Dissapointed, Again

Needless to say I am disappointed with yesterday's FOMC decision.  Since I am currently afflicted with FDFS*, I will outsource discussion of my disappointment to Ryan Avent and Scott Summer. 

*FDFS = Fed Disappointment Fatigue Syndrome.

Will the FOMC Repeat the Mistake of September, 2008?

I hope not.  As you may recall, the FOMC met a day after Lehman collapsed on September 16, 2008 and decided against lowering the federal funds rates.  Yes, the Fed decided to keep its targeted interest rate unchanged at 2% just as the financial crisis was reaching its peak.  Amazingly, the reason the FOMC acted this way was its concerns about inflation, which at the time were driven by commodity prices and reflected a backward-looking view of inflation.  Had the Fed given more weight to forward-looking indicators like the expected inflation rate coming from TIPS and a host of other market indicators, the Fed would have realized the market was pricing in a sharp recession.  Even though the Fed intervened more aggressively after this point, it never rose to the point that would restore current dollar spending to a healthy, sustainable level.  The Fed, therefore, effectively tightened monetary policy at that time. 

Though the circumstances are somewhat different today, the same Fed inertia that kept it from responding appropriately in late 2008 could similarly prevent the Fed from getting ahead of the current crisis.  Now is not the time to be conservative and cautious.  It is time for Chairman Bernanke and the FOMC to take the initiative and provide some real "shock and awe" monetary policy stimulus. Adopt the Joseph E. Gagnon program or the quasi-monetarist goal of nominal GDP level targeting.  Yes, both approaches would be very controversial and have many observers freaking out, but that is the point.  It would provide a much needed slap to the face of public's economic expectations.  

Now some observers claim there is nothing more the Fed can do since short-term interest rates are already close to 0%.  Moreover, they argue the Fed already is pushing easy monetary policy without any success.  So why bother trying to do more monetary stimulus?  Two things these folks need to remember.  First, low interest rates are not stimulative if the natural (or neutral) interest rate is low too.  The natural interest rate is driven by the fundamentals of the economy.  When the economy improves the natural rate increases and when the economy falters it decreases.  It is the interest rate that would prevail in the absence of the Fed intervening.  Over the past few years the economy has been weak and appears to be weakening even more.  Thus, the natural rate is low and falling, implying the Fed's low interest rate target isn't very expansionary, if at all.

Second, even though the Fed cannot push the short-run nominal interest below 0% and below the short-run natural interest rate value, it can push the real short-term interest rate below 0% and the real short-run natural interest rate value.  Moreover, if needed, the Fed can start working its way up the term structure of interest rates by purchasing longer-term assets and pushing their yields below their natural interest rate values.  Another way of saying this, is that the Fed needs to keep buying assets until money demand is satiated and nominal spending resumes.  The 0% bound on short-term interest rates is simply a red-herring.  It did not prevent FDR from creating a robust monetary-driven recovery in the Great Depression, it did not prevent the Swedish central bank from spurring a remarkable recovery in this crisis, and it should not prevent Fed officials currently.  

So please FOMC, do not make the September, 2008 mistake again.  Get ahead of this unfolding crisis.

The Market Meltdown Highlighted the Fed's Failures

The market meltdown yesterday and the cumulative market losses of the past few weeks have showcased two important failures of the Fed.  First, the Fed has yet to seriously anchor short-to-medium term nominal spending expectations.  This is not particularly surprising since at best the Fed has an implicit and fuzzy inflation target.  It is bad enough that the inflation target is vague, but being a growth rate target also means it also has no memory.  That is, any deviation from the inflation target is allowed to persist.  Consequently, the price level and nominal spending become a random walk, creating more long-term uncertainty than if the Fed had a level target. 

Now the market meltdown seems to have started in Europe yesterday, but it really was a culmination of a number of bad economic news releases over the past few weeks and more importantly over the past few years.  Ultimately, these developments can arguably be traced to a U.S. monetary policy that has been passively tight over the past three years.  Thus, the second failure highlighted by the market meltdown yesterday was the Fed's ongoing tight monetary policy. The market meltdown provides confirmation that us quasi-monetarists were right all along on this point.

So what can be done?  As Scott Sumner, myself, and other quasi-monetarists have been saying for some time the Fed needs to get off its rear and announce an explicit nominal GDP level target.  Such an approach has many virtues, but probably the best one is that it would anchor nominal spending expectations.  This, in turn, would make the U.S. economy less vulnerable to shocks.  Just knowing and believing the Fed would buy up as many assets as needed to maintain a stable growth path for nominal spending would make if far less likely economic shocks would have much of an adverse impact in the first place. It would also make for a nice way of narrowing the Fed's mandate.  Here is how it would work.

The Fed Can Raise Nominal Incomes Too!

Ken Rogoff is one smart guy and his writings are typically fun to read.  His latest piece, however, left me feeling a little disappointed.  It concedes too much to the "balance sheet" view of recessions which for reasons spelled out here and here is an inadequate view of the crisis.  Moreover, his analysis ignores what monetary policy is really capable of doing for the U.S. economy: increasing nominal spending and nominal incomes.  Ramesh Ponnuru, the resident quasi-monetarist and Senior Editor at the National Review, makes this point:

Kenneth Rogoff writes that “the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years.” It certainly would be a way to reduce the real burden of debt, but is it the only or the best way?

The Federal Reserve has more direct control over nominal spending/nominal income than it has over inflation, and higher nominal income—whatever the ratio between the higher inflation and higher real growth that compose it—makes it easier to pay down debts (most of which are contracted in nominal terms). Because of wage stickiness, at least some of any increase in nominal spending that the Fed generates will take the form of real growth—and obviously one would prefer that portion to be as large as possible.

What we need, then, is not more inflation. We need for the Fed to stop holding the money supply below the demand for money balances. That might increase inflation, which would be a price worth paying to get nominal spending back to trend. But inflation shouldn’t be the goal.

Well said.

Update: Marcus Nunes makes a similar point here.

Fiscal Austerity Requires Monetary Liberality

Over at Cafe Hayek, Russ Roberts takes on Paul Krugman's claim that most studies show fiscal policy tightening will stall a recovery rather than help it:

Unfortunately, Krugman doesn’t provide a link to those “many studies” of the historical record. Maybe he was busy or simply didn’t have room to provide them. But I will just mention that in 1946, federal spending fell about 55% when the war ended. The Keynesians predicted a horrible depression. Yet despite the release of 10 million people into the labor market with demobilization private sector employment boomed and the economy thrived. That’s a great natural experiment. I am eager to read any of the alleged many studies of the historical record.

Like Roberts, I am skeptical about the ability of discretionary fiscal policy to stabilize the business cycle.  His critique, however, is too quick to embrace the popular view that fiscal policy consolidation actually improves the economy.  On this point, Krugman is correct that most of the empirical evidence (e.g. here, here, and here) does not support this view.  What the evidence does show is that in most cases where fiscal consolidation was accompanied by a robust recovery it happened because monetary policy was accommodative.  In other words, a loosening of monetary policy made it appear that fiscal policy tightening was the cause of the economic recovery when in fact it was not.  For example, the much celebrated case of Canada's fiscal retrenchment in the later half of the 1990s coincided with the Bank of Canada dropping interest rates about 5% which supported domestic demand and increased exports via currency depreciation.  For fiscal austerity to work then, monetary policy needs to be accommodating. 

Along these lines, a more general point is that the impact of any fiscal policy action--where expansionary or contractionary--depends on the stance of monetary policy.  Thus, from 2008-2009 when monetary policy was effectively tight the easing of fiscal policy didn't quite pack much of a punch.  Conversely, in late 2010, early 2011 when there was not much fiscal stimulus, but some monetary policy easing under QE2 there was some improvement in the pace of recovery.  Another way of saying this is that an independent monetary policy will always dominate fiscal policy.

So if Russ Roberts is like me and wants fiscal policy consolidation that works he should really be clamoring for more monetary stimulus.  Otherwise he may get more than he bargained for.

Update: Awhile back I did a related post criticizing hard money advocates to which Paul Krugman replied.  Here was my response to Krugman.

Brad DeLong and Brink Lindsey Agree the Fed Could Be Doing More

Here is an video excerpt from the Brad DeLong-Brink Lindsey bloggingheads discussion that lends itself nicely to my claim in the previous post of the Fed passively allowing monetary policy to tighten.

The Three-Year Tightening Cycle of U.S. Monetary Policy

Back in August, 2010 Fed Chairman Ben Bernanke claimed that monetary policy can be passively tightened by the Fed doing nothing in the midst of a weakening economy.  A failure to act by the Fed when aggregate demand was faltering, he argued, was effectively the same as the Fed tightening monetary policy.   He made this point in 2010 to explain why the FOMC's decided to stabilize the size of the Fed's balance sheet.  Here is Bernanke:

At their most recent meeting, FOMC participants observed that allowing the Federal Reserve's balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee's intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome. In response to these concerns, the FOMC agreed to stabilize the quantity of securities held by the Federal Reserve by re-investing payments...By agreeing to keep constant the size of the Federal Reserve's securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred. The decision also underscored the Committee's intent to maintain accommodative financial conditions as needed to support the recovery.

In short, the FOMC was concerned that a failure by the Fed to reinvest its payments, which amounts to a reduction in the monetary base, would be contractionary in an economy that was struggling at this time.  The FOMC wanted to avoid this passive tightening of monetary policy.

I agree with this line of reasoning about the passive tightening of monetary policy.  I, however, see a passive tightening of monetary policy as being more than just the shrinking of the Fed's balance sheet.  It occurs whenever the Fed passively allows total current dollar or nominal spending to fall, either through a fall in the money supply or through an unchecked decrease in velocity.  In other words, even if the Fed maintained the size of its balance sheet, a sudden rise in money demand not matched by the Fed would also amount to a passive tightening of monetary policy.  With this understanding, monetary policy has been on a passive tightening cycle for the past three years.  For nominal spending began to fall in June 2008 and has yet to return to any reasonable trend level growth path (i.e. one that accounts for the housing boom). It is even worse if we look at domestic nominal spending per capita.  Not only has it not returned to a reasonable trend level growth path, it has yet to return to even its peak value in late 2007, as seen in the figure below.

A key problem behind this passive tightening of monetary policy is that money demand has been and remains elevated and the Fed has yet to successfully address it.  What is frustrating is that the Fed could meaningfully undo this three-year passive tightening cycle by adopting something like a nominal GDP level target.  For many reasons--its political capital is spent, internal Fed divisions, the popularity of hard-money views, etc--it won't and so the U.S. economy remains mired in an anemic recovery.