A few weeks ago I gave the Wall Street Journal a hard time over this recent quotation:

This is the real root of our current economic malaise—the conceit of Congress and the White House that more government spending, taxing and rule-making can force-feed economic expansion. Now that this great government experiment is so obviously failing, the politicians and the Wall Street Keynesians who cheered the stimulus are asking the Federal Reserve to save the day. Mr. Bernanke should tell them politely but firmly that his job is to maintain a stable price level, not to turn bad policy into wine.

Here was my reaction:

So that’s what it’s really all about.  I agree that Obama’s economic policies are highly counterproductive.  But unlike some conservatives I am not willing to unemploy millions of workers to win a policy argument.  I guess that’s the difference between hard core conservatives and pragmatic classical liberals like Friedman and I.  We should do the right thing and then put our trust in the democratic system.

Was I being unfair?  Maybe the WSJ would have made the same argument if a Republican was president.  After all, they say they favor a stable price level, and prices are still rising at 1%, and are expected to continue rising at that rate.  Do I have any right to infer they were trying to prevent Obama’s policies from looking more effective than they really are?

Fortunately, there is a very good way of showing whether they are advocating tight money for idealistic reasons, and not merely to insure the US economy is performing poorly in November.  A few weeks back I asked commenters to supply a WSJ editorial on monetary policy from back when Reagan was president.  Benjamin Cole came up with a very revealing editorial called “Who’s Easy” from December 18, 1984.  Here’s the first paragraph:

As the Federal Reserve Open Market Committee meets to chart monetary policy, real growth is equivocal and prices are rising at most slowly.  The arguments are for an easier policy, but probably the Fed thinks it’d eased already.

Sounds reasonable.  Presumably in December 1984 prices and output were rising much more slowly than the recent rates, and hence there was a need for easier money.  Just to make sure, let’s check the data:

Most recent 12 month growth rates, 2009:2 to 2010:2:

NGDP — 3.85%      RGDP — 2.98%     GDP deflator – 0.85%

Most recent 12 months growth rates as of December 1984 (1983:3 to 1984:3):

NGDP — 10.84%     RGDP — 6.87%   GDP deflator – 3.73%

Interesting that when Reagan was president the WSJ saw 4% inflation as too low, as prices that were “rising at most slowly.”  Now anything higher than 0.85% constitutes an abandonment of the Fed’s duty to maintain price stability.  If price stability is truly the goal, then why advocate greater monetary ease when inflation is almost 4%?   And if 6.87% real growth is “equivocal” then what is 2.98% growth? 

I’m afraid the WSJ was wrong in 1984 (we didn’t need easier money) and they are wrong now (we do need easier money.)  I favor the same NGDP target whoever is president–a 5% growth trajectory, level targeting.  That means we need more than 5% NGDP growth for the next year or two.

Perhaps the WSJ got confused over interest rates; after all, they were much higher then than now.  Actually, in 1984 the WSJ had an almost Friedmanesque understanding that interest rates are highly misleading:

Interest rates, we should have learned these past few years, are not a reliable guide to monetary policy.

Unfortunately by 2010, when Obama was president, the WSJ seems to have forgotten what it once knew:

As for the current moment, the Fed has maintained its nearly zero interest rate target for 20 months, while expanding its balance sheet by some $2 trillion. By any definition this is historically easy monetary policy, and not without costs of its own.

The balance sheet numbers are not accurate, and even if they were they were, “historical” definitions of easy money would be meaningless once the Fed started paying interest on reserves.  I suppose they might argue that even though inflation is now low, easier money would lead to dangerous increases in inflation.  Here’s what the WSJ said in 1984:

For our part though, we have trouble understanding what’s wrong with economic growth.  What does the open market committee have against it?  In particular, growth is not inflationary; inflation is too many dollars chasing too few goods, and growth produces more goods.   When was it the committee came down from the mountain with stone tablets saying that 3% real growth is OK, but 4% will produce “bottlenecks and “overheating”?

Or “structural problems,” or “job mismatches,” I might add.  I can’t answer their question, you’ll have to ask the hawks at the Fed.

OK, so the WSJ has changed its mind on monetary policy.  Surely there is no reason to think that this reflects political bias.  It’s not like their earlier views were aimed at making Reagan’s policies look good.  Or were they?

Fed policymakers tend to discount any significant possibility of a 1985 recession, and on that assumption feel free to take another yank or two at the remnants of inflation.  But if they are wrong, the price will be high.  Indeed, a 1985 recession would probably mean not only the political failure of Reagan’s budget cuts, but an economic donnybrook with new international and banking-system problems.

Two terms jump out at me; ‘remnants’ of inflation, and the ’political’ failure of Reagan’s budget cuts.

So what do you guys think?  Does political bias lead the WSJ to call for monetary policies that are good for the economy when Republicans are in office and bad for the economy when Democrats are in office?

Caroline Baum of Bloomberg recently suggested that Milton Friedman would have been appalled by the many top economists arguing the Fed is out of ammunition:

Milton Friedman, Nobel Laureate in Economics, died in 2006. Monetarism, the school of thought he founded, seems to have died with him, judging from recent comments.

Academics, such as Princeton’s Alan Blinder and Harvard’s Martin Feldstein, are claiming there’s very little the Federal Reserve can do to stimulate the U.S. economy. Newspaper headlines deliver the same message: the Fed is “Low on Ammo.” The public is feted with explanations — couched in technical terms, such as the “zero-bound” and a “liquidity trap” — as to why the Fed’s hands are tied.

What planet are these people on?

They’re clearly not on planet monetarism.  On the other hand John Taylor thinks Friedman’s message still resonates, but that he would have been opposed to additional monetary stimulus:

I see neither those ideas nor their adherents going to the grave. Indeed, the experience of this crisis is proving that Milton Friedman’s ideas were right all along, and I can see them gaining favor.

Two of Friedman’s most famous ideas in the macroeconomic sphere were (1) that monetary policy should follow a simple policy rule and (2) that discretionary fiscal policy is not useful for combating recessions, and indeed could make things worse. Both ideas have been reinforced by the facts during the recent crisis.

The first idea is reinforced by the evidence that the crisis was brought on by the failure of the Fed to keep following the rules-based monetary policy that had worked well for 20 years before the crisis. Instead, it deviated from such a policy by keeping interest rates too low for too long in 2002-2005. But Caroline Baum wonders whether the Fed should now just print a lot more money and buy more mortgages or other securities. That might sound like a monetarist solution, but Friedman did not believe in big discretionary changes the money supply. Rather, he advocated a constant growth rate rule for the money supply. I doubt that he would have approved of the rapid increase in the money supply last year, in part because he would have known that it would be followed by a decline in money growth this year. He always worried about monetary policy going from one extreme to the other and thereby harming the economy. That is why the Fed should be clear and careful as it brings back down the size of its balance sheet, which exploded during the crisis.

While Taylor’s argument is defensible (and I agree with him on fiscal policy), I believe the weight of evidence supports Baum’s interpretation.  Let’s look at what Milton Friedman had to say about Japan in December 1997.  The subtitle is as follows:

Nobel laureate and Hoover fellow Milton Friedman gives the Bank of Japan step-by-step instructions for resuscitating the Japanese economy. A monetary kiss of life.

And here’s Friedman’s argument:

The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

The Interest Rate Fallacy

Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

In the article, Friedman presents data showing Japanese monetary growth slowing sharply in the 1990s.  He also notes that RGDP growth slowed from 3.3% during what he calls the “Golden Age” of 1982-87 to only 1.0% during 1992-97.  Inflation slowed from 1.7% to 0.2%.  From this we can infer:

1.  Friedman does not seem to agree with Fed hawks who think price stability is a good thing.  After all, Japanese prices were very stable during the 5 year period when he thinks money was far too tight.  Admittedly, some at the Fed define price stability as 2% inflation, but the hawks clearly don’t agree, as inflation is 1% and falling, yet the hawks still oppose stimulus. 

2.  Friedman thinks near-zero interest rates are a sign that money has been too tight.  And he suggest that QE is the proper response.

3.  Friedman cites data showing that Japanese NGDP growth has slowed from 5% during the golden age to 1.3% in 1992-97.  Of course 5% NGDP growth is quite close to the US experience from 1992-2008, another “golden age.”  But then US NGDP fell 3% between mid-2008 and mid-2009, nearly 8% below trend.  And it continues to grow at well under trend during the “recovery.”  Friedman would have seen that as a warning sign.

4.  Friedman advocates raising money growth rates in Japan (M2) up much closer to the 8.2% of Japan’s Golden age.

5.  In the US monetarists tend to look at broader aggregates like M2 and MZM (although unfortunately we lack the ideal divisia index that monetarists like Mike Belongia say is needed.)  For what it’s worth, here are the growth rates of M2 and MZM from mid-2008 to mid-2009, and then from mid-2009 to mid-2010:

2008-09:   M2 grew 8.8%,  MZM grew 10.2%

2009-10:  M2 grew 2.1%, MZM fell 1.8%

So on average the aggregates grew around 9-10% during the financial turmoil, and then barely changed over the following 12 months.  It is difficult to know what Friedman would say about the increase in the money supply between 2008 and 2009.  Obviously the facts don’t exactly fit either my interpretation or Taylor’s.  But if we take a more expansive view of Friedman’s approach to macroeconomics, then I believe there is even more reason to believe that he would now favor monetary stimulus, just as in Japan:

1.  In the Monetary History, Friedman and Schwartz decided not to use the monetary base as their indicator of the stance of monetary policy.  In my view, this was partly because the base increased sharply between 1929 and 1933.  Friedman understood that NGDP had fallen in half during those four years, and thus monetary policy had obviously been too contractionary for the needs of the economy.  He also understood that the increase in the base reflected hoarding of cash and reserves during the banking panics.  Thus the most natural monetary indicator for a libertarian, the one directly controlled by the government, was not going to work.  Instead he and Anna Schwartz focused on broader aggregates, which declined sharply between 1929 and 1933.

2.  Now consider the 2008-09 increase in the broader aggregates.  Because we now have FDIC, people no longer hoard cash during a liquidity crisis; instead they hoard the very liquid and safe assets that make up MZM.  Friedman would have understood that the financial crisis was a special situation, and hence required economists to look past the temporary blip in MZM, just as he had overlooked the rise in the base during 1929-33.  He understood that money was actually tight during 1929-33, despite the increase in the base and the low interest rates.  (And he’d understand that the bloated base since 2008 largely reflects interest-bearing excess reserves, where yields exceed the rate on T-bills.)

3.  Friedman also understood that in uncertain times markets can provide an indication of whether money is too tight.  Recall his defense of speculators, and also floating exchange rates.  He clearly thought market signals were meaningful.  In 1992 [Money Mischief] he endorsed Robert Hetzel’s idea of having the Fed directly target expected inflation, by trying to peg the spread between nominal and indexed bonds.  Now recall that the TIPS spread briefly went negative in late 2008, and even today is only about 1% for one and two year T-bonds.  So if Friedman thought Hetzel’s proposal was a good idea, I think it unlikely he would brush off the message in the TIPS markets, as many conservatives seem to do.  The markets are clearly indicating both inflation and output will remain below the Fed’s implicit target for quite some time.  Friedman would have seen the importance of those market signals.

4.  There are some modern monetarists, such as Tim Congdon  (and this), who have made many of the same arguments that I’ve used in this post.  

To summarize:

1.  In 2009 NGDP fell at the sharpest rate since 1938.  And NGDP growth is expected to remain very weak.   If M*V is that weak, something must be wrong.

2.  Friedman argued the low rates in Japan were actually evidence of tight money.

3.  Friedman would have been concerned by the abrupt slowdown in the growth rates of the monetary aggregates since mid-2009.

4.  Some modern monetarists like Tim Congdon think money is way too tight.

The burst of M2 and MZM in 2008-09 does point slightly in John Taylor’s favor, but overall I believe the evidence supports Baum’s view.

Of course neither John Taylor nor I hold identical views to Friedman.  He supports the Taylor Rule (why not, he invented it!)  I give him a lot of credit, as the Taylor principle is the primary factor behind the Great Moderation.  However I believe a Svenssonian “targeting the forecast” approach is even better.  In September 2008 the Fed failed to cut rates below 2%, looking backward at the high rates of headline inflation during the summer of 2008.  But forward-looking real growth and inflation indicators were already slowing rapidly, indeed the TIPS spread on 5 year bonds fell to 1.23% just before the post-Lehman Fed meeting.  I think almost everyone would now agree the Fed should have moved much more aggressively in September 2008, before rates had fallen to zero.  A forward-looking approach would have allowed them to do so, but instead they relied on historical data that seemed to suggest the risks of inflation and recession were equally balanced.  They did nothing.

I suppose the fight over Friedman’s legacy is related to the fact that he is the one right-wing macroeconomist who is almost universally respected by conservative/libertarian economists.  Even though I’m not a strict monetarist, I’d like to think he would support my view of the current crisis.  I’m guessing Taylor feels the same way.

HT:  DanC, Benjamin Cole, David Pearson, Richard W.

PS:  After 16 months of leisure frantic blogging activity, school starts tomorrow.  Unfortunately, posting and comment replies will have to slow down.

The commenter Benjamin suggested that I supplement my “moderate” proposal for Fed policy, with what I really believe.  So here it is; I’ll just cut and paste from Bill Woolsey:

I favor some opportunistic disinflation from the Great Recession, shifting to a new, 3 percent target growth path for money expenditures, starting at the end of the Great Moderation, which I take to be the third quarter of 2008. The target for the second quarter 2010 would be $15.8 trillion, so the current value is 8.8 percent below target. The target for second quarter 2011 will be $16.3 trillion, so returning to target would require 13.4 percent growth in money expenditures [did he mean 12.4%?] over the next year. (That includes the already completed part of the year.) Of course, the targeted growth path of money expenditures would afterwards grow at 3 percent into the indefinite future.

My initial reaction was negative when I read Bill’s post, as I had just spent a lot of time criticizing opportunistic disinflation in a series of posts.  But the more I thought about it, the more I liked it:

1.  Getting back to the old 5% trend line is now a complete pipe-dream.  Given that many contracts have now been signed reflecting the new world of low NGDP, it probably isn’t even wise any longer.  After all, the Fed wasn’t promising level targeting of NGDP in 2008.

2.  I’m a bit puzzled by the numbers Bill uses, but perhaps that’s because he uses nominal final sales instead of NGDP.  I calculate the US as being about 5% below a 3% trend rate of NGDP growth, starting at 2008:2.  Let’s split the difference and assume we are now 7% too low.  In that case shoot for 10% NGDP growth next year, and 3% thereafter.  Target NGDP futures contracts.

3.  The negative associated with lower NGDP growth is the risk of liquidity traps.  But under my ideal policy there would be no zero rate bound, as we’d be targeting NGDP futures prices.  It would also eliminate the need for Josh Barro’s proposal to index taxes on capital, which is necessary if inflation is positive, but adds undesirable complexity to the tax code.

4.  To avoid the “circularity problem” identified by Bernanke/Woodford, and also Garrison/White, you’d have to let the market actually determine the setting of the monetary base most likely to produce on-target NGDP growth.  I described how in this post.  

5.  I have an open mind about the exact amount of catch-up, and whether it should be spread over one or two years.  But the amount of catch-up should probably be in the 6% to 8% range. 

Here’s what’s so clever about Bill’s idea.  It gives us the more rapid recovery that people like me insist is possible and desirable, and yet it lowers long term inflation toward zero, a cherished goal of the Fed hawks.  And it also eliminates any chance of future liquidity traps, which is what people like Paul Krugman worry so much about.  What’s not to like?

PS:  Just to be clear, this is my ideal proposal.  I am not officially shifting from 5% to 3% NGDP targeting, as we don’t yet have an ideal NGDP futures targeting regime in place, which would prevent zero rate traps.

Suppose the ideas in my previous post were implemented.  What impact would they have on the financial markets, and the economy?

The place to start is not with the QE, which is the least important part of the proposal.  Instead, consider the impact of price level targeting.  This should raise the two-year expected inflation rate to about 2.7%, and raise the expected two year NGDP growth rate by even more.  The problem is to determine the demand for base money at that higher expected inflation rate.  This turns out to be very difficult, particularly if the IOR is reduced to zero.  During normal times the demand for base money is less than 10% above currency in circulation, not more than double the currency stock, as it is today.  The reason is simple, during normal times the interest rate on T-securities is high enough to make it very unattractive for banks to hold excess reserves, which normally earn no interest. 

So the answer to the demand for base money question hinges partly on the demand for excess reserves, and that depends on nominal interest rates.  We normally think of monetary stimulus as reducing interest rates, and vice versa, but that is not always the case.  Indeed, I’d be surprised if two year T-note rates stayed as low as 0.5% if the Fed committed to 2.7% inflation over two years.  Is it possible they’d fall even lower?  Certainly.  But I think it unlikely.  Thus it is quite possible that the Fed would actually have to sharply reduce the monetary base after committing to higher inflation.  Because the policy has never been tried, we simply don’t know.

I suggested the Fed buy T-bills and short term T-notes partly because I see the price level target as the key policy and the QE as just a method of accommodating the demand for base money at the new price level target.  It doesn’t do any of the heavy lifting.  That’s why buying longer term bonds (as recommended by Andy Harless in the comment section) wouldn’t do much better in my view.  If the policy was not credible, and markets did not expect higher inflation, then the OMOs would be viewed as temporary, and prices wouldn’t rise regardless of what type of bond was purchased.  If they were viewed as credible, then the policy would be expected to persist until we escaped the liquidity trap at some future date.  But in that case it also wouldn’t matter which type of bond was purchased, as OMOs would be effective with any security once we had exited the liquidity trap.

I suppose the key difference is the way we visualize the transmission mechanism.  I see policy boosting expected future NGDP, then current asset prices, then current AD.  Keynesians see it reducing real interest rates, boosting investment, then boosting AD.  Another difference might be credibility.  Perhaps markets might be more impressed by the purchase of long term bonds, as Andy suggests, and thus more confident that the Fed would persevere with its plan to boost prices. 

Because of all this uncertainty, I’m not opposed to Andy’s suggestion that the Fed purchase of longer term bonds.  I suppose my suggestion was motivated by the fact that Krugman once mentioned the risk of capital losses from QE.  This is actually a fascinating issue, which involves everything from rational expectations to insider trading.  In a basic ratex model, a fully announced program of inflation should not imply any expected capital losses for the Fed, even if it lowered long term rates in the short run and raised them in the long run.  Indeed, if this were not the case there would be lots of $100 bills lying on the sidewalk, for anyone who went short on government bonds right after the QE was announced. 

On the other hand one can imagine a scenario where the Fed knows more about its determination to carry through with the policy than the markets do.  So short rates fall due to the liquidity effect, but long rates don’t rise due to the expected inflation effect.  In that case if the Fed bought L-T bonds they’d be insider trading against their own interest.  I seem to recall Nick Rowe discussing this point, and recommending they buy equities or something else that would do well if the economy recovered.

Thinking about these issues can be depressing, as it makes clear just how daunting the challenges ahead really are.  To get the sort of recovery we really need, the Fed would have to really surprise the markets, in some sense be smarter than the markets about the future direction of Fed policy.  In fact, the reverse is usually true.  My favorite example is December 2007, when a smaller than expected rate cut led to a plunge in stock prices, and a drop in bond yields (the opposite of what the Keynesian model predicts) as the markets correctly understood that the Fed had erred, and that as a result the economy would weaken so much that they’d have to reverse course quickly and cut rates very sharply.  And within weeks this happened, another 125 basis points in fed funds rate cuts.

That shows how sophisticated the bond markets are.  To get a robust recovery we need the Fed to be even smarter than those very smart bond markets, to do more than what is currently expected.  They have the advantage of insider information, but I’m just not sure that’s enough.

In March of 2009 I presented a proposal for monetary stimulus, in the form of a petition.  I think it’s fair to say that it didn’t attract much attention.  The commenter Benjamin suggested it’s time for a new and specific proposal.  After all, now that fiscal stimulus has failed to generate an adequate recovery, there is a renewed focus on the need for monetary stimulus.

There is no point in proposing my dream monetary policy–NGDP futures targeting and all.  The Fed would never contemplate anything so radical at this time.  Instead I am going to suggest something that just might be acceptable, should the Fed decide the economy needs more demand.  The term ‘moderate’ refers to the fact that I won’t ask the Fed to deviate from their 2% implicit inflation target, and the term ‘pragmatic’ refers to the fact that I won’t ask for risky and untested ideas such as negative interest rates on excess reserves and/or NGDP futures contracts.

Any monetary stimulus proposal has at most three primary components:

1.  A bigger supply of base money

2.  Less demand for base money

3.  A commitment for greater monetary stimulus in the future

I will try to use all three approaches, and do so in a synergistic plan that consists of more than merely the sum of the parts.

1.  Quantitative easing

The Fed should commit to doing as much quantitative easing as necessary to hit its macroeconomic objectives.  They might want to initially commit to a specific figure like $100 billion a month, but over time I believe they should adjust the amount of QE to reflect the demand for base money.  What makes this so tricky is that the demand for base money is itself very sensitive to expectations of NGDP growth, i.e. expectations about whether the policy will fail.  Thus QE will work much better if combined with other policy tools that increase the likelihood of success.  If the Fed does QE, and QE alone, it is very possible that it will be no more effective than the previous $1 trillion in reserves that were injected into the banking system in late 2008.

People like Andy Harless have suggested the Fed buy long term bonds.  I’d prefer just the opposite—the purchase of low risk T-bills and short term T-notes.  By doing so they avoid the risk of significant capital losses if (as I expect) the operations had to be reversed as a result of a robust economic recovery.  I understand that most people envision the transmission of monetary policy through the Keynesian lens of changes in interest rates.  And that it looks like the only interest rates that can now be significantly lowered are the longer term rates.  But I just don’t believe that we can get a robust recovery in NGDP growth without substantially higher long term rates.  Yes, it’s possible that long rates would fall sharply immediately after the Fed purchased lots of T-bonds, and then rise sharply a few months later as economic recovery picked up.  But I have trouble reconciling that scenario with rational expectations.  And I am reluctant to recommend a mechanism that seems to rely on sophisticated bond traders being too dense to understand what is going on.  In Andy’s favor, something like that quick reversal did seem to occur in the spring of 2009, but I think we’d be pushing our luck to rely on it happening again.  For me the transmission mechanism is higher asset prices (stocks, commodities, commercial RE, etc) as expectations of future NGDP growth rise.  That avoids the paradox that we seem to need lower long term interest rates, even as higher rates are associated with prosperity.  

Before proceeding to the other two policies, it might be helpful to use an automobile analogy.  Consider QE to be like the car’s engine.  If the transmission is not engaged, the car will not move.  In addition, the car needs to be steered, so that it doesn’t shoot off into a ditch.  The other two proposals are intended to do just that.  Lower IOR can serve as a sort of transmission mechanism, making sure the added QE actually drives the car forward.  And price level targeting will serve as both a transmission mechanism and the steering mechanism letting the Fed know if they have done too much or too little QE.

2.  Eliminate interest on excess reserves

At first glance this seems like a no-brainer.  Many people seem concerned about all the money the Fed has been printing.  Eliminating IOR would allow for the same amount of monetary stimulus with a far smaller monetary base.  Apparently the Fed is concerned about the effect on MMMFs, which might see their rates of return fall to near zero, and thus threaten again to “break the buck,” as occurred to one fund in late 2008.  In that case, I presume that my idea of negative rates on ERs (recently endorsed by Blinder!) would be even more problematic for the MMMF industry, so I won’t advocate that now. 

This is not my area of expertise, but the need for monetary stimulus is so great that I think the Fed should eliminate IOR on excess reserves and hope for the best.  Indeed the need is so great that I think they should proceed even if it necessitates the Fed engage in some sort of microeconomic intervention in the MMMF industry that is otherwise undesirable.

I would add that the proposal only applies to ERs, not required reserves.  Thus banks may still be able to profitably offer checking accounts, as each additional account creates a derived demand for more required reserves, which still earn interest.  If the Fed is worried about how removing IOR would impact the banking industry, they have several options.  They could actually raise the rate on required reserves.  This would still encourage banks to reduce their holdings of ERs, which would no longer earn any interest at the margin.  Or, they could “grandfather in” existing reserve holdings for each bank, and only eliminate IOR for the new money that is to be injected in my first proposal; the roughly $100 billion a month in QE.

By eliminating IOR, any additional QE is more likely to find its way out of ERs and into circulation.  But even that may not be enough.  The last proposal is by far the most important.  It provides additional impetus to getting the new money into circulation, and also calibrates how much is needed:

3.  A 2% price level growth path from September 2008, level targeting

Cutting edge monetary models by people like Woodford emphasize that in a liquidity trap you really need price level targeting, not inflation targeting.  The problem with inflation targeting is that it is “memoryless.”  That means if you miss your inflation target for last year, you “let bygones be bygones” and continue to shoot for the same inflation target next year.  Despite the name, “level targeting” doesn’t really mean keeping the price level constant (unless zero inflation is the target) rather it means trying to return to the planned price level trajectory anytime you temporarily diverge from the desired inflation rate.  The intuition is so appealing that none other than Ben Bernanke recommended that the Japanese do exactly that when their CPI had undershot their zero inflation target in the early 2000s.  Bernanke suggested they should temporarily aim for 3% or 4% inflation to catch-up to their original target path.

I am asking the Fed to do the exact same thing that Bernanke recommended for the Japanese.  The only difference is that the Japanese inflation target is 0%, whereas the Fed’s implicit target (they don’t have an explicit target) is believed to be about 2%.

[As an aside, some have argued that the implicit target is actually 1.5% to 2%.  On the other hand over the past two decades they have behaved as if their implicit target is a tad over 2%.  And you could argue that a period of 9.5% unemployment is not the best time to try to bring inflation down to 1.75%.  So you could just as well argue for 2.25% inflation, given actual Fed policy over recent decades.  My 2% proposal is a very reasonable and moderate compromise between their actual policy of slightly over 2%, and the oft-mentioned range of 1.5% to 2.0%, which centers on 1.75%.]

If we track core inflation since the liquidity trap started around September 2008, we find that the core CPI has fallen about 1.4% below the Fed’s implicit 2% target.  In that case, the Fed should commit to trying to raise prices by 2.7% a year over the next two years, and 2% thereafter.  Markets currently seem to expect about 1% annual inflation over the next two years (based on TIPS spreads.)  Why would an extra 1.7% inflation have such a big effect?  Because the SRAS curve is fairly flat when unemployment is high.  

After the 1982 recession, Paul Volcker engineered 11% NGDP growth over the first 6 quarters of recovery.  Real growth was 7.7%.  I am not claiming we could achieve the same.  After all, the supply-side fundamentals are not quite as strong as in 1983, as many right-wing economists have pointed out.  But only the most extreme RBC economist could claim the SRAS is vertical, and that moving inflation from 1.0% to 2.7% for 2 years would not substantially boost growth.  FWIW, I’d expect 2.7% core inflation to result from 7% to 10% NGDP growth, implying a real recovery of 4.3% to 7.3%.  That’s much better than we are currently getting. 

Now for the hardest part, how do we make it all happen?  A target is just an aspiration, isn’t it?  Not quite.  That is true of inflation targets, but not price level targets.  Importantly, price level targets are both goals, and commitments to do something later to catch up if you fail to meet your goal.  And that future commitment is also very important.  We won’t be at the zero rate bound forever, thus it’s important for the Fed to give markets some sense of the price level trend line they plan to return to when the recession is over.  If the trend line is about what TIPS markets currently expect, we’ll get a weak recovery.  If it is the one I suggest, we’ll get a much more robust recovery.  Would Congress object?  I doubt Barney Frank (a Congressional inflation target critic) would complain, if it was explained that prices had fallen short and that the proposal was aimed at boosting growth.

So what about my first proposal to do QE?  How do we know when we have done enough?  I believe we should follow Svensson’s maxim that we “target the forecast.”  The Fed should do QE until its internal forecast of core CPI growth two years out is on target.  Bernanke and Woodford once pointed out that sole reliance on market CPI forecasts (such as the TIPS market) would create a circularity problem.  There are ways to rely completely on market forecasts w/o a circularity problem, but they are too radical for the Fed, as the market would essentially become the FOMC.  But Svensson’s idea for targeting the Fed’s own internal forecast is eminently reasonable.  Set your steering wheel at a position where you expect to reach your destination.  Do the amount of QE that leads you to expect on-target core CPI growth.

I’m certainly not suggesting the Fed ignore market signals.  They should look at a wide range of market indicators.  Bernanke and Woodford acknowledged those could be helpful, as a supplement to the Fed’s internal structural models.  And let’s face it; QE is going into uncharted waters, so we can’t rely exclusively on structural models.  The Fed should not let market forecasts diverge too far from their policy goal.

4.  Summary

There is nothing radical in my proposal:

1.  QE with T-bills is a plain vanilla open market purchase.

2.  A zero IOR rate is the way the Fed operated for 98% of its history.

3.  Two percent core inflation is widely seen as the Fed’s implicit target.

4.  Level targeting has an impeccable pedigree, with strong support from people like Bernanke and Woodford

And let’s be clear about one thing.  I am not proposing any sort of dramatic change in Fed policy.  Their policy has generally been roughly 2% inflation (I’d prefer 5% NGDP growth.)  All I am saying is let’s stick to that policy.  It is the hawks who suggest policy settings likely to reduce inflation below the Fed’s traditional 2% target (despite 9.5% unemployment) that are the true radicals. 

In his public speeches Bernanke really has no choice but to advocate current policy.  And he is reluctant to change policy if it leads to a badly split FOMC.  That gives 3 or 4 hawks an effective veto on change, and insures the status quo hawkish policies continue.  But what does Bernanke believe in his heart?  Does he support the views of people like Charles Plosser, who seem to claim faster NGDP growth would not boost RGDP growth?  Does Bernanke now hold views that are completely inconsistent with his entire academic career, and his recent advocacy of fiscal stimulus?  Or would he prefer something closer to the plan that I have outlined.  Someday we’ll find out the truth.

HT:  Marcus, Liberal Roman, Benjamin Cole