 (Click on figure to enlarge.):

I was planning on waiting for further confirmation before commenting on this apparent shift in inflation expectations, but decided to go ahead and note it given its recognition by Paul Krugman. So here are my thoughts:

(1) This upward movement in expected inflation means the Fed has already begun a passive easing of monetary policy well before the actual QE2 has been implemented. Because future economic activity influences present economic activity, the Fed is already influencing current aggregate spending by altering expectations.   

(2)  There is still an overall downward trend for 2010.  This downward trend means the Fed allowed passive monetary tightening for most of the year and it now is being reversed.   There is a lot  of ground to made up.    

(3) Nothing guarantees that this uptick has permanently changed the downward trend for 2010. As can be seen in the figure above, expectations started to recover in April by a similar amount but subsequently fell as the Eurozone mess intensified and drove up the demand for liquidity.  Something similar could happen this time too as there are still plenty of problems lurking in the global economy.  Moreover, we may get to the November FOMC meeting and find the actual QE2 may be much less than the market expected. Not everyone on the FOMC is supportive of QE2. This too would push expectations back down and led to more passive tightening of monetary policy.

(3) Right now the change in expectations is based on the chatter coming from Fed officials.  This requires carefully examining their words and determining how much influence each Fed official has on the FOMC.  How much better it would be if the Fed followed Milton Friedman's suggestion outlined in his book Money Mischief and set an explicit target for the expected inflation rate. This would add more certainty than currently comes form diving the words of Fed officials. I actually would prefer--and believe Friedman would endorse it--for the Fed to target expected NGDP.  But for reasons outlined by Karl Smith, I would settle for an explicit expected inflation target at this point.

So is this really it? Has the Fed finally decided to get serious about stabilizing nominal spending?  I hope so.

Update: Dallas Fed President Richard Fisher in a speech today suggests that the market might be ahead of itself in assuming that QE2 is done deal (my bold):

I am afraid that despite recent speculation in the press and among market pundits, we did little at that meeting to settle the debate as to whether the Committee might actually engage in further monetary accommodation, or what has become known in the parlance of Wall Street as “QE2,” a second round of quantitative easing. It would be marked by an expansion of our balance sheet beyond its current footings of $2.3 trillion through the purchase of additional Treasuries or other securities. To be sure, some in the marketplace―including those with the most to gain financially―read the tea leaves of the statement as indicating a bias toward further asset purchases, executed either in small increments or in a “shock-and-awe” format entailing large buy-ins, leaving open only the question of when.
[...]
There is a great deal of legitimate debate still to take place within the FOMC on the subject of quantitative easing and the pros and cons and costs and benefits of further monetary accommodation. Whatever we might do, if anything, must be consistent with long-term price stability and not add to the nightmare of confusing signals already being sent to job creators.

The Quasi-Monetarist

Scott Sumner summarizes the key tenets of those who observers, including myself, who have been labeled as quasi monetarists by Paul Krugman :

1.  Like the monetarists, we tend to analyze AD shocks through the perspective of shifts in the supply and demand for money, rather than the components of expenditure (C+I+G+NX).  And we view nominal rates as an unreliable indicator of the stance of monetary policy.  We are also skeptical of the view that monetary policy becomes ineffective at near-zero rates.

2.  Unlike monetarists, we don’t tend to assume the demand for money is stable, and are skeptical of money supply targeting rules.

As I noted before, quasi-monetarists are not that different from other folks who see an AD problem in the economy.  One defining difference, though, is that quasi-monetarists see the insufficient AD issue ultimately as an excess-money demand problem and believe the Fed could meaningfully address it.   Another defining difference is that quasi-monetarists were calling for more Fed action long before it was vogue.  Thus, early on in the recession when other folks were calling for fiscal policy to address the AD problem, quasi-monetarists were instead calling for the Fed to step up and address the fall in nominal spending. 

Does the quasi-monetarist's emphasis on excess money demand have any merit? Is there any evidence that the AD problem is ultimately an excess money demand problem?  Drawing on Gary Gorton's work that shows repos are a form of money--an understanding supported by the fact the now discontinued M3 money supply  included repos--for the shadow banking system, the blogger 123 presents evidence from a natural experiment around the time of the Lehman collapse that  shows there was a sudden spike in the demand for money.  Below are charts that present further evidence that there has been an elevated increase in the holdings of cash and other highly liquid (i.e. cash equivalent) securities by households, businesses, and banks.  These charts come from Eric Rosengren's recent speech:  (Click on figures to enlarge.)

Though Eric Rosengren does not call himself a quasi-monetarist, his speech is consistent with this view: it argues there is a AD problem, it shows the above graphs that indicate an elevated increase in money demand, and it calls for more aggressive Fed action to address these problems. Rosengren's implicit endorsement of the quasi-monetarist's view is probably not unique.  I suspect most folks who see the need for more Fed action would, after some reflection on the excess money demand take on the AD problem, consider themselves a quasi-monetarist.  Are you?

More Evidence That There is a Serious AD Problem

Eric Rosengren, President of the Federal Reserve Bank of Boston,  recently delivered a speech  where he presented further evidence that the problems in the labor market are more the result of weak aggregate demand than structural factors:

[I]n each of the three previous recessions there was a decline [in employment] of 5 percent or more in no more than two industry categories – as the figure shows – with many industries experiencing little or no net job loss over the course of the recession. Structural hifts acrossindustries are not uncommon in recessions – and also, some structural dislocation seems inevitable as it will always take some time for capital and labor to flow to those industries with the greatest opportunities.

In rather stark contrast, the most recent recession is far less a reflection of dislocation in a few industries but rather reflects a general decline in almost all industries. As the chart  [below] shows, in this recession there has been a peak to trough loss of employment of 5 percent or greater in construction, manufacturing, retail trade, wholesale trade, transportation, information technology, financial activities, and professional and business services. To me, this does not suggest that the driver is structural change in the economy increasing job mismatches – although no doubt some of that exists – but instead I see here a widespread decline in demand across most industries.

Here is the accompanying figure from his speech (Click on figure to enlarge):

With this evidence from the labor markets in mind take a look at this figure on final sales of domestic product, a measure of aggregate demand: (Click on figure to enlarge.)

This figure shows that the growth rate of AD remains low and by implication the level of AD is also well below trend. After examining these graphs it is hard not to think insufficient aggregate spending is a serious problem now facing the economy.  Yes, there are structural problems but they are only being made worse by the lack of appropriate monetary policy actions to stabilize AD. 

More on TARP

As a follow-up to my previous post on TARP, here are some more commentaries on the end of this proram. A key point these pieces make is that while TARP saved the financial system it did so at the cost of significantly increasing moral hazard and thus planted the seeds of the next financial crisis:

(1) Count on Sequels to TARP--Gretchen Morgenson

(2) Going Viral: Why TARP, Like Herpes, is a "Gift" that Keeps on Giving--Alain Sherter

(3) The End of TARP: Goodbye and Good Riddance--Henry Blodget and Aaron Task

We Are All Quasi-Monetarists

Paul Krugman weighs in on the debate stirred up by my post on the excess demand for money:

Brad DeLong manfully takes on the efforts of various commentators to define away the paradox of thrift and redefine our current problems as somehow wholly monetary. As I see it, this is all a desperate attempt to cut and stretch things into a quasi-monetarist framework, for no good reason. 

So those of us who believe that all along the Fed could have done more, should have done more, and still should be doing more are now "quasi-monetarists." Fine, but addressing the above list of  Fed shortcomings was the  ultimate point of  my post.   Yes, I did this by pointing out that the current aggregate demand problem is at its core an excess money demand problem.  And, thus, policymakers who wish to address the AD problem must ultimately address an excess money demand problem.  Here, I was just attempting to take a deeper look at the AD problem from a monetary perspective.  DeLong really didn't disagree with my assessment, he just questioned how the Fed could address the excess money demand problem in practice.   The fact is we really aren't all that different on this issue.  Even Krugman at some level is a quasi-monetarist--he has to be given we live in monetary economy.  This point is forcefully made by both Nick Rowe and Scott Sumner in their replies to Krugman.

Update: Josh Hendrickson adds further perspective on this debate.