Fed Fail: The Implosion of a Policy Regime

Everyone from Paul Krugman to Steve Waldman to Yichuan Wang is giving their spin on the plunging nominal interest rates.

It’s beginning to look like Keynes was wrong about liquidity traps, at least when he argued that there’s a certain minimum nominal yield that government bond investors demand, and that long term rates can be reduced no further.  Wherever people draw a line, bond yields just seem to plunge right through, to one record low after another.  And we know from Japan that they can go even lower.  But what does this mean?

It probably means multiple things.  For instance it suggests that the Keynesian/market monetarist AD pessimists and the Great Stagnation AS pessimists are both right.  We are looking at BOTH low inflation and low real GDP growth for many years to come.  Why don’t I think AD explanations are enough?   Partly because even the 20 year T-bond now has a negative real yield. Indeed it suggests the Bernanke “global savings glut” hypothesis is also correct, a point I’ve argued previously.  Japan is the future of the world.

But I’m more interested in what it means for Fed policy.  Even if the Fed does something semi-bold on August 1st, it most likely won’t be enough to change the underlying dynamic.  And the reason is pretty basic; the Fed simply doesn’t have a grip on what went wrong.  They had a policy regime that targeted short-term interest rates as a way of targeting inflation.  Both of those decisions were flawed, and now the regime has collapsed.  Markets are saying that the Fed may never again be able to using its preferred interest rate targeting mechanism.  Let me emphasize that I still believe interest rates are more likely than not to eventually rise above zero.  But these low yields are consistent with a non-zero probability of the US essentially becoming Japan.

This reminds me a lot of the end of Bretton Woods.  When Bretton Woods collapsed the central banks of the world were in a completely new policy environment, with the price level having no nominal anchor.  It took them a decade to figure this out, and come up with a new policy regime that could operate in a world with no gold price peg.  When they finally did it was something close to the Taylor Rule.  And its was actually a pretty decent monetary policy regime, as long as short term nominal rates were not zero.

But if they were zero, then things got much trickier.  Now it was only a workable policy regime if the rate was expected to rise above zero in a reasonable period of time.  In that case, the Fed could do a sort of Woodfordian policy, steer the economy by making explicit or implicit promises about what circumstances would lead them to raise interest rates.

Unfortunately, it turns out the Fed was too conservative, too cautious, to adopt the Woodfordian policy.  They weren’t willing to commit to a future path of the price level or NGDP.  Instead they simply hoped that things would somehow get better.  And although I’ve been pretty harsh in my criticism, let me express a tiny bit of sympathy.  The rate of nominal GDP growth in the US over the past 3 years has been above 4%, which is considerably higher than in Japan.  I would have thought that might well be enough.  (The fact that it wasn’t makes me think Japan is light years away from exiting the zero bound.)

But things didn’t turn out as the Fed hoped.  Instead of gradually approaching the date when we would exit the zero bound, and resume normal monetary policy, that date is receding ever further out into the future.  Indeed the bond markets are now signaling that there’s a non-zero risk that we’ll never exit.  Again, I think that unlikely.   But the difference between “never” and “in 27 years” is actually pretty unimportant here.  If we don’t exit for 27 years, then we are in big trouble . . . unless . . .

The Fed really needs to face up to the fact that their policy regime has failed.  It’s crashed and burned.  They are like a ship captain holding steering wheel that is detached from the rudder, blandly assuring the passengers that all is well.  In fact all is not well.  There is no steering mechanism for the US nominal economy, and no sign that there will be one for the foreseeable future.

Yichaun Wang argues that NGDP futures contracts are our only hope:

However, one form of nominal GDP targeting seems to sidestep these problems: nominal GDP futures targeting. This would allow market participants to instantly improve estimates of future inflation by bidding on futures contracts. Their bidding one way or another would immediately translate into changes in central bank open market operations such that nominal GDP always stays on track. This approach sidesteps the non-linearity of expectations because it allows the market to aggregate all the necessary information and automatically has the central bank adapt to the new found information. Even if expectations did shift in response to unforecasted shocks, the policy response would be immediate and taken in decentralized steps as individual investors bid on futures contracts. In this case, mechanics-credibility theorem is satisfied because the mechanic by which the Fed earns its nominal GDP credibility directly interacts with market expectations while avoiding the circularity problem. Market expectations of nominal GDP feed into futures market volumes, which directly changes the monetary base. The market answers the questions of “how much” with the level it thinks is “just right”.

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This is one of the key advantages of an nominal GDP futures targeting regime relative to a conventional “wait-and-see” regime. It cements in credibility, and rolls with the waves of external volatility. In a sense, it floats like a butterfly and stings like a bee. It takes monetary policy from the world of “Bernanke Smash” to “Sumner Slice”, and allows for greater accuracy and precision in the control of a central nominal aggregate: nominal GDP.

I’m more optimistic.  We aren’t going to see futures targeting in the near future, but if things get bad enough I see a slim possibility that a consensus might develop in favor of level targeting.  Then the key questions become:

1.  How much base money does the public want to hold if the future expected price level or NGDP is on target?

2.  And is the Fed willing to supply that much base money, or do they consider it too risky?

The key question is not whether some desultory gesture by the Fed will “work.”  It won’t.  We already know that.  It’s a question of how long it now takes the Fed to figure out that its entire policy regime has collapsed.  So far I have not seen a single comment by any Fed official that suggests they have even a clue as to how far off course they’ve drifted, and the challenges they face ahead.

Indeed many don’t even seem to understand that the Fed steers the nominal economy, and that the steering mechanism is broken.  They are like a ship captain complaining that he constantly has to “rescue” the ship by nudging the steering this way and that.  Why can’t the ship steer itself!  Why do I always have to intervene?  Um, because that’s your job?

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