Friday, July 9, 2010

What Can the Fed Do Now?

A lot, actually. We know this because (1) Fed officials believe there is much more they could do if they wanted and (2) monetary policy has been shown to be highly effective in far worse situations. The problem is the Fed has been reluctant to act so far. It has failed to pull out all of its big guns though there are some rumblings it may be considering doing so.

So what exactly are the big guns the Fed could employ in our current situation? According to these Fed economists there are three big guns that could be used:
(1) [S]haping the expectations of the public about future settings of the policy rate, (2) increasing the size of the central bank’s balance sheet beyond the level needed to set the short-term policy rate at zero (“quantitative easing”); and (3) shifting the composition of the central bank’s balance sheet in order to affect the relative supplies of securities held by the public.
The first big gun is in my view the most important one and can be restated as shaping expectations in general, not just expectations about the policy interest rate. Here the main idea is to convince the public that Fed is committed to a higher inflation rate or price level for the foreseeable future. This would lower current real interest rates, decrease the demand for money (i.e. increase velocity), and help stabilize (and maybe even restore) household and other troubled balance sheets. Currently, however, this big gun is just sitting in the Fed's arsenal collecting dust. The other two big guns, as is well known, have been used as seen by the enlargement and asset alteration of the Fed's balance sheet. While these big guns have been effective in stemming the credit crisis they have been less effective in stabilizing velocity. What has been frustrating about the Fed's choice of the big guns to use so far is that there is reason to believe the first big gun by itself would have accomplished as much or more than what the second two big guns have done. This first big gun was used during the Great Depression by FDR with much success and suggests it should have been tried already by the Fed. Here are those same Fed economists on this experience:
An historical episode that may illustrate this channel at work (although the policymaker in question was the executive rather than the central bank) was the period following Franklin Roosevelt’s inauguration as U.S. president in 1933. During 1933 and 1934, the extreme deflation seen earlier in the decade suddenly reversed, stock prices jumped, and the economy grew rapidly. Romer (1992) has argued persuasively that this surprisingly sharp recovery was closely associated with rapid growth in the money supply that arose from Roosevelt’s devaluation of the dollar, capital inflows from an increasingly unstable Europe, and other factors... Temin and Wigmore (1990) [argue] that the key to the sudden reversal was the public’s acceptance of the idea that Roosevelt’s policies constituted a “regime change.” Unlike the policymakers who preceded him showing little inclination to resist deflation and, indeed, seeming to prefer deflation to even a small probability of future inflation, Roosevelt demonstrated clearly through his actions that he was committed to ending deflation and “reflating” the economy. Although the president could have simply announced his desire to raise prices, his adoption of policies that his predecessors would have considered reckless provided a powerful signal to the public that the economic situation had fundamentally changed. If one accepts the Temin-Wigmore hypothesis, then it appears that the signal afforded by Roosevelt’s exchange rate and monetary policies were central to the conquest of deflation in 1933-34.
So altering expectations here required both substantive action--actual sharp increase in the monetary base--as well as a public perception of a regime change by FDR. These actions worked and according to Christina Romer were the main reason for the robust recovery of 1933-1936. This experience suggests something similar should be done by the Fed today. So how could Fed employ this first big gun now? First, the Fed needs to to introduce an explicit inflation, price level , or nominal GDP target (my preference is for the later) and say that it is committed to this target no matter what it takes. Second, it needs to accompany this move with a PR blitzkrieg that makes it very clear this is a game changer, a real regime change. Of course, all this assume that the Fed decides that it wants to make such changes. Currently it is not clear that all Fed officials would welcome such changes.

Hopefully there are some folks inside the Fed who are listening. At a minimum I hope the Fed economists cited above are listening. One of them happens to lead the Fed.


  1. To be honest, David, when a country or empire is in structural decline, with a dysfunctional political system, a corrupted financial system and and a rotting away of its civic institutions and its educational system, then monetary policy is really of second order importance. The Fed's only role in the economy now is to redistribute the pain of shrinking wealth and decline across interest groups, (as we have witnessed all too clearly) but that about it.

  2. David,

    It seems that there were two different effects to FDR's abandonment of the gold standard: 1) an increase in the money supply; and 2) perceptions of a regime change. Is the first effect much different than that produced by Fed asset purchases now? That leaves "regime change" perceptions as the important catalyst for AD expansion.

    I wonder what defines "regime change" today. Is it the adoption of a formal 2% target with a bit of catch-up to trend on the price level? Is this comparable to going off the gold standard? How likely is it to counteract the deflationary inertia caused by household leverage and the resulting desire for precautionary cash balances? Perhaps, because we have not been in outright deflation as for years as in 1993, we might get away with less. Still, on the face of it, there seems little evidence that households will react to a one-year inflation penalty of, say, 3.5%.

    Its a chicken-or-egg problem. If you assume 3.5% is achieved, households may react to it. If you first ask whether households will react to it, 3.5% may not be achieved. A higher number may be necessary.

  3. "What Can the Fed Do Now?"

    How about, admit their Ponzi scheme has run its course and give monetary authority back to the US Government, who would apply the Milton Friedman constant expansion model?

    Privately owned central banking interests, supporting the commercial banking industry's gambling addiction, under the guise of monetary policy, IS THE PROBLEM.

  4. ECB: Have you no hope for the USA? I agree there are lots of real, structural problems here, but relative to problems elsewhere America's problems seem less formidable.

    David Pearson: We will never know for sure how effective such a regime change would be unless we try. By the way, I saw that Scott Sumner recently got swarmed by Post Keynesians and others skeptical of the standard money multiplier story with regards to the excess reserves question. I finally said enough talk, what does the data show? Consequently, I estimated a vector autoregression that looks at unexpected changes in non-borrowed reserves and their effect on deposits, loans, and economic activity in general. I found great evidence for the standard story. I hope to post on it soon.

  5. David, as Adam Smith said, "there is a great deal of ruin in a nation", so I am not expecting a dramatic decline. It unfolds over decades. Are you sure you are not being overly influenced by your position in the Austin-SA corridor, one of the few bright spots?
    Of course, things can turn around -the UK was at a nadir in 1979 when Mrs T took over and wrought a dramatic transformation.
    But my specific criticism of you and others re the Fed, is that you are commentating and taking a normative stance as if the Fed is an honest technocratic broker in the economy, and I contest that is a severe misreading.