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.
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 have a related but somewhat different view. I'm pessimistic enough about the economy that I doubt the natural rate will be very high in 2012 or 2013---certainly not so high that a zero-rate policy will result in undesirably high inflation. So I'm not worried about the irresponsibility of this particular policy.
ReplyDeleteMy complaint is that the need to be responsible does constrain this form of commitment. It's quite plausible that we will need even more stimulus than a promise to hold rates low through mid-2013 can offer. My guess is that we should really be holding rates low through, say, 2015. But we can't promise that, because 2015 (unlike 2013) is far enough in the future that it's quite difficult to say whether low rates will be tenable at that point. In other words, the crude "hold rates low for a certain period" mechanism creates a tension between the responsibility of a commitment and its effectiveness, one that prevents us from reaching a sufficiently accommodative policy. In this instance, the Fed erred on the side of responsibility, and we'll have to live with the consequences.
I am a bit of an ABCT skeptic, but I am more and more concerned that using a committment to keep interest rates low in the future is the most likely way to generate malinvestment. In my view, the way to avoid malinvestment despite errors in monetary policy is for people to understand that future short term rates will reflect future conditions. An investment project that is only profitable if short term rates are maintained into the future, is an error. And, by the way, having the Fed purchase long term bonds to directly lower long term rates has a similar problem.
ReplyDeleteA target for GDP will certainly help and maybe avoid the problem--short and long term rates could rapidly rise. But it is concerns like this that have led me to focus on how privatized hand-to-hand currency would allow nominal short rates to go negative. Spend now, and don't imagine this means short rates will be negative or even particularly low over the next 3 or three years, much less 10 or 20. Long rates are only impacted in this scenario by the exceptionally short rates now.
David, you are all disappointed - Scott Sumner, Bill Woolsey and you - and I think Nick Rowe are always. And so am I - at least in some way.
ReplyDeleteHowever, lets ask another question: Would the alternative of doing nothing have been better? It seems like Bill Woolsey - maybe inspired by George Selgin - thinks that this is worse than just continuing the policy, which already is in place. I surely share the concerns of Woolsey and Selgin and I truly hate this continued Neo-Wicksellian interest rate focus in Fed policy, but judging from the market reaction this is actually "working". I have especially noted that 30y Treasury yields have increased significantly on the back of the announcement to keep rates on hold until 2013.
Obviously the Fed should do the right thing and introduce a NGDP target asap, but there is clearly not a majority for this on the FOMC – so maybe this interest rate targeting is what Bernanke is able to get through. I hate being pragmatic here, but I think that if the choice was between continue the policy in place and the 2013 rule I would support the 2013 rule. That obviously does not mean that that in anyway is “optimal” – far from it and as Bill notes it is certainly not with out certain dangers. I the meantime the effort to argue for NGDP targeting should be continued and be explained (…and be put into economic textbooks!).
For at least 12 years there´s been a lot of discussion (conferences & papers) about "How to conduct MP in a low inflation environment".
ReplyDeleteBut Bernanke has 2 things going against him doing the "right" thing:
1. He has a "credit view" of the transmission mechanism.
2. He firmly believes in 'inflation targeting".
Lars, I very specifically limited my criticism to the two year commitment, not to the rate change as such; and I have now written in several places that I don't believe there is any such thing as a central bank "doing nothing." The notion is nonsense, for a supposedly unchanged central bank monetary stance is still a central bank monetary stance.
ReplyDeleteLike David and Scott, I'm a nominal spending stability sort, having defended that ideal when I wrote my dissertation back in 85 or so, which became Theory of Free Banking. But I have always doubted that central banks could ever be relied upon to achieve stable spending growth.
So my position is better described, not as one favoring "doing nothing" but rather as one favoring doing away with the Fed, or at least (for starters) with its seat-of-the-pants manner of making monetary policy. While I appreciate the efforts of David and Scott and others to try and nudge the Fed in a better direction, I think disappointment is all they can expect from such efforts. It is high time, in other words, for more persons to start calling for radical institutional reform, even if doing so seems impractical. By pretending that the Fed might do the right thing even with the current institutional structure in place is to give a very misleading impression of the true roots of our monetary policy woes.
George, I agree with 95% of the stuff you have written over the years and I completely agree that Free Banking should be advocated has a clear alternative to central banking.
ReplyDeleteI did not mean to suggest that central banks can do nothing and be central banks at the same time. I am in total agreement with you on that. What I basically meant to say that if any of us had been on the FOMC and we had been presented with two alternatives “business as usual” (“doing nothing”) and the “2013 rule” then I would probably have voted in favour of the later.
Regarding, Scott’s and David’s efforts to advocate reform of the Federal Reserve versus your more radical view I don’t really see a conflict. To me NGDP level targeting is exactly the outcome, which we would get in a system of competitive Free Banking as you have demonstrated in The Theory of Free Banking. Of course Free Banking is the first best, while NGDP targeting is second or third best.
These are however normative rather than positive discussions. I see very little difference between your economics and the economics of for example Scott Sumner or Nick Rowe. Bill Woolsey I would guess i 99% in agreement with you on economic analysis. That said, I would love to hear your take on the economics of Scott or David - are there in areas of analysis where you are in disagreement? I do not mean the policy advocacy, but the monetary analysis. I can only come you with one area (maybe!) and that is your discussion (with Bill Woolsey) of risks of misallocation in zero inflation monetary system.
Basically I think it is a matter of libertarian strategy and it can be compared to the use of school vouchers that Friedman advocated. We all know that Friedman wanted government out of education, but also that he thought at vouchers at least would give some kind choose to parents.
That said, it would be very interesting we Scott and David would follow the lead from Bill Woolsey and discuss the Free Banking alternative.
I have myself criticised Scott for being a little bit to “eager” in his comments in terms of arguing in favour of “stimulus”. Obviously Scott is not in favour of “stimulus” in an activist fashion, but if you don’t know that then one could be led to think so. See here: http://www.themoneyillusion.com/?p=9939 (at 11:41). Here I state:
“What is needed is a clear RULE on some kind of nominal target. You and others have convinced me that a NGDP rule would be the preferable option. Or even better lets go for some kind of “automatic” rule based on market pricing. This is what we need to go for.”
"“automatic” rule based market pricing" – we could easily call that Free Banking.
Not to be missed:
ReplyDeleteAnd the semi official “birth of QM”. Hot of the FT:
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.
And there´s much, much more:
http://www.ft.com/intl/cms/s/0/ac5804a6-c413-11e0-b302-00144feabdc0.html#axzz1V3wdI2MD
Lars, I see that on the matter of concern here our agreement may be 100%. I think Scott's N-FIT (to coin a new acronym) can be a good stepping stone toward a free banking arrangement. Ideally, as the banking system is freed from its fetters (I should say, as with give banks a choice of being free OR taking advantage of guarantees and being heavily shackled), I imagine that the need for base adjustments in accordance with an NGDP Futures Index Target base feedback rule will slowly diminish to the point where a freeze might be contemplated. The goal should be--and I believe that for most of us on this forum it is--one of eventually removing the very possibility of discretion-based monetary innovations.
ReplyDelete