Frequent commenter Derrill Watson sent me a recent post from his own blog:
Mr. Dudley, President of the NY Federal Reserve Bank, is speaking at Cornell today. One of the economics faculty got him to make a presentation in his class. He could speak a little more freely in exchange for no audio or video recording. I eagerly attended and took copious notes.
. . .
I had communicated with Sumner about Dudley’s arrival and asked what question I should ask if I got the chance. I got the chance. Given that the Fed’s purpose right now is to lower the cost curve, it seems to me that there is a political economy question of how to sell it. If stimulating aggregate demand is your goal, why not tell people you are targeting a proxy for aggregate demand, like NGDP growth, and announce you are working on raising people’s average incomes rather than trying to raise inflation? His response:
[Dudley:] That is the right point. We would like to see something like 1.75% inflation. It’s too low right now. We are worried about NGDP because people can’t leverage. [He made several statements about why low NGDP growth is bad.] We could try targeting NGDP, but would it be credible? Could we actually hit our targets? There’s also a communication problem. People hear “nominal income” and don’t know what to do with it. But this is a key issue. If we could guarantee 5% NGDP growth per year for several years, it would be great.
[Me:] Personally, I score a big win here for Sumner et al. I’ll do another post tomorrow about his comments on the recession itself and the steps Congress, the Fed, and international policy makers are doing to prevent this all from happening again.
I do understand that the underlined statement is ambiguous. I recall Krugman once said something similar, and was expressing skepticism about whether the Fed could actually hit that NGDP target. Nonetheless, I think the most likely interpretation is that Dudley thinks a 5% NGDP target would actually be a good idea, as long as some practical communication issues could be overcome. I think this bodes well for the future. The appeal of NGDP growth (and 5% no less!) is becoming better understood. Of course I’d actually like to see above 5% growth for a couple years, and then 5% thereafter.
However this comment worried me:
When is the time to exit? At one point, he tossed a couple numbers into the air. Until aggregate demand has grown enough that unemployment is back down to below 8% or if inflation got above 2%, they really aren’t looking at exit.
I hope something was lost in translation. It should be “and,” not “or.” If Dudley actually said or, and meant it, he would be violating the Fed’s dual mandate. There would be no justification for the Fed to tighten policy if inflation was 1% and unemployment was 7.5%. And that scenario might well occur in 2012 or 2013.
This is also slightly worrisome:
[Back to me:] Paying interests on reserves (IOR) has been fingered by Sumner, Beckworth, and others as a cause of much of the monetary contraction since 2008. Yes, the Fed sent out $800 billion, but all of it went straight back into Fed deposits instead of into the economy. It shored up banks and kept more of them from failing, but didn’t produce growth. The big take away for me was understanding what the Fed thinks it’s doing, keeping up a contractionary policy while claiming it’s trying to ease more.
[Back to Dudley:] The answer is that IOR is a major new tool to reduce the costs of quantitative easing. It allows the Fed to convince investors and other people that they can and will mop up excess reserves later. By shifting the cost curve down, it allows them to do more easing. “We can control the demand for credit” by changing the costs of credit directly. The combination of reserves which cost them 25 basis points (0.25%) and the long term assets they purchase at about 4% return means that the Fed is currently bringing in an $80 billion annual profit, so they are very popular on the Hill right now. If, in order to mop up excess liquidity, they have to raise the IOR to more than 4%, however, they start losing money. So the risk of QE2 is that it becomes a major liability later.
If the Fed was forced to raise IOR to 4%, that would mean we got a very robust recovery. In that case the gains to the Treasury would far outweigh any losses to the Fed from QE2. The Fed is part of the US government’s consolidated balance sheet. I hope misguided fears of capital losses are not holding back the Fed.
Off topic, Tyler Cowen raised this interesting question today:
Question: When the measured expected real return is below zero, how well can any recovery program work?
Recovery programs can work quite well. Let’s break this down into two parts:
1. Can the monetary authority raise NGDP when real rates are negative?
2. Does higher NGDP boost RGDP when the economy has slack and real rates are negative?
The answer to both questions is clearly yes. If on a gold standard, just raise the price of gold. Svensson correctly called that a “foolproof”; method of inflation. If on a fiat money standard, peg the price of NGDP or CPI futures at the desired level, or at the very least raise your inflation target and do level targeting.
Once NGDP rises, output will rise if there is slack. This is because nominal wages are sticky when unemployment is high, so the higher NGDP will induce firms to produce more.
I think it’s a mistake to see interest rates (nominal or real) as an important part of the monetary policy transmission mechanism. They mostly reflect the state of the economy—whether output is expected to be high or low relative to trend. Of course if the economy did recover, real rates would rise back above zero.