Is There Any Hope for Improving the Fed?

For those of us disappointed with the Fed's performance over the past decade, it is natural to wonder if the conduct of monetary policy will be better going forward.  Well, if history is any guide then don't get your hopes up.  That is the conclusion  I draw from a new paper by George Selgin, William D. Lastrapes, and Lawrence H. White where they systematically explore the Fed's performance since its inception in 1913.  Here is the abstract:

As the one-hundredth anniversary of the 1913 Federal Reserve Act approaches, we assess whether the nation's experiment with the Federal Reserve has been a success or a failure. Drawing on a wide range of recent empirical research, we find the following: (1) The Fed's full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed's establishment. (2) While the Fed's performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.

In short, it is difficult to make the case that Fed has truly made a meaningful improvement in macroeconomic stability over its almost 100 years of existence.  Sigh.     

QE2 Will Not Usher in the Apocalypse

Though some folks would have you believe so.  It is far from perfect--it needs an explicit nominal target to make it truly effective--but it is a step in the right direction. Martin Wolf agrees:

The sky is falling, scream the hysterics: the Federal Reserve is pouring forth dollars in such quantities that they will soon be worthless. Nothing could be further from the truth. As in Japan, the policy known as “quantitative easing” is far more likely to prove ineffective than lethal. It is a leaky hose, not a monetary Noah’s Flood.

[...]

 The sky is not falling. But this does not mean the Fed’s policies are the best possible. It is probable that any impact on the yields on medium-term bonds will have a modest economic effect. It would be far better if the Fed could shift inflation expectations upwards, by issuing a commitment to offset a prolonged period of below-target inflation with one of above-target inflation.

In other words, Wolf believes QE2 may not pack a real economic punch in the absence of price level target.  Michael Woodford, William Dudley, Charles Evans, and  Paul Krugman agree with this assessment.  I too am a fan of level targeting (versus growth rate targeting), but would prefer to see it done by targeting some measure of aggregate spending such as final sales of domestic product or nominal GDP.  There are good reasons to favor an aggregate spending level target over a price level target, but either approach would bring the nominal economy closer to its trend and in turn spur real economic growth.  Unfortunately, though, the FOMC for some reason has chosen not to adopt a level target. This decision may amount to keeping the United Sates in economic purgatory.  So, rather than worrying about QE2 ushering in the apocalypse worry about it being much ado about nothing. 

US-China Currency Rap Battle

No explicit mention of QE2 is this rap video, but it covers all the other economic issues facing Chimerica:

Memo to the Fed: Fix the Aggregate Demand Externality

Paul Krugman makes an important point in his NYT column: there is an excess money demand problem (my bold below):

For the big concern about quantitative easing isn’t that it will do too much; it is that it will accomplish too little... The only way the Fed might accomplish more is by changing expectations — specifically, by leading people to believe that we will have somewhat above-normal inflation over the next few years, which would reduce the incentive to sit on cash.

Yes, somewhere there are households and firms that are sitting on excess money balances.  And understand these are not the debt-strapped households and firms that should be refraining from further spending.  No, these are the households and firms that are creditors and thus the beneficiary of the debtors who are now saving more.  Instead of spending their growing stock of money they are sitting on it because they see an uncertain economic future.  Here is the rub: it doesn't have to be this way.  If these creditor household and firms all simultaneously started spending their excess money balances this would increase aggregate spending and in turn spur the real economy.* Moreover, knowing that the real economy would improve going forward would feed back and reinforce current aggregate spending. A virtuous cycle would take hold and push the economy back toward full employment.  But this not happening,  there is still an excess money demand problem.  No creditor household or firm wants to be the first mover and spend his/her money for a good reason: there is no guarantee anyone will follow.   This amounts to a negative aggregate demand (AD) externality.  

In order to fix this AD externality one needs an entity powerful enough to incentivize all the creditor households and firms to start spending their money simultaneously. Enter the Federal Reserve. It alone can change inflation expectations and thus motivate these creditors to start spending.  Note that by changing inflation expectations the Fed is really changing expectations of future aggregate spending, the source of  expected inflation.  And by changing expectations of future aggregate spending it is changing the economic outlook for the better too.  The Fed, then, is the one entity that can kick-start this virtuous aggregate spending cycle.  However, in the absence of an explicit nominal target to shape inflation expectations it is not clear to me the Fed will be successful in fixing this aggregate demand externality.   

*It is not always the case that an increase in total current dollar spending will shore up the real economy.  But it is the case now because (1) there is resource slack and (2) there are sticky wages and prices.  

Last Word on What Milton Friedman Would Say

So the debate over what Milton Friedman would say continues to be debated  by policymakers and other monetary luminaries. This debate started with an Op-Ed I coauthored with Will Ruger in the Investor's Business Daily, received more attention from a similar article by David Wessel in the Wall Street Journal, and was further promoted by Terence Corcoran in the Financial Post.  These articles upset the old school monetarists and apparently were discussed at a recent  Karl Brunner conference where they were gathered.  Next, Allan Meltzer published this Op-Ed in the Wall Street Journal where he argued Friedman would not support QE2.  John Taylor chimed in that he agreed with Allan Meltzer's assessment.  I replied that even by Allan Meltzer's criteria of what Milton Friedman stood for one could make the case that he would still support some form of QE2.   And now the issue gets discussed by Ben Bernanke at the Jekyll Island conference. 

Now I really don't want to spend any more time on this debate, but given that it has not died down let me add these few final remarks.

(1) I agree with Paul Krugman that ultimately we should make our decisions about monetary policy without appealing to authority.  My original intent in publishing the Op-Ed was as a way to reach out to inflation hawks who claimed to be followers of Milton Friedman. I was hoping they would see Friedman's views were nuanced and that this would encourage them to take a more nuanced view.  Ultimately, though, economic analysis should be based on facts and good macroeconomic theory, not an appeal to authority. 

(2) With that said, the data do not lend themselves to the view that Friedman would necessarily be against QE2.  As I show in this post, all measures of broad money growth are far from stable and are low.  A properly executed QE2 could actually work to stabilizes these measures.  Moreover, Friedman actually said a monetary policy that targeted the expected inflation rate was better than a money supply target.  By that criteria there is no question he would support some kind of QE2.

(3) The only reason why Milton Friedman would be critical of QE2 is its ad-hoc nature.  While Friedman would be for restoring monetary equilibrium, he would want it to be done in a predictable, rule-like manner.  So far that has not happened.  It is likely he would have argued the Fed should adopt an explicit nominal target and commit to doing whatever is necessary to maintain it rather than the make-it-up-as-we-go-along approach behind the QEs so far. The economy needs more certainty now and  an explicit nominal target would help immensely on this front. 

Update: I failed to mention that Scott Sumner talked about what Milton Friedman would do long before I did.  In fact, my Op-Ed was motivated in part by his work on this topic.  

The Real Objective of QE2

I have noted several times now that our current economic problems are fundamentally the result of  excess money demand.  This understanding implies QE2 is ultimately about solving  an excess money demand problem.  Along these lines, Josh Hendrickson notes that the current excess money demand problem is unique because the Fed is paying interest on excess reserves:

With the Fed paying interest on reserves, open market operations literally entails the Fed exchanging debt for debt — specifically, Federal Reserve debt for Treasury debt...  it should be clear that the Fed is not being expansionary when it exchanges debt for debt. Nonetheless, this is not the same thing as saying that the Fed cannot be expansionary.

Some commentators have assumed that the sole effect of quantitative easing is to reduce long-term interest rates and stimulate investment. This is wrong-headed and demonstrates... why obsessions with the interest rate effect are misguided. The point of quantitative easing is not to reduce the long-term interest rate, but rather to resolve monetary disequilibrium.

Suppose that there is an excess demand for money. Since money is the medium of exchange and is traded on all markets, this necessarily causes an excess supply of goods and services. The central bank can eliminate the excess demand for money by increasing the money supply. However, as has been discussed above, if the central bank is exchanging interest-bearing reserves for interest-bearing debt, it is essentially exchanging perfect substitutes. If this is the case, traditional open market operations will not resolve the excess demand for money. Rather, the central bank needs to exchange the interest-bearing reserves for something that is not a perfect substitute. Potential assets that satisfy this criteria could be anything from long-term bonds to a portfolio of stocks. The central bank purchases these assets in order to increase the money supply and resolved monetary disequilibrium.

Read the rest of Josh's post here.  By the way, Josh just finished his Ph.D. and is on the job market.  Give him a look.

Not Bad, But Where Is the Explicit Nominal Target?

There has been plenty said about the FOMC decision to go ahead with QE2.  Let me add that this plan could have packed a lot more punch if the Fed had committed to an an explicit nominal target.  Instead we get several loosey-goosey references in the FOMC press release about Fed needing to keep inflation  at a level consistent with its mandate.  To be fair, Ben Bernanke does mention in his Op-Ed today that most members of the FOMC believe 2% is the inflation rate consistent with a healthy economy. Still, there would be a lot more certainty and wallop to the Fed's action if it would just come out and say "The FOMC is now committed to a X% nominal target and will do whatever is necessary to maintain it." Doing so would go a long way in shoring up and stabilizing inflation expectations.  For some reason, though, the FOMC is afraid to make such an explicit commitment. Maybe it will still do so in the future.  And maybe, just maybe it will really be bold and commit to a NGDP level target.

Here are some of the discussions on the FOMC's decision: Scott Sumner, Ryan Avent, Mark Thoma, Brad DeLong, James Hamilton, Paul Krugman, Gavyn Davies, and Bill Craighead.