Friday, August 5, 2011

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.

3 comments:

  1. David Quite right. As I wrote recently, the Fed has to get up from the "ring side seat" and go play ball.
    It´s amazing how all the discussion revolves around fiscal policy. "Progressives" peddle for more stimuls and "Conservatives" also distort history to argue for fiscal consolidation as the best growth strategy. Bernanke, Krugman et al. have convinced most journalists and analysts that MP can´t do anything. Conservatives only think it will make inflation explode!
    http://thefaintofheart.wordpress.com/2011/08/05/the-%E2%80%9Cdistortions%E2%80%9D-continue/

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  2. Dr. Beckworth -- HOORAY for you my good sir.

    It is LONG PAST time for people to begin getting ANGRY at the Fed.

    Rage even.

    Would only question your verb tense: I fear that the market meltdown is only just beginning. This could make 2008 look like a cakewalk.

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  3. Excellent post.

    I wish I could summon profanities foul enough to describe the Fed and Bernanke-san. Maybe if I listen to some rap music...

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