What is Clear, and Not So Clear, About Fed Policy

I want to comment on some of the reactions I’ve been reading about lately concerning the Fed’s recent policy statement. The full text of the statement can be found here: FOMC September 21, 2010. Here is the last paragraph:

The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

One reaction to this statement can be found here: Fed’s Hint of Further Easing Leaves Wall Street Guessing.

Evidently, the Fed is creating some confusion for the markets. This quote from that article essentially sums it up:

Depending on whom you asked, the central bank either said too much, too little or said it poorly…

Well, the Fed can be annoying at times, I guess. It would be nice if the next time it would say neither too much, nor too little, and–of course–to say all it is saying (and not saying) much more clearly!

But kidding aside, is there a legitimate complaint here? Maybe. What I thought I would do is to list in my own mind the things I think are more and less clear, and then maybe talk about whether any lack of transparency (if it exists) really matters. (Note: I am writing this on the fly, so I’m not really sure where this is going to end up).

What is clear

First, although the Fed has no explicit long-run inflation target (something I believe should be rectified), it’s implicit target is widely viewed to be around 2%.  Of course, inflation fluctuates around this target and normally, this short-run behavior is of no great concern. The Fed does appear, however, to go on alert when it detects what might be the beginning of an upward or downward trend in the inflation rate (away from the 2% target).

Second, inflation is currently running at around 1% and the short-run recent trend (if it is indeed a trend) is pointing in the downward direction. This event, in and of itself, might normally elicit only a modest concern. But combined with an economy presently weaker than expected, the concern is now heightened. And, in particular, the worry at present is the risk of a Japanese style deflation (a “deflation trap” in the minds of some, though I’m not even sure if such a thing exists).

Third, it seems clear that this risk is presently judged to be “small.” But small is not the same thing as zero. Accordingly, the Fed has judged it prudent to issue a contingency plan (note the big IF in the FOMC statement quoted above). You might recall that not too long ago, the Fed was more concerned with another part of its contingency plan (the so-called exit strategy, designed to mitigate inflation fears following the massive expansion in its balance sheet).

Fourth, it seems clear that the Fed stands prepared to “do whatever it takes” to prevent inflation from trending downward any further. (It is also committed to keep inflation reigned in, should we find ourselves on the other side of the inflation target–again, this is the much talked about exit strategy).

What is less clear

The recent FOMC statement did not, however, delve into the details of what tactics the Fed would employ in the event of undesirably low inflation. On the other hand, the Fed has given us a pretty good hint at how it might proceed in its earlier statement: FOMC August 10, 2010; i.e.,

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.

In short, the Fed’s going to do what it always does when it wants to loosen policy: purchase assets in exchange for newly created money. Which assets? Not short term treasuries–their yields are close to zero. No, it will almost surely include longer dated treasuries, whose yields are currently in the 2.5% range.

There remains some uncertainty in terms of how such a loosening might be implemented over time. A good bet, in my view, would be a state-contingent sequence of purchases, with the quantities purchased depending on how output and inflation evolve over time. The policy rule might take a form like this:

Asset Purchase Rule: B_t – B_t-1 =  f ( π_t – π, … )

where the left-hand-side denotes the size of the desired bond purchase (sale, if negative) as a decreasing function of the inflation gap (and possibly other things).

What is not so clear

What if they do all that and it turns out not to be working? In particular, suppose that inflation continues to trend downward as yields on long dated treasuries approach zero? Then what?

Well, there really aren’t a lot of options. If the Fed wants to talk inflation up and back its talk with action, it will have to expand the set of securities it is willing to purchase. This much seems clear enough (to me, at least). The only question, in this event, is which securities? (Maybe this is what upsets Wall Street traders, because they would like to know which securities to long and short? If so, they should look on bright side of this opacity: they can continue to blame the Fed for their trading losses).

Now, let’s see. Additional MBS purchases are a distinct possibility. Another possibility might be purchases of state and municipal bonds.  Of course, moving along this branch of action raises additional questions. High grade or low grade assets, or both? Should the Fed discount a junk municipal bond and, if so, at what rate? But perhaps I am getting ahead of myself. The Fed (Ben Bernanke, in particular)–and indeed, even the Treasury–have both expressed reluctance at the idea of purchasing low-level government debt; e.g., see here: Fed Limited in Ability to Buy Muni Bonds. (Note: “ability” should be properly be replaced with “willingness,” I think. And I’m not sure whether this alleged limited ability to buy necessarily rules out an ability to accept these objects as collateral. I will have to look into this).

What is downright blurry

In the event that the economy finds itself in an undesirable deflation dynamic, will any of what I described above actually work? Is this a question that should even be raised in public? (I ask, in part, because there are some people who believe that the Fed should not even have raised the possibility of deflation in the first place, for fear that it would create a self-fulfilling prophesy.)

If we ever arrive in such a world, it will indeed be a strange one. After all, what sort of central bank, with its power to create money “out of thin air,” is powerless to affect nominal variables? The Reserve Bank of Zimbabwe  appears to have had little difficulty in creating inflation (Note: the hyperinflation in Zimbabwe ended on April 12, 2009. Note too that the Zimbabwean currency no longer exists; see here).

I’m not entirely sure what happened in Zimbabwe, but let me guess: Their fiscal authority used the central bank to create money that was then spent on goods and services that were largely consumed (someone correct me if I am wrong). Money created and used in this manner is never retired and generates no income (income that could, for example, be used to finance future purchases of goods, or retire the money stock). Yes, I think we can all be fairly confident that fiscal authorities have the power to create inflation (and expectations of inflation).

In the U.S., however, the Fed is independent of the fiscal authority (at least, it likes to think it is). When the Fed creates new money,  it is restricted to inject it into the economy  via asset purchases only (normally U.S. treasury debt, or other high-grade securities). How might this restriction matter?

Here is one possibility. Imagine that, for some reason, everyone expects a persistent deflation of, say, 2%. Moreover, imagine that the “natural” (real) rate of interest on high-grade securities is also 2%. Then, if the Fed targets the nominal interest rate anywhere above zero, the real rate of interest will be “too high” (depressing aggregate demand). The Fed is compelled to cut its interest rate to zero. A no-arbitrage-condition implies that the nominal yields on similar assets will also fall close to zero. In this event, swaps of zero interest money for zero interest securities is not likely to have any effect at all.

The Fed could, however, try to purchase higher-risk asset classes.  The yields on these assets are far above zero, reflecting the probability of default, one would guess. Now, these assets will either pay off or not. If they pay off, the Fed is obliged to remit this profit to the Treasury (hence, the Fed has no control over how this profit is ultimately spent). If they don’t pay off, the Fed will take a loss. Well, not a loss exactly. The Fed might (in principle, at least) simply keep the nonperforming loan on its books as an asset that expected to pay off sometime in the infinite future. In short, it becomes a perpetual zero interest loan–in effect, a lump-sum transfer of cash into the economy.

I haven’t thought through the logic entirely yet, but it appears that out of these two scenarios, the expectation of outright defaults would resemble a series of lump-sum cash injections into the economy; something that we are fairly confident would generate inflationary pressure (it works well in our models, at least). On the other hand, if the assets are largely expected pay off, with the profits remitted to the Treasury, the inflationary consequences will depend on the subsequent actions of the fiscal authority.

So, at the end of the day, the Fed acting on its own, and under the current institutional framework, may not even have the capacity to influence nominal variables in some (low probability) states of the world. A commitment to an inflation target would, in this case appear to require explicit language explaining the joint monetary/fiscal behavior deemed necessary to achieve the stated goal.

I’m not holding my breath waiting for this language to appear anytime soon, primarily because I think that the risk of this scenario is still judged to be relatively small.  But, we shall see.

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