Look! The Economy’s Sinking! Someone Should Do Something!

Ben Bernanke doesn’t think the economy needs any more monetary stimulus, even though many types of monetary stimulus are essentially costless.  Oddly, however, Bernanke does seem to think we need fiscal stimulus, even though fiscal stimulus is extremely costly, imposing huge dead-weight costs on the economy from future tax increases:

Federal Reserve chief Ben Bernanke told Congress on Thursday that the economy needs continued government stimulus spending to strengthen the recovery and reduce unemployment. But more stimulus spending would be a tough sell with congressional Republicans, who say the first round hasn’t helped enough.

This has never made any sense to me.  In the comment section of a recent post, Andy Harless provided the most plausible explanation that I have seen thus far:

Under today’s circumstances, fiscal policy is more precise than monetary policy. (It’s easy to get a vaguely reasonable estimate of the effect of a fiscal policy move, e.g. extending unemployment benefits, on AD. Much harder to estimate the effect of, say, a $200 billion purchase of 5-year T-notes by the Fed.) I think this is somehow related to the conception that most people seem to have that fiscal policy affects real output and monetary policy affects the price level. I’m not sure exactly how.

The term ‘today’s circumstances’ refers to the current monetary base setting and near-zero interest rates.  Harless is arguing that this fulfills the “other things equal” assumption required to get relatively accurate fiscal stimulus multiplier estimates.  Elsewhere I have criticized that view, noting that Fed signals about future policy intentions (exit strategies, etc) are its most powerful tool.  But as this is a minority view, I’d like to focus on some other issues.

1.  The first thing I’d say is that if the Fed believes it doesn’t have any precise tools to use, then it has no one but itself to blame.  In 1988 or 1989 I presented a paper at the New York Fed advocating the targeting of NGDP futures.  The audience assured me that the Fed already had all the tools it needed to target NGDP, and didn’t need any help from futures markets.  So how’s their interest rate targeting working out now?  Even worse, if you run out of interest rate “ammunition,” you’d presumably want to turn to QE.  Unfortunately the Fed began paying interest on reserves in October 2008, which essentially sterilized the effects of QE.  The Fed is like someone who puts on boxing gloves, and then complains that they are having trouble sewing on a button.  Take off your gloves!

2.  The Fed definitely needs to move toward level targeting, and give up on the inflation targeting approach, which has obviously failed.  Under level targeting the economy is much less likely to overshoot toward high inflation, because commodity speculators will know that if inflation rises above target, tight money will later bring it back down to the target.  Even better, since markets are forward-looking, the mere expectation of future corrective action will make overshooting much less likely (as with a credible currency peg.)

3.  But even if the Fed sticks with inflation targeting, they ought to be able to prevent overshooting.  I think many economists are still over-reacting to a very painful episode in American monetary history, 1965-1981.  As you may recall (if you are an old guy like me), the economics profession was continually surprised by unexpected increases in inflation during that period, as the trend rate rose from about 1% to over 10%.  But there are two very good reasons why that won’t happen today.  Unlike during 1965-81, we have TIPS markets which allow us to measure inflation expectations in real time.  And second, the Fed has a much greater understanding of the risks associated with letting inflation expectations drift to higher levels.

You may ask why I focus on inflation expectations, and not inflation.  After all, market expectations can be wrong.  It turns out that it isn’t just me; the Fed also focuses on inflation expectations.  The reason is that transitory movements in actual inflation, which don’t get embedded into expectations, are not very harmful to the economy.  For instance, inflation might rise temporarily because of an oil shock.  But if inflation expectations don’t rise then the temporary rise in actual inflation won’t become embedded in core inflation and wages (which respond to inflation expectations.)

If inflation starts to creep up to unacceptable levels the Fed can raise rates.  There is nothing equivalent to the zero rate bound on the high side.  And the mere fact that markets know the Fed can do this will tend to keep inflation expectations well anchored.  Of course all of this would be much easier if the Fed came up with an explicit price level, or better yet, an NGDP target.

Since I’ve responded to Harless’s comment, I’ll give him the last word.  In a different post’s comment section he expressed skepticism about whether TIPS spreads can be counted on to accurately measure inflation expectations:

Also, it risks getting whipsawed by changes in risk/liquidity premia associated with TIPS vs. nominal bonds. (I’m guessing this might be an even bigger problem with long-horizon NGDP futures, since my impression is that futures with distant settlement dates usually have low liquidity, and I can’t see a way to do NGDP futures with a settlement date before the actual horizon date.)

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