My latest Macro Musings is with Gauti Eggertson. Gauti is a professor of economics at Brown University and formerly worked in the research departments of the International Monetary Fund and the Federal Reserve Bank of New York. He has written widely on liquidity traps, deflation, and the zero lower bound (ZLB) and joined me to talk about these issues.
This was a fun conversation and a good look back at the challenges and shortcomings of macroeconomic policy since the crisis in 2008. One of the big takeaways from our conversation, at least for me, is that central banks during this time ignored many of the key findings in the literature when it comes to best practices at the ZLB.
Before getting to these missed opportunities, it is worth recalling the nature of the ZLB problem. It emerges when there has been a severe recession that forces down the 'natural' or market-clearing level of short-term interest rates to a level well below 0%. The Fed's normal response, lowering interest rates to the level of the natural interest rate, does not work here because the Fed will run up against a lower bound where people would rather hold cash than earn a negative interest rate on their deposits. This lower bound is effectively a price floor that prevents the economy from properly healing and quickly returning to full employment.
So what can policymakers do? Gauti's work gives an answer. Specifically, his 2003 paper with Michael Woodford (which builds upon Paul Krugman's 1998 paper) shows that policymakers need to credibly commit to an expected path of interest rates that will restore the pre-crisis path of the price level. Put differently, Gauti's work implies the best defense against and escape from a depressed economy is some kind of level targeting. Gauti favors an output-gap adjusted price level target. As Michael Woodford noted in his 2011 talk, this effectively amounts to a nominal GDP level target or restoring the growth path of nominal spending.
One implication of this understanding is that if there is any disinflation or deflation from a collapse in aggregate demand during a recession there needs to be an offsetting period of reflation to restore the aggregate demand growth path. This did not happen after 2008 and implies aggregate demand growth was persistently weak. This was a missed opportunity by the Fed.
The Fed, instead, tried various rounds of QE. And it did so in exactly the manner that Eggertson and Woodford (2003) and Krugman (1998) said would lead to the famous 'irrelevance results'. That is, the Fed did these programs using temporary monetary base injections, whereas only permanent injections matter.
What is truly surprising about this observation is that the permanent injections point is widely understood. For example, here is a list of prominent New Keynesians who acknowledge it (including former Fed chair Ben Bernanke). And here is a list of quantity theory advocates making the same point.
To be clear, this point does not mean QE will have no effect. Rather, is says that temporary injections will not generate the robust aggregate demand growth needed to quickly escape a ZLB environment.
To be clear, this point does not mean QE will have no effect. Rather, is says that temporary injections will not generate the robust aggregate demand growth needed to quickly escape a ZLB environment.
So why did the Fed ignore the literature and fall right into the irrelevance results trap? I have a working paper that takes a stab at this question. I argue there were both external forces (public's fear of inflation vented via Congress) as well as internal ones (Fed still fighting the last battle and suffering from loss aversion) that kept the Fed timid. In our interview, Gauti made an interesting observation related to this point. The Fed seemed okay being aggressive with QE, but not with reflation. It is a bit of puzzle why it was so bold in the former but timid in the later.
This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.
Gauti and I also touched on how best to sell level targeting to policymakers and the public. Here is a recent Bloomberg article that looks at Gauti's innovative attempt to do so at the New York Fed in 2010 using 'Inflation Budget Accounting". Below is an excerpt:
We suggest that the FOMC keeps track of the extent to which it has "missed" its inflation target. Let us call these accumulated misses "inflation debt". Hence if the inflation target is 2 percent, and inflation is at 1 percent for two years in a row, then the accumulated "inflation debt" is 2 percent.
The FOMC would then announce an "easing bias" until the inflation debt accumulated in the current recession has been extinguished. If this is credible, a deflationary reading of the data would signal a larger "easing bias" going forward.P.P.S.
As I note in my working paper mentioned above, the Fed has been explicit about its plan to eventually shrink its balance sheet. It said so in its exit strategy plans reported in the June 2011 and September 2014 FOMC meetings. Janet Yellen recently reiterated those plans in her August 2016 Jackson Hole speech (see footnote 13). More recently, the Federal Reserve updated its basic guidebook to monetary policy in October 2016. Here too it stresses the balance sheet will be reduced:
As the policy normalization process proceeds, the Federal Reserve’s securities holdings—and the supply of reserve balances—will be reduced in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the portfolio...The FOMC intends that the Federal Reserve will, over the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities (p.52)
And if there were any questions about what this means, the Fed later notes that "no more securities than necessary" means doing away with the overnight reverse repurchase facility:
During normalization, the Committee is using an overnight reverse repurchase (ON RRP) facility as a supplementary tool as needed to help control the federal funds rate... The FOMC plans to use the ON RRP facility only to the extent necessary and will phase it out when it is no longer needed to help control the funds rate (p.51).
I would also add from a political economy perspective that the balance sheet will have to be reduced given IOR. The increasingly bad optics of the Fed paying banks larger interest payments as interest rates go up will force the Fed's hands on reducing its balance sheet.
