If Only Bloggers Ran the Fed...

From the latest Kauffman Economic Outlook, a quarterly survey of economic bloggers, we find this figure:

Too bad bloggers cannot run the Fed.  At least we have changed the conversation so that the Fed is talking about NGDP targeting.

P.S. A note to those bloggers who want the central bank to target repo rates.  If a central bank successfully adopts a NGDP level target, then many of the problems surrounding repos and interbank lending would disappear. 

Yes, the Fed Still Has a Communication Problem

Ryan Avent's initial enthusiasm for the Fed's new communication strategy is beginning to wane.  Avent began to lose his new-found Fed religion after reading Lorenzo Bini Smaghi's critique of the Fed's new policies.  Here is Smaghi:

[I]f the objective of price stability is defined over the longer term, communication becomes more complex. In particular, the link between the inflation forecasts and the policy decision is unclear. What should market participants derive from a published inflation forecast above the two per cent target in the long run (but not necessarily over the next two years)? Should they expect a tightening to take place? And when? The long run is not a “policy-relevant” time horizon and thus has little value for those attempting to understand the central bank’s next moves.

Welcome to the club.  As I have been arguing the past few weeks, the Fed's new communication strategy is at  at best white noise to the market and at worst worst a quagmire of confusion. For example, how should one interpret the fact that FOMC's forecast did not just push out the horizon for increasing the federal funds rate but also lowered the expected growth rate for real GDP in 2012 and 2013? Is the  FOMC signalling additional monetary stimulus or  a weaker economy to come over the next two years? Some observers noticed long-term nominal interest rates dropped after the official launch of the policy last week and concluded the Fed was signalling more monetary stimulus.  The fact that long-term real interest rates also declined suggests that the market interpreted the policy as signalling lower expected growth.  So much for a policy that is supposed to add clarity and stimulus through expectation management.  There is a better way to this. 

The FOMC Confuses Me

The FOMC has spoken and here is what it said (my bold):

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

Now what does this all mean?  The first bold claims the Fed has been running a highly accommodative monetary policy and will continue to do so. Really, the Fed has been running a highly accommodative monetary policy?  I did not realize that an ongoing nominal spending slump, high cyclical unemployment, elevated money demand, a shortage of safe assets, and a persistent output gap were signs of a highly accommodative Fed policy. Nor did I realize that the Fed Chairman acknowledging that the Fed may need to do further large scale asset purchases in the near future was also considered a sign that the Fed was being highly accommodative.  Silly me, I must be confused.

But no worries, I can take comfort in knowing the Fed going forward will be providing aggressive monetary stimulus based on the second bold above, right?  Ryan Avent seems to think so:

[T]he decision to push out the horizon for a rate increase isn't simply an admission that the economy will be weak in 2014. With the target rate at zero, the Fed can only bring down the real interest rate by raising inflation expectations. To generate higher inflation expectations, the Fed may have to promise to be imprudent at some future date—like 2014. Essentially, the Fed is hinting that it won't stomp on a boom in 2014 even if it's generating increases in prices and wages that might normally make the central bank a little uncomfortable. 

That makes sense and others like Gavin Davies and Paul Krugman agree. But wait, I just looked at the FOMC's economic projections and now I am confused again. The FOMC did not just push out the horizon for increasing the federal funds rate, it also lowered its forecast for real GDP for 2012 and 2013.  So is the  FOMC pushing out the horizon because it now expects a weaker economy or is it really trying to be imprudent?  And what is the Fed's definition of imprudence? In 2014 when the FOMC projects it will finally raise interest rates the unemployment rate is expected to be near 7% and inflation should be hovering under the Fed's new inflation target of 2%.  That sounds more like prudence than imprudence to me.

But silly me, what do I know.  Let's turn to the real arbiter of such issues, the bond market.  How do they interpret this policy innovation?  Has expected inflation taken off indicating the bond market expects higher aggregate demand because of this new policy?  Uhm, no:

Expected inflation on the 10-treasury remains about where it has been over the last few months.  Not exactly the what one expects from an aggressive stance of monetary policy.  Nothing to see here, move along.

Okay, enough snark from me.  The real problem with the Fed's new communication strategy is that it looks only at the expected path of the federal funds rate.  But that really does not tell us much because a low federal funds rate is only stimulative if it is low relative to the neutral interest rate. And since the Fed is not providing an estimate of the neutral federal funds rate at the various horizons its really hard to know the implications of these forecasts. This lack of clarity is why I am confused and why this new policy probably will not pack much of a punch.

If the Fed really wants to manage expectations, then the FOMC should (1) add an expected path of the neutral interest rate to its forecast or (2) drop the forecast altogether and set up an explicit objective for monetary policy.  I favor the latter and would have the Fed target a nominal GDP level target.  It would be a whole lot easier to understand and implement.  Maybe someday.

Update: I should have said for (2) that the Fed needs to set an explicit level target.  Yes, it now has an explicit inflation target, but unless it is a really flexible one that corrects for for past misses and ignores supply shocks it is bound to create problems.

The Shining Star of Europe?

Fareed Zakaria points us to what may be the shinning star of Europe:

[P]erhaps the biggest reason for poverty-stricken nations like Egypt to pay close attention to Poland is that it is a very rare breed in today's world, especially in Europe. Poland has a strong economy - the sixth biggest in the European Union now and the only European Union country to avoid a recession altogether. None of its banks needed to be rescued.   Its economy grew 4% last year, and is on track to grow 3% in 2012. Why, you'll ask. How did it survive the turmoil in the Euro Zone? One answer is that it has strong domestic demand and has been pouring money into infrastructure projects.   But the real - and fortuitous - reason is that Poland has yet to be allowed in to the Euro Zone - it continues to use zlotys instead of the euro. So unlike Greece or Italy, it was able to devalue its currency to stay competitive.

I know that last part will leave some of my hard money readers in angst, so think of it this way.  Poland has been able to stabilize domestic demand by adjusting its monetary policy accordingly. The Eurozone periphery has not been able to do this and paid dearly as seen below:

Now Poland has done other things right as noted by Zakaria, but what this contrast highlights is that the Eurozone crisis is as much a monetary crisis as anything else.  Yes, there are deeper structural problems with the Eurozone, but if Eurozone officials want to address these deeper problems they need to first address the immediate monetary problems behind the crisis.  Maybe the shining star of Europe will help them appreciate the monetary nature of the crisis. 

The Fed's Long-Term Interest Rate Forecast May Backfire

The Fed is about to release it first long-term interest rate forecast. Gavyn Davies explains how this could enable U.S. monetary policy to add more stimulus without actually expanding its balance sheet. It would do so  by managing nominal expectations. Here is Davies:

What is the motivation behind these changes? Mr Bernanke has normally justified such steps in terms of stabilising expectations about the Fed’s genuine intentions, especially on inflation and the forward path for interest rates. At a time when the extension of the balance sheet is causing political difficulties for the Fed, and when inflation expectations could become unhinged by the rapid expansion of the monetary base, the chairman is looking for alternative ways of easing monetary conditions without printing more money. Modern macro-economics suggests that operating on expectations is one of the most powerful tools available to him, though he is using it much more cautiously than many economists would like to see...

[T]he new mechanism will provide the Fed with a potentially important tool to influence expectations, and therefore the course of the economy. Paul Krugman was the first to argue in the 1990s that, in the modern version of the liquidity trap, an economy could get stuck permanently with high unemployment because of undesirable expectations of deflation. With short rates not able to drop below zero, the real rate of interest could be too high to equilibrate savings and investment in the economy, so the normal monetary route back to lower unemployment might be blocked. The answer, said Krugman, was for the central bank deliberately to increase the expected rate of inflation, and therefore to cut the real rate of interest while nominal short rates were fixed at zero.

That is how the Fed hopes it will turn out. I think it will backfire because what observers really need is to know where the expected path of the federal funds will be relative to the expected path of the natural (or equilibrium) federal federal funds.  Here is what I said about this previously:

The FOMC lowering its expected path of the target federal funds rate, however, might also be interpreted as the Fed revising down its economic forecast and adjusting its target interest rate forecast accordingly to maintain the current stance of monetary policy.  In other words, a lower long-term interest rate forecast might simply be viewed as the Fed expecting the natural interest rate to remain depressed longer than previously expected and thus needing to hold down its target federal funds rate target longer than expected.  Here, the Fed would not be adding stimulus, but maintaining the status quo as the economic outlook worsened. Given the Fed's failure over the past three years to add sufficient stimulus to restore robust nominal spending and close the output gap, this less favorable interpretation in the current environment would amount to more passive tightening.

Gavyn Davies also recognizes another problem with using this policy innovation to steer monetary policy via expectations management: it may not be credible. Credibility, however, would not be a problem if the Fed would set an explicit nominal destination.  Doing so would avoid the time inconsistency problem that concerns Davies.  From my same post:

That there could be different interpretations of the Fed lowering its long-term forecast for the target federal funds rate speaks to a more fundamental problem with this new policy: the Fed has failed to set an explicit nominal target for monetary policy.  Not knowing where the Fed is ultimately heading makes it difficult to interpret changes in the FOMC's long-term interest rate forecast. It is like a captain of a ship who navigates by focusing on the rudder, but fails to set a destination point.  It would be far better for the captain to pick his target destination and then adjusts the rudder accordingly.   This is why it is so important for the Fed to set a nominal GDP level target.  It would provide a clearer road map of where the Fed wants the nominal economy to go and it would make interpreting changes in the expected path of interest rates easier, if not redundant.  It is time for the Fed to focus on the destination.

Okay, so the Fed is not likely to announce a NGDP level target tomorrow.  I do wish, though, that it would  also provide the expected path of  the natural federal funds rate on its long-term interest rate forecasts.  If so, it would help the public better understand the implications of the FOMC's expected path of the federal funds rate. 

How to Fix the ECB's Communication Problem

The ECB has a serious communication problem.  It has undertaken a number of unconventional measures lately--the three year LTROs, the acceptance of questionable assets for collateral, and the large expansion of its balance sheet--that amount to a QE program by stealth.  And therein lies the problem.  The ECB's actions have not been communicated to the public ex-ante nor have they been linked to a targeted outcome.  In short, the ECB is failing to manage expectations, the most important monetary policy transmission channel at its disposal.  

Now Goldman Sachs would say that the above is a charitable interpretation of the ECB's recent actions. They note in a research paper (via Cardiff Garcia) that the ECB is not just failing to manage expectations, but is actually destabilizing expectations.  

The ECB offers little ex ante information about its outright asset purchases via the securities markets programme (SMP). The stock of outstanding purchases is only revealed ex post, and no information ispublished on the composition of that stock, either by maturity or by country of issuer. There is no preannounced schedule of purchases. Market participants thus face substantial uncertainty about when and where the ECB will intervene: this probably serves to reduce the liquidity of the underlying market and precludes the possibility that the market will anticipate the ECB’s actions, helping policy makers to achieve their policy objectives.

This approach extends to other aspects of the ECB’s nonstandard policy measures. For example, the ECB has yet to announce whether further 3-year LTROs will be conducted beyond February this year. Such an announcement would serve to help stabilise market conditions further, by providing further reassurance about the availability of funding over longer horizons. Should we not see such an announcement at the February Governing Council meeting, the potential for a regression in market developments is obvious. The kink in peripheral yield curves at around 3-year maturities is evidence of this concern.

More generally, the wider ECB communication surrounding its enhanced credit support has always been grudging: the ECB has, at times, appeared reluctant to offer such support, despite the fact that, in practice, it has done so in vast amounts. By implication, the reassurance offered to households and firms about the ECB’s commitment to macro stabilisation has been weakened, to the prejudice of the effectiveness of the policy as a stabilisation tool.

There is an easy solution to the ECB's communication problem that directly and aggressively addresses the insufficient aggregate demand problem while still maintaining a long-run nominal anchor. And to boot, it does not depend on bank lending (though financial intermediation would probably increase as a result).  The solution is setting a nominal GDP level target. The level part is important because it signals clearly to the public that the ECB would commit to buying up (or selling) as many assets as needed until nominal GDP hit some pre-crisis trend path.  Not only would this fix many of the Euro debt problems, it would create more certainty and cause the public to much of the heavy lifting in restoring aggregate demand (i.e. the public would adjust their portfolios in anticipation of the ECB buying up more assets and in the process cause nominal spending to adjust largely on its own. See here for more details.)  This is what makes the ECB's floundering so frustrating for me to watch.

Update: Be sure to read Cardiff Garcia's post on the ECB's communication problem. It was the motivation for this one.

Hey Newt, We Need Sound Money Not Hard Money

This is disappointing:

Speaking at a foreign policy forum in South Carolina on Tuesday, Gingrich advocated a "commission on gold to look at the whole concept of how do we get back to hard money."

I guess Newt Gingrich has not been reading fellow conservative Ramesh Ponnuru, the mostly right-of-center Market Monetarists, or even libertarian Tyler Cowen.  If he had he would know what we need is sound money, not hard money.  

P.S. There is no need for a new commission on the gold standard.  It has been extensively studied and there is a huge literature on it.  I would start with Barry Eichengreen.