One need to look no further than the market for 5 year T-notes to see the increasing tightness of monetary policy. NGDP growth expectations are now falling rapidly. Indeed things are now so bad that even the New York Times has woken up to the fact that the Fed might have to act.
Even as Congress escapes from its brush with default, political divisions have all but immobilized the levers of fiscal policy, raising pressure on the Federal Reserve to address the nation’s economic lethargy.
And yet almost no one seems to understand the nature of the problem we face. Here the Times describes Ben Bernanke’s perspective:
Ben S. Bernanke, the chairman of the Federal Reserve, said in the spring that it was time to see whether the economy could stand on its own. Last month he said the Fed would consider new steps if conditions deteriorated significantly. As the Fed’s policy-making committee prepares to meet Aug. 9, the drums are beating louder.
Right now the Fed is like a ball and chain, dragging the economy down. Yet Bernanke still seems to see it as a pair of crutches.
The Fed already is engaged in a vast and unprecedented effort to bolster economic growth. It has held short-term interest rates near zero for almost three years, and amassed more than $2 trillion in Treasuries and mortgage bonds to hold down long-term rates. But since the end of June, when it completed its most recent round of asset purchases, the Fed has chosen to stand pat.
Yes, just like the Fed of the 1930s and the BOJ over the past 17 years have engaged in “vast and unprecedented efforts to boost economic growth.”
Its available options now are modest steps including replacing its promise to maintain low rates “for an extended period” with a more specific commitment, like a six-month minimum. More aggressive steps could include tilting the composition of its investment portfolio toward longer-term Treasury securities, to increase the downward pressure on long-term rates. The most drastic step, which analysts also consider least likely, would be a decision to increase the size of its portfolio.
This is just sad. The markets are telling us that the Fed will hold rates at zero for far more than 6 months. So that would hardly be a revelation. Even worse, the Fed doesn’t seem to realize that near zero rates are a sign of tight money, not a sign of easy money. (Queue up Friedman quotation here.)
For the moment, and for as long as possible, the central bank would like to do nothing. There is broad agreement that the unprecedented size of the Fed’s portfolio has complicated its ability to control the pace of inflation, and that additional purchases would exacerbate the difficulty.
No, the Fed is never doing nothing. The fact that people think it is just demonstrates what we are up against.
Mr. Bernanke has said that growth must weaken and price increases abate. A vocal minority of Fed officials has gone further, arguing the central bank has reached the limit of its powers.
Maybe it’s a blessing that Milton Friedman is not around to read this stuff. I can’t even imagine how frustrating it would have seemed to see one’s magnum opus on the Great Depression (which Bernanke said the Fed had accepted), thrown in the trash bin.
“It seems unlikely that the forces limiting the pace at which U.S. growth is recovering are amenable to monetary policy,” Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, said in a speech last week. “Additional monetary stimulus at this juncture seems likely to raise inflation to undesirably high levels and do little to spur real growth.”
That’s right; the extremely low level and growth rate of NGDP right now has nothing to do with the slow recovery. Why would it? There’s nothing in modern macro theory that would suggest NGDP falling 11% below trend would depress growth, is there?
The Fed is even less eager to renew its interventions into financial markets. The central bank has hovered on the edge of the debt ceiling debate like a homeowner riding out a hurricane, hoping for limited damage to the lethargic economy.
The operative word is ‘hoping.’ The Fed is hoping, not acting.
The Fed also could buy dollars in the event of a downgrade. Uncertainty already is driving investors to other currencies, and a sharper decline could undermine the dollar’s role as an international reserve currency — a status that has significant benefits for the American economy.
That’s right; a stronger dollar will fix our AD shortfall.
Perhaps most important, intervening in exchange markets may not prevent the dollar’s fall. “If the dollar were just weak because people had lost confidence in the U.S. government, I don’t see why buying dollars is going to restore confidence,” said Mr. Kohn, now a senior fellow at the Brookings Institution. “The cure for that isn’t intervention. The cure is the government acting like adults.”
No, they are currently acting like adults. The cure is to start acting like macroeconomists. To start taking macro theory seriously. To set policy at a level expected to produce the nominal spending they would like to see. To set policy at a level where downside risks to nominal growth and upside risks are balanced. To set policy at a level expected to succeed.
I am leaving in a few minutes for a vacation, and so I won’t have much time, if any, to respond to comments.