The Federal Reserve's Dirty Little Secret

The Fed has a dirty little secret, one it has closely guarded over the past six years of unconventional monetary policy. This secret has eluded many journalists, commentators, and economists and led to much confusion over monetary policy. If it were widely known it would create far more criticism of Fed policy. For Fed officials, then, it is a secret better left unsaid. So what is this dirty little secret? To answer this question, we need to review two underappreciated facts about the Fed's quantitative easing (QE) programs.  

The first underappreciated fact is that the large expansion of the monetary base under QE is temporary. The Fed has always planned to eventually return its balance sheet and, by implication, the monetary base back to the trend path it was on prior to the QE programs. This point has been communicated in several ways. First, the Fed issued exit strategy plans in its June, 2011 and September, 2014 FOMC meetings that point to a reduction in the monetary base. Here is an excerpt from the latter meeting:

The Committee intends to reduce the Federal Reserve’s securities holdings in a gradual and predictable manner...The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively. 

Second, Fed officials, including Ben Bernanke and Janet Yellen, have reiterated these plans in speeches, talks, and Op-Eds. In short, the Fed's exit strategy was widely publicized.

Third, several official Fed studies have examined what these exit strategies mean for the Fed's balance sheet and find that it puts the future path of the monetary base close to its pre-crisis trend. This 2013 Board of Governors study, for example, shows this projected path:

Similarly, a 2014 New York Fed study comes up with this future path for the Fed's balance sheet: 

Fourth, the Fed signaled its intention to normalize the size of the monetary base by refusing to raise its inflation target even though some Fed officials believed it could have helped the economy. (See the last question in this exchange between former Fed Chairman Ben Bernanke and Senator David Vitter where Bernanke acknowledges potential benefit of higher inflation). By explicitly committing to not raise the inflation target, the Fed was implicitly committing to only a temporary expansion of the monetary base.

Finally, and most importantly, bond markets have signaled they take seriously the Fed's commitment to normalizing the size of its balance sheet. This is evidenced by the relatively stable expected inflation implied by asset prices in the treasury market. If this group--the one that has the most skin in the game--believes the Fed's expansion of the monetary base expansion is temporary it should be a signal to the rest of us that the Fed is truly committed to doing so.

The second underappreciated fact is that in order for QE to have made a meaningful difference in aggregate demand growth at the zero lower bound (ZLB) the associated monetary base growth needed to be permanent. This understanding is the standard view in modern macroeconomics. The reasoning behind it is that a permanent expansion of the monetary base implies in the long-run a permanent rise in the price level (even with with interest on reserves as shown by Peter Ireland). In turn, a permanently higher price level in the future creates the incentive to start spending more in the present when goods are cheaper. Or, from a Wicksellian perspective, it would imply a temporary surge in expected inflation that would lower real interest rates to their market clearing level.

Below is a table that highlights a few prominent economists who speak to the importance of permanent monetary base injections at the ZLB. Given this understanding, many of them advocate some form of level targeting (either a price level or NGDP level target) as way to credibly commit the central bank to permanently expanding the monetary base in a depressed economy.

Economist(s)	Permanent Monetary Base Injection Quote	Source
Michael Woodford	The economic theory behind QE has always been flimsy...The problem is that, for this theory to apply, there must be a permanent increase in the monetary base… The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves permanent and also to allow the temporary increase in inflation that would be required to permanently raise the price level in that proportion.	Source: Financial Times. See also his comments at this Vox article or the bottom of page 237 through 239 of his famous Jackson Hole article.
Lars Svensson	[I]n a liquidity trap… an expansion of the monetary base would increase inflation expectations and reduce the real interest rate only if it is seen as a permanent expansion.	Source: Escaping from a Liquidity Trap
Alan Auerback and Maurice Obstfeldt	[O]ur analysis shows... that credibly permanent open- market operations will be beneficial as a stabilization tool as well, even when the economy is expected to remain mired in a liquidity trap for some time. That is, under the same conditions on interest rates that make open- market operations attractive for fiscal purposes, a monetary expansion that markets perceive to be permanent will affect prices and, in the absence of fully flexible prices, output as well...Our analysis suggests that Japanese policymakers should underscore the permanence of past operations, perhaps through an announced inflation target range including positive rates, and may need to increase the monetary base even more.	Source: American Economic Review (2005)
Paul Krugman	[W]hen you’re at the zero lower bound, the size of the current money supply does not matter at all…what the models actually say is that doubling the current money supply and all future money supplies will double prices. If the short-term interest rate is currently zero, changing the current money supply without changing future supplies — and hence raising expected inflation — matters not at all… Central banks can change the monetary base now, but can they commit not to undo the expansion in the future, when inflation rises? Not obviously.	Source: The Conscience of a Liberal. See also his post on helicopter drops here.
Willem Buiter	A permanent helicopter drop of irredeemable fiat base money boosts demand both when Ricardian equivalence does not hold and when it holds. It makes the deficient demand version of secular stagnation a policy choice, not something driven by circumstances beyond national policy makers’ control. It boosts demand when nominal risk-free interest rates are positive and when they are zero – and even in a pure liquidity trap when nominal interest rates are zero forever	Source: The Simple Analytics of Helicopter Money.
Scott Sumner	Monetary policy is never very effective if the injections are temporary, and (almost) always very effective if permanent.	Source: TheMoneyIllusion.
Simon Wren-Lewis	Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over.	Source: Mainly Macro. Also see his helicopter drop discussion here.

A good example of the importance of a permanent monetary base expansion at the ZLB can be seen in the Great Depression. As seen in the figures below, the monetary base grew rapidly between 1929 and early 1933 compared to previous growth. Yet during this time the money supply and nominal GDP continued to fall. The reason is that the monetary base was still tied to the gold standard and therefore not expected to be permanent. But that changed in 1933. FDR created what Christy Romer calls a "monetary regime shift" both by signalling a desire for a higher price level and by abandoning the gold standard which led to even more rapid monetary base expansion. This shift is apparent in the figures below. FDR's actions caused the public to expect a permanent monetary base expansion that would raise future nominal income. A sharp real recovery followed in 1933. Though this real recovery was later stalled by other New Deal programs, it did permanently raise aggregate demand.

By  now you have probably noticed an inherent tension between these two underappreciated facts. On the one hand, the Fed never intended the expansion of the monetary base under the QE programs to be permanent. On the other hand, the monetary base injections needed to be permanent for the QE programs to really spur aggregate demand growth. And therein lies the Fed's dirty little secret: the Fed's QE programs were muted from the beginning. They never could on their own create the amount of catch-up aggregate demand growth needed to restore full employment. So despite all the Fed has said over the past six years, it made an explicit policy choice to avoid fully restoring aggregate nominal expenditures. 

The Fed, in short, never chose to unload both barrels of its gun. And the QE barrel that it did unload depended on a portfolio channel that could only promise modest benefits at best. Had it committed to a permanent expansion of the monetary base via a level target, the Fed would have unloaded both barrels of its guns and made the QE programs far more effective.  Instead, the Fed opted for bird shot when it could have used a slug. This is the dirty little secret Fed officials would rather leave unsaid.

Update I: Permanent monetary base injections are also important for fiscal policy to generate aggregate demand growth. This point is often overlooked by advocates of helicopter drops. See Paul Krugman, Simon Wren-Lewis, and myself for more on this point. If you are going to do helicopter drops, you need to do it the right way.

Update II: This post should not be construed as me advocating a monetary aggregate or monetary base target for the Fed. I want to see the Fed adopt a NGDP level target which would imply a commitment by the Fed to permanently increase the monetary base if necessary to hit the target. The commitment is what matters, not whether it actually has to do so since a credible belief in it may cause the the public to do the heavy lifting via changes in velocity.