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.