Expectations Matter More than Size

Martin Wolf says its time to unload both barrels of the gun and resort to true helicopter drop-types stimulus.  He has the right idea, but it could be better implemented through an explicit price level or nominal GDP level target.  Doing so is important because as Josh Hendrickson notes no one at the Fed or the ECB knows exactly how much to print. What the central banks can do, though, is properly shape expectations about future nominal spending and price growth.  Doing so would cause the markets themselves to do much of the heavy lifting (through expectation-induced portfolio rebalancings) and in the process ensure the Fed's goals are realized. Josh Hendrickson sums it up this point nicely:

The Federal Reserve’s focus on the size of its asset purchases represents a grave mistake. There is no model that tells us the precise size increase in the central bank balance sheet will get us to a desired level of nominal income. Those who continue to claim that the magnitude of monetary and fiscal policy haven’t been large enough fail to recognize this point. This is the lesson of the Lucas Critique. Expectations matter.

Update: Here I go into more detail as to how the Fed would work to shape expectations through a nominal GDP level target.

What Is Wrong With this Statement?

Following a speech on Wednesday, Fed Chairman Ben Bernanke had this to say in a Q&A:

"If inflation itself falls too low or inflation expectations fall too low, that would be something we'd have to respond to because we don't want deflation[.]"

At first glance this statement seems reasonable, but upon further reflection there is something troubling about it.  It is the monetary policy equivalent of locking the barn door after the horse is already out.  Bernanke is saying here the Fed will respond after inflation falls too low.  Why not lock the barn door up front by explicitly targeting inflation expectations so that the public's expectations about future spending and price growth are anchored and not likely fall in the first place?   If this were the way monetary policy were conducted the Fed would be a little more concerned right now about the now 6-month downward trend in inflation expectations.  

If there is one lesson the Fed should have learned from this crisis is that it needs to take a more forward-looking approach to monetary policy.  Nowhere is this more clearly seen than in the Fed's September, 2008 FOMC meeting where it decided against further monetary easing because of concerns about rising inflation.  Had the Fed been giving more weight to the forward-looking inflation expectations coming from TIPs, it would have noticed that the outlook had been deteriorating since mid-2008.  Instead, the Fed was looking in its rear view mirror and saw the realized inflation rates of the past few months that had temporarily gone up because of supply shocks.  

Of course, in my ideal world the Fed would go one better and target nominal GDP futures contracts.  They don't exist now, but I am hoping that one they do and the Fed explicitly targets them.  Not only would such a policy better anchor nominal spending expectations, it would also make the Fed a whole lot more transparent and thus accountable to the public.

How Big is the Fiscal Multiplier?

Scott Sumner once compared arm wrestling with his daughter to the relationship between monetary and fiscal policy.  Scott explained that no matter how hard his daughter tried to win the arm-wrestling contest he would always apply just enough pressure to offset her efforts and keep her in check.  Likewise, no matter how hard fiscal policy may attempt to stimulate aggregate spending the Fed has the ability to offset such actions and place aggregate demand where it so chooses.  In other words, the size of the fiscal multiplier ultimately depends on the stance of monetary policy.

Recent studies by Eric Leeper, Nora Traum and Todd Walker, Lawrence Christiano, Martin Eichenbaum, and Sergio Rebelo, and Michael Woodford all lend support to this understanding.  They show using formal models that in a world where nominal and real rigidities exist the impact of fiscal policy on economic activity is muted when the central bank follows something like a Taylor Rule.¹  Eric Leeper et al. explains why:

Active monetary policy reacts to a persistent fiscal expansion and the attendant increase in inflation by sharply raising the nominal policy interest rate. This raises the real interest rate, which reduces consumption and investment demand to attenuate the stimulative effects of the fiscal expansion. It is not too surprising that in this monetary-fiscal regime, very large fiscal multipliers are unlikely.

These studies also show, however, that the fiscal policy multiplier can be large if monetary policy is passive and does not raise the policy interest rate to check expansionary fiscal policy.  These studies say this is particularly true when monetary policy hits the zero bound since at that point the short-term interest is effectively pegged.  Here again is Leeper et al.:

Since the 2007–2009 recession, many central banks have shifted their emphasis from stabilizing inflation to stimulating demand by maintaining low and constant policy interest rates—near zero in some economies. When monetary policy makes the interest rate unresponsive to inflation, a “passive” stance, it amplifies fiscal policy’s impacts. By fixing the interest rate, monetary policy allows higher current and expected inflation to transmit into lower real interest rates. Instead of attenuating the demand stimulus of a fiscal expansion, monetary policy amplifies it: lower real rates encourage greater consumption and investment demand. Lower real rates induce a positive substitution effect from higher government spending, substantially raising output, consumption, and investment multipliers.

All the papers make this point that the fiscal multiplier is large and above 1 at the zero bound.  I, however, see several problems with this argument. First, just because the short-run nominal interest rate hits zero percent it does not follow that stimulus will be added by lowering the real interest rates via fiscally-induced higher inflation expectations.  What if, because of worsening economic conditions, the natural interest rate was falling faster than the real policy interest rate? There would be no stimulus.

Second, in the scenario above it is possible that the reason the economy is getting worse and causing the natural interest rate to fall in the first place is because the central bank is falling to sufficiently respond to adverse aggregate demand shocks. For example, if the zero bound is already binding and then a spate of bad news causes the public to become even more pessimistic about future economic growth the central bank would need to aggressively respond to these developments just to maintain the existing stance of monetary policy.  If the central bank failed to respond, this unchecked worsening of expectations would amount to a passive tightening of monetary policy.  In other words, even at the zero bound a central bank can passively tighten monetary policy and offset any attempt at fiscal expansion.   This point is particularly relevant for the Fed today.  Even though the federal funds rate is more or less at the zero bound, the Fed is still concerned about stabilizing inflation and unwilling by its own admission to use all of its monetary tools even though the U.S. economic outlook is worsening.  How possibly could a fiscal multiplier be above 1 in this environment?  Fiscal policy at this point looks to me like a fool's errand.

Third, even if fiscal expansion were to work as well at the zero bound as these studies claim, the expected and actual improvement in economic activity from the fiscal expansion should quickly lead to higher interest rates.  But if there are higher interest rates then this zero bound channel through which fiscal policy works disappears.  So there is a paradox here.
 
So where does that leaves us?  The aggregate demand slump problem is and has always been the Fed's.  It  has been shaping the path of nominal spending during this crisis and therefore has been determining the effectiveness of fiscal policy.  Yes, monetary policy to some extent becomes fiscal policy if Fed did something like a helicopter drop, but this is not the type of fiscal policy  being considered above and does not seem to be a politically viable option.  My takeaway from this is that our time is better spent encouraging the Fed to act more aggressively than pushing for more fiscal policy stimulus. 


¹Leeper et al. show that these rigidities are essential for fiscal policy to have any expansionary effect at all in these models. See Robin Harding's discussion of this point.

Stephen Colbert's Solution to Global Economic Woes

Stephen Colbert invokes his inner Keynesian spirit to propose a plan to end the Eurozone crisis and and revive the U.S. economy at the same time.

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The Geithner Plan to Save Europe is Not Enough

The latest initiative to save the Eurozone is the "Geithner Plan." It would have the Eurozone leverage up the EU's €440 billion bailout fund to €1 trillion by making it act as an insurance fund for investors buying up debt of the troubled Eurozone countries.  Though big, this plan would only address the current debt problems.  It would not solve the large real exchange rate misalignment--30% according to Ambrose Evans-Pritchard--between the core countries and the the troubled periphery. The ECB, on the other hand, could address fix this problem.

Here is how.  If the ECB were to sufficiently ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity and nominal spending is more robust.  Currently, that would be the core countries, particularly Germany.  Consequently, the price level would increase more in Germany than in the troubled countries on the Eurozone periphery.  Goods and services from the periphery then would be relatively cheaper.  Therefore, even though the fixed exchange rate among them would not change, there would be a relative change in their price levels.  This would provide the much needed real depreciation for the Eurozone periphery as they move forward in their attempts to salvage their economies.  

Ambrose Evans-Pritchard explains it this way:

Nor can this gap in competitiveness be bridged by austerity alone, by pushing Club Med deeper into debt-deflation and perma-slump. Such a strategy must slowly eat away at Italian and Spanish society, undercutting the whole purpose of the EU Project. It would ultimately risk trapping them in a debt spiral aswell, leading to collosal losses for Germany in the end. 

The Geithner Plan must be accompanied a monetary blitz, since the fiscal card is largely exhausted and Germany refuses to lower its savings rate to rebalance the EMU system. The only plausible option is for the ECB to let rip with unsterilized bond purchases on a mass scale, with a treaty change in the bank's mandate to target jobs and growth.

This would weaken the euro, giving a lifeline to southern manufacturers competing with China. It would engineer an inflationary mini-boom in Germany, forcing up relative German costs within EMU. That would be the beginning of a solution, albeit a bad one.

So how much inflation would this approach entail?  Paul Krugman gives his estimates based on a 20% real misalignment:

A reasonable estimate would be that Spain and other peripherals need to reduce their price levels relative to Germany by around 20 percent. If Germany had 4 percent inflation, they could do that over 5 years with stable prices in the periphery — which would imply an overall eurozone inflation rate of something like 3 percent.

Ambrose Evans-Pritchard says this solution would be unfair to Germany, but he also says that is the cost of a monetary union.  It may be unfair to Germany now, but arguably Germany helped pave the way for this crisis over the past decade.  For the decisions of the ECB were influenced heavily by developments in Germany at the expense of the periphery.  Could this dynamic change in a new and improved Eurozone?  If not, it may make more sense to have two currencies in the EU.

Actually, the Markets Did Drive Down Their Growth Forecasts Because of the Fed

What explains the big sell off in markets today? As Ezra Klein notes, many observers are attributing it to the FOMC saying it sees "significant downside risk" to the economy.  Felix Salmon, however, objects to this line of reasoning:

It’s silly to think that the decline in stock-market prices was a rational reaction to the FOMC statement. If the FOMC is more pessimistic than the market expected, that’s normally a good sign for markets, since it implies that monetary policy will remain looser for longer. The market cares about the Fed because the Fed controls monetary policy. And so Fed forecasts are important because they help drive that policy. No one revised down their growth expectations as a result of the FOMC statement.

Actually Felix, the decline in equity markets, the drop in treasury yields, and fall in expected inflation all indicate the public has revised down its growth expectations and the most likely reason is Fed policy.  Over the past three years the FOMC has effectively kept monetary policy too tight by failing to respond to shocks that have kept current dollar spending (i.e. aggregate demand) depressed.  This passive tightening of monetary policy started in mid-2008 and continues to this day.  Based on this experience,  markets understand that when the Fed downgrades its economic forecast it means the Fed is going to allow things to get worse. 

Thus, when the FOMC announced last month that it anticipated keeping its target federal funds rate at exceptionally low levels through mid-2013, it was most likely interpreted as the Fed revising down its economic forecast over the next two years and adjusting accordingly the forecast of its target interest rate over this time to maintain the current (not very stimulative) stance of monetary policy.  In other words, the Fed was expecting the natural interest rate to remain depressed longer than previously expected and thus needed to keep its federal funds rate target lower longer than previously expected.  The Fed wasn't adding stimulus, but maintaining the status quo as the economic outlook worsened.  Such an interpretation was entirely reasonable given the FOMC's failure to fully restore aggregate demand over the past three years.

The question, then, is what can the Fed actually do to change the economic outlook.  As I have argued numerous times, the Fed needs to commit to an explicit nominal GDP level target.  To do this, the Fed would (1) announce its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it.  Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting.  That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause current dollar spending to adjust largely on its own.   I go into more detail here how this would work, but the key point is the Fed would be better managing nominal spending expectations.  No more spooking the markets.  Something like it worked for FDR in far more dire circumstances and would most likely work for the Fed today.  And, as Scott Sumner argues, had a nominal GDP level target been in place in 2008 it is likely the economic crisis would have been far milder all along.

Twist and Yawn

The Fed decided today it would lower the average maturity of publicly-held treasuries by selling $400 billion of shorter-term treasuries and buying the same amount of longer-term treasuries.  In addition, the Fed also reconfirmed its commitment to maintain the size of its mortgage holdings and anticipated its targeted interest rate would remain low through mid-2013.  The burning question now is how big of an impact will the Fed's new treasury maturity transformation or "operation twist" program have on the economy?  Not much in my view.  It should add some monetary stimulus, but like the original operation twist its effects will probably be modest and do little to spark a robust recovery.  

So how would it add monetary stimulus?  The standard story is that it would transfer duration and other risks from the private sector's balance sheet to the public sector and thus add to the private sector's ability to take on more risk.  Other riskier asset would be bought by the private sector including corporate bonds and stocks.  This would create wealth and positive balance sheet effects that would spur spending.  In turn, this would increase demand for credit and banks would start lending more. In addition, banks would be willing to lend more because the Fed's program would have increased their capacity to take on more risk. Deposits, therefore, would grow and cause the money supply to increase.  The Fed's actions, then, would ultimately result in a larger money supply.

Another way of looking at this is from a monetary disequilibrium perspective.  Currently, there is an elevated, unmet demand for safe and liquid assets, mainly treasury bills. This elevated demand for treasury bills has pushed their yield down to zero and made them near-perfect substitutes for money.  Because the demand for these safe and liquid assets is not being met by the available supply of treasury bills, it is spilling over into the demand for money assets, the near-substitute for treasury bills at the zero interest rate bound.  This creates an excess demand for money that in turn leads to a drop in aggregate spending.   The Fed's new program puts more treasury bills back into the private sector and thus removes some of the overflow excess demand into money assets.  It should also raise the yield on treasury bills and make them less of a substitute for money assets.  Either way, there should be less of an excess money demand problem and thus more aggregate spending.

Still, I am not sure this new operation twist will pack much of a punch.  The reason being is that the Fed is once again adding monetary stimulus without setting an explicit target. Without an explicit target to permanently shape expectations about future spending and inflation, it is hard to see how this new stimulus program will have any more lasting power than QE2.  The Fed needs to quit throwing  large dollar programs at the economy and instead commit to buying up as many assets as needed until some nominal GDP (or price) level target is hit.  This would signal to the public that the Fed is willing to spend whatever is necessary to restore robust aggregate demand.  QE2 and the new the operation twist, on the other hand, only commit to spending a limited amount of dollars and after that point, well, the economy is on its own.  Nominal expectations are allowed to drift and become unanchored. This is why I find this the Fed's announcement today underwhelming.  Wake me up when the Fed really gets serious about doing monetary policy.

Update: Mark Thoma, Brad DeLong, and Bill Woolsey take a similar view on operation twist. Also, FT Alphaville provides a nice roundup of Wall Street views on operation twist.  Finally, Edward Harrison does a great code red take on operation twist.