Here are two possible messages from the upcoming September Fed meeting:
1. We are coming out of this meeting with all guns blazing. We will cut the interest rate on reserves–to below zero if necessary, and do so much QE that we expect NGDP growth to accelerate sharply. Indeed we expect to have to raise the fed funds target at some time during the next 18 months to prevent NGDP growth from exceeding 7%.
2. We are growing increasingly glum about the prospects for the economy. As a result we feel confident that we can hold interest rates near zero for at least another 3 years, and probably much longer.
Which does the Fed see as the more expansionary option?
Over the past few years I’ve been surprised at how hard it is for central banks to move away from interest rates as the lever of monetary policy. It’s not impossible, just this morning the Swiss National Bank used the exchange rate as a policy tool. But consider the plight of the Fed. First they cut rates to zero. When short term rates can’t be cut any more, they start QE. But they insist the purpose of QE is not to increase the money supply, but rather to lower long term rates–even though low long term rates are a sign that monetary stimulus has failed. When QE2 doesn’t seem enough, they move on to promises to hold short rates near zero for an extended period of time. The Fed seems extraordinarily reluctant to use policy tools that actually would be effective—particularly an explicit nominal target, level targeting. And then they wonder why their “extraordinarily accommodative monetary policies” never seem to be enough.
Low interest rates didn’t work for the Fed in the 1930s, and they haven’t worked for Japan since 1994. Why would anyone expect a different result in America today?