Nice Exit Strategy; When Can We Expect an Entrance Strategy?

This is my most requested post so far (and thanks to JKH for the idea for the title.) I hope it’s not as “awful” (to quote Bill) as my previous post.

Here’s how Bernanke started off his recent editorial in the WSJ:

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed’s balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

Isn’t this basically what Herbert Hoover’s Fed did? Didn’t they also cut rates to near zero levels? Didn’t they also massively expand the Fed’s balance sheet, causing rapid growth in the monetary base? Didn’t Hoover also bail out the banking system with taxpayer money through his Reconstruction Finance Corporation? So does that mean the Fed was also “accommodative” in the early 1930s? And if so, what’s the difference between ‘accommodative’ and ‘expansionary.’

Am I being too hard on Bernanke? After all, the Fed has done a lot. But so did Hoover’s Fed, the question is whether the Fed is doing anything effective. The only difference I can see is that the base rose even more under Bernanke than under Hoover, but that was fully neutralized by the policy of bribing banks to hoard excess reserves. (A mistake that in the Great Depression wasn’t made until late 1936, when they adopted an “exit strategy” of raising reserve requirements.)

But what about all the QE this year? Isn’t Bernanke finally coming around to my view? See what you think:

To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities, and ultimately to their wind down.

As I have been arguing for some time, that’s not QE. Rather than targeting the monetary base, the Fed is passively accommodating changes in the banking system’s demand for loans. In the old days it was called the “real bills doctrine.” I was under the impression that that view had been discarded by the Fed.

Here is what Bernanke says about the policy of interest on reserves:

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Fair enough. But then doesn’t it also stand to reason that when the time comes to loosen policy, you should reduce the interest rate on reserves? In October 2008 the Fed raised the interest rate on reserves from 0% to somewhere between 1% and 2%. Was October 2008 a “time to tighten policy?” Or was it the time to loosen policy?

I’ve also argued that by paying interest on reserves at a rate higher than banks can earn on T-bills the policy discourages banks from moving the excess reserves out into circulation. It seems that Bernanke agrees:

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

I was also interested in seeing Bernanke’s outlook for the economy:

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period.

That’s what I was afraid of. The term “extended period” brings back unpleasant memories of Japan. What I can’t figure out is why not a more expansionary policy right now? We know that unemployment is likely to be too high for an extended period, and all the forecasts show inflation well below the Fed’s target for years to come. And Bernanke clearly indicates that these are the Fed’s two policy targets:

We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

So why not adopt an explicit price level or NGDP target?

After taking office in March 1933, FDR discarded Hoover’s failed policies and adopted an effective monetary policy—an explicit promise to raise the price level to pre-Depression levels. Four months later industrial production had risen 57%. Something to think about.

He also missed one important part of the exit strategy, fiscal policy. Bernanke called for fiscal stimulus last year. Fiscal stimulus has a far worse impact on the budget deficit than monetary stimulus. It stands to reason that fiscal policy should be wound down before any monetary tightening occurs. At the appropriate time will Bernanke then make the following statement to Congress:

“We believe AD over the next few years is likely to grow too fast without some contractionary policies by the government. We call on the Congress to repeal the fiscal stimulus that has not yet been spent. If you do not do so we will tighten monetary policy enough to neutralize the impact of the remaining stimulus. That means all of the remaining stimulus will merely add to the national debt, and will have no impact on expected growth in AD.”

My next post will be about the only central banker in the world who seems to understand that we do need an explicit price level target, and a policy of negative interest rates in reserves.

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