San Francisco Fed President John Williams is finally coming to the view that Market Monetarists have advocating for some time: the Fed should do open-ended QEs tied to some explicit economic objective. Here is Williams:
He added that there would also be benefits in having an open-ended programme of QE, where the ultimate amount of purchases was not fixed in advance like the $600bn “QE2” programme launched in November 2010 but rather adjusted according to economic conditions.
“The main benefit from my point of view is it will get the markets to stop focusing on the terminal date [when a programme of purchases ends] and also focusing on, ‘Oh, are they going to do QE3?’” he said. Instead, markets would adjust their expectation of Fed purchases as economic conditions changed.
This is encouraging that Fed officials are beginning to see the wisdom of this approach. The irony of an open-ended QE program, however, is that it should actually reduce the burden on the Fed to buy up assets while at the same time keep long-run inflation expectations anchored. Here is how I explained this approach to Jim Hamilton in an earlier post.
[T]he 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.
The ability of the Fed to shape expectations such that the market does most of the heavy lifting has become known among Market Monetarist as the Chuck Norris effect. First coined by Nick Rowe, the idea is that just like Chuck Norris can use the threat of force to clear out a room without actually using force, so can a central bank use the threat of unlimited asset purchases to raise aggregate nominal spending without actually buying a lot of assets. It is a powerful idea that dates back several hundred years to Henry Thornton. The Chuck Norris effect is not so much new as it is forgotten.
Excellent post, and nice to have you back blogging.ReplyDelete