I know that you are already rolling your eyes over the corny Star Wars reference, but I’ve never been more serious in my life. The Fed has a simple decision to make. Do they want to achieve some sort of nominal target, or not.
There are two metaphors one can use for monetary policy initiatives. One metaphor is the scientific experiment. The Fed will try QE to see if it works. Or they’ll try Operation Twist to see if it works. The other metaphor is steering a ship. They adjust their policy levers to keep the economy moving in the appropriate direction.
During normal times everyone assumes the steering a ship metaphor is the right one. The Fed nudges interest rates higher or lower to steer the economy in the direction they want to go. At the zero bound almost all commentators switch to the scientific experiment metaphor. The Fed tries something, and then waits 6 to 12 months to see how it works. But this is the wrong metaphor. In my view the experimental approach will almost always fail. The steering metaphor is always the right one. The Fed must stop trying, and they must decide what they actually want to do.
Let’s consider QE2 as a nudge of the steering wheel. Did it work? Almost all the indicators suggest it did, indeed both Keynesians and monetarists were proclaiming it a (very limited) success in early 2010. Relative to the non-QE2 situation, it clearly boosted AD, at least slightly.
Now let’s consider QE2 as an experiment. Did it work? I’d say no. I don’t think anyone can be satisfied with NGDP growth over the past 12 months.
And the reason for the failure of QE2 as an experiment is easy to see. Ben Bernanke is no Luke Skywalker. In order to follow Yoda’s maxim the FOMC would have to wake up every morning and ask themselves whether they were satisfied with the path of expected NGDP growth. At some point during the spring of 2011 the answer would have switched from yes to no. At that point they’d need to nudge the steering wheel enough so that expected NGDP was again on target. But they didn’t.
Given enough time, a Yoda-like commitment will always succeed, at least in terms of boosting NGDP growth. It might fail in other respects:
1. Higher NGDP growth may fail to boost RGDP.
2. The Fed might have to buy up an extraordinary amount of risky assets, and they might then suffer large capital losses.
But it will boost NGDP.
As a practical matter the two risks cited above are not serious concerns. The Fed should aim for steady 5% NGDP growth even if the monetarist/Keynesian model is completely wrong, even if NGDP has no impact on RGDP. So it’s no loss if more NGDP fails to boost RGDP. And as for capital losses, the Fed can always avoid having to buy up large quantities of risky assets by ending IOR (or even going negative) and buying Treasury notes. As a practical matter the public is not going to want to hold a massive amount of non-interest bearing cash if the Fed is committed to keeping NGDP rising at trend. Never has happened, and never will.
Many people worry about whether the Fed can boost NGDP. The market reaction to QE2 makes it obvious that the answer is yes. The only question is whether the Fed will decide to do whatever it takes. If they ever make that decision, they will be stunned to learn just how little it takes. But if they fail to make that commitment, nothing they do will ever seem to be enough. Unfortunately it looks like they will keep trying, and hence not doing.
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