Monday, May 7, 2012

Monetary Policy Change James Hamilton Can Believe In

What more can the Federal Reserve do at this point in the business cycle?  Can it really help spur a more robust recovery?  James Hamilton is not so sure and is concerned that calls for more monetary stimulus may come at a high cost.  He believes that further large scale asset purchases (LSAPs) would have at best a modest effect on economic activity and worries that they would make the United States more susceptible to a fiscal crisis.  Given how the Fed has done LSAPs so far, his concerns about the effectiveness of additional LSAPs are understandable.  But advocates of more monetary stimulus, like myself, are not asking the Fed to do business as usual.  We are asking for something different, an approach that would better combine the threat (or, if need be, the action) of LSAP with an explicit target.  If this approach to monetary policy were adopted, his concerns about a  fiscal crisis would also become moot. 

So what is this alternative approach?  It is simple: the Fed announces it plans to return the level of NGDP to some pre-crisis growth path and commits to buying up as many treasuries, GSEs, and foreign exchange as needed to accomplish that goal.  Note that this is a conditional LSAP tied to an explicit level target.  It sets a destination for monetary policy and thus firmly manages the expected path of nominal spending.  Previous LSAPs did not set an explicit destination and were very ad-hoc in nature.  They committed explicit dollar amounts of spending up front with vague objectives.  It was the monetary policy version of throwing something against the wall and hoping it would stick.  This, however, was an impossible hope since there never was a commitment by the Fed to allow any of the LSAPs to permanently stick to the wall.  And, as Michael Woodford notes, without this commitment the Fed failed to shape expectations in a way that would spur rapid nominal spending growth. It should not be surprising then that the effect of such LSAPs were modest.  

Now imagine how the public would respond if tomorrow Ben Bernanke called a press conference and announced the Fed was adopting this new monetary regime.  This announcement would send shock waves through  the markets.  Portfolios would automatically adjust toward riskier assets in anticipation of the Fed actually doing these conditional LSAPs.   This would raise asset prices and raised expectations of future nominal income growth.  Current aggregate nominal spending would respond to these developments, helping push NGDP to its targeted path and thus reduce the onus on the Fed to do LSAPs.  In short, a conditional LSAP program tied to an explicit NGDP level target would be a significantly different and far more effective monetary program than any of the LSAPs the Fed has tried so far.

The nice thing about this target is that though it allows rapid catch-up growth in nominal spending it also provides a firm nominal anchor since it is a level target.  Nominal GDP growth that exceeded the  targeted growth path would be corrected too.  Long-run inflation expectations, therefore, would not become unanchored. This would minimize concerns about the Fed's balance sheet. Also, a sharp recovery brought about by a NGDP level target would increase the denominator in the debt/GDP ratio and slow down the growth in the numerator as the cyclical deficit disappeared.  These action would make it less likely a fiscal crisis would emerge in the first place.

I also think that Hamilton's concerns about reducing the average maturity of the public debt are overstated.  It is one thing if the U.S. Treasury moved all of its debt into short-term securities.  That would increase the stock of short-term treasuries and make the U.S. government more susceptible to higher financing costs should a fiscal crisis emerge.  The Fed doing LSAPs, on the other hand, shortens the average maturity but does not increase the stock of short-term treasuries.  If anything, LSAPs makes financing costs easier for the Treasury by removing from the public the longer-term securities the Fed purchases.1 Moreover, given the huge global shortage of safe assets and the ability of the Fed to finance Treasury if needed, it seems unlikely that a fiscal crisis will emerge anytime soon.

So there you have it.  Monetary policy change that James Hamilton can believe in.

1Bank reserves which now earn interest and are a close substitutes for short-term treasuries would increase with LSAPs.  But the Fed can adjust what it pays on reserves and the nominal anchoring a NGDP level target provides should prevent  the growth of reserves from becoming a problem.

24 comments:

  1. David:

    I agree with your analysis, of course.

    Still, the financial crisis scenario is that people believe that the Federal government cannot or will not pay. While it is true that the Fed can always government debt at a high price, under this scenario, this creates high inflation expectations, nominal expenditure rises violently, and there is massive inflation. And so, we are in deflationary default scenario. The Fed can't contract because no one will buy the securities it holds. If interest rates on reserves are raised enough to get demand that high, the Fed goes broke and the Treasury can't bail it out because it can't raise funds.

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  2. ... and Andolfatto, Bullard and 15 other FOMC members....

    hopefully i will beat Benjamin Cole: excellent, excellent blogging.

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  3. ... and Andolfatto, Bullard and 15 other FOMC members....

    hopefully i will beat Benjamin Cole: excellent, excellent blogging.

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  4. Bill:

    Yes, from a consolidated government balance sheet view of the Fed and Treasury there could still be a problem. But it seems highly unlikely that the Fed doing a NGDP level target like the one I outline above would trigger a crisis so severe that the Fed would end up broke and the Treasury incapable of bailing it out. For something that catastrophic it would require some kind of collapse of the government.

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  5. dwb, I am working on Andolfatto...

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  6. Or it would be easier (and less controversial) if the Fed just stopped paying interest on excess reserves held by the banks.

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  7. I agree with Bill: you cannot assume that the Fed could hold down the interest rate on its massive reserves liability - unless you are not serious about monetary stability that is. This is why people like Krugman are wrong to dismiss the inflationary threat of QE on the grounds that there is no inflation now - the test comes when it is time to withdraw QE.

    Similarly, you assume that NGDP growth that exceeded the targeted growth path could be corrected, but I suspect that, when the time came, the authorities would find this politically difficult. As I keep saying about NGDP targeting, I can see the attraction now, but the framework is not time-consistent. I fear that the "market monetarists" are being used as dupes by the inflationistas.

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  8. David:

    Of course, I agree that an explicit nominal GDP target is a substitute for quantitative easing with no specific goal.

    Rebel Economists:

    Dupes? Market monetarists have favored nominal GDP targets for 20 years.

    An explicit target for nominal GDP reduces the amount of quantitive easing needed. I don't think that reducing the quantity of base money will be difficult in the context of recovered nominal GDP.

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  9. @RevelEconomist,

    "but I suspect that, when the time came, the authorities would find this politically difficult."

    political will can be lost at any time, under any circumstances, even under the current regime- There is nothing special or unique about ngdp targeting. It might even be instigated by continually supressing the economy below potential. those voters are pesky people.

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  10. I know, Bill; I first encountered the NGDP targeting idea as argued by Samuel Brittan in the FT many years ago.

    It is the present that concerns me, however. There are many people, especially in the current account deficit countries like the US and Britain, who would be pleased to have the real burden of their debt reduced now that it is time to repay it. And many in the financialised economies, again like the US and Britain, who are holding bad assets and would be grateful for other prices to rise to validate their marked value for those assets. Therefore, any policy ideas that involve a short-term surge in inflation will get their support, whether it is NGDP targeting or MMT.

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  11. You are right of course, dwb. All monetary policy regimes are vulnerable to backsliding. But the transition from one regime to another presents a particularly large backsliding opportunity. Which is why, to ensure that NGDP targeting is introduced for the right reasons, I would like to see advocates of NGDP targeting suggesting a target growth rate of, say, 4% or less, starting from the present level of NGDP.

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  12. @RebelEconomist,

    burden of their debt reduced now that it is time to repay it

    we've had this discussion many times, its just Austrian nonsense.

    unemployment causes mortgage delinquencies, and unemployment is well above normal still.

    You cannot compare the UK and US. the UK has some supply side issues that it needs to work out. No monetary policy will ever fix supply side issues.

    The Fed allowed ngdp to fall significantly below trend. Putting ngdp back to trend merely means that people can repay debts they contracted for at full employment, nothing more.

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  13. But the transition from one regime to another presents a particularly large backsliding opportunity.

    I doubt that: historically an institution like the Fed is peevishly focused on credibility (thats its largest asset).

    So whatever target they pick, I feel very confident they will go out of their way to defend it.

    People in the UK seem to feel that the BoE keeps missing its inflation target. I can't really speak to that, except maybe they are doing a form of flexible or conditional inflation targeting.

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  14. "Putting ngdp back to trend merely means that people can repay debts they contracted for at full employment"

    Wrong, dwb. People contract to repay in nominal terms regardless of the conditions that prevail when repayment is due, and the price (interest rate) is negotiated on that basis. And the present level of unemployment is hardly unprecedented in the context of, say, a typical mortgage loan of thirty years - unemployment was around or above the present level in the 1970s, 1980s and the 1990s.

    It is only rational for debtors required to service their debts in hard times to welcome any initiative to adjust the contract in their favour, and only rational for their creditors to resist such a move, in Austria or anywhere else.

    Perhaps as an American, you have private sector health insurance? If so, how would you feel if you got sick and your insurer refused to pay for your treatment, saying, "you were well when you took out your insurance".

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  15. Sorry RB, but government can tax inflation right out of the system if they so choose. If inflation is surging, so is incomes somewhere........so? You get the picture, even now. Anybody with a controllable currency can facilitate the necessary steps in rebalanceing. It is who will take the loss. For "inflationistas" it is the rentier. For the deflationista, it is the laberer

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  16. @RebelEconomist
    Please spare me the morality and class warfare arguments.

    There is nothing going on here but bare knuckled, empirical, quantitative economics.

    For example, when Jan Hatzius (Chief economist of Goldman Sachs) endorsed NGDP targeting I dont think its was out of some charitable motivation towards debt holders. I've never known those Fleet street people to be particularly charitable.

    Now as to facts: in the US, the output drop and larger measure of unemployment (about 15% right now) are the largest since the Great Depression.

    So, if you want to persuade me, please use facts and logic not morality. I've worked in finance for umpteen years (some in London) so assume I am deeply familar with how debt and credit works.


    http://macromarketmusings.blogspot.com/2011/12/jan-hatzius-interview-on-ngdp-targeting.html

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  17. dwb, excuse me, did I mention morality or class conflict?

    I have come to realise that when the inflationistas like Martin Wolf, Paul Krugman etc start using loaded words like "moralistic", "fetish", "rentier", "peevish" (Benjamin!) etc, it is because they know that the argument they oppose makes sense, but they dislike its motivation.

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  18. @RebelEconomist,
    "excuse me, did I mention morality or class conflict"

    yes, you said:

    "There are many people, especially in the current account deficit countries like the US and Britain, who would be pleased to have the real burden of their debt reduced now that it is time to repay it."

    and

    "It is only rational for debtors required to service their debts in hard times to welcome any initiative to adjust the contract in their favour, and only rational for their creditors to resist such a move, in Austria or anywhere else"

    and

    "I fear that the "market monetarists" are being used as dupes by the inflationistas."

    you are arguing as i see it:
    0. ngdp targeting will lead to higher inflation
    1. higher inflation will redistribute incomes; and
    2. ngdp targeting is mainly being pushed by people who will benefit from higher inflation (or are being duped by such people).

    MMTers by the way dont believe in expectations ("magic") or QE. Its all fiscal policy 24-7 for them, not ngdp targeting.

    (0) may or may not be the case ( I strongly doubt it in the US with 8.2% UE and 15% shadow UE); (1) is true however, redistribution is going on anyway due to foreclosures/defaults so its immaterial, higher real rates under ngdp targeting are net beneficial; and (3) is a motivation based argument.

    Please leave motivation based arguments at the door (glad we understand each other on that point).

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  19. dwb, you clearly do not understand my point. Economics is largely built from motivation-based arguments; you can't just "leave [them] at the door"! What I say is that economics should not judge motivation, but take it, and its influence on likely behaviour, into account.

    You are however, spot on with points 0 to 2.

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  20. @RebelEconomist,
    can you show me any evidence of (0) that ngdp targeting will imply higher long-run trend inflation (in fact I am persuaded its the opposite), or is this just a general fear? I'd love to see actual evidence of this.

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  21. dwb, you really are not getting this! Did I say that NGDP targeting implies higher LONG RUN inflation? No. It is the SHORT RUN inflation implications of introducing NGDP targeting that bother me.

    Assuming that NGDP targeting aims to get NGDP onto a 5% trend starting from its pre-crisis level as Scott Sumner would favour, what I think it will do, as I think most of its advocates would accept, is raise inflation in the short run, by way of catching up to the old trend. And it is that which makes NGDP targeting immediately attractive to many in financial markets and politics.

    As I am sure you know, the long run rate of inflation implied by NGDP targeting depends on the NGDP growth rate targeted (and the underlying growth rate of real output).

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  22. @RebelEconomist

    ok so your issue is not with ngdp targeting per se, but how much of the output gap to close.

    Last I checked, Sumner only advocated going 1/3 of the way back to trend.

    I don't think its a hidden agenda. If I got 17 economists in a room I'd get 51 different opinions on how much of the output gap in the US is structural vs. how much is cyclical.

    reasonable people can vastly disagree on the Phillips Curve regardless of their agenda.

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  23. dwb,

    Yes, that's it. If the proposal was to introduce NGDP targeting from present NGDP at 4%, I could live with it. I suspect that that would be hard to maintain during the next boom though!

    Now you mention it, I do recall Scott Sumner saying something like a third of the way back to the pre-crisis trend - my bad. The pace at which the central bank is required to get there also matters of course. I still think that Scott Sumner would not dispute the view that his proposal would involve higher inflation for a while though.

    Thanks for the discussion.

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  24. Dave Rosenberg recently had this to say about negative interest rates. Sounds wrong to me but I can’t exactly explain why…..

    http://www.zerohedge.com/news/gold-%E2%80%98will-go-3000-dollars-ounce%E2%80%99-rosenberg

    Rosenberg says that it is not about being “bullish or bearish,” it is about “stating how you view the world” and he warns that the major central banks are all going to print more money and keep real interest rates negative “as far as the eye can see.”

    This is “critical” as one of the key determinants of the gold price are real short term interest rates.

    The longer they stay negative “the longer the bull market in gold is going to be.”

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