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.