Suppose you have a crystal ball, and are given one peak at the future, say May 2011. But you are only allowed to look at one variable—and it’s not the Dow, it’s the fed funds rate. Now suppose I tell you the following, it will be one of these two numbers:
Which one are you rooting for? Which number do you hope to see as you look into the crystal ball? I know what I’d like to see, but before giving you my answer, let’s look at some expert opinion. Mankiw linked to the following SF Fed article today:
Like many private forecasters, FOMC participants foresee persistently high unemployment and low inflation as the most likely outcome over the next few years. The recommended future policy setting of the funds rate based on the estimated historical policy rule and these economic forecasts is given as the dashed line in Figure 2. This dashed line shows that, in order to deliver a degree of future monetary stimulus that is consistent with its past behavior, the FOMC would have to reduce the funds rate to -5% by the end of this year—well below its lower bound of zero. . . .
According to the historical policy rule and FOMC economic forecasts, the funds rate should be near its zero lower bound not just for the next six or nine months, but for several years. The policy shortfall persists even though the economy is expected to start to grow later this year. Given the severe depth of the current recession, it will require several years of strong economic growth before most of the slack in the economy is eliminated and the recommended funds rate turns positive.
Economic theory suggests that it is useful for the Fed to communicate the likely duration of any policy shortfall. Monetary policy is in large part a process of shaping private-sector expectations about the future path of short-term interest rates, which affect long-term interest rates and other asset prices, in order to achieve various macroeconomic objectives (McGough, Rudebusch, and Williams 2005). In the current situation, the FOMC (2009) has noted that it “anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Other central banks have been even more explicit about the duration of low rates. For example, the central bank of Sweden has recently stated explicitly that it expects to keep its policy rate at a low level until the beginning of 2011. Rudebusch and Williams (2008) describe how such revelation of central bank interest rate projections may help a central bank achieve its policy goals.
Last February, FOMC participants also started to publish their long-run projections for output growth, unemployment, and inflation—in keeping with a trend toward greater transparency (Rudebusch 2008). Such long-run projections can help illuminate the FOMC’s policy strategies and goals, and these revealed that most FOMC participants would like to see an annual inflation rate of about 2% in the longer run. Such an expression of a positive inflation objective may help prevent inflationary expectations from falling too low and forestall any excessive decline in inflation.
What a dreary discussion. Gloom and doom for years out into the future. And how do we improve things? We credibly promise an expansionary monetary policy that will persist for years into the future. Long time readers of this blog will note that I continually harp on the idea that what matters isn’t the current setting of monetary policy, but rather the expected future path of policy. So in that respect I am with Mr Rudebusch—we need to commit to a highly expansionary monetary policy for an extended period of time. But here’s where he loses me, unlike most economists I don’t equate near zero interest rates with monetary ease, I equate them with monetary failure, and more specifically with ultra-tight money.
Now let’s return to the crystal ball question. If I looked into the ball and saw 0.25% fed funds rates in 2011, I would have a sickening feeling—like I’d been punched in the solar plexus. Krugman would be right, we’d be another Japan. After catching my breath I’d rush out to sell all my stocks. I’d put 50% into 30 year T-bonds, and the other 50% into HK/China equities, in the hope that the Chinese aren’t as foolish as we are. In contrast a 3.75% fed funds rate would put a big smile on my face, as it would indicate nominal GDP growth had bounced back strongly. It would have been a V-shaped recovery.
But obviously I am in the minority here. Krugman and Mankiw keep linking to these studies again and again, so I have to assume they see something that I don’t. In my view, promising year after year of near zero rates is like promising year after year of sub-par nominal growth. The central bank should adopt a policy that is expected to produce a quick recovery from recession, not years more of economic misery. A policy that if successful will result in much higher nominal interest rates in the future.
To paraphrase frequent commenter JImP, it is not the Fed’s job to predict failure; their job is to create success. When the economy is severely depressed, backward looking Taylor Rules are nothing but failure rules. The thing I find so frustrating is that the Fed doesn’t seem to have any ideas about how to create faster nominal GDP growth. FDR was able to create inflation expectations in a far worse economic environment. A Fed policy of targeting NGDP futures contracts at a 5% premium would immediately energize the asset markets. I don’t know if it’s a failure of will, or a failure of imagination, but something is very wrong when after 76 years of dramatic improvements in macroeconomics, we aren’t even able to recreate the successes of the spring of 1933.
We’ve retrogressed since the Great Depression, despite all our smug textbooks that tell us how much smarter we are than the policymakers of the 1930s. “Oh no, we’d never raise reserve requirements in the middle of a depression.” Of course we might adopt a policy of paying banks to hoard excess reserves just as the economy is about to fall off a cliff, which has an identical impact on the multiplier. And at least in the 1930s they had the excuse that the gold standard constrained their actions.
This post is related to an earlier post criticizing Krugman’s argument that in order to be effective monetary stimulus would have to create high inflation expectations. I think that argument is profoundly wrong, and seems to be based on these frequent Taylor rule studies that Krugman and Mankiw keep linking to. The inflation numbers cited imply a completely implausible estimate of the slope of the SRAS. In reality, we don’t need high inflation, we need rapid NGDP growth. If fear of inflation is holding us back, then we have made a very costly miscalculation.
That post only received 2 comments, about 25 below my average, despite being one of the two or three most important posts that I have ever done. I’d like to see the blogosphere spend more time discussing this important issue. To put it as simply as possible, does rapid nominal growth (say 5-7% for example) require high inflation as Krugman seems to assert, or can we get by with relatively low inflation because of the depressed condition of the economy? I believe that inflation would stay low, even if monetary policy was expansive enough to generate brisk NGDP growth.
For many years now the new Keynesian elite has been assuring us that we would never make the same mistake as the BOJ, that our Fed would not sit by for year after year with sub-par NGDP. They assured us that the BOJ had weapons they were not using. If so, then why are we planning years of the same failed policy of near zero interest rates and grudgingly inadequate QE? Why not pull out one of those foolproof escapes right now? Why wait?