Epic fail

That’ll teach me to go on a one week vacation! 

Over the past few weeks the Fed has reduced NGDP expectations even further below their already dismal levels.  Today’s decision reached a new level of futility.  The Fed did correctly diagnose the problem, slowing growth and slowing inflation (i.e. slower growth in NGDP.)  But they failed to construct any sort of effective policy response.  The FOMC doesn’t seem to understand that it’s not the Fed’s responsibility to forecast slower NGDP growth, it’s the Fed’s responsibility to prevent slower NGDP growth.

Yes, there was the decision to promise low interest rates as far as the eye can see; but ultra-low rates are merely a sign that money has been too tight.  The bankrupt Keynesian theory (that central banks must target interest rates) is what got us into this mess.  Keynesians had no answer for a scenario where rates hit zero.  And now the same bankrupt Keynesian model is preventing us from exiting the low spending morass.  Zero rates won’t solve the problem as Bernanke ought to understand from his studies of Japan.

And as for the three hawks, who argued that even doing nothing is much too stimulative in a world of collapsing nominal growth expectations, I hardly know what to say.  One would have to go back to the 1930s . . .

Don’t be fooled by the late rally in stocks.  The real stock market response to the Fed has occurred over the past few weeks, as NGDP growth expectations have plunged (based on plummeting yields in the T-bond market.)  Stocks may benefit slightly from the fact that rates will stay very low for an extended period, but the level of stocks is still far below what one would expect if there was a healthy growth outlook (as in 2007.)

In recent weeks the stock and bond markets have predicted a Federal Reserve policy failure of epic proportions.  Let’s hope they are wrong.  Unfortunately, when bold action is needed, hope is all the Fed seems willing to offer.

[I'll do a few more short posts, and catch up on comments tomorrow.]


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23 Responses to “Epic fail”

  1. Gravatar of foosion foosion
    9. August 2011 at 15:17

    Shorter fed: conditions are terrible, we discussed tools to improve conditions, so we’ll do nothing for the moment.

    “The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.”

    What exactly does “in the context of price stability” mean? What are they thinking?

  2. Gravatar of Benjamin Cole Benjamin Cole
    9. August 2011 at 15:46

    The Fed evidently think that price stability is when prices are perfectly poised between deflation and inflation.

    This echoes sentiments rebounding the conservative blogosphere that any inflation is a moral sin, and that a nation that debases its currency is likely to do anything, like welshing on contracts or bonds, or setting up a gay brothel in the White House.

    BTW: The CPI-U was at 219.964 in July 2008. It is now at 225.722. Run for the exits–that is a huge 2.62 percent increase in just three years!!!! And that we will see some outright deflation in coming months to no reason to let your guard down.

    Buy gold! Use your dollar bills for toilet paper! Set up barter networks!

  3. Gravatar of Liberal Roman Liberal Roman
    9. August 2011 at 15:50

    Scott,

    I am interested what you think about the ECB response. Right now I am grasping for anything positive, so I already know that you think their responsible has been awful.

    But do you see anything positive in their bond purchasing program? Have they accidently stumbled into a proper response? Granted I don’t know why they don’t lower rates back down to 0%, but by committing to buy massive amounts of government bonds, haven’t they done something at least marginally positive?

  4. Gravatar of Hugh D’Andrade Hugh D'Andrade
    9. August 2011 at 15:53

    Scott,
    If the objective is to increase money balances in private hands ought not the Treasury to satisfy its obligations without borrowing until NGDP growth returns to targeted levels?
    Hugh

  5. Gravatar of EcoEchoes EcoEchoes
    9. August 2011 at 16:16

    Granted the Keynesian framework stalls in the face of a liquidity trap scenario,but that’s exactly when you expect government to step in and begin re-levering. Easy money at near-floor interest rates have solved the liquidity problems of ’08-’09. Fed can’t possibly force the consumers and the private sector to de-lever with a dim growth outlook and doesn’t have any more arrows in its quiver(those expecting QE3 can leave for a backpacking trip to Machu Picchu and once you find your way back alive..it still won’t happen!!)That’s when you look to Capitol Hill. But alas!! This is the time they chose to address a decade-old fiscal deficit situation. I’m curious to know what a Monetary Authority would do in this scenario. Anyone???????

  6. Gravatar of Andy Harless Andy Harless
    9. August 2011 at 16:56

    Keynesians do have an answer for a scenario where rates hit zero, and that is to promise to keep rates at zero for a longer period of time than their usual reaction function (conventionally specified in the form of a Taylor rule) would imply. That’s where the Bank of Japan failed, because it tightened in response to inflationary shocks as it normally would have rather than waiting (as it should earlier have promised to do). Nobody knows exactly what the Fed’s reaction function is, but based on the reaction by the short end of the bond market, we can at least interpret the Fed’s action as an indication that it intends to keep rates at zero for longer than the bond market expected. Since short-term interest rate movements will be dominated by liquidity effects at the relevant horizon, we could also interpret this as an intention to keep the money supply up for longer than what was previously expected. And this should imply that NGDP will be higher than what was previously expected. Not high enough, but higher than expected.

  7. Gravatar of pct pct
    9. August 2011 at 16:57

    Three reasons why Bernanke may be getting too much blame:
    (1) He is only the Chairman, not the Dictator. He got three “no” votes with the relatively modest action of today. This drops my Bayesian estimate of his odds of pushing QE3 through quite a bit. (2) Monetary stimulus is less effective if people think the punchbowl could be removed at any moment. Now we know it’s out ’till 2013, even if with less Everclear than Scott would like. (3) Returning to (1), Bernanke’s standing in the FOMC could be enhanced by political support, either by statements or appointments of kindred souls to the Board. I find Obama’s evident lack of attention puzzling under the circumstances.

  8. Gravatar of Mike Sandifer Mike Sandifer
    9. August 2011 at 17:11

    Welcome back Scott. Unfortunately, the world as you see it seems to exist.

  9. Gravatar of Steve Steve
    9. August 2011 at 17:11

    Scott,

    For once I think you are being unfairly critical. Today showed that Heli-Bernanke-san grew a pair. He was willing to take three dissents in order to support the economy.

    Plus, while low interest rates do indicate that money has been too tight as you like to say, there is still some stimulus effect from driving the two year to 0% and the ten year (mortgage benchmark) to 2%. Who knows, maybe the 2-10 or 10-30 will steepen up in the coming months, indicating that money is becoming less tight.

    And, maybe the market will take a signal for Bernanke’s newfound mojo, and realize that he is no longer going to do the hawk’s bidding.

  10. Gravatar of Mike Sandifer Mike Sandifer
    9. August 2011 at 17:31

    Here’s another reason to frown, if you’re interested. This is a discussion that includes at least 3 former Fed economists(including Kudlow), and they’re all very anti-additional Fed stimulus.

    http://video.cnbc.com/gallery/?video=3000038313

  11. Gravatar of r.r. r.r.
    9. August 2011 at 18:59

    I love your blog, and your ideas make a lot of sense, but I still have some questions and it’d be great if perhaps you or another commenter could shed some light (I asked similar questions in another thread but didn’t get an answer).

    Regarding inflation: How high would be too high for inflation? Why is NGDP the best way to manage inflation? Why shouldn’t we just always target say, 5 percent inflation. If inflation is good in a downturn, why wouldn’t it be good in an upturn too?

    Wasn’t Bernanke an inflation targeter as an academic; why doesn’t he target inflation now? In other words; Why doesn’t the fed aggressively aim for higher inflation. There seems to be no downside to acting, and a huge downside to not acting.

    Why does the fed rely on federal fund rates rather than quantitative easing as its main mechanism? Why does “quantitative easing” require a special name if presumable that’s precisely what the federal fund rates tries to do as well through a separate mechanism?

  12. Gravatar of johnleemk johnleemk
    9. August 2011 at 19:12

    r.r.,

    People base their expectations implicitly on nominal income. Deviation from trend in either direction upends the decisions and expectations people had.

    Re Bernanke, your guess is as good as mine, but I think many here, perhaps Scott included, believe Bernanke is too consensus-driven, and has been reluctant to accommodate demand for money because of the three vocal hawks on the Fed. This is why some people are optimistic based on today’s decision; Bernanke seems to have previously only promulgated decisions based on consensus at the Fed, but he now seems willing to shove the inflation hawks aside.

    Re policy instruments, standard macro has for a while taught that interest rates, although the price of credit, can proxy for the price of money. Lowering the interest rate is tantamount to lowering the price of money — but the missing link, of course, is that you need to boost the money supply to lower the price of money. This link seems to have been forgotten, which is why many are so critical of the Fed and current mainstream economics. I’m not the expert on QE, but I think you have it right; QE is a different mechanism for boosting the money supply, so it gets its own name, since ordinarily the Fed adjusts the money supply by other means.

  13. Gravatar of Lars Christensen Lars Christensen
    9. August 2011 at 22:52

    I totally agree with Andy Harless – the Fed is effectively borrowing monetary easing from the future, by announcing to wait longer than expected to initiate hike rates. And the market reaction indicates that the announcement is credibly seen as monetary easing – stocks up, dollar weaker and gold up (TIPS breakeven inflation expectations are flat).

    It might not be enough to increase NGDP growth for a V-shapes NGDP recovery back to the “old” (pre-crisis) NGDP trend level but it is a step in the right direction. In fact it might not even be a Keynesian policy. Hence, this might be quasi-monetarist monetary policy within the framework of a modified Taylor rule and remember a monetarist like Robert Hetzel is happy to formulate is preferred policy rule within a real interest rate setup (See for example http://www.richmondfed.org/publications/research/economic_quarterly/2008/spring/hetzel.cfm). This would not be my preferred rule but might nonetheless work – especially if the markets trust Bernanke. And this is the biggest problem for the 2013 rule – it faces a traditional time inconsistency problem.

    I fact think there are two other advances in the 2013-rule. It is a rule that basically stimulates that unless the NGDP gap closes interest rate hikes will be postponed until it happens. This is better than QE1 and QE2 that was not rule based and hence every time NGDP growth picked up the markets started to price in an end to QE. Second, QE1 and QE2 might not even have been QE as it basically was credit policy rather than monetary easing (this is not totally correct as market reactions clearly showed that it worked as monetary easing…).

    In my view the markets are priced for NGDP growth around 5%, which is not enough to close the NGDP gap. But Scott, what NGDP growth should the Fed aim for to close the NGP gap? 6, 7 or 10?

    Concluding, the 2013 rule is not enough, but it might be better than Scott thinks…

  14. Gravatar of W. Peden W. Peden
    10. August 2011 at 03:34

    r.r.,

    I don’t regard inflation as good in an upturn. During a downturn, inflation is just a conglomeration of signals to producers telling them to produce more; assuming demand isn’t being driven out of whack, this kind of inflation is benign and self-limiting. During an upturn, inflation disrupts the functioning of the price mechanism by sending false signals e.g. telling people that they are earning more than they “really” are. This is the difference between demand-driven inflation and supply-driven inflation.

    Equally, deflation driven by an increase in production is more or less benign and self-limiting. If the Fed was successfully targeting NGDP at 5% and there was a 1984-style surge in output, 2% deflation wouldn’t be a bad thing and would be limited by consumers’ ability to purchase cheap goods with appreciating wages.

    This is why NGDP, rather than inflation, is the best (least bad) thing to target if we have to have a central bank.

  15. Gravatar of George Selgin George Selgin
    10. August 2011 at 03:48

    I think, Scott, that you miss half of the picture. However true it may be that the Fed’s stance remains insufficiently loose at present, Bernanke’s promise to keep the funds target where it is for two years is utterly irresponsible. Two years is a very long time–longer than most cycles last. And as any student of Wicksell will appreciate, whatever the natural or neutral rate may be today, it is unlikely to stay there that long. If the neutral rate rises sufficiently, Bernanke will either have to eat his words, or he will find himself presiding over another asset bubble, if not an inflationary spiral.

    In 2003, Greenspan’s FOMC, in which Bernanke participated, announced that the Fed would keep the funds target at 1% “for a considerable period.” The language was prudent compared to Bernanke’s “two years.” Yet it was enough to make the Fed reluctant to raise the rate on time to check the boom that was the root of the present crisis.

    Like you, I don’t want to see nominal spending sag. But neither do I want to have to live through yet another boom-bust cycle. A prudent monetary policy doesn’t sacrifice future stability for the sake of achieving an immediate stimulus.

  16. Gravatar of W. Peden W. Peden
    10. August 2011 at 06:16

    George Selgin,

    Very well put. Signalling with interest rates is a bad idea. Far better to set a clear target (be it price level, NGDP, M3 or whatever) and then adjust instruments accordingly. That’s the proper way to signal.

    By-the-by, I enjoyed your debate with Skidelsky on the radio recently. I found myself disagreeing considerably less often with you than with him.

  17. Gravatar of Scott Sumner Scott Sumner
    10. August 2011 at 07:41

    Foosion and Ben, Yes, I wonder what they are doing.

    Liberal Roman, I honestly haven’t had time to focus on the ECB, as I’ve been traveling. But as you can tell from my newest post, I am skeptical.

    Hugh, That might work, but it could lead to hyperinflation as well. I really think that right now there is no substitute for sound Fed policy–which means more stimulus.

    EcoEchoes, I’m not sure I follow. The answer is to have the Fed stimulate with non-conventional policies.

    Andy. The problem I see is that the long bond yields and equities are signaling much lower NGDP growth ahead, so the Fed attempt to communicate doesn’t seem to have worked, even if short rates have fallen. I agree that there is a possible rationale in the New Keynesian model, but that model also says you need to do level targeting at the zero bound—and the Fed refuses to do so. So why should the markets have confidence that the Fed is following the New Keynesian playbook, and not the BOJ playbook?

    I suppose you’d reply that the New Keynesian model can’t be blamed for Fed ineptitude. I agree. But it seems to me that if the Fed adopted price level targeting, there would be no need for an interest rate commitment. I don’t see the value added from the interest rate instrument. Why not do QE until prices hit the price level path?

    I have a new post on this issue.

    pct, Those are good points, but I wonder if the other 7 (non-hawks) could have done even more. Still I agree that one should not focus solely on Bernanke.

    Regarding low rates, the problem I see is that the Fed is playing catch-up. The markets already signaled that slow NGDP growth was coming, by bidding down yields prior to the Fed meeting. Yesterday the Fed merely ratified that forecast. See also my response to Andy.

    I agree about Obama.

    Thanks Mike. That’s depressing about the former Fed officials.

    Steve, You said;

    “Plus, while low interest rates do indicate that money has been too tight as you like to say, there is still some stimulus effect from driving the two year to 0% and the ten year (mortgage benchmark) to 2%. Who knows, maybe the 2-10 or 10-30 will steepen up in the coming months, indicating that money is becoming less tight.”

    Your “who knows” basically refutes your claim. Remember, never reason from a price change. The markets are telling us that the low rates reflect falling NGDP growth expectations, not easy money.

    You may be right about the three dissents–see my new “Supreme Court” post.

    rr, Bernanke does want to target inflation, but thinks the Congress would object. Ironically, Congressional opposition was based on a fear that it would be too contractionary.

    I have several posts that you can google on NGDP targeting. It is superior to inflation targeting, especially during periods of supply shocks.

    You are right that there really isn’t much technical difference between QE and interest rate targeting. The Fed normally adjusts rates by changing the level of reserves. But their respective roles in the process of communicating Fed intentions can be quite different.

    Lars, I’m not so sure about the market reaction, which seemed to be rather erratic yesterday. And I have trouble seeing how we are going to get 5% NGDP growth in a world where 5 year bond yields are below 1%. The markets are forecasting low NGDP for as far as the eye can see.

    I’d be happy with a 6% or 7% NGDP target for two years, and then 5% thereafter (or even 4.5%)

    Also check out my reply to Andy, and my new post on transparency.

    George, You said;

    I think, Scott, that you miss half of the picture. However true it may be that the Fed’s stance remains insufficiently loose at present, Bernanke’s promise to keep the funds target where it is for two years is utterly irresponsible. Two years is a very long time–longer than most cycles last. And as any student of Wicksell will appreciate, whatever the natural or neutral rate may be today, it is unlikely to stay there that long. If the neutral rate rises sufficiently, Bernanke will either have to eat his words, or he will find himself presiding over another asset bubble, if not an inflationary spiral.”

    I think you misread my post, I didn’t express myself clearly.
    Bernanke did something that could be highly inflationary, but is far more likely to be utterly inadequate. I wasn’t saying rates should be held at zero for more than 2 years, but rather rates shouldn’t be targeted at all. I was merely expressing my view as to the most likely way the policy would fail–it would be inadequate stimulus. I agree that it also could be much too much stimulus, which is another reason to oppose interest rate targeting.

  18. Gravatar of foosion foosion
    10. August 2011 at 07:48

    I’m beginning to see the virtues of NGDP targeting – it’s a mechanical rule so we don’t have policymakers who should act instead decide to chicken out. The downside is the fear of inflation. I’d much rather see RGDP targeting, but am not at all sure how to accomplish that.

    No doubt all of this is addressed in your earlier posts.

  19. Gravatar of Contemplationist Contemplationist
    10. August 2011 at 07:49

    George Selgin

    I agree, but doesn’t that indicate the prudence in an NGDP target instead?

  20. Gravatar of George Selgin George Selgin
    10. August 2011 at 10:18

    I’m glad that we agree Scott; I understand and share your opinion about correct policy not being merely or even primarily a matter of interest targeting. But I wanted to make sure that the “other” danger inherent in Bernanke’s recent move wasn’t overlooked here.

    And to Contemplationist: yes, nominal income targeting would be far more prudent than ffr targeting, and especially more prudent than ffr “pegging,” because it poses no danger of unchecked P movement.

  21. Gravatar of Lars Christensen Lars Christensen
    10. August 2011 at 11:22

    Scott, I agree that it is very hard to read much from the kind of market action we are seeing these days. What I tried to say was rather that Bernanke really don’t many options political and given the composition of the FOMC. So what he did was probably what is possible at the moment.

    At the same time I think George has a good point. I think it is important that the (quasi)monetarist argument is not seen as a form of activist policy recommendation and that inflation is a real longer term danger. Obviously that is not the case right now, but 3-4 month ago I actually think that the US economy was on the way to a NGDP recovery.

    Anyway, we can all agree a NGDP target would be the right thing to do…

  22. Gravatar of TheMoneyIllusion » Why the Fed’s policy won’t lead to high inflation TheMoneyIllusion » Why the Fed’s policy won’t lead to high inflation
    11. August 2011 at 07:31

    [...] Selgin made some similar criticisms in the comment section of this post and this post (where Nick Rowe also makes comments.).  I completely accept their analysis.  [...]

  23. Gravatar of Scott Sumner Scott Sumner
    11. August 2011 at 19:13

    foosion, The Fed can’t target RGDP. The price level becomes indeterminate.

    Lars and George, I agree.

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