For decades the Fed has steered the economy along a path of two to three percent inflation. The policy has not been controversial. Sometimes they ease, and sometimes they tighten.
Recently inflation has run closer to 1%, and Bernanke has suggested pushing the rate back up to 2%. Others at the Fed are more radical, calling for level targeting. This would allow a bit above 2% inflation to offset periods of below 2% inflation. Even those radical proposals are more conservative than the actual 2% to 3% average rate of recent years. So how is the public reacting to monetary policy proposals that are more conservative that what actual occurred in recent decades? According to Time magazine, they’re so angry it might lead to a civil war:
What is the most likely cause today of civil unrest? Immigration. Gay Marriage. Abortion. The Results of Election Day. The Mosque at Ground Zero. Nope.
Try the Federal Reserve. November 3rdis when the Federal Reserve’s next policy committee meeting ends, and if you thought this was just another boring money meeting you would be wrong. It could be the most important meeting in Fed history, maybe. The US central bank is expected to announce its next move to boost the faltering economic recovery. To say there has been considerable debate and anxiety among Fed watchers about what the central bank should do would be an understatement. Chairman Ben Bernanke has indicated in recent speeches that the central bank plans to try to drive down already low-interest rates by buying up long-term bonds. A number of people both inside the Fed and out believe this is the wrong move. But one website seems to believe that Ben’s plan might actually lead to armed conflict. Last week, the blog, Zerohedge wrote, paraphrasing a top economic forecaster David Rosenberg, that it believed the Fed’s plan is not only moronic, but “positions US society one step closer to civil war if not worse.” (See photos inside the world of Ben Bernanke)I’m not sure what “if not worse,” is supposed to mean. But, with the Tea Party gaining followers, the idea of civil war over economic issues doesn’t seem that far-fetched these days. And Ron Paul definitely thinks the Fed should be ended. In TIME’s recently cover story on the militia movement many said these groups are powder kegs looking for a catalyst. So why not a Fed policy committee meeting. Still, I’m not convinced we are headed for Fedamageddon. That being said, the Fed’s early November meeting is an important one. Here’s why:
Usually, there is generally a consensus about what the Federal Reserve should do. When the economy is weak, the Fed cuts short-term interest rates to spur borrowing and economic activity. When the economy is strong and inflation is rising, it does the opposite. But nearly two years after the Fed cut short-term interest rates to basically zero, more and more economists are questioning whether the US central bank is making the right moves. The economy is still very weak and unemployment seems stubbornly stuck near 10%.
In the past I’ve argued their mistake was to argue for more inflation, which sounds undesirable. Contrast Fed policy with fiscal stimulus. In early 2009 there was lots of criticism about the fiscal stimulus plan, but I don’t recall a single critic arguing that fiscal stimulus was a mistake, because it “might work.” Instead, they argued it was a waste of money and would probably “fail,” which meant it wouldn’t boost AD. It was taken as a given that more AD was desirable. Now monetary policy has become so controversial that people are talking about civil war. Why? Because some of the more radical members of the Fed are proposing average inflation rates almost as high as what we have experienced over the last two decades.
What are some possible explanations:
1. Higher inflation sounds bad–the Fed should have said it was trying to boost AD, or NGDP, or the average income of Americans.
2. The monetary base has already exploded in size, so people are already worried that only “long and variable lags” separate us from Zimbabwe-style inflation—despite 2% bond yields and despite the fact that similar policies had no effect on long run inflation in Japan.
Today I’d like to suggest a different explanation. Perhaps this crisis is a sort Waterloo for Keynesian interest rate targeting, analogous to the effects of 1982 on monetarism. You may recall that in the early 1980s monetarist ideas were popular. Slower money supply growth helped slow inflation. But velocity seemed to decline sharply in 1982, so the Fed let the money supply rise above target, and went back to interest rate targeting. (Indeed some claim they never really abandoned interest rate targets, but let’s put that aside.)
This crisis has put the economy into a position where the Fed’s normal interest rate mechanism doesn’t work. It can’t steer the economy in the only way it feels comfortable steering the economy. Maybe we need a new steering wheel. And the search for a new steering wheel is what is so controversial.
If we had been doing NGDP futures target all along, nothing interesting would have happened in late 2008. Expected NGDP growth would have stayed at 5%, nominal rates would have stayed above zero, and the monetary base might not have exploded (that is less clear.) The severe financial crisis would have been far milder, if it occurred at all. The Fed would have continued steering the economy in the same way it always had. (BTW, the decline in house prices in bubble areas was already largely complete by late 2008—the second leg down was caused by falling NGDP.)
Instead, when rates hit zero the Fed stopped trying to steer the economy at all; it followed Stiglitz’s advice and stopped using monetary policy. Of course they were still doing policy (and highly contractionary policy at that) but didn’t realize it, as their normal policy tool had jammed just as the wheels of the car were pointed toward a ditch called “recession.” In the next post I’ll explain why it’s almost impossible to pry the Fed’s hands off the old steering wheel, even though it is now broken and not connected to the wheels.