A Sharp Expectation Shock is Needed

Via the FT's Alphaville we learn that Goldman Sachs is discussing some "radical" options the Fed could use if economic conditions deteriorate further. One of the options discussed is a nominal GDP level target. It would be a radical change from way the Fed currently operates, but such a shock is exactly what the public now needs.  For the past few years the economic outlook of households and firms has been dismal and consequently they have had been accumulating a large stock of money assets.  If the Fed were to announce a nominal GDP level target it would provide a big expectation shock that would reverse much of this buildup.  

One of the ways this shock would play out is through the many more observers who would be wailing about the reckless course of monetary policy, the horrors of debasing the dollar, the end of Western Civilization, and other hard money concerns.  Similar concerns were raised when FDR effectively did the same thing in 1933 with his own QE and price level target program.  These concerns about FDR's program provided a much needed shock to nominal spending and inflation expectations.  As a result, there was robust recovery from 1933 to 1936.   A nominal GDP level target would provide the same kind of shock today if it were properly signaled and followed through by the Fed.

It would require the Fed to buy up assets until the nominal GDP level target was reached. In other words, the Fed would be committing if needed to a permanent increase in the monetary base, something it has yet to do as recently noted by Michael Woodford.  The effectiveness of such a shock would not be contingent on increased financial intermediation (though it ultimately would be affected too). Rather, this shock would work two ways. First, by raising inflation expectations, it would increase the cost of holding money assets for the non-bank public. This would create a hot-potato effect for non-bank holders of money assets and that, in turn, would lead to a mother-of-all portfolio rebalancings. Ultimately, this rebalancing would end with higher nominal spending. Second, it would simultaneously cause nominal spending forecasts to rise and this too would lead to more current nominal spending. Given the large slack in the economy, the increase in nominal spending would mean a rise in real economic activity.

But enough from me. Here is what Goldman Sachs has to say about nominal GDP targeting:

[W]e have again received some questions about the possibility that the FOMC might move to a nominal GDP target ... It’s important to note that depending on the interpretation, the Fed’s dual mandate (in which policy responds to both employment/real GDP and inflation) already has some similarities with a nominal GDP target (in which policy responds to the product of real GDP and the price level). The key differences are that (1) an announced nominal GDP target is much simpler and therefore more powerful than the hazier dual mandate, which is interpreted differently by different people; and more importantly, (2) the dual mandate is defined in terms of rate of change of prices, while a nominal GDP target depends on the level of prices. ...The implication is that a nominal GDP target, Fed officials attempt to “make up” for past undershooting of inflation via future overshooting. In other words, a move to a nominal GDP target is tantamount to a temporary increase in the inflation target.

I am glad to see Goldman Sachs telling its clients about nominal GDP targeting.  The fact that nominal GDP targeting is now being discussed by Goldman Sachs, The Economist, The Financial Times, The Wall Street Journal, The Telegraph, The National Review, and other media outlets means this idea is gaining traction. The public needs a sharp expectation shock and a nominal GDP level target is radical enough to do it.

The Economist Magazine Takes a Closer Look at NGDP Targeting

Here is the article.  It does a fair job discussing the pros and cons of such a rule.  Among the advantages for NGDP level targeting is that it better handles supply shocks:

They could also react more appropriately to supply shocks. Take the example of an economy that is hit by a negative supply shock through high oil prices depressing output and raising inflation. An inflation-targeting central bank may feel compelled to tighten policy, worsening the slump in output, whereas one mandated to hit NGDP could be more flexible. There could be advantages, too, in the opposite case where a positive supply shock through productivity-enhancing new technology boosts real GDP growth while lowering inflation. An inflation-targeting central bank would respond by easing monetary policy, which could produce asset bubbles, whereas an NGDP-targeting central bank would hold steady. Certainly inflation would be more volatile, but the overall economy would not be.

One of the disadvantages is how to adopt and implement a new rule when it is not widely known:

 For all its theoretical merits, a switch to NGDP targeting would throw up some new problems—and old ones. The Fed has not exactly sat on its hands since the financial crisis began in 2007, so it is far from clear it could easily reach the new goal.

The short answer is that the Fed would announce (1) its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it.  Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting.  That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause nominal spending to adjust largely on its own.   I go into more detail here how this would work, but the key point is the Fed would be better managing nominal spending expectations.  Such a rule would have better contained nominal spending expectations in 2008 and avoided the worst of the crisis. Just look at Sweden who effectively does something like a nominal GDP level target.

Update: Bill Woolsey provides much more commentary on The Economist article.

Does Higher Expected Inflation Really Spur Spending?

I will let the data answer the question.  To do that, I took the Cleveland Fed's monthly 10-year expected inflation rate series and plotted it against the subsequent growth in nominal consumer expenditures.  I looked at a one, two, and three-year horizons for subsequent consumer spending growth.  Below are the scatterplots created from this exercise. (The data starts in 1982:1 since that is the beginning of the Cleveland Fed's expected inflation series.) 

Not only is there a strong relationship, but it gets stronger at longer horizons for consumer expenditures.  So changes in expected inflation do affect nominal spending.  This is nothing new and is a central tenet of modern macroeconomics.  I only bring it up now because some observers have questioned whether there really is this relationship.  Reviewing this relationship also reminds us why it is important for the Fed to be clearer about the future path of monetary policy.

Update: I used expected inflation above because that has been the focus of recent debates. As an advocate of nominal GDP targeting, I believe a better perspective is to look at nominal spending expectations.  To do that, I  went to the Survey of Professional Forecasters and took the average annualized quarterly growth rate forecasted for nominal GDP over the next year and compared it to the actual growth of nominal GDP over the next year. Here is the figure:

Once again, expectations matter.

Michael Woodford Explains the Problem with Fed Policies

Michael Woodford, one of the top monetary theorist in the world, has an Op-Ed today that does a great job explaining why the Fed's policies have failed to gain traction in the economy.  His key point is that the Fed has failed to clearly communicate the path of future monetary policy.  In so doing, the Fed has failed to shape expectations forcefully enough to make a dent in nominal spending.  In other words, the problem is not that the Fed cannot do anything, but that the Fed has failed to act properly.  Woodford says a price level target would solve the problem (and by implication so would a nominal GDP level target) of properly shaping nominal expectations. 

Here is Michael Woodford making his point by showing the flaws with the Fed's QE programs:

The economic theory behind QE has always been flimsy...The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan’s experiment with QE, the added reserves were all rapidly withdrawn in early 2006. The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves permanent and also to allow the temporary increase in inflation that would be required to permanently raise the price level in that proportion.

The one time QE did work was for FDR during the 1933-1936 period.  The big difference between then and now is that FDR's QE program was supported by an explicit price level target that FDR himself promoted.  Also, the monetary base creation supporting FDR's QE program was permanent as can be seen by the figures in this post. FDR knew how to do QE right. 

Michael Woodford also addresses the portfolio channel of monetary policy that been used as an argument to support the Fed's QE programs (my bold below):

A more recent argument for QE stresses not the increase in reserves, but the change in the composition of assets held by the Fed. But asset trades of modest size by a central bank are unlikely to affect prices, unless the markets in question have seized up. 

Once again, the point is not that portfolio channel does not work but rather that the Fed has to be fully committed to using it. The Fed needs to unload both barrels of the gun.  By only engaging in asset trades of modest size, the Fed is not doing enough to meaningfully shock and shape nominal expectations.  Here too an explicit price level or nominal GDP level target would be useful.  For such a monetary policy target would tell the public that the Fed intends buy up as many assets as necessary to hit the level target. It would not stop at some arbitrary amount like it did with the $600 billion of QE2.   Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its level target would cause the market itself to do much of the heavy lifting.  Investors would adjust their portfolios in anticipation of the higher inflation and nominal spending. This seems to have worked in Sweden where larger asset purchases (25% of GDP versus the Fed's 15% of GDP) combined with an explicit inflation target (that works more like nominal GDP level target) has brought a robust recovery.

Michael Woodford ends his piece with these recommendations:

Mr Bernanke can and should use his speech today to explain how his policy intentions are conditional upon future developments...A clarification could help the economy in two ways. First, he could signal that a temporary increase in inflation will be allowed, before policy tightening is warranted. This would stimulate spending by lowering real interest rates. Second, specifying the size of any permanent price-level increase would avoid an increase in uncertainty about the long-run price level. This in turn would ward off an increase in inflation risk premiums that might otherwise counteract the desirable effect of the increase in near-term inflation expectations.

In other words, he thinks the Fed should adopt a price level target. I wonder what he thinks about a nominal GDP level target.

The Washington Post Is Confused About Monetary Policy

Fortunately, Ramesh Ponnuru is here to clear up the confusion.

The Other Side of Household Balance Sheets

A popular explanation for the ongoing economic slump is that the United States is in the midst of a balance sheet recession.  This view holds that the vast amount of household debt built up during the housing boom is now being unwound and that this deleveraging is creating a drag on the economy.  Though intuitive, this balance sheet recession view is inadequate because one, it ignores the potential offset in spending by creditors and two, it misses a more fundamental problem: the elevated demand for liquidity.  I believe one of the reasons for this confusion is that advocates of the balance sheet recession view tend to focus on the liability side of household balance sheets while ignoring the details of the asset side.  A close look at the asset side reveals that despite the collapse in overall household assets, there has been a inordinately large buildup of liquid assets.  It is this accumulation of money and money-like assets rather than the deleveraging itself that has kept nominal spending from experiencing a robust recovery.  Here are the numbers.

From the peak of household asset values in 2007:Q2 to the latest data for 2011:Q1, households have lost around $9.4 trillion worth of non-liquid assets. Despite these large losses and the subsequent slump in personal-income growth, households have somehow increased their holdings of money and money-like assets by a staggering $1.6 trillion as seen in the figure below:  

The composition of the increase in liquid assets is also interesting. Most of the increase has come in the form of time and saving deposits, though treasuries have been important too.  Money assets alone (cash, checking account, time and saving deposits, money market accounts) have remained elevated and close to their peak value in late 2008.  And, as John B. Taylor notes, money demand appears to be growing even more. 

I personally place more importance on the growth of the money assets  in slowing down nominal spending for two reasons.  First, they are fixed in nominal value and thus only grow by households actively acquiring them.  Treasuries, on the other hand, may be increasing through acquisition and valuation change.  Second, the demand for liquid assets in general can only affect nominal spending by influencing the medium of exchange, money.  It is the only asset on every other market and thus is the only asset that can directly affect nominal spending.  An elevated demand for treasuries matters, then, by by spilling over to the demand for money.   

As a share of total assets, household's liquid assets have risen and remained elevated as seen in the figure below.

Now some may note that the rise in the share of liquid assets is not all that large in terms of percentage points.  A rise in the share of liquid assets, however, does not need to be terribly large to impede nominal spending.  This is especially true with money assets because they are the medium of exchange.  One would expect nominal spending to be sensitive to changes in money demand.  The figure below confirms this.  It shows the relationship between the growth rate of money assets as a share of total assets and the growth rate M3 velocity for the period 1951:Q4 through 2011:Q3.  (The M3 data comes from NowandFutures.) The relationship is surprisingly strong, given that money velocity can also be affected by factors like innovations in financial transactions.  

Observers, therefore, need to be paying more attention to the build up of money assets in household balance sheets.  Until this development changes, there will be an ongoing drag on nominal spending.  One way to address this problem is to introduce a nominal GDP level target. This is how it would work in practice.

Update:  In the comment section I further explain why excess money demand rather than deleveraging is the reason for the weak aggregate demand.

Central Banks Still Have Much Ammunition

Ambrose Evans-Pritchard writes there is still much monetary policy can do to support the economy:

[W]ith fiscal policy exhausted, the burden must fall on monetary policy. Here we have barely begun to use our atomic arsenal even at zero rates. As Milton Friedman taught us – though nobody in Frankfurt -- it is a fallacy to think that low rates are loose. Zero can be extremely tight. 

That may be the case now with US Treasury yields signalling deflation and M2 velocity collapsing as it did pre-Lehman. 

To those who argue that the Fed is pushing on the proverbial string, David Beckworth from the University of Texas replies that the Fed showed between 1933 and 1936 that it could deliver blistering growth of 8pc a year despite debt deleveraging in the rest of the economy.

He is referring to this post where I noted the following:

[H]ouseholds were also significantly deleveraging during the Great Depression.  This experience would fit the standard definition of a balance sheet recession.  Below is a table from his paper that shows household balance sheets in real terms.  Note that between the 1933 and 1936 U.S. household underwent a cumulative deleveraging  in real terms of 20%. This is far more in percentage terms that has happened over the past few years. And yet between 1933 and 1936 the U.S. economy had a robust recovery.  Real GDP averaged almost 8% growth during these years. 

   Source: Mishkin

The balance sheet recession view cannot easily reconcile the large deleveraging by households and the rapid real economic growth that occurred between 1933 and 1936.  What can explain it is a more nuanced view that acknowledges creditors with excess money demand were confronted by FDR's original quantitative easing program.  This QE program was far better than recent ones in that FDR clearly signaled a price level target and backed it up by devaluing the gold content of the dollar and allowing unsterilized gold inflows. In otherwords, FDR signaled that he was going to allow a significant and permanent increase in the monetary base and followed through on it.  This change nominal expectations and caused creditors to start spending their money balances.  

Unfortunately, the 1933-1936 recovery was cut short by a tightening of monetary and fiscal policy.  Consequently, many observers overlook this great natural experiment of monetary policy that shows monetary policy does not push on a string when there is significant deleveraging.  

Another natural experiment is present-day Sweden.  Its housing sector also acquired much debt and its economy was also hit hard by the economic crisis.  However, it has had a robust recovery and the reason appears to be a much more aggressive monetary policy.  All of this shows that monetary policy still can pack a punch.  The question, then, is whether the Fed has the desire and political capital to do so.

Update:  The Mishkin table above is in real terms.  To see what was happening to nominal household debt, I constructed the two tables below.  The first one converts the Mishkin table into nominal growth rate terms using the CPI.  The second one uses current dollar data from the 1940 statistical abstract on "individual and other noncorporate" debt.  Both tables indicate nominal household debt was falling through 1935.  So the recovery of 1933-1936 largely coincided with a reduction in household nominal debt too.

It's Getting Ugly

Michael Darda sees trouble in the decline of long-term yields and attributes it to a negative velocity shock:

The U.S. 30-year “long bond” yield has collapsed below the 2010 lows, an ominous sign, in our view. Although some (mistakenly, in our opinion) associate low rates with easy money, we view the collapse in yields across the Treasury term structure as an unambiguous sign of weaker nominal growth expectations. In technical terms, it would appear that a negative velocity shock is under way...

Broad money velocity in the U.S. is collapsing at the fastest rate since the end of the 2007-2009 recession. In other words, the recent pickup in broad money in the U.S. looks like a dash for risk-free cash assets, which also occurred in 2008 and 2001 as velocity collapsed. Widening credit spreads, a collapsing term structure and flat bank credit also are consistent with low/falling velocity.

In more graphic terms, the recent spate of bad economics news coming from the U.S. and Europe is ramping up the money demand black hole as investors rush back into money and money-like assets.  Velocity is dropping fast because of this spike in money demand and, as a result, current and expected current dollar spending is falling too.  This is, in turn, is causing the economic outlook to decline and is the development to which long-term yields are responding.  Ideally, the Fed would respond to the money demand black hole in a systematic, predictable manner that would bring certainty to the market.  Unfortunately, the Fed is not doing that and continues to allow a passive tightening on monetary policy. 

Getting Serious About the Tight Money Problem

Ramesh Ponnuru says monetary policy is not loose, but tight:

The Federal Reserve is now the subject of more political controversy than at any point since the beginning of the 1980s.  The debate centers on what the Washington Post calls its “ultra-easy” monetary policy: Is it hurting or helping the economy? Has the Fed already loosened so much that it has used up its ability to stimulate the economy?

It’s a heated debate, but its premise happens to be wrong. We don’t have loose money, and we haven’t during our entire economic slump. A big reason that slump has been so deep and long is that the Fed is keeping money tight: It’s not letting the money supply increase enough to keep current-dollar spending growing at its historical rate.

In other words, by not responding to changes in money demand since the crisis started, the Fed is effectively tightening monetary policy.  This passive tightening of monetary policy is just as damaging as an active tightening of monetary policy.  The result is that current dollar spending--the product of the money supply and money demand--is not where it should be, as seen in the figure below:

Bruce Bartlett makes a similar point.  He says that though the Fed has made some effort, it has not gone nearly far enough to offset the sustained decline in velocity: 

[T]he Federal Reserve could have offset the decline in spending and velocity resulting from the fall in home prices with a sufficient increase in the money supply. And it tried. Since 2006, money supply has increased by about $2 trillion. But velocity fell faster than the money supply increased as households reduced spending and increased saving — the saving rate is now over 5 percent — and banks and businesses hoarded cash.

The key, then, is to undo this largely passive tightening of monetary policy.  Here is how I would do it.

How Would Monetary Stimulus Help?

Edward Harrison and I have been cordially discussing what, if anything, the Fed could do to improve economic conditions.  Like many, he is understandably skeptical about the efficacy of monetary policy. He notes that households are repairing their balances sheets and the massive deleveraging they are doing along the way is putting a strain on the economy.  He wonders how the Fed could help in such a situation.   I, on the other hand, am more optimistic about monetary policy and believe the delevaraging is not much of a  constraint for the Fed.  Monetary stimulus was able to spur a robust recovery during the depths of the Great Depression from 1933 and 1936 and did so despite households delevaraging then too.  The question, then, is how could the Fed actually make a difference?  Below is part of an email exchange we had where I attempted to answer this question.  Harrison posted it on his blog and I thought it was worth reposting here.  Though I explain in the note how price level or nominal GDP level targeting could bring about a robust recovery in nominal spending, I really prefer nominal GDP level targeting for reasons laid out here. 

The key for the Fed to be effective is for it to radically change or "shock" expectations about future nominal spending.  The Fed would do this by announcing an explicit NGDP level (or price level) target where it publicly committed to buying up as many assets as it needed to return NGDP  (or the price level) to some pre-crisis level trend.  Since this would mean higher-than-normal NGDP (or price level) growth for some time (until the pre-crisis trend is restored), it would imply the Fed would be purchasing a lot more assets.  This would "shock" households and firms into spending their money assets on other riskier assets (like stocks and physical capital) as well as goods and services lest their money assets lose value from the higher expected inflation during the catch up growth period.

Some points:

1. Even if only the riskier financial assets are initially purchased, the sellers of the financial assets would now have money balances they will want to unload because of the higher inflation.  They too will start buying up other assets, goods, and services.  Eventually, then, the money assets will buy capital, goods, and services. This requires, though, that the Fed continues to buy up assets--including longer-term treasury securities-- until this happens, which is the very point of having a spending target like a NGDP level target--keep adding stimulus until nominal spending hits its target.
2. The key is to have a level target, not a growth rate target.  A growth rate target like inflation targeting lets bygones be bygones.  A level target allows for catchup growth and vice versa when there is a deviation from the target.  This allows for more aggressive monetary action in the short term, but at the same time creates more certainty over the long term since the policy aims for a target level growth path.
3. Having an explicit, well communicated nominal target means the Fed does not need to commit up front to an explicit  dollar amount of asset purchases.  This makes the policy less controversial, eliminates the need for successive rounds of ad-hoc QEs, and if credible will cause the markets to do the heavy lifting (i.e. if the markets believe the Fed is serious about higher nominal spending and inflation, they will respond on their own before the Fed purchases assets and thus lessen the needed amount of asset purchases by the Fed).
4. Not only have corporations, but households too have  built up relatively large share of liquid, money-like assets since the crisis.  All the talk about household deleveraging ignores that they have also been rapidly building up the share of liquid assets and thus curtailed spending.  The process above should help reverse this development.
5. Once the nominal spending takes off, there will be real economic gains, not just inflation, given the amount of excess economic capacity. (i.e. the increased spending will put unemployed resources back to work).
6. Because of (5), expectations of higher real growth will further reinforce current nominal spending and increase the demand for loans from banks.  Banks will respond to the increased demand for credit by extending loans.  The money supply grows in turn.

Rick Perry on Monetary Policy

There are many things I like about Governor Rick Perry, but his remarks on monetary policy make me what to cringe.  He had this to say in Iowa about Ben Bernanke and the possibility of QE3:

“If this guy prints more money between now and the election, I don’t know what y’all would do to him in Iowa, but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost … treasonous in my opinion.”

Governor Perry may have scored some points in the primary race with this comment, but the implication of the Fed doing nothing--a passive tightening of monetary policy--or even actively tightening would be very unpleasant for him.  Not only does tightening make it likely the U.S. economy will continue to weaken, it also makes it much harder to balance the federal budget.  As I have noted before, successful fiscal consolidation requires monetary easing. Doing so raises aggregate demand which, in turn, raises tax revenues and decreases cyclically-driven government spending (e.g. unemployment insurance).  Studies show (e.g. here, here, and here) that when fiscal austerity was associated an economic recovery it occurred because monetary policy was easing.  Tightening, on the other hand, would only further increase the cyclical budget deficit.  

Along these lines, a key lesson from the recent crisis and the Great Depression that Governor Perry should take to heart is that tight monetary policy opens the door for more active fiscal policy.  Imagine if the Fed had  stabilized nominal spending more effectively and thus prevented the economic collapse in late 2008, early 2009. It would have been a lot harder to justify the large fiscal stimulus package. The same is true for 1929-1933.  Had the Fed not been passively tightening monetary policy at that time there would have been far less political support for fiscal policy and government intervention in the economy.

I hope Governor Perry is listening. 

Monetary Policy Stimulus at the Zero Bound is Hard...

Except when it was done in Sweden over the past few years or when it was done between 1933 and 1936 in the U.S. economy.  In both cases short-term interest rates were at 0% and almost all the other characteristics of what a New Keynesian like Matt Rognlie would call a liquidity trap were present.  Monetary policy stimulus, however, proved to be very effective in both economies.

In Sweden, monetary authorities were aggressive with quantitative easing--their central bank's balance sheet rose to 25% of the GDP versus the Fed's 15%--and had an explicit inflation target.  This was enough to push nominal spending back to its pre-crisis, long-run growth path.  FDR also used aggressive monetary stimulus--arguably the original QE program--in conjunction with a price level target to spark a robust recovery that saw real GDP growth average around 8% per annum between 1933 and 1936. And it occurred despite a massive deleveraging by an indebted household sector. Unfortunately, this recovery was cut short by a tightening of monetary and fiscal policy in 1937.

So maybe monetary policy stimulus at the zero bound really isn't that hard after all.  Maybe we have made monetary policy harder than it really needs to be.

Clive Crook Says Fed Should Target Nominal GDP

The Financial Times (FT) is the one newspaper that has columnists who understand the virtues of nominal GDP targeting.  Samuel Brittan has been making the case for it over many years on the pages of the FT.  He did it most recently last year when he called for a rebranding of nominal GDP targeting so that it would be more easily understood by the public.  He suggested calling it something along the lines of  a total money spending objective.  Martin Wolf has also implicitly endorsed something like a nominal GDP target in his columns and has told me in an email exchange that he thinks it is a good idea.  Finally, Clive Crook has come out with a strong endorsement of nominal GDP targeting in his most recent column.  Here is an excerpt:

To make the case for new stimulus, the Fed needs better arguments. The past few weeks have settled, to my satisfaction at least, a long-running debate on this very topic. Rather than targeting inflation, central banks should keep nominal incomes growing on a pre-announced path: say 5 per cent a year. Nominal gross domestic product is the sum of inflation and growth in real output – and is the variable that monetary stimulus directly drives.

...The crucial point – how an increase in nominal GDP breaks down between output and inflation – is not something the Fed can determine, or should have to explain. There are pros and cons to this approach, but that is the decisive political virtue of casting the target this way.

When nominal GDP falls below track, monetary stimulus pushes it back. If inflation rises temporarily during catch-up, that is tolerated. In current conditions, this makes all the difference. The new GDP figures showed demand has fallen much further below trend than had been appreciated. With a nominal GDP target, that announcement would have led investors to expect new monetary stimulus.

 It is good to see these FT columnists supporting nominal GDP targeting.  Lest you think it is a pipe dream that the Fed will ever adopt a nominal GDP targeting rule, just remember that the FOMC talked about a  Nominal GDP level target back in its September, 2010 FOMC meeting.  Adopting a nominal GDP level target would also provide a nice way for Congress to narrow the Fed's mandate.

The FOMC Decides on Monetary Stimulus That is Fraught With Uncertainty and Danger

My initial reaction to the FOMC decision this week was disappointment.  That has not changed, but after reading other observations and thinking about it some more I am now disappointed for other reasons.  For the FOMC decision can be interpreted as adding monetary stimulus, but only in a way that creates further uncertainty and problems for the Fed.  Let me explain why.

The FOMC's new declaration that it will likely hold its target interest rate at 0.25 percent until mid-2013 can be viewed as creating new monetary stimulus.  As Matt Rognlie notes, the Fed through this policy has changed the expected path of future short-term interest rates to a lower level, one that implies greater monetary stimulus and thus higher economic activity in the future.  This future expansion, in turn, makes households and firms more likely to spend today because one, it improves their economic outlook and two, it lowers the real interest they face via higher expected inflation. Alternatively, one can take Justin Wolfer's view that this new path of low short-term interest rates in conjunction with the term structure of interest rates means lower long-term interest rates than would otherwise prevail.  This, then, provides the same outcome of another round of QE, but does so without the controversy surrounding the QE programs.  

This approach to monetary stimulus, however, is fraught with uncertainty for several reasons.  First, as noted by Bill Woolsey, the  lower interest rate path could alternatively be viewed as the Fed simply revising down its forecast through mid-2013 and accordingly adjusting its target interest rate to maintain the current stance of monetary policy, which has not been very stimulative.  In other words, the Fed now expects the natural interest rate to remain lower longer than expected and thus now expects to keep its federal funds rate target lower for a longer time too.  The more optimistic view of Matt Rognlie assumes that the expected future path of the federal funds rate will not only be lower longer, but that it will also be below its natural rate level and thus be stimulative.  Woosley's point is that this may not be the case.   Likewise, in Justin Wolfer's scenario this reasoning implies a drop in long-term interest rates could be reflecting a drop in the economic outlook rather than the Fed pushing long-term rates below their natural rate level.  Since no one knows for sure, this creates more economic uncertainty. 

A second reason this policy creates more economic uncertainty is that it was not accompanied by an explicit level nominal target.  Thus, even if Rognlie's and Wolfer's assessments are correct, one still does not know how long or where the monetary stimulus would lead.  All that is known is that the FOMC "currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."  What does "likely" mean here?  Such vague guidance is the consequence of there being no explicit level nominal target.  Had the Fed had announced a price level or nominal GDP level target, then one would have a much clearer road map of how the federal funds rates would be allowed to evolve over time.  The destination would be clearly spelled out (e.g. the Fed will maintain low federal funds rate until nominal GDP hits pre-crisis 1984-2007 trend) which would make it easier to do long-term planning.  Such certainty would make the monetary stimulus more effective.

The lack of explicit level target also creates another concern with such a policy.  In the absence of  such a target, which allows aggressive monetary stimulus in the short-run but constrains and anchors the long-run path of nominal variables, an interest rate peg like the one the Fed has announced has the the potential to create another unsustainable boom down the road.  Imagine the economy eventually begins to recover and causes the  natural rate of interest to increase.  Without a clear road map and strong nominal anchor, the Fed may be slow to react and inadvertently keep the federal funds rate too low after the natural rate has increased.  This is George Selgin's concern with the FOMC decision.  Although this outcome may seem remote now, it shows that without the guidance of an explicit level nominal target the Fed's interest rate peg can have problems in both stimulating the economy and in keeping it on a sustainable growth path.   

I remain, therefore, disappointed with the FOMC's decision. 

Dissapointed, Again

Needless to say I am disappointed with yesterday's FOMC decision.  Since I am currently afflicted with FDFS*, I will outsource discussion of my disappointment to Ryan Avent and Scott Summer. 

*FDFS = Fed Disappointment Fatigue Syndrome.

Will the FOMC Repeat the Mistake of September, 2008?

I hope not.  As you may recall, the FOMC met a day after Lehman collapsed on September 16, 2008 and decided against lowering the federal funds rates.  Yes, the Fed decided to keep its targeted interest rate unchanged at 2% just as the financial crisis was reaching its peak.  Amazingly, the reason the FOMC acted this way was its concerns about inflation, which at the time were driven by commodity prices and reflected a backward-looking view of inflation.  Had the Fed given more weight to forward-looking indicators like the expected inflation rate coming from TIPS and a host of other market indicators, the Fed would have realized the market was pricing in a sharp recession.  Even though the Fed intervened more aggressively after this point, it never rose to the point that would restore current dollar spending to a healthy, sustainable level.  The Fed, therefore, effectively tightened monetary policy at that time. 

Though the circumstances are somewhat different today, the same Fed inertia that kept it from responding appropriately in late 2008 could similarly prevent the Fed from getting ahead of the current crisis.  Now is not the time to be conservative and cautious.  It is time for Chairman Bernanke and the FOMC to take the initiative and provide some real "shock and awe" monetary policy stimulus. Adopt the Joseph E. Gagnon program or the quasi-monetarist goal of nominal GDP level targeting.  Yes, both approaches would be very controversial and have many observers freaking out, but that is the point.  It would provide a much needed slap to the face of public's economic expectations.  

Now some observers claim there is nothing more the Fed can do since short-term interest rates are already close to 0%.  Moreover, they argue the Fed already is pushing easy monetary policy without any success.  So why bother trying to do more monetary stimulus?  Two things these folks need to remember.  First, low interest rates are not stimulative if the natural (or neutral) interest rate is low too.  The natural interest rate is driven by the fundamentals of the economy.  When the economy improves the natural rate increases and when the economy falters it decreases.  It is the interest rate that would prevail in the absence of the Fed intervening.  Over the past few years the economy has been weak and appears to be weakening even more.  Thus, the natural rate is low and falling, implying the Fed's low interest rate target isn't very expansionary, if at all.

Second, even though the Fed cannot push the short-run nominal interest below 0% and below the short-run natural interest rate value, it can push the real short-term interest rate below 0% and the real short-run natural interest rate value.  Moreover, if needed, the Fed can start working its way up the term structure of interest rates by purchasing longer-term assets and pushing their yields below their natural interest rate values.  Another way of saying this, is that the Fed needs to keep buying assets until money demand is satiated and nominal spending resumes.  The 0% bound on short-term interest rates is simply a red-herring.  It did not prevent FDR from creating a robust monetary-driven recovery in the Great Depression, it did not prevent the Swedish central bank from spurring a remarkable recovery in this crisis, and it should not prevent Fed officials currently.  

So please FOMC, do not make the September, 2008 mistake again.  Get ahead of this unfolding crisis.

The Market Meltdown Highlighted the Fed's Failures

The market meltdown yesterday and the cumulative market losses of the past few weeks have showcased two important failures of the Fed.  First, the Fed has yet to seriously anchor short-to-medium term nominal spending expectations.  This is not particularly surprising since at best the Fed has an implicit and fuzzy inflation target.  It is bad enough that the inflation target is vague, but being a growth rate target also means it also has no memory.  That is, any deviation from the inflation target is allowed to persist.  Consequently, the price level and nominal spending become a random walk, creating more long-term uncertainty than if the Fed had a level target. 

Now the market meltdown seems to have started in Europe yesterday, but it really was a culmination of a number of bad economic news releases over the past few weeks and more importantly over the past few years.  Ultimately, these developments can arguably be traced to a U.S. monetary policy that has been passively tight over the past three years.  Thus, the second failure highlighted by the market meltdown yesterday was the Fed's ongoing tight monetary policy. The market meltdown provides confirmation that us quasi-monetarists were right all along on this point.

So what can be done?  As Scott Sumner, myself, and other quasi-monetarists have been saying for some time the Fed needs to get off its rear and announce an explicit nominal GDP level target.  Such an approach has many virtues, but probably the best one is that it would anchor nominal spending expectations.  This, in turn, would make the U.S. economy less vulnerable to shocks.  Just knowing and believing the Fed would buy up as many assets as needed to maintain a stable growth path for nominal spending would make if far less likely economic shocks would have much of an adverse impact in the first place. It would also make for a nice way of narrowing the Fed's mandate.  Here is how it would work.

The Fed Can Raise Nominal Incomes Too!

Ken Rogoff is one smart guy and his writings are typically fun to read.  His latest piece, however, left me feeling a little disappointed.  It concedes too much to the "balance sheet" view of recessions which for reasons spelled out here and here is an inadequate view of the crisis.  Moreover, his analysis ignores what monetary policy is really capable of doing for the U.S. economy: increasing nominal spending and nominal incomes.  Ramesh Ponnuru, the resident quasi-monetarist and Senior Editor at the National Review, makes this point:

Kenneth Rogoff writes that “the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years.” It certainly would be a way to reduce the real burden of debt, but is it the only or the best way?

The Federal Reserve has more direct control over nominal spending/nominal income than it has over inflation, and higher nominal income—whatever the ratio between the higher inflation and higher real growth that compose it—makes it easier to pay down debts (most of which are contracted in nominal terms). Because of wage stickiness, at least some of any increase in nominal spending that the Fed generates will take the form of real growth—and obviously one would prefer that portion to be as large as possible.

What we need, then, is not more inflation. We need for the Fed to stop holding the money supply below the demand for money balances. That might increase inflation, which would be a price worth paying to get nominal spending back to trend. But inflation shouldn’t be the goal.

Well said.

Update: Marcus Nunes makes a similar point here.

Fiscal Austerity Requires Monetary Liberality

Over at Cafe Hayek, Russ Roberts takes on Paul Krugman's claim that most studies show fiscal policy tightening will stall a recovery rather than help it:

Unfortunately, Krugman doesn’t provide a link to those “many studies” of the historical record. Maybe he was busy or simply didn’t have room to provide them. But I will just mention that in 1946, federal spending fell about 55% when the war ended. The Keynesians predicted a horrible depression. Yet despite the release of 10 million people into the labor market with demobilization private sector employment boomed and the economy thrived. That’s a great natural experiment. I am eager to read any of the alleged many studies of the historical record.

Like Roberts, I am skeptical about the ability of discretionary fiscal policy to stabilize the business cycle.  His critique, however, is too quick to embrace the popular view that fiscal policy consolidation actually improves the economy.  On this point, Krugman is correct that most of the empirical evidence (e.g. here, here, and here) does not support this view.  What the evidence does show is that in most cases where fiscal consolidation was accompanied by a robust recovery it happened because monetary policy was accommodative.  In other words, a loosening of monetary policy made it appear that fiscal policy tightening was the cause of the economic recovery when in fact it was not.  For example, the much celebrated case of Canada's fiscal retrenchment in the later half of the 1990s coincided with the Bank of Canada dropping interest rates about 5% which supported domestic demand and increased exports via currency depreciation.  For fiscal austerity to work then, monetary policy needs to be accommodating. 

Along these lines, a more general point is that the impact of any fiscal policy action--where expansionary or contractionary--depends on the stance of monetary policy.  Thus, from 2008-2009 when monetary policy was effectively tight the easing of fiscal policy didn't quite pack much of a punch.  Conversely, in late 2010, early 2011 when there was not much fiscal stimulus, but some monetary policy easing under QE2 there was some improvement in the pace of recovery.  Another way of saying this is that an independent monetary policy will always dominate fiscal policy.

So if Russ Roberts is like me and wants fiscal policy consolidation that works he should really be clamoring for more monetary stimulus.  Otherwise he may get more than he bargained for.

Update: Awhile back I did a related post criticizing hard money advocates to which Paul Krugman replied.  Here was my response to Krugman.

Brad DeLong and Brink Lindsey Agree the Fed Could Be Doing More

Here is an video excerpt from the Brad DeLong-Brink Lindsey bloggingheads discussion that lends itself nicely to my claim in the previous post of the Fed passively allowing monetary policy to tighten.

The Three-Year Tightening Cycle of U.S. Monetary Policy

Back in August, 2010 Fed Chairman Ben Bernanke claimed that monetary policy can be passively tightened by the Fed doing nothing in the midst of a weakening economy.  A failure to act by the Fed when aggregate demand was faltering, he argued, was effectively the same as the Fed tightening monetary policy.   He made this point in 2010 to explain why the FOMC's decided to stabilize the size of the Fed's balance sheet.  Here is Bernanke:

At their most recent meeting, FOMC participants observed that allowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome. In response to these concerns, the FOMC agreed to stabilize the quantity of securities held by the Federal Reserve by re-investing payments...By agreeing to keep constant the size of the Federal Reserve's securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred. The decision also underscored the Committee's intent to maintain accommodative financial conditions as needed to support the recovery.

In short, the FOMC was concerned that a failure by the Fed to reinvest its payments, which amounts to a reduction in the monetary base, would be contractionary in an economy that was struggling at this time.  The FOMC wanted to avoid this passive tightening of monetary policy.

I agree with this line of reasoning about the passive tightening of monetary policy.  I, however, see a passive tightening of monetary policy as being more than just the shrinking of the Fed's balance sheet.  It occurs whenever the Fed passively allows total current dollar or nominal spending to fall, either through a fall in the money supply or through an unchecked decrease in velocity.  In other words, even if the Fed maintained the size of its balance sheet, a sudden rise in money demand not matched by the Fed would also amount to a passive tightening of monetary policy.  With this understanding, monetary policy has been on a passive tightening cycle for the past three years.  For nominal spending began to fall in June 2008 and has yet to return to any reasonable trend level growth path (i.e. one that accounts for the housing boom). It is even worse if we look at domestic nominal spending per capita.  Not only has it not returned to a reasonable trend level growth path, it has yet to return to even its peak value in late 2007, as seen in the figure below.

A key problem behind this passive tightening of monetary policy is that money demand has been and remains elevated and the Fed has yet to successfully address it.  What is frustrating is that the Fed could meaningfully undo this three-year passive tightening cycle by adopting something like a nominal GDP level target.  For many reasons--its political capital is spent, internal Fed divisions, the popularity of hard-money views, etc--it won't and so the U.S. economy remains mired in an anemic recovery.