Should the Fed Be Doing More?

Monetary policy looks to be at a protracted standstill – or even arguably becoming less accommodative as purchases of long dated securities draws to a close – despite incoming information that points toward persistently high unemployment rates and an ongoing disinflationary environment. Is policy stability the consequence of changing economic conditions, a perceived ineffectiveness of nontraditional policy, or a willingness of policymakers to be constrained by conventional policy limitations in the absence of impending financial doom? My sense is that all three elements are in play.

It is pretty clear that economic conditions changed dramatically mid-year as inventory correction and policy stimulus brought the recession to a close, at least if measured by growing output. To be sure the sustainability of the gains are in question. I hold little hope that growth could be sustained in the absence of the policy efforts to date, and the Administration is likely starting to realize that it underplayed its hand this year, offering far to little stimulus to effect stabilization from the all important jobs perspective. Calculated Risk sees growing potential for a second stimulus package (in spirit if not in name), the support for which will gain as concerns about midterm elections grow. Still, from the perspective of monetary policymakers, positive growth after such a long recession could only be met with a sigh of relief and, perhaps inevitably, a willingness to pause and assess the implications and impact of policy to date.

The problem with pausing, however, is that a combination of maximum sustainable growth and price stability are in fact the Fed’s objective, we seem to be falling short on both measures. Unemployment continues to climb, nonfarm payrolls continue to fall, and core-PCE inflation continues to decelerate. Moreover, Fed forecasts suggest that these trends will continue for literally years. Leaving aside inflation fears that seem to be largely contained in a handful of what I think are crowded trades (gold and TIPS), what should the Fed be doing on the basis of actual, incoming data? Have they truly hit the limits of policy? This brings be to an ongoing debate between Paul Krugman and Scott Summner, with the recent participation of Joe Gagnon.

A starting point for further analysis is Krugman’s assertion that conventional policy has been brought to a standstill. Zero is zero:

I keep seeing economics articles and blog posts that insist that we’re NOT in a liquidity trap (and, of course, that yours truly is all wrong) because the situation doesn’t meet the author’s definition of such a trap. E.g., the interest rates at which businesses can borrow aren’t zero; or there are still things the Fed could do, like buying long-term bonds or corporate debt, or something.

Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story.

Now, if you prefer a different definition of a liquidity trap, OK; call our current situation a banana, instead. But changing the name does not change the essential fact — namely, conventional monetary policy has lost effectiveness.

The loss of conventional monetary tools led Krugman, and many others, to conclude that stimulus efforts should focus on the fiscal side of the equation. In response, Scott Sumner has long argued that more aggressive monetary expansion was needed, to which Krugman replies that at zero rates, more money is ineffective at stimulating output:

A dozen years ago I would probably have agreed. But way back in 1998 I tried to think my way through Japan’s situation with a little intertemporal model, and surprised myself with the conclusion: under liquidity-trap conditions, it doesn’t matter at all what happens to M.

In that model, prices are assumed sticky in the short run, so P is predetermined. What, then, determines Y? Well, it’s a real thing — as opposed to a nominal thing. In the model it’s actually tied down by an Euler condition, by future consumption and the real interest rate (which is stuck thanks to the zero lower bound). Monetary policy has no traction at all against the right hand side of the equation.

Now, the equation still holds. But all that tells us is that any changes in the money supply are offset one for one by changes in velocity. Focusing on nominal spending makes you think that low nominal spending is the problem, a problem with a monetary solution; but actually it’s the symptom, and monetary policy doesn’t matter (unless it can affect expected future inflation, but that’s another story).

Joe Gagnon delivers evidence that in a world with multiple interest rates, unconventional policy did in fact depress interest rates at longer horizons or on non-Treasury debt:

In recent months, central banks have purchased large quantities of longer-term assets. These purchases appear to have been effective at pushing down longer-term interest rates, which should stimulate economic activity. For example, the Federal Reserve (Fed) has purchased large quantities of longer-term agency-backed securities and Treasury bonds. The following table shows that Fed communications about such purchases had substantial effects on a range of long-term interest rates, including on assets that were not included in the purchase program, such as interest rate swaps and corporate bonds….Since March 19, the Fed has not made any substantive changes to its planned purchases of longer-term assets. Over this period, the 10-year Treasury yield has risen about 75 basis points and the corporate yield has fallen about 200 basis points, reflecting a relaxation of the extreme financial strains and flight-to-quality that characterized the first few months of this year. Conventional fixed mortgage rates, a key target of the Fed’s policy easing, have changed little on balance since late March.

Which would appear to support the contention that unconventional policy does have a stimulus impact, and that monetary policy could push further by continuing the soon-to-end Treasury purchase program, and thus would it would be worth revisiting its expected conclusion. Still, would this be enough in light of the crux of Krugman’s argument that is worth repeating: “… monetary policy doesn’t matter (unless it can affect expected future inflation, but that’s another story).”? Krugman elaborates:

We’re in a liquidity trap, with interest rates up against the zero bound. This means that conventional monetary policy isn’t sufficient. What should we do?

The first-best answer — that is, the answer that economic models, like my old Japan’s trap analysis, suggest would be optimal — would be to credibly commit to higher inflation, so as to reduce real interest rates.

But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii).

In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good.

From Krugman’s perspective, the key is not simply increasing the money supply via increasing nonconventional purchases. The key is fundamentally changing inflation expectations. This fits with Brad DeLong’s definition of quantitative easing:

Quantitative easing policy is the altering of market expectations of the long-run path of the money stock.

By this definition, I don’t believe the Federal Reserve has pursued anything close to quantitative easing because policymakers have consistently defined their actions as temporary “credit easing.” At best, they have acted to ensure that the long-run path of the money stock (and thus inflation) will not decline from previously stated objectives. But avoiding outright deflation is not the same as increasing expectations of inflation.

For his part, Sumner says this is what he has been saying all along:

Krugman should have been advocating monetary stimulus all along. The real problem is that his allies in government; Obama, Pelosi, Reid, etc., don’t even know the first best option exists. And how could they? How often is monetary stimulus mentioned in columns written by liberal pundits? If they realized that they were about to get decimated in the 2010 midterm elections because a few nutty right-wingers at the Fed think the economy needs less stimulus, not more, there would be outrage in Congress and the Administration. They’d be marching down to the Fed (metaphorically of course, to avoid looking heavy-handed) and make it very clear that the Fed needs to produce robust growth in aggregate demand or else there will be big changes in the way the Fed is set up and regulated. If they don’t seem “receptive,” then quietly tell the FOMC; “Think the Dodd bill is bad? You can’t even imagine how much worse we can make it.”

I think a case can be made that in a world were interest rates have been pushed to zero, first in Japan, then in the US, etc., policymakers would be forced to rely on heighten inflation expectations should they hope to have an impact on activity – essentially, resetting the bar. Sumner essentially argues that resetting that bar is exactly what is needed. And Krugman appears to believe this as well, but ultimately he is correct on the political economy angle. The Fed seems in no way to be dissuaded from its central tendency for inflation in the range of 1.7-2%. And the challenge is much more widespread than Sumner implies. A “few nutty right-wingers at the Fed” almost certainly cannot include San Francisco Fed President Janet Yellen. Her last speech was instructive. She possess a clearly pessimistic outlook:

It’s popular to pick a letter of the alphabet to describe the likely course of the economy. The letter I would choose doesn’t exist in our alphabet, but if I were to describe it, it would look something like an “L” with a gradual upward tilt of the base. With such a slow rebound, unemployment could well stay high for several years to come. In other words, our recovery is likely to feel like something well short of good times.

Note – several years of high unemployment! Regarding inflation:

…But experience teaches us that budget deficits do not cause inflation in advanced economies with independent central banks that pursue appropriate monetary policies. As for the Fed, you can be 100 percent certain that price stability will remain our objective, regardless of the stance of fiscal policy.

..I believe that the more significant threat to price stability over the next several years stems from enormous slack in the economy that is pushing inflation lower. Today, inflation is already very low. Over the past 12 months, consumer prices as measured by the personal consumption price index actually fell by one-half percent. After removing the effects of volatile food and energy prices, core prices rose by 1¼ percent. That’s below the 2 percent rate that I and most of my fellow Fed policymakers on the Federal Open Market Committee (FOMC) consider an appropriate long-term price stability objective. The public’s inflation expectations, which can independently influence inflation, remain well anchored, which is appropriate given the Fed’s record and its commitment to price stability. And with slack likely to persist for years and wages barely rising, it seems probable that core inflation will move even lower over the next few years.

Now we have several years of unemployment and lower core inflation over two years. Consider that forecast carefully – Janet Yellen, not a right-wing nut job, is giving a forecast that makes clear the Fed will fall short over the medium term in its pursuit of price and output stability. And not just by a narrow margin. What does this mean for policy?

…This landscape presents clear challenges for monetary policy. We face an economy with substantial slack, prospects for only moderate growth, and low and declining inflation. With the federal funds rate already at zero for all practical purposes, the Fed’s traditional policy tool is as accommodative as it can be. To provide more stimulus, the Fed has used unconventional policy tools, including emergency lending programs to promote liquidity and push longer-term interest rates lower. However, many of these programs are winding down or nearing completion. That is why the FOMC stated that “economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period” following our meeting last week.

Yellen states policy now amounts to wait and see – or, possibly more accurately, be contractionary by allowing the existing unconventional tools to wind themselves down and not be replaced. That is because they viewed those tools not as expansionary in their own right, as efforts to change expectations about the long-run path of the money stock, but as temporary credit easing measures. In the absence of those measures, policy reverts back to the zero bound.

In short, Janet Yellen is saying that they are at the limits of policy despite an outlook that is inconsistent with sustainable output and stable prices. A cynic might point out that when Wall Street is in danger, the Fed rewrites the play book, but for Main Street, policymakers have only one message: We have done all we can do.

Moreover, she finishes up with the required warning from all Fed officials:

At some point, of course, we will have to tighten policy—and we certainly have the means and the will to do so. We are—and always will be—steadfast in our determination to achieve both of our statutory goals of full employment and price stability. Until that time comes though, we need to provide the monetary accommodation necessary to spur job creation and prevent inflation from falling any further below rates that are consistent with price stability. Thank you very much.

The Fed has done all it can – or is willing – to do at this point. We have no intention to do more. Our focus is only on preparations to reverse what we have already done. The commitment to price stability remains unchanged.

Bottom Line: Economic conditions are improving, but at a pace that promises that unemployment will remain unacceptably high for years. Millions of workers left on the sidelines for years. Acceptable from a policy perspective? No. But is the Fed ready to engage in what would be the real next step for policy – a concerted effort to boost inflation expectations and regain control over monetary policy? A stated higher objective for inflation and a massive quantitative easing program to support achieving that ojective? No. There is simply nothing to suggest the Fed is waiting for anything other than the first chance to “normalize” policy in the traditional sense. That may still be a long time from now, but is nonetheless the shore the Fed seeks as they attempt to navigate out of unconventional policy, not deeper in.

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