A Modest Monetary Proposal

I have been reading and rereading Raghuram Rajan’s piece questioning the effectiveness of proposals to raise inflation targets.  I tend to be pretty sympathetic to such proposals; traditional monetary policy obviously hit it limit long ago, and active commitments to higher inflation to depress real rates seems to be a logical next step.  That said, Rajan has a number of good points questioning both the implementation and efficacy of higher inflation targets.  Can the Federal Reserve credibly commit to higher inflation?  Can they credibly commit to regain control over inflation at some later time?  Most striking, I think, was Rajan’s reflection, that a small inflation increase really will not do much good at all:

Moreover, the central bank needs rapid, sizeable inflation to bring down real debt values quickly – a slow increase in inflation (especially if well signaled by the central bank) would have limited effect, because maturing debt would demand not only higher nominal rates, but also an inflation-risk premium to roll over claims.

A mechanism to rapidly accelerate the process of household rebalancing would be extremely helpful.  It is not clear that an inflation target of 3 percent is such a mechanism.  Something more dramatic is required.

Would that something more dramatic be QE3?  I see that over the weekend, St. Louis Federal Reserve President James Bullard came out in favor of QE3 should more easing be necessary.  From the Wall Street Journal:

In an interview with the Business News Network, James Bullard said “I still think our most potent weapon is to do more QE3 if necessary,” in a reference to the QE2 bond buying program that ended in the summer.

He goes on to undermine the policy that Fed seems to be coalescing around:

Bullard said the experience of the 1960s-era “Operation Twist,” when the Fed and Treasury together worked to try to push down long-term borrowing rates, should be cautionary. Bullard said that effort was not particularly effective, which is why more outright purchases would most likely be the way to go.

My sense is that Bullard prefers whatever policy option produces the biggest headline for him.  That said, he is probably right on this one – a portfolio rebalancing is a move in the right direction, but don’t expect miracles.  But could any miracles really be expected from more quantitative easing? As Rajan notes:

Start with the question of whether central banks that have spent decades establishing and maintaining anti-inflation credibility can generate faster price growth in an environment of low interest rates. Japan tried – and failed: banks were too willing to hold the reserves that the central bank released as it bought back bonds.

To be most effective, monetary policy needs to push on some variable that will have a substantial impact on demand.  Trading safe assets for cash at near zero interest rates just doesn’t accomplish that.  But it’s the only biggish lever we seem to have left, but it simply is not direct enough.  What is needed is to get the money in the hands of someone who will use it, rather than just sloshing around banks as excess reserves.   If it is stuck in the banking system, it can’t create demand that at least causes a big shift in the prices of both goods and wages.

Maybe at this point we need to be thinking about something a little more direct – one of the proposals floating around is to use Fannie and Freddie to purchase nearly all the outstanding mortgages and refinance them at lower interest rates regardless of loan to value ratios.  Better yet, to apply some consistent system of principle reduction for everyone, not just underwater mortgages.  Lift the entire boat at once, rather than trying to discern between the most and least deserving lifeboats.

Something like this is not a new idea, but it gets held up by, among other things, the issue of the cost.  So maybe the Treasury needs to issue a class of bonds the Federal Reserve agrees to purchase and hold – essentially monetizing the rebuilding of household balance sheets and freeing future tax payers from the burden of repaying the debt.

I suspect that this entails a sharp, one time increase in the price level, and this is the tricky part.  The Fed would have to both accept that increase and make clear they are committed to return to their 2 percent target.  I don’t think this is impossible, but it might be difficult to accomplish quickly.  Also note that once we can lift up off the zero-bound, traditional monetary policy can come back into play to manage inflation.  Moreover, they have room to reduce the remainder of the balance sheet, but, when all is said and done, they should not expect to return to the pre-crisis trend, and instead acknowledge the one-time shock to the balance sheet.

Bottom Line: Rather than the more indirect approaches left to monetary policy, maybe there is room for a one-time effort to monetize the rebalancing of household balance sheets, which perhaps can be viewed as a more “modest” alternative to monetization of general government spending.  Perhaps the former can be more credibly contained to a one-time event.

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