The Fed and Its Impact on the Global Economy

Paul Krugman writes about a two-speed global economy where the emerging economies are experiencing rapid economic growth and rising inflation while the advanced economies remain in a slump. A key point he makes is that the countries still in a slump should focus on their own economic problems, not those of other countries. This especially applies to concerns about the Fed's monetary policy being exported across the globe:

What about complaints from other countries that they’re suffering inflation because we’re printing too much money? (Vladimir Putin has gone so far as to accuse America of “hooliganism.”) The flip answer is, Not our problem, fellas. The more serious answer is that Russia, Brazil and China don’t have to have inflation if they don’t want it, since they always have the option of letting their currencies rise against the dollar. True, that would hurt their export interests — but economics is about hard choices, and America is under no obligation to strangle its own fragile recovery to help other nations avoid making such choices.

He makes a fair point here in that the reason the Fed's policies are being felt overseas is because those affected countries have chosen to link their currency to the dollar.  By linking to the dollar these emerging economies have made a decision to allow their monetary policy to be set in Washington, D.C.  That is a choice outside the Fed's control. 

Here is where I wish Krugman would go with his argument.  Because these dollar block countries--all those emerging economies that either explicitly or implicitly peg to the dollar--are a significant share of the global economy, the BoJ and the ECB have to be mindful of what the Fed does too.  If the BoJ and the ECB try to ignore the Fed's easing of monetary policy in the United States and in the dollar block countries, then they risk having their currency appreciate too much against a large portion of the global economy.  That is why, as I noted earlier, the ECB could not possibly maintain its plans to steadily raise its targeted policy interest rate throughout the rest of the year.  For better or for worse, then, the Fed is a monetary superpower.

Now if you buy this reasoning so far, think about this question: could the Fed's monetary superpower status have played a role in the global credit and housing boom in the early-to-mid 2000s? I say yes and explain why in this working paper.

The Dollar vs. the Euro: Then and Now

The U.S. dollar vs. the Euro view circa 2005-2006:

 The U.S. dollar vs. the Euro view today: 

What a change in perspective.  Barry Eichengreen reminds us, however, that eventually the dollar will be one of probably two or three reserve currencies.

An Open Letter to Congressman Paul Ryan

Dear Congressman Paul Ryan,

In a recent speech you made the case for a more rules-based approach to monetary policy:

The Fed’s recent departures from rules-based monetary policy have increased economic uncertainty and endangered the central bank’s independence...  Congress should end the Fed’s dual mandate and task the central bank instead with the single goal of long-run price stability. The Fed should also explicitly publish and follow a monetary rule as its means to achieve this goal. 

I agree that we need a more systematic approach to monetary policy.  The ad-hoc nature of the QEs adds uncertainty and makes the Fed a political lightning rod for criticism.  Ultimately, this reduces the effectiveness of monetary policy.  So, yes, we need a predictable, rules-based approach to monetary policy.  We also need, however, an approach that responds appropriately to supply shocks.  For example, we wouldn't want the Fed to follow a rule that would call for a tightening of monetary policy just because a major computer virus shut down most computer systems and, as a result, caused prices to go up.  Instead, what we need is an approach to monetary policy that keeps the growth of total current dollar spending stable so that the booms and bust are minimized.   The good news is there is a way for monetary policy to do this in a systematic manner.  It is called nominal GDP level targeting.  This approach would narrow the Fed's mandate to single measure and thus make it more accountable.  I ask you to please consider this idea.   

For further reading on nominal GDP level targeting I suggest you read this article, this article, and this article from the National Review.

All the best,

David Beckworth

The Original QE Program: A Smashing Success

I made the case in an exchange last year with Paul Krugman that QE2 was not the first time quantitative easing had been tried in the United States.  Moreover, I noted that the original QE was a smashing success with nominal spending experiencing a robust recovery despite the zero bound problem.  So when was this original QE program? The answer is from 1933-1936.  

I bring this up now for two reasons.  First, I just came across this short essay by Richard G. Anderson of the St. Louis Fed that confirms my view that the monetary stimulus program during this time was effectively a QE program (though he says it started in 1932).  Second, the original QE program provides a nice counterexample to the more modest accomplishments of QE2.  This QE program was put in motion by FDR telling the public he wanted to return the price level to its pre-crisis level.  In other words, FDR was signalling a price level target. Gautti Eggerton shows it was well understood by the public.  FDR backed up his price level target by getting the Fed to buy more securities, by getting approval (via Congressional pressure) for the U.S. Treasury to issue currency, and by devaluing the gold content of the dollar from $20.67 to $35 a ounce.  These actions sent an unmistakable signal to the public that they should take the price level target seriously.  

Now the price level did not fully return to its pre-crisis level until the early 1940s, but the expectation that it would spurred a robust recovery through 1936. (It probably would have lasted longer had the Fed not snuffed it out.) The original QE success, therefore, occurred because there was a price level target that properly shaped expectations.  QE2, on the other hand, was not implemented with a price level target and even the Fed's implicit inflation target was and is not clearly defined.*  Thus, its results have been more modest.**  Ryan Avent recently summed up QE2 very nicely.  He said QE2 changed the direction of monetary policy, but it didn't set the destination.  That is the problem.

*Though a price level target would have been a vast improvement, it is not always ideal because it handles supply shocks poorly.  Thus, a better choice is a nominal GDP level target.

**It also did not help that the U.S. Treasury was increasing the average duration of public debt during QE2.

My Reply to Paul Krugman

Paul Krugman appreciates my efforts against the hard money advocates.  He questions, however, my and other quasi-monetarists' belief that monetary policy can still pack a punch when short-term interest rates hit the zero bound:

[T[hey want to keep that policy action narrowly technocratic, limited to open-market operations by the central bank.  As I’ve argued before, this doctrine has failed the reality test: liquidity traps are real, and blithe assertions that central banks can easily pump up demand even in the face of zero short-term rates have not proved correct.

It is true that us quasi-monetarists believe that the efficacy of monetary policy is not limited by the zero bound, but we have never said the that all it takes is further open-market operations.  Rather, we have said that monetary policy can be highly effective regardless of circumstance if the following steps were taken by the Fed:

(1) Set an explicit nominal GDP level target so that expectations are appropriately shaped.  If such a rule were adopted expectations of current and future nominal spending would be anchored around the level target and make it less likely there would be aggregate demand crashes like the one in late 2008, early 2009. Even if a spending crash did occur the catch-up growth needed to return nominal spending to its level target would most likely imply an expected path of short-term real interest rates consistent with restoring full employment. (See here, here, and here for more on a nominal GDP rule.)

(2) Purchase assets other than t-bills as needed to make sure the nominal GDP level target is maintained.  Thus, if the monetary base and t-bills became perfect substitutes because the 0% bound is reached the Fed should buy longer-term treasuries or foreign exchange.  Nowhere have we said simple open market operations in t-bills would always suffice. A big difference, though, is that where Krugman and others see the move from t-bills to other assets as a discrete jump from conventional to unconventional monetary policy, quasi-monetarists see it as simply moving down the list of assets that can affect money demand.  The 0% bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument.

In practice, this understanding is not that different operationally than a New Keynesian invoking a higher inflation target to lower the expected path of real interest rates or the portfolio channel to drive down the term premium on long-term bonds.  We just do it with a lot less angst.  Maybe Andy Harless with his modified Taylor Rule can bridge the gap between us.

Finally, because of these views we believe the Fed could have done much more in late 2008, early 2009.  Its failure to do so amounted to a passive tightening of monetary policy then.  Even now monetary policy is not all that loose given that money demand continues to be elevated.  Don't believe me? Then just look at domestic spending per capita, it is still below its pre-crisis peak. 

Update:  Fellow quasi-monetarist Bill Woolsey also responds to Krugman.

The PIMCO Mystery

There is an interesting article on Bill Gross and PIMCO in The Atlantic.  It highlights PIMCO's decision to dump and then bet against U.S. treasury bonds.  According to Tyler Durden, the amounts involved are significant.  Bill Gross' explanation for these decisions is that the bond market is being artificially propped up by QE2 and once it ends so will bond prices. 

These decisions have me stumped.  First, Gross' view assumes that the flow of QE2 purchases is what matters to bond prices.  There are good reasons to think, however, that it is the stock of QE2 purchases that matter.  If so, there should be no bond market correction since the Fed is not planning to sell its newly-acquired assets anytime soon. Second, given the weak economic outlook the expected short-term interest rates going forward should remain low.  That in turn should translate into low long-term bond yields.  Finally, if PIMCO's view were correct would not the bond market be pricing it in already? The figure below gives no indication of the U.S. bond market bottoming out.  If anything, there is a downward trend in the long-term treasury yield since the start of the year.

Now Bill Gross and the folks at PIMCO are smart.  They saw the housing bust well in advance and have made lots of money over the past few decades. So when they place so big a bet against U.S. bonds it should give us pause.  Maybe they are bond vigilante harbingers. Or maybe they are wrong.  For now the bond market seems to be supporting the latter view. 

Hard Money Advocates are Their Own Worst Enemy

Hard money advocates have been taking a beating in the blogosphere over the past few days, complements of Matthew Yglesisas, Paul Krugman,  Mike Konczal, and Ryan Avent.  These critics make some good points about the hard money view.  Here is Avent's critique:

The hard money approach is atrocious economics. I don't think it's outlandish (or even particularly controversial) to say that the biggest difference in the outcome of the Great Recession and the Great Depression was the change in central bank approach to policy. An economic catastrophe was averted. What's more, hard money is a great force for illiberalism. Sour labour market conditions fuel anger at the institutions of capitalism and free markets. And when countries are denied the use of normal countercyclical policies, they quickly reach for illiberal alternatives like tariff barriers.

These points are often overlooked by hard money supporters.  There is, however, an even bigger problem for them.  Most hard money advocates are in the GOP which also happens to be calling for fiscal policy restraint.  The belief is that hard money and sound government finances are necessary for a robust recovery to take hold.  The problem is that the hard money approach--which means tightening monetary policy--makes it next to impossible to stabilize government spending.  It also makes it likely the economy will further weaken. 

How do we know this?  First, in almost all cases where fiscal tightening was associated with a solid  recovery  monetary policy was offsetting fiscal policy.  Last year there was a lot of attention given to a study by Alberto F. Alesina and Silvia Ardagna that showed large deficit reductions were often followed by rapid economic expansion.  Further digging by the IMF and by Mike Konczal and Arjun Jayadev found, however, that this was only true when monetary policy was lowering interest rates.  Fiscal tightening coincided with a recovery only because monetary policy was easing. 

Second, a key lesson of recent years is that monetary policy overwhelms fiscal policy.  Thus, from 2008-2009 when monetary policy was effectively tight the easing of fiscal policy didn't quite pack much of a punch.  Similarly, in late 2010, early 2011 when there was not much fiscal stimulus, but some monetary policy easing under QE2 there was some improvement in the pace of recovery.  

Third, another lesson from the recent crisis and the Great Depression is that if tight monetary policy is dragging down the economy it opens the door for more active fiscal policy.  Imagine if the Fed had been able to stabilize nominal spending more effectively and thus prevented the economic collapse in late 2008, early 2009. It would have been a lot harder to justify the large fiscal stimulus package. The same is true for 1929-1933.  Had the Fed not been passively tightening monetary policy at that time there would have been far less political support for fiscal policy and government intervention in the economy.

All of this indicates that calls for tight monetary and tight fiscal policy simply don't make sense for the GOP.  Such an approach would most likely cause the cyclical budget deficit to increase even if the GOP successfully lowered the structural budget deficit.  More importantly, with tight monetary policy there would probably be no recovery to show for the budget deficit cutting. This would make it politically tough to do further fiscal reforms. If the GOP wants to meaningfully address budget problems it needs to soften its stance on monetary policy.  Otherwise, it risks becoming its own worst enemy.

Update:  Paul Krugman comments on this post.  Here is  my reply to him.