Wednesday, December 12, 2012

Historic Times for Monetary Policy

This past summer Ramesh Ponnuru and I wrote that it is time for monetary regime change:
Twice in the last century, economic turmoil revealed the failure of a monetary regime and forced the West to abandon it for another. During the Great Depression of the 1930s one country after another abandoned the gold standard—a decision vindicated when they recovered in the same order. The inflation of the late 1960s and 1970s, meanwhile, persuaded most of the developed world’s central bankers to quit trying to “fine-tune” the real growth rate of the economy and instead concentrate on
achieving price stability.

It is once again time for regime change. The crisis in Europe and our stagnation at home both have primarily monetary causes, and a solution will require a new approach to monetary policy that learns from both the successes and the failures of the past.
We argued that NGDP level targeting is the new monetary regime needed. Since we wrote this piece, there have been some major changes in Fed policy that have increased the likelihood of this approach becoming reality.  First, the Fed decided at its September FOMC meeting to start a new large-scale asset purchase program, QE3, conditional on the state of the economy, rather than tie it to a specific dollar amount up front. This conditionality approach was a vast improvement over previous QE programs in that it better tied expectations of future monetary policy to economic outcomes, similar to NGDP level target.  QE3, however, was linked to the vague objectives of "labor market the context of price stability."  More clarity was needed to for this program to fully utilize the power of expectations management.

Today the FOMC unexpectedly did just that. It tied QE3--or more accurately QE Flex since it now includes both MBS and treasury purchases--to the specific targets of 6.5% unemployment rate and 2.5% inflation. This is huge. It makes very clear to the public that the Fed will not stop until these targets are hit. Markets, in turn, should respond in anticipation of these goals being hit.  That is, the elevated demand for liquid assets should start declining as households and firms start moving their funds into higher yielding assets. This rebalancing should raise asset prices, help repair balance sheets, and ultimately spur nominal spending.  In other words, by better managing expectations, the Fed should cause the public to do the heavy lifting--and they already have started.  If all goes according to plan, the Fed may not have to actually purchase that many additional assets.  Ironically, this means that had the Fed been doing this all along its balance sheet would be much smaller now.

So this announcement is big news and fundamentally changes how U.S. monetary policy gets conducted.  Matt Yglesias sums it nicely up as only he can:
With today's policy announcement, the Federal Reserve's Open Market Committee has stopped screwing around and started doing real expectations-based monetary easing.
Indeed.  But the transformation is not complete. The Fed needs to take the final step and adopt an explicit NGDP level target.  The new unemployment rate and inflation targets get us closer to this ideal, but as Michael Woodford notes they are not the same. The Fed can only target nominal variables in the long-run and that is where it emphasis should ultimately be. A NGDP level target would do just that.

Interestingly, the Fed's actions today were not the only winds of change bearing down on monetary policy this week. Current Bank of Canada governor and future Bank of England governor Mark Carney came out and endorsed NGDP level targeting in a speech. Wow! It was not so long ago he was against it. These ongoing developments all point to a sea change in how monetary policy gets conducted. These truly are historic changes.

Update: Let me clear that I am not a proponent of targeting real variables, especially the unemployment rate.  But let's keep things in perspective.  First, if high unemployment is structural then the new asset purchases will cause inflation to hits its target and the Fed will be forced to tighten.  Second, given the Fed already embarked on this path with QE3, these explicit thresholds make the Fed more accountable and transparent. Finally, these thresholds are presumably just a halfway step to a full NGDPLT.


  1. Professor Woodford made it clear that "the most obvious recipe for success is one that requires coordination between the monetary and fiscal authorities. The most obvious source of a boost to current aggregate demand that would not depend solely on expectational channels is fiscal stimulus — whether through an increase in government purchases, tax incentives for current expenditure such as an investment tax credit, or subsidies for lending like the FLS".

    NGDP level targeting is helpful but not enough. Futhermore, QE operations are not purely monetary policy. They can change government debt level. Without OE and fiscal policy, it's difficult to implement NGDP targeting.

  2. Great post.

    This is what I advised all along--except even more aggressively. $120 billion a month and rising, in QE.

    I place less faith in guidance. Most people could not pick Bernanke out of a line-up of NFL linemen.

    Most know if they are making money. Let them make money.

    If I have a critique, it is that this $85 billion a month is still too timid. Man, blow the doors off of the the currency printing plants.

    There should be little doubt that much more money is in circulation, and the bars are packed with big tippers, and you can't find a space in the mall, and you have get on a waiting list to buy the car you want car etc etc etc.

    Som inflation is the result?

    Oh, I am so scared.

  3. Relax, Benjamin.
    NGDP level targeting is not as effective as Monetarists claim. Increasing reserves alone is not inflationary. They have no teeth without fiscal policy.

  4. Quasi-NGDP level targetting as the current Federal Reserve System is attempting,indeed is not inflationary.

    Notice consumer durables have surged because that is where real lower interest rates have gotten through. This is where the "real" bubble could start forming rather than finance.

    But the rest, nah. The FED can announce "10000000000000" in new "asset" purchases and I wouldn't wiggle a nose hair. That isn't real money. Only the government can push that out.

  5. you and your ilk are socialist thieves and inflation promoters. a pox on you all.

  6. thanks for sharing.

  7. Observe buyer durables possess increased simply because that is certainly where actual reduced rates have obtained by means of. This is where the actual "real" bubble might start off building rather than financing.
    runescape gold for sale
    FF14 CD Key