Slowly but surely the Fed is discovering the components of a sound monetary policy.  Here New York Fed President William Dudley discusses the advantages of price level targeting:

If we judged it desirable, we could go still further and provide more guidance on how monetary policy would react to deviations from any stated inflation objective. One possibility would be to keep track of inflation shortfalls when the federal funds rate is constrained by the zero bound, as is the case today. For example, if inflation in 2011 were a 0.5 percentage point below the Fed’s inflation objective, the Fed might aim to offset this miss by an additional 0.5 percentage point rise in the price level in future years.

If only they had gone with level targeting in 2008, and used a 4.5% NGDP trajectory rather than the price level, we’d have mostly avoided the Great Recession.  NGDP would be about 8% above its current level.  Even core CPI level targeting would have made the recession far milder.

The last half of the speech is worth reading.  He is clearly in the dovish camp, and it’s hard not to conclude that the Fed will move in November—especially with two Obama people coming on board.

On another topic, long time commenter Marcus Nunes has a new blog.  Unfortunately for me, it’s in Portuguese.  Are Spanish speakers able to read economics articles in Portuguese?  In any case, Marcus is one of my most valuable commenters, having provided me with many very valuable links, including those Bernanke papers from 1998 and 2003 that showed how much the Fed’s current policy has differed from what Bernanke recommended to the Japanese.  The papers were later cited by many other bloggers and news magazines—which shows how much influence a single commenter can have.

HT:  Bruce Bartlett

Here’s what FDR told the country in October 1933, when the recovery was faltering under the higher business costs imposed by the National Industrial Recovery Act (perhaps the most misnamed act in US history.)

“although the prices of many products of the farm have gone up . . . I am not satisfied . . . If we cannot do this [reflation] one way we will do it another.  Do it, we will. . . . Therefore the United States must firmly take in its own hands the control of the gold value of the dollar . . . I am authorizing the Reconstruction Finance Corporation [RFC] to buy gold newly mined in the United States at prices to be determined from time to time after consultation with the Secretary of the Treasury and the President.”  (NYT, Oct. 23, 1933, p. 3.)

FDR doesn’t blame foreigners; he realized we needed to put our own house in order, make our own monetary policy much more expansionary with an explicit price level target, and reduce the value of our own dollar.

And here is President Obama:

UNITED NATIONS “” President Obama increased pressure on China to immediately revalue its currency on Thursday, devoting most of a two-hour meeting with China’s prime minister to the issue and sending the message, according to one of his top aides, that if “the Chinese don’t take actions, we have other means of protecting U.S. interests.”

No call on the Fed to adopt a higher price level target.  Instead, we are blaming foreigners for our weak aggregate demand.  Of course the “other means” refers to protectionism, which FDR understood was not the answer.  And what does he mean by “protecting US interests?”  Not yours or mine, but rather car parts makers in the rust belt threatened with Chinese competition.  I suspect it’s too late; five weeks from now the rust belt will vote Republican, repudiating a modern technocratic Democratic party that has lost touch with its working class constituents.

Where’s our modern William Jennings Bryan?

My friends, we declare that this nation is able to legislate for its own people on every question, without waiting for the aid or consent of any other nation on earth; and upon that issue we expect to carry every state in the Union. I shall not slander the inhabitants of the fair state of Massachusetts nor the inhabitants of the state of New York by saying that, when they are confronted with the proposition, they will declare that this nation is not able to attend to its own business. It is the issue of 1776 over again. Our ancestors, when but three millions in number, had the courage to declare their political independence of every other nation; shall we, their descendants, when we have grown to seventy millions, declare that we are less independent than our forefathers?

No, my friends, that will never be the verdict of our people. Therefore, we care not upon what lines the battle is fought. If they say bi-metalism is good, but that we cannot have it until other nations help us, we reply that, instead of having a gold standard because England has, we will restore bi-metalism, and then let England have bi-metalism because the United States has it. If they dare to come out in the open field and defend the gold standard as a good thing, we will fight them to the uttermost. Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests and the toilers everywhere, we will answer their demand for a gold standard by saying to them: “You shall not press down upon the brow of labor this crown of thorns! You shall not crucify mankind upon a cross of gold!”  (italics added)

Suppose the ideas in my previous post were implemented.  What impact would they have on the financial markets, and the economy?

The place to start is not with the QE, which is the least important part of the proposal.  Instead, consider the impact of price level targeting.  This should raise the two-year expected inflation rate to about 2.7%, and raise the expected two year NGDP growth rate by even more.  The problem is to determine the demand for base money at that higher expected inflation rate.  This turns out to be very difficult, particularly if the IOR is reduced to zero.  During normal times the demand for base money is less than 10% above currency in circulation, not more than double the currency stock, as it is today.  The reason is simple, during normal times the interest rate on T-securities is high enough to make it very unattractive for banks to hold excess reserves, which normally earn no interest.

So the answer to the demand for base money question hinges partly on the demand for excess reserves, and that depends on nominal interest rates.  We normally think of monetary stimulus as reducing interest rates, and vice versa, but that is not always the case.  Indeed, I’d be surprised if two year T-note rates stayed as low as 0.5% if the Fed committed to 2.7% inflation over two years.  Is it possible they’d fall even lower?  Certainly.  But I think it unlikely.  Thus it is quite possible that the Fed would actually have to sharply reduce the monetary base after committing to higher inflation.  Because the policy has never been tried, we simply don’t know.

I suggested the Fed buy T-bills and short term T-notes partly because I see the price level target as the key policy and the QE as just a method of accommodating the demand for base money at the new price level target.  It doesn’t do any of the heavy lifting.  That’s why buying longer term bonds (as recommended by Andy Harless in the comment section) wouldn’t do much better in my view.  If the policy was not credible, and markets did not expect higher inflation, then the OMOs would be viewed as temporary, and prices wouldn’t rise regardless of what type of bond was purchased.  If they were viewed as credible, then the policy would be expected to persist until we escaped the liquidity trap at some future date.  But in that case it also wouldn’t matter which type of bond was purchased, as OMOs would be effective with any security once we had exited the liquidity trap.

I suppose the key difference is the way we visualize the transmission mechanism.  I see policy boosting expected future NGDP, then current asset prices, then current AD.  Keynesians see it reducing real interest rates, boosting investment, then boosting AD.  Another difference might be credibility.  Perhaps markets might be more impressed by the purchase of long term bonds, as Andy suggests, and thus more confident that the Fed would persevere with its plan to boost prices.

Because of all this uncertainty, I’m not opposed to Andy’s suggestion that the Fed purchase of longer term bonds.  I suppose my suggestion was motivated by the fact that Krugman once mentioned the risk of capital losses from QE.  This is actually a fascinating issue, which involves everything from rational expectations to insider trading.  In a basic ratex model, a fully announced program of inflation should not imply any expected capital losses for the Fed, even if it lowered long term rates in the short run and raised them in the long run.  Indeed, if this were not the case there would be lots of $100 bills lying on the sidewalk, for anyone who went short on government bonds right after the QE was announced.

On the other hand one can imagine a scenario where the Fed knows more about its determination to carry through with the policy than the markets do.  So short rates fall due to the liquidity effect, but long rates don’t rise due to the expected inflation effect.  In that case if the Fed bought L-T bonds they’d be insider trading against their own interest.  I seem to recall Nick Rowe discussing this point, and recommending they buy equities or something else that would do well if the economy recovered.

Thinking about these issues can be depressing, as it makes clear just how daunting the challenges ahead really are.  To get the sort of recovery we really need, the Fed would have to really surprise the markets, in some sense be smarter than the markets about the future direction of Fed policy.  In fact, the reverse is usually true.  My favorite example is December 2007, when a smaller than expected rate cut led to a plunge in stock prices, and a drop in bond yields (the opposite of what the Keynesian model predicts) as the markets correctly understood that the Fed had erred, and that as a result the economy would weaken so much that they’d have to reverse course quickly and cut rates very sharply.  And within weeks this happened, another 125 basis points in fed funds rate cuts.

That shows how sophisticated the bond markets are.  To get a robust recovery we need the Fed to be even smarter than those very smart bond markets, to do more than what is currently expected.  They have the advantage of insider information, but I’m just not sure that’s enough.

In March of 2009 I presented a proposal for monetary stimulus, in the form of a petition.  I think it’s fair to say that it didn’t attract much attention.  The commenter Benjamin suggested it’s time for a new and specific proposal.  After all, now that fiscal stimulus has failed to generate an adequate recovery, there is a renewed focus on the need for monetary stimulus.

There is no point in proposing my dream monetary policy–NGDP futures targeting and all.  The Fed would never contemplate anything so radical at this time.  Instead I am going to suggest something that just might be acceptable, should the Fed decide the economy needs more demand.  The term ‘moderate’ refers to the fact that I won’t ask the Fed to deviate from their 2% implicit inflation target, and the term ‘pragmatic’ refers to the fact that I won’t ask for risky and untested ideas such as negative interest rates on excess reserves and/or NGDP futures contracts.

Any monetary stimulus proposal has at most three primary components:

1.  A bigger supply of base money

2.  Less demand for base money

3.  A commitment for greater monetary stimulus in the future

I will try to use all three approaches, and do so in a synergistic plan that consists of more than merely the sum of the parts.

1.  Quantitative easing

The Fed should commit to doing as much quantitative easing as necessary to hit its macroeconomic objectives.  They might want to initially commit to a specific figure like $100 billion a month, but over time I believe they should adjust the amount of QE to reflect the demand for base money.  What makes this so tricky is that the demand for base money is itself very sensitive to expectations of NGDP growth, i.e. expectations about whether the policy will fail.  Thus QE will work much better if combined with other policy tools that increase the likelihood of success.  If the Fed does QE, and QE alone, it is very possible that it will be no more effective than the previous $1 trillion in reserves that were injected into the banking system in late 2008.

People like Andy Harless have suggested the Fed buy long term bonds.  I’d prefer just the opposite—the purchase of low risk T-bills and short term T-notes.  By doing so they avoid the risk of significant capital losses if (as I expect) the operations had to be reversed as a result of a robust economic recovery.  I understand that most people envision the transmission of monetary policy through the Keynesian lens of changes in interest rates.  And that it looks like the only interest rates that can now be significantly lowered are the longer term rates.  But I just don’t believe that we can get a robust recovery in NGDP growth without substantially higher long term rates.  Yes, it’s possible that long rates would fall sharply immediately after the Fed purchased lots of T-bonds, and then rise sharply a few months later as economic recovery picked up.  But I have trouble reconciling that scenario with rational expectations.  And I am reluctant to recommend a mechanism that seems to rely on sophisticated bond traders being too dense to understand what is going on.  In Andy’s favor, something like that quick reversal did seem to occur in the spring of 2009, but I think we’d be pushing our luck to rely on it happening again.  For me the transmission mechanism is higher asset prices (stocks, commodities, commercial RE, etc) as expectations of future NGDP growth rise.  That avoids the paradox that we seem to need lower long term interest rates, even as higher rates are associated with prosperity.

Before proceeding to the other two policies, it might be helpful to use an automobile analogy.  Consider QE to be like the car’s engine.  If the transmission is not engaged, the car will not move.  In addition, the car needs to be steered, so that it doesn’t shoot off into a ditch.  The other two proposals are intended to do just that.  Lower IOR can serve as a sort of transmission mechanism, making sure the added QE actually drives the car forward.  And price level targeting will serve as both a transmission mechanism and the steering mechanism letting the Fed know if they have done too much or too little QE.

2.  Eliminate interest on excess reserves

At first glance this seems like a no-brainer.  Many people seem concerned about all the money the Fed has been printing.  Eliminating IOR would allow for the same amount of monetary stimulus with a far smaller monetary base.  Apparently the Fed is concerned about the effect on MMMFs, which might see their rates of return fall to near zero, and thus threaten again to “break the buck,” as occurred to one fund in late 2008.  In that case, I presume that my idea of negative rates on ERs (recently endorsed by Blinder!) would be even more problematic for the MMMF industry, so I won’t advocate that now.

This is not my area of expertise, but the need for monetary stimulus is so great that I think the Fed should eliminate IOR on excess reserves and hope for the best.  Indeed the need is so great that I think they should proceed even if it necessitates the Fed engage in some sort of microeconomic intervention in the MMMF industry that is otherwise undesirable.

I would add that the proposal only applies to ERs, not required reserves.  Thus banks may still be able to profitably offer checking accounts, as each additional account creates a derived demand for more required reserves, which still earn interest.  If the Fed is worried about how removing IOR would impact the banking industry, they have several options.  They could actually raise the rate on required reserves.  This would still encourage banks to reduce their holdings of ERs, which would no longer earn any interest at the margin.  Or, they could “grandfather in” existing reserve holdings for each bank, and only eliminate IOR for the new money that is to be injected in my first proposal; the roughly $100 billion a month in QE.

By eliminating IOR, any additional QE is more likely to find its way out of ERs and into circulation.  But even that may not be enough.  The last proposal is by far the most important.  It provides additional impetus to getting the new money into circulation, and also calibrates how much is needed:

3.  A 2% price level growth path from September 2008, level targeting

Cutting edge monetary models by people like Woodford emphasize that in a liquidity trap you really need price level targeting, not inflation targeting.  The problem with inflation targeting is that it is “memoryless.”  That means if you miss your inflation target for last year, you “let bygones be bygones” and continue to shoot for the same inflation target next year.  Despite the name, “level targeting” doesn’t really mean keeping the price level constant (unless zero inflation is the target) rather it means trying to return to the planned price level trajectory anytime you temporarily diverge from the desired inflation rate.  The intuition is so appealing that none other than Ben Bernanke recommended that the Japanese do exactly that when their CPI had undershot their zero inflation target in the early 2000s.  Bernanke suggested they should temporarily aim for 3% or 4% inflation to catch-up to their original target path.

I am asking the Fed to do the exact same thing that Bernanke recommended for the Japanese.  The only difference is that the Japanese inflation target is 0%, whereas the Fed’s implicit target (they don’t have an explicit target) is believed to be about 2%.

[As an aside, some have argued that the implicit target is actually 1.5% to 2%.  On the other hand over the past two decades they have behaved as if their implicit target is a tad over 2%.  And you could argue that a period of 9.5% unemployment is not the best time to try to bring inflation down to 1.75%.  So you could just as well argue for 2.25% inflation, given actual Fed policy over recent decades.  My 2% proposal is a very reasonable and moderate compromise between their actual policy of slightly over 2%, and the oft-mentioned range of 1.5% to 2.0%, which centers on 1.75%.]

If we track core inflation since the liquidity trap started around September 2008, we find that the core CPI has fallen about 1.4% below the Fed’s implicit 2% target.  In that case, the Fed should commit to trying to raise prices by 2.7% a year over the next two years, and 2% thereafter.  Markets currently seem to expect about 1% annual inflation over the next two years (based on TIPS spreads.)  Why would an extra 1.7% inflation have such a big effect?  Because the SRAS curve is fairly flat when unemployment is high.

After the 1982 recession, Paul Volcker engineered 11% NGDP growth over the first 6 quarters of recovery.  Real growth was 7.7%.  I am not claiming we could achieve the same.  After all, the supply-side fundamentals are not quite as strong as in 1983, as many right-wing economists have pointed out.  But only the most extreme RBC economist could claim the SRAS is vertical, and that moving inflation from 1.0% to 2.7% for 2 years would not substantially boost growth.  FWIW, I’d expect 2.7% core inflation to result from 7% to 10% NGDP growth, implying a real recovery of 4.3% to 7.3%.  That’s much better than we are currently getting.

Now for the hardest part, how do we make it all happen?  A target is just an aspiration, isn’t it?  Not quite.  That is true of inflation targets, but not price level targets.  Importantly, price level targets are both goals, and commitments to do something later to catch up if you fail to meet your goal.  And that future commitment is also very important.  We won’t be at the zero rate bound forever, thus it’s important for the Fed to give markets some sense of the price level trend line they plan to return to when the recession is over.  If the trend line is about what TIPS markets currently expect, we’ll get a weak recovery.  If it is the one I suggest, we’ll get a much more robust recovery.  Would Congress object?  I doubt Barney Frank (a Congressional inflation target critic) would complain, if it was explained that prices had fallen short and that the proposal was aimed at boosting growth.

So what about my first proposal to do QE?  How do we know when we have done enough?  I believe we should follow Svensson’s maxim that we “target the forecast.”  The Fed should do QE until its internal forecast of core CPI growth two years out is on target.  Bernanke and Woodford once pointed out that sole reliance on market CPI forecasts (such as the TIPS market) would create a circularity problem.  There are ways to rely completely on market forecasts w/o a circularity problem, but they are too radical for the Fed, as the market would essentially become the FOMC.  But Svensson’s idea for targeting the Fed’s own internal forecast is eminently reasonable.  Set your steering wheel at a position where you expect to reach your destination.  Do the amount of QE that leads you to expect on-target core CPI growth.

I’m certainly not suggesting the Fed ignore market signals.  They should look at a wide range of market indicators.  Bernanke and Woodford acknowledged those could be helpful, as a supplement to the Fed’s internal structural models.  And let’s face it; QE is going into uncharted waters, so we can’t rely exclusively on structural models.  The Fed should not let market forecasts diverge too far from their policy goal.

4.  Summary

There is nothing radical in my proposal:

1.  QE with T-bills is a plain vanilla open market purchase.

2.  A zero IOR rate is the way the Fed operated for 98% of its history.

3.  Two percent core inflation is widely seen as the Fed’s implicit target.

4.  Level targeting has an impeccable pedigree, with strong support from people like Bernanke and Woodford

And let’s be clear about one thing.  I am not proposing any sort of dramatic change in Fed policy.  Their policy has generally been roughly 2% inflation (I’d prefer 5% NGDP growth.)  All I am saying is let’s stick to that policy.  It is the hawks who suggest policy settings likely to reduce inflation below the Fed’s traditional 2% target (despite 9.5% unemployment) that are the true radicals.

In his public speeches Bernanke really has no choice but to advocate current policy.  And he is reluctant to change policy if it leads to a badly split FOMC.  That gives 3 or 4 hawks an effective veto on change, and insures the status quo hawkish policies continue.  But what does Bernanke believe in his heart?  Does he support the views of people like Charles Plosser, who seem to claim faster NGDP growth would not boost RGDP growth?  Does Bernanke now hold views that are completely inconsistent with his entire academic career, and his recent advocacy of fiscal stimulus?  Or would he prefer something closer to the plan that I have outlined.  Someday we’ll find out the truth.

HT:  Marcus, Liberal Roman, Benjamin Cole

So I had the following dream last night:

Me:  Honey, I decided not to teach summer classes this year.

Honey:  Oh Scott, you’ll just spend the time out on the golf course

(I grab a shotgun and shoot off one of my feet)

Honey:  Why did you do that?

Me:  To convince you that I won’t go golfing this summer.

Honey:  Um, you could have just promised not to go golfing.

Me:  But I thought you won’t believe me.

Honey:  But you never even tried to convince me. I might have believed you.

Me:  Oh.

Honey:  I never realized how weird you are.

(Just then my friend Paul walks in to the room)

Paul:  You’re not going to believe him are you?  He could put on a peg-leg and hobble around the golf course.

Honey:  And your friends are even weirder than you are.

If your brain is as twisted as mine, you see the obvious connection to helicopter drops of cash.  To me, there is a sort of surreal quality to discussions of liquidity traps.  The discussion starts with the premise that it is hard to expand aggregate demand when nominal rates are close to zero.  (Which is false.)  Then there is a discussion of all sorts of crackpot schemes like negative interest rates on $20 bills.  Or dropping cash out of helicopters.  Then the liquidity trap proponents come up with ever more far-fetched reasons why this wouldn’t work.

In fact, these discussions are flawed from the very beginning, as they assume there is some sort of “trap” that prevents central banks from boosting AD.  Central banks operating under floating exchange rate fiat regimes can always increase AD if they want to; in all of recorded history there are no failures.  But people think otherwise because they see central banks do things that look expansionary when rates hit zero, and in many cases AD does not increase.

Krugman’s right that a helicopter drop is not necessarily inflationary.  Suppose the government dropped 50 $100 bills for every US citizen out of an airplane.  If the public expected the government to institute a $5,000 per capita tax in the very near future, and retire all that cash from circulation, it would have no effect.  But of course that would be a really, really stupid thing to do.  Taxes have deadweight losses, so the net effect of the money drop plus tax would be simply the destruction of wealth, that is all.  It would be like me shooting off my foot to convince my wife that I wouldn’t play golf, but then putting on a peg leg and going out golfing anyway.  Sure that’s theoretically possible, but why would I do it?  If the government behaves like a bunch of reckless lunatics hell-bent on hyperinflation, it is a good bet that they are a bunch of reckless lunatics hell-bent on hyperinflation.

[You might argue that fiscal authorities do nutty things like this.  Yes, but they don’t have the alternative of using the printing press.]

So I think a big helicopter cash drop would almost certainly boost AD.  But it would still be a terrible idea.  Here’s why.  If the Fed did this without an explicit inflation or NGDP target, then it would likely result in hyperinflation.  The public would be frightened, and I can’t say I’d blame them.  But if the Fed did accompany the drop with an explicit price level target, then the optimal helicopter drop would be less than zero.  Indeed if the Fed committed to say 4% inflation, the public would not want to hold even the current $2 trillion in base money (unless they were paid to do so with an interest on reserve program.)  So to summarize:

1.  Helicopter drops might not work, but almost certainly would.

2.  Helicopter drops are a really stupid idea, especially if the central bank did not first try to inflate using traditional tools.  There are numerous recent statements by Fed officials to the effect that they have the tools they need, it’s just that they don’t think the economy needs more AD.  Why pull the nuclear option without first doing something simple, LIKE SAYING YOU’D LIKE TO HAVE HIGHER INFLATION?

3.  The helicopter drop might result in hyperinflation, which would be worse than what we have now.

4.  Even if an explicit 4% inflation target prevented hyperinflation expectations, the Fed would probably have to reduce the base to hit the target.  I.e., no helicopter drop.

Just to be clear, it isn’t just a really silly idea for the real world because it might overshoot to hyperinflation.  It is really bad to even discuss it as a hypothetical, because it feeds into the view that the Fed, ECB, and BOJ want faster inflation, but just don’t know how to get it.  And that’s false.  They don’t want faster inflation, and they know perfectly well how to get it if they change their minds.

PS.  I agree with Tyler Cowen’s take on this issue.  My only problem with his analysis is that he shows too much respect to the idea itself, and the hypothesis that a helicopter drop might not boost inflation expectations.  Cowen’s right, but as soon as you start trying to defend these ideas in a serious way, you play right into the hands of sort of people who think it is sensible to consider a scenario where someone shoots off their foot with a shotgun, and then installs a peg-leg so they can play golf.

When the day arrives where the BOJ says they want 2% inflation but can’t achieve it, come back to me and we can start talking about shooting off feet with shotguns.  Until then I see no point in having this conversation.  It’s like arguing with 9/11 conspiracy nuts.

And I hate golf.

PPS.  After I wrote this it occurred to me that people might think I was talking about the “drop” of commercial bank deposits at the Fed.  It’s cash to the public I have in mind.  Reserves are too esoteric, and too much like T-bills these days—so they might not affect inflation expectations very much.  I am talking about actual helicopter drops, not tax cuts/open market purchases.