Friday, December 26, 2014

Follow-Up to the Fed's Dirty Little Secret

My last post made the argument that monetary base injections at the zero lower bound (ZLB) can be effective if they are permanent. I also noted that this understanding is a standard view in macroeconomics and that it implies the Fed's QE programs were muted from the beginning given their temporary nature. The post generated further discussion from Paul Krugman, David Glasner, Scott Sumner, and Bill Woolsey. In addition, others responded in the comments sections of their blogs as well in twitter. I want to respond several of the issues raised in these discussions.

First, some commentators were confused by the notion of a permanent monetary base injection. What is important is the commitment to permanently expand the monetary base. The actual expansion may not be needed or be very small if this commitment is credible. To see this, imagine the Fed targets the growth path of nominal GDP (i.e. a NGDP level target). If the public believes the Fed will permanently expand the monetary base if NGDP is below its targeted growth path, then the public would have little reason to increase their holdings of liquid assets when shocks hit the economy. That is, if the public believes the Fed will prevent the shock from derailing total dollar spending they would not feel the need to rebalance their portfolios toward safe, liquid assets. This, in turn, would keep velocity from dropping and therefore require minimal permanent monetary injections by the Fed to hit its NGDP level target. Michael Woodford made this point in his famous 2012 Jackson Hole speech:
A commitment not to let the target path shift down means that, to the extent that the target path is undershot during the period of a binding lower bound for the policy rate, this automatically justifies anticipation of a (temporarily) more expansionary policy later, which anticipation should reduce the incentives for price cuts and spending cutbacks earlier, and so should tend to limit the degree of the undershooting
Based on this understanding, the Fed has taken the wrong approach. It could have had a much smaller balance sheet expansion with far more effect on the economy than what actually took place over the past six years. Instead, the Fed failed to take advantage of it and instead relied upon the segmented markets-portfolio channel to work its magic. 

This leads me to my second comment. My critique of the QE programs should not be construed to mean these large scale asset programs did nothing. There is plenty of empirical evidence they had positive but modest effects on the economy. My view is that they they put a floor under the economy and prevented it from getting worse. A casual reading of the evidence suggests the QE programs were turned on when core inflation started to drift toward 1% and turned off as it drifted toward 2%. So while they provided a floor on the economy, they were never allowed to reach their full potential as argued in my previous post. 

A third comment is that I do not think Paul Krugman, Simon Wren-Lewis, and other fiscal policy fans appreciate the implications of this critique for fiscal policy. We agree that monetary policy can only work at the ZLB with a commitment to a permanent monetary base injection. We also agree that it would require monetary policy to adopt something like a price level target--a monetary regime that would allow reflation of a depressed economy. But this is also true for fiscal policy to work, yet they push for more of it without calling for the needed regime change to make it work. Paul Krugman, for example, in his response to my post said this:
[E]ffective monetary policy in a liquidity trap requires both an actual and a perceived regime change, and that’s very hard to engineer. Japan may be pulling it off now, but only after 15 years of deflation — and even so the achievement is very fragile, vulnerable to fiscal tightening. Was there ever a realistic possibility of getting that in America, this time around? I wrote about this back in 2011, explaining why I devoted my efforts in 2009 to pushing for fiscal stimulus.
Okay, monetary regime change is hard. But why do we think that fiscal policy would work any better given the Fed's dedication to its low inflation target? For example, if the U.S. Treasury Department sent $5000 checks to every household and if they began to spend it as many helicopter drop advocates claim they would, then we would begin to see inflation go up. And at that point the Fed would tighten policy and snuff out the recovery. The response from the ECB to a similar helicopter drop in the Eurozone would be even more forceful. 

In other words, for the same reason QE was limited from the beginning it also true that fiscal policy was limited from the beginning. With highly-credible inflation targeting central banks, both monetary and fiscal policy require monetary regime change to work at the ZLB. So I am puzzled as to why Krugman put his energy into drumming up support for more fiscal policy rather than drumming up support for a change in monetary regimes.

My final comment is to respond to this from Paul Krugman:
David Beckworth has a good post pointing out that the Fed has been signaling all along that the big expansion in the monetary base is a temporary measure, to be withdrawn when the economy improves. And he argues that this vitiates the effectiveness of quantitative easing, citing many others with the same view. My only small peeve is that you might not realize from his list that I made this point sixteen years ago, which I think lets me claim dibs. Yes, I’m turning into one of those crotchety old economists who says in response to anything, “It’s trivial, it’s wrong, and I said it decades ago.”
Okay, I could have done a better job organizing that table in way to reflect his seminal contribution. I did, however, sort of acknowledge it in the cartoon at the bottom of the post. Look carefully at the message on his t-shirt.

Update: Paul Krugman responds to this post and I respond to him here.


  1. Commitment is important, but just as important is the fed's capacity to achieve targets using its current policy tools. The fed can be committed but be incapable of achieving targets so expectations wont move. A commitment isn't credible if its capacity to hit targets isn't there or is diminished. High levels of debt to GDP and unemployment make investing and lending less of a prospect for corporations which are fed counterparties.

    Expanding the MB even further may not have increased inflation more due to diminishing effect of MB expansion. The fed has expanded the MB massively already. Expanding further may simply signal fed impotence and further undermine fed credibility.

    Even under level target the fed may not be capable of hitting targets through asset purchases if its capacity to affect the system isn't there no matter how committed they are.

    Incorporating more effective policy tools such heli drops should be a key component of a regime change. Dropping money to all people will be effective because all the unemployed, people of low wealth and incomes will spend or improve their balance sheets. They wont just park their money in the bank. To achieve the same low inflation we have now under heli drops the fed would have to barely have expanded the monetary base since the crisis which would be harder to justify. If the fed is committed to a lower inflation target because of the huge MB build up then heli drops would make the fed commit to a higher inflation target because the MB increase would be small.

    For a regime change you need accountability. Make the governors explain themselves as to what their targets are, fire them if their explanations don't make sense and put incentives in place also.

  2. "Effective monetary policy in a liquidity trap requires both an actual and a perceived regime change, and that’s very hard to engineer"

    If by "zero-bound", one means rates can't be adjusted to increase AD, then yes. However, under monetarism, you can adjust the money stock without any rate adjustment.

    Remunerating excess reserves simultaneously monetized debt while sterilizing their purchase. If the Fed's rapid balance sheet expansion could be neutralized, so will be its not so urgent contraction.

    Monetary policy (per William Dudley, former Vice Chairman & a permanent member of the FOMC, the group responsible for formulating the nation’s monetary policy), sought “an IOeR rate consistent with the (1) amount of required reserves, (3) money supply & (3) commercial bank credit outstanding"

  3. Excellent blogging, per usual.

    But, I do wonder about the "forward guidance" aspect of market monetarism.

    1. I am not sure anything but the merest sliver of Americans understand the Fed, or monetary policy or QE. So does forward guidance work if the public is deaf?

    2. Presently, there are many FOMC loose cannons on deck, such as Richard Fisher. Even if I understand the Fed and QE, then what should I plan to do, given the sweat-drenched theatrics of a Fisher? Even if a Yellen says QE is permanent, who has assurance she will outlast the Fisher plank? Or that the next Presidential election might not see the ascendance of tight-money nuts and a rapid liquidation of the fed QE hoard?

    3. Greenspan was famous for mumbling. Yet that was a successful period for the Fed. What forward guidance?

    4. Am I really to believe that the Fed buying $100 billion a month in bonds has less effect that the Fed talking about its intended monetary policy?

    In brief, yes I think QE should be permanent, open-ended, results-oriented, and broadcast widely, as transparency is a hallmark of democracy.

    I don't think the public "gets it." I worked in lots of businesses over a checkered career, and even in the real estate and architectural trades, no one ever talked about the Fed's future policy. There is a vast gulf between the public and professional economists.

    And, to repeat myself, even if one does understand the Fed--so what? Some say QE is anti-inflationary. Others say it will result in hyperinflation, The Fed says it will persist with QE. As an investor, or business operator, what is my take-away in such a cacophony?

    Bottom line: QE works as prints new money and forks it over to bond-sellers. The bond-sellers than spend the money (good), invest the money (good) or put it in the bank. If the banks do not lend the money out, then you have a problem, and have to do more QE.

    1. Don't you think that if central banks make it clear that as soon as they can, they will make inflation overshoot and let prices play catch up, people, banks and business will try to get rid of cash in fear that it will get devalued? That is all that needs to happen.

    2. Benoit---
      I suspect the American public is largely deaf to the Fed, so Fed proclamations mean little. Even Americans with ears are justifiably confused by FOMC loose cannons and pundits screaming that QE is hyperinflationary or deflationary.

      I think QE works mechanically, not through PR.

  4. For example, if the U.S. Treasury Department sent $5000 checks to every household and if they began to spend it as many helicopter drop advocates claim they would, then we would begin to see inflation go up. And at that point the Fed would tighten policy and snuff out the recovery.

    I don't think this is right. (Actually I do think it's true now, because I don't think the zero lower bound is really still binding, but I'm talking about a couple of years ago.) If the short-run natural interest rate is less than the negative of the inflation target, then fiscal policy can raise it up to just the negative of the inflation target, so that the Fed will be satisfied, in both the short run and the long run, with the effect of its zero interest rate policy.

    In practice, of course, the dynamics are more complicated, and fiscal policy can't be implemented with sufficient precision to exactly plug the gap in monetary policy, so of course any fiscal change is likely to provoke some monetary response, but if there's a zero lower bound issue, the response need not be strong enough to offset the fiscal action entirely.

    One way to look at this is that, when the zero bound is binding, the Fed has inconsistent objectives for the price level. On the one hand, it wants the price level to be 6% higher in 3 years. On the other hand, it knows that the price level will be, say, only 1% higher in 1 year, and it wants the price level in 3 years to be 4% higher than it will be in 1 year. So it's attempting simultaneously to target a 3-year ahead price level that is both 5% higher than now and 6% higher than now. Fiscal policy can solve the Fed's problem by raising the 1-year-ahead price level to one that makes the Fed's objectives consistent.

  5. Combined use of both fiscal and monetary, if done better, might have needed only temporary application?

    This would be due to the nature of the circumstance. The crash and output depression were caused by two different bubbles, in the housing market, and in the value of mortgage derivatives as collateral in the intershadowbank repo market.

    QE stabilizes the ownership structure of the financial subsystem by replacing that interbank collateral, but does nothing to address household deleveraging. More helicopter would have reduced household debt and reinvigorated both consumer spending and the consumer/mortgage credit channels.

    The Treasury/fiscal and Fed/financial subsystems are linked via the printing of bonds and the instrumental use of those bonds for assets and collateral. A temporary, combined super-recharge of both sides might have put both upward pressure on interest rates in the bond market + upward pressure on rates in the consumer/household credit channels = getting us off the ZLB faster.

    Making almost everybody happier, sooner.

    This wouldn't solve any of our longer-term problems of trade balance, stagnation, and inequality, but we might be in a bit better position (or at least, be in an intellectual framework that is clearer to more people) to fix them?

  6. Krugman and Beckworth are in agreement about monetary policy at the ZLB.

    The disagreement is here: (from Beckworth)

    "For example, if the U.S. Treasury Department sent $5000 checks to every household and if they began to spend it as many helicopter drop advocates claim they would, then we would begin to see inflation go up. And at that point the Fed would tighten policy and snuff out the recovery."

    Krugman believes the Fed wouldn't tighten and would use "opportunistic inflation" to reach its target more quickly.

    Beckworth believes the Fed believes it has done enough QE to close the output gap at its desired pace, so if Congress did a fiscal stimulus, it would tighten to maintain its desired pace of closing the output gap.

    This is what the Fed would have us believe but I have to go with Krugman. The Fed is prevented from doing a regime change by politics but would accept fiscal help so it could "normalize" rates and policy more quickly. The Fed is stuck in "self-induced" paralysis" as Bernanke put it.

    But Krugman doesn't really frame it that way. He leads the reader that the economics is preventing the Fed from gaining traction. It's politics, both with monetary and fiscal policy. And with currency policy.

    1. Throughout these past seven years, Bernanke would complain about how Congress's austerity was making its job more difficult. If the Fed wouldn't accept fiscal help - it's doing all it can politically speaking - would Stanley Fischer say the followin?

      " Last year, for example, the Congressional Budget Office estimated that fiscal headwinds slowed the pace of real GDP growth in 2013 by about 1-1/2 percentage points relative to what it would have been otherwise. Moreover, state and local governments, facing balanced budget requirements, have responded to the large and sustained decline in their revenues owing to the deep recession and slow recovery by reducing their purchases of real goods and services. Job cuts at federal, state, and local governments have reduced payrolls by almost 3/4 of a million workers, resulting in a decline in total government civilian employment of 3-1/4 percent since its peak in early 2009. The fiscal adjustments of the last few years have reduced the federal government deficit to an expected level of 3 percent of GDP in 2014 and fiscal drag over the next few years is likely to be relatively low. "

      Could the Fed just compensate if it wasn't being limited by politics?

    2. Ok but if we are already near 2% inflation, a 2% target is clearly not enough to allow the 5000$ to have an effect on the economy and probably not enough to make the investment and labor market clear and the economy to go to full output.

      And if fact, if we are near 2% inflation and 0% Fed rate and those markets are not clearing, it means there may not be a path to full employment without an overshoot in inflation. I'm not sure about NGDPLT being the best solution practically (even if it looks like it may be near optimal theoretically) but I am sure we need something that allows inflation to be higher at least temporarily when output drops bellow potential, unemployment rises, and the money multiplier drops.

  7. I have a question. As the Fed was buying MBS it was adding to non-borrowed reserves. Am I correct these are opposite sides of the balance sheet (MBS assets, NBR liabilities)? Couldn't the Fed simply make their MBS holdings disappear by offsetting against non-borrowed reserves?

    1. If I understand your question correctly, yes the fed can always sell their assets back and take the money away. That is what they do to regulate the monetary base.

    2. Then couldn't they just as easily just write off the assets and reduce the monetary base? Since they were non-borrowed reserves and didn't truly expand the money supply on the way up, they could offset their MBS portfolio against non-borrowed reserves and shrink their balance sheet. No harm, no foul.

  8. I think we are getting to the point where Fed policy will be much more clear. If the Fed is unwilling to let the UE run below "normal" to allow inflation to run at 2.01%, it (should become) crystal clear that the real target is sub-2%.

  9. If I understand your criticism of the Fed's QE measures correctly, what you're asking for – a credible, permanent commitment – is almost impossible. The requirements of being "credible" and "permanent" just don't mesh. I do get your point about market psychology, and it would certainly be nice if everybody took the Fed's word as gold... unfortunately, we've long since abandoned that standard, so the Fed's word has very little to back it up.

    Almost every time I've heard Chairman Bernanke or Yellen speak, they've used phrases like, "for the foreseeable future."

    It seems like you would counsel the use of phrases such as "permanently." But such phraseology would itself not be credible, because anybody (not just sophisticated investors) would realize that the Fed cannot commit to permanent, unconditional QE. At some point, inflationary pressures will necessitate a pulling back.

    Personally, I am not a fan of QE for several reasons. But I WILL give the Fed credit for walking a fine, uncharted rhetorical line as best as could expected.

  10. But why do we think that fiscal policy would work any better given the Fed's dedication to its low inflation target? For example, if the U.S. Treasury Department sent $5000 checks to every household and if they began to spend it as many helicopter drop advocates claim they would, then we would begin to see inflation go up. And at that point the Fed would tighten policy and snuff out the recovery.

    There are two problems I see here.

    1. Tightening policy = raising rates = getting out of the ZLB trap. Not only would fiscal policy be helpful, but I would go further than Andy Harless above and argue that the goal should be to do more than necessary with fiscal policy so that the Fed can raise rates and have more wiggle room to act in the future.

    2. What if the Fed isn't dedicated to keeping inflation as low as it has been? As others have pointed out this is consistent with what they've been saying so I don't see why it shouldn't be considered. It seems to me there is a circular logic underlying the monetary-policy-uber-alles view that goes something like: 1. Inflation is entirely under the Fed's control. 2. Therefore the best way to determine what inflation rate the Fed really wants is to look at what inflation rate they are achieving. 3. Therefore the Fed really wants inflation to remain what it has been. 4. Therefore the Fed will act to counter whatever fiscal policy does. 5. Therefore inflation is entirely under the Fed's control.

    Surely, if as you grudgingly acknowledge, "monetary regime change is hard," then you must also allow for the possibility the Fed could want inflation to be something other than what it is, and if the Fed isn't crazy they will accept it if fiscal policy achieves the desired result for them?

  11. Eric L., see my next post. It answers some of your questions.