Archive for the Category Quantitative Easing


The conservative Fed

Most people agree that the Fed is a conservative institution. But conservative in what sense? Temperamentally, or ideologically? A temperamentally conservative Fed is reluctant to go out on a limb and try new techniques. An ideologically conservative Fed abhors greater than 2% inflation in much the same way that a vampire abhors sunlight. It turns out that it matters a lot whether the Fed is temperamentally conservative, ideologically conservative, or both.

In recent posts, Ryan Avent and Matt Yglesias have criticized the widespread view among Keynesians that the Fed is out of ammunition. People like Larry Summers are skeptical about whether the Fed could stimulate the economy, because doing so would require them to boost inflation. These Keynesians have tended to recommend fiscal stimulus as the only way to boost aggregate demand.

In my view there are two flaws with this argument. First, some Keynesians seem to believe that fiscal stimulus can work without raising inflation expectations, whereas monetary stimulus is only effective at the zero bound if the Fed succeeds in convincing the public that higher inflation is on the way.  But both fiscal and monetary policy work through higher AD.  And unless the SRAS curve is completely flat, higher AD means higher inflation. The markets know this; hence fiscal stimulus will be expected to work if and only if it boosts inflation expectations.  Yes, the early Keynesians believed the SRAS was flat when the economy had lots of slack, but after watching how sensitive oil prices are to growth expectations, I can’t imagine that anyone still believes in a flat SRAS curve.

So if fiscal stimulus is to work, it must boost inflation expectations. This is why we need to know the Fed’s motives. Will the Fed attempt to squash the higher inflation resulting from fiscal stimulus, or will they allow inflation expectations to rise?  Most Keynesians seem to have assumed the Fed was temperamentally conservative. That they were reluctant to make the sort of bold moves required to boost AD at the zero bound, but wouldn’t stand in the way of fiscal stimulus. And in fairness, there are statements by Bernanke that seems to support that assumption. But the actions of the Fed strongly suggest otherwise. Consider Fed policy since 2008:

1. The Fed started paying IOR for the first time in its history.

2. The Fed got involved in bailing out the banking system to an unprecedented extent.

3. The Fed got heavily involved in buying MBSs (QE1)

4. The Fed did QE2, with longer term bonds

5. The Fed did Operation Twist

That doesn’t seem like a timid or cautious Fed to me, that seems quite aggressive. Not at all temperamentally conservative. Now let’s consider evidence for ideological conservatism. Here’s Ryan Avent:

According to the Cleveland Fed’s estimates, 10-year inflation expectations haven’t risen above 2.1% since the end of 2008. At least three times during that span, the Fed has halted or reversed its easing, first by ending its initial asset purchases, then by allowing its balance sheet to contract naturally as securities matured, and then by ending the asset purchases known as QE2. Expectations have remained in check because the Fed has opted not to continue policies that would raise them. The myth of Fed helplessness is just that.

I think that’s exactly right. Ryan is describing a temperamentally ambitious Fed willing to try all sorts of unconventional policies, but which pulls back whenever inflation threatens to exceed 2%. My question to the Keynesians is:

How does fiscal stimulus overcome an ideologically conservative Fed?

I think they have in mind a scenario where the Fed won’t take affirmative moves to kill a recovery, such as raising interest rates. And that may be right. (We’ll see when we actually get a recovery—the FDR-era Fed, the BOJ, and the ECB all raised rates prematurely.) But that’s not the right question. The problem is that the Fed needs to do extraordinary things just to keep inflation from falling well below 2%. And it seems like when inflation rises to 2%, they stop doing those things. That’s ideological conservatism. It may be unintentional on the Fed’s part (I believe it is unintentional on Bernanke’s part) but it means the Fed is not just failing to do its part, it’s actually sabotaging fiscal stimulus.

PS. I’d also note that with an ideologically conservative Fed the most effective fiscal policies (for reducing unemployment) are not at all what progressives would like.  You’d need to lower employer-side payroll taxes, lower minimum wages, cut back on the maximum duration of UI benefits, in order to shift aggregate supply to the right. It’s interesting that a Fed dominated by Republicans does policies that make conservative fiscal policy the only effective option. Morgan Warstler’s fantasy.

Statsguy on the environmental impact of Fed/ECB policy

Here’s Statsguy from the comment section of an earlier post:

I would add only this: The Fed (and ECB) are doing tremendous STRUCTURAL damage by over-targeting (rear-looking) headline inflation. That doesn’t mean I don’t think headline inflation is important (it’s quite real, particularly if you’re in the lower income strata), but it’s counterproductive.

Why? Essentially, we’re knee-capping the economy to drop AD to bring down the price of oil (in dollars), which in a sense is SUSTAINING THE OIL INTENSITY OF THE ECONOMY to a great[er] degree than is optimal. What do I mean by that? Simply this: if the price of oil went up (relative to labor and debt), then economic actors would accelerate substitution away from oil – that is, they would substitute more people and more technology for expensive oil. INSTEAD, we’re dropping oil use not by encouraging substitution to alternatives (including increasing labor intensity, which would help with unemployment) but by preserving the current oil intensity and reducing overall consumption (including reduction of consumption of non-oil-intense products, like digital “goods”). It’s dumb.

In a sense, that Fed policy is also encouraging developing economies to move toward a more oil-intense infrastructure than would otherwise exist if oil were priced higher. It is encouraging LESS drilling, LESS technological innovation in the drilling sector, LESS demand for fuel efficient vehicles, LESS investment in alternative transportation, and WORSE city planning.

I don’t have strong views on this issue, but it’s an interesting perspective.

2.  Off topic, but I was originally planning on doing a post criticizing Felix Salmon.  Fortunately, David Beckworth saved me the trouble.  I highly recommend the post.

3.  I get frustrated with a developing argument that it’s tough to address this AD problem because inflation is unpopular.  There are all sorts of flaws with this, which I have discussed elsewhere.  (Opinion polls on inflation are meaningless, and in the past the public has seemed far more satisfied with a bit higher inflation and a lot more jobs.)  But here’s what really frustrates me.  We are letting the Fed off the hook.  The Fed used the biggest debt crisis in world history as an opportunity to drive inflation (and inflation expectations) to the lowest levels in 50 years, to levels lower than their mandate, to 1% over the past three years.  And all along the way Bernanke kept insisting that they had more ammo, but just didn’t think more stimulus would be appropriate.  None of the recent posts claiming the Fed has a political problem because the public hates inflation have addressed this issue.  I guarantee that if interest rates were 8.5%, many unions, Congressmen and business people would be demanding rate cuts right now, inflation or no inflation.  The Fed is EXTREMELY lucky that 99.999% of people don’t have a clue as to how monetary policy works (beyond interest rates.)

4.  Totally off topic, but Matt Yglesias’s predictions are quite similar to my own.  I’m agnostic on his health cost argument, and would clarify his point that although China can grow fast for many years, the actual growth rate will likely slow somewhat.  But those are my forecasts.  However if they are wrong I’ll blame Yglesias, as he’s much smarter than me and should have known better.

PS.  Yesterday I finally answered lots of old comments from a week back.  The backlog was overwhelming.  I do eventually read all the comments, and answer most.  But after three years I am reaching the end of the road for these two:

A.  Liberals asking how monetary policy can work when rates are zero.

B.  Conservatives conceding QE2 raised inflation, but asking how more inflation can boost output.

I think I’ll just start directing people to FAQs.  The blog isn’t really set up for people who don’t understand the AS/AD model.  If they disagree with it fine, tell me why.  But faking ignorance by claiming not to understand how nominal shocks can have real effects is very annoying.

Happy now?

During the last 4 months of 2010 and early 2011 I got a lot of grief from the inflation hawks.  Yes, QE2 seems to have lowered unemployment from 9.8% to 8.8% in 4 months, but they were having to pay more at the pump (I assume these commenters had jobs.)  They warned that it was devaluing the dollar, leading to high inflation.

Unfortunately, in today’s world oil market with Chinese demand pushing production to near capacity, any recovery in the US (even an expected recovery) will push oil prices significantly higher.  And of course Libya was an additional bit of bad luck.  Payback for the good karma of the 1990s.

But this isn’t “inflation” in the 1970s sense.  Back then wages rose rapidly and every time you went out to buy a new car it cost almost twice the previous one.  This is an increase in the relative price of an important commodity, which strongly affects the headline CPI for a few months.  Even worse, our insane ethanol policies cause it to bleed over a bit into food prices.

Well now the inflation hawks have gotten their way.   Oil fell into the high 70s today.  The Fed did something completely trivial on Wednesday, and basically washed its hands of the responsibility to keep NGDP at an adequate level.  Both inflation and employment are now forecast to be far below the Fed’s implicit target over the next 5 years, and they don’t seem willing to do anything about it.  BTW, according to the Cleveland Fed the TIPS spreads I often point to actually slightly overstate expected inflation; they have a more complicated formula that I don’t understand very well.  It shows 10 year inflation expectations below 1.4%.  Five year expectations are even lower.

So that’s our choice.  Do we want to keep gas nice and cheap for those who have jobs, or do we want an economic recovery for the millions whose lives are being ruined by this recession.

And I’m not sure that even those with jobs benefit from these policies.  Every time I save a few pennies at the gas pump I lose many thousands of dollars off my retirement fund.  Economics is not a zero sum game.  When millions are producing no output, almost everyone will suffer.

HT:  Thanks to Lars Christensen for the Cleveland Fed data.

Do or do not. There is no try.

I know that you are already rolling your eyes over the corny Star Wars reference, but I’ve never been more serious in my life.  The Fed has a simple decision to make.  Do they want to achieve some sort of nominal target, or not.

There are two metaphors one can use for monetary policy initiatives.  One metaphor is the scientific experiment.  The Fed will try QE to see if it works.  Or they’ll try Operation Twist to see if it works.  The other metaphor is steering a ship.  They adjust their policy levers to keep the economy moving in the appropriate direction.

During normal times everyone assumes the steering a ship metaphor is the right one.  The Fed nudges interest rates higher or lower to steer the economy in the direction they want to go.  At the zero bound almost all commentators switch to the scientific experiment metaphor.  The Fed tries something, and then waits 6 to 12 months to see how it works.  But this is the wrong metaphor.  In my view the experimental approach will almost always fail.  The steering metaphor is always the right one.  The Fed must stop trying, and they must decide what they actually want to do.

Let’s consider QE2 as a nudge of the steering wheel.  Did it work?  Almost all the indicators suggest it did, indeed both Keynesians and monetarists were proclaiming it a (very limited) success in early 2010.  Relative to the non-QE2 situation, it clearly boosted AD, at least slightly.

Now let’s consider QE2 as an experiment.  Did it work?  I’d say no.  I don’t think anyone can be satisfied with NGDP growth over the past 12 months.

And the reason for the failure of QE2 as an experiment is easy to see.  Ben Bernanke is no Luke Skywalker.  In order to follow Yoda’s maxim the FOMC would have to wake up every morning and ask themselves whether they were satisfied with the path of expected NGDP growth.  At some point during the spring of 2011 the answer would have switched from yes to no.  At that point they’d need to nudge the steering wheel enough so that expected NGDP was again on target.  But they didn’t.

Given enough time, a Yoda-like commitment will always succeed, at least in terms of boosting NGDP growth.  It might fail in other respects:

1.  Higher NGDP growth may fail to boost RGDP.

2.  The Fed might have to buy up an extraordinary amount of risky assets, and they might then suffer large capital losses.

But it will boost NGDP.

As a practical matter the two risks cited above are not serious concerns.  The Fed should aim for steady 5% NGDP growth even if the monetarist/Keynesian model is completely wrong, even if NGDP has no impact on RGDP.  So it’s no loss if more NGDP fails to boost RGDP.  And as for capital losses, the Fed can always avoid having to buy up large quantities of risky assets by ending IOR (or even going negative) and buying Treasury notes.  As a practical matter the public is not going to want to hold a massive amount of non-interest bearing cash if the Fed is committed to keeping NGDP rising at trend.  Never has happened, and never will.

Many people worry about whether the Fed can boost NGDP.  The market reaction to QE2 makes it obvious that the answer is yes.  The only question is whether the Fed will decide to do whatever it takes.  If they ever make that decision, they will be stunned to learn just how little it takes.  But if they fail to make that commitment, nothing they do will ever seem to be enough.  Unfortunately it looks like they will keep trying, and hence not doing.

Further thoughts on Switzerland

The recent Swiss devaluation has led to some interesting reactions in the blogosphere.  But one angle that I haven’t seen discussed is the relationship of the Swiss action and bubble theory.  I’m a believer in the EMH and hence skeptical of the idea of bubbles, a least as the term is usually interpreted.  But I’m in the minority, the vast majority of people think bubbles exist.  And if they do, then the recent move of the Swiss franc to near parity with the euro was surely a major bubble–as the currency appeared to be at a level that was unsustainable in the long run.

If the Swiss franc is wildly overvalued, then what should the Swiss do?  Because I don’t believe governments can identify bubbles, I’d be inclined to say they should do nothing.  But most people think bubbles are identifiable–indeed that’s a sine qua non for the existence of bubbles.  In that case the policy implications are clear–the Swiss government should buy massive quantities of foreign exchange, and then sell off the assets at a future date when the real exchange rate is at a more “reasonable” level.  The very rich Swiss would become even richer.  And because governments last indefinitely they can afford to wait out market irrationality, no matter how long it takes to dissipate.  BTW, this action need not involve monetary policy at all.

Now suppose Switzerland faces the threat of deflation, either due to an overvalued currency, or some other problem like currency hoarding.  What should the Swiss government do?  They should sell massive quantities of SF, until deflation is no longer expected.  BTW, this action need not involve the foreign exchange market at all.

As a practical matter the two actions I just describe will often be combined.  The Swiss will sell massive quantities of SF, and buy lots of foreign assets.  This would be appropriate if they think that Switzerland faces a threat of deflation and its currency is hugely overvalued.

Given my belief in the EMH, you might ask why I endorsed the Swiss intervention.  I don’t care at all about the overvaluation of the SF, my support was solely based on the assumption that the Swiss do face an actual risk of deflation.  I would also have supported a policy of price level targeting, or NGDP targeting.  I don’t much care if the Swiss end up winning or losing their bet on the SF.  The EMH says it’s a coin toss, and Switzerland’s a very rich country.  If they plan this game frequently, they’ll win as many as they lose.  Or if I’m wrong about the EMH, they’ll win way more than they lose.

Tyler Cowen had this to say about the action:

I am not unhappy but I am nervous.  Keep in mind the Swiss tried such pegs before, in 1973 and 1978, and neither lasted.  At some point limiting the appreciation of the Swiss franc implied more domestic price inflation than they were willing to tolerate (seven percent, in one instance, twelve percent in another).  You can argue about whether they should be, or should have been, nervous about seven percent price inflation but the point is that they were and indeed they might be again.

Fast forward to 2011.  It’s the Swiss saying “we can create money more decisively and more quickly than the speculators can bet against us, and keep it up.”  If the flight to safety continues, the Swiss can reap seigniorage by creating money but also there may be spillover into price inflation.  You can fix a nominal exchange rate but the market sets the real exchange rate through price movements and so Swiss exports could end up growing more expensive anyway, through the price adjustment channel.  If you’re holding and trading euros, and the Swiss central bank keeps churning francs into your hand at a good rate, at some point you will consider buying a chalet in Schwyz.

If the speculators sense less than a perfectly credible commitment from the central bank, they will continue to bet on franc appreciation.  In other words, the Swiss are putting their central bank credibility on the line, at least in one direction.  And even if they stay credible, they may not much lower their real exchange rate over a somewhat longer run, so why should they be fully committed to credibility?

I think I understand Tyler’s argument, but am not sure quite what to make of it.  It might help to slightly change the policy, and then see how it affects things.  Suppose the SNB says they will buy foreign exchange in order to drive down the value of the SF until inflation expectations rise to 2%.  In that case, it wouldn’t be much of a problem if inflation started rising, the SNB could simply abandon the program and declare “mission accomplished.”  This suggests that the real problem is a specific commitment to peg the SF at 1.20.  The SNB might have to abandon the peg if inflation started moving in a direction that conflicted with their macro policy goals.

In another post Tyler Cowen makes this comment:

And here is Scott on the Swiss unlimited pledge, a real test of credibility theories.

Just as with QE2, it’s not clear what is being tested.  QE2 was certainly credible—markets reacted powerfully to the news.  But the policy didn’t pan out as the had hoped.  And the Swiss announcement yesterday was certainly credible.  If it wasn’t markets would not have reacted so strongly.  It’s important not to confuse credibility and fidelity.  For instance a Don Juan may be credible, but not faithful.

It might be instructive to compare the ways in which QE2 might fail, with the ways in which the SNB policy might fail.  QE2 might have failed because it was not credible, because it didn’t increase NGDP expectations.  In fact, it did not fail for that different reason.  The real problem was that Fed didn’t commit to enough QE to hit a particular NGDP target, they committed to $600 billion in QE2.  Both the Fed and the markets initially thought that would be enough to significantly boost NGDP growth.  If it did (which is unclear) all it did was to prevent an even steeper slowdown than what actually occurred.  On the other hand if the Fed had promised to do whatever it takes in the form of QE, and if it was believed, it might have failed because it later reneged on that promise.  The Don Juan problem.  That’s a problem some people worry about, but not me.  Central banks aren’t Don Juans.  They don’t have fidelity problems, they have commitment problems.

In my view people are making too much of an issue of the risk that the SNB may not end up adhering to the 1.20 currency peg.  The SNB frequently intervenes in the forex market, as described in this recent post.  During recent years there were several interventions that seemed to achieve the SNB’s objectives, and then were abandoned when no longer needed.  Mission accomplished.  The macro aggregates in Switzerland are about where the SNB wants them, but there is concern about future trends.  Thus they are taking a pre-emptive action.

This recent action may be abandoned because the SNB’s macroeconomic goals are achieved.  But I don’t see how that would be a source of embarrassment for the Swiss.  It’s inflation and NGDP that matter, not the exchange rate–which is merely a means to an end.

Here’s Matt Yglesias:

I continue to be fascinated by the fact that lots of issues in monetary policy that are controversial when you talk about “monetary policy” become uncontroversial when the subject switches to exchange rates. Everybody knows that currency depreciation expands aggregate demand. This is what the Swiss are talking about. This is what Americans are talking about when they complain about Chinese “currency manipulation.” And everyone agrees that a determined central bank can achieve whatever exchange rate goals it sets. So despite the apparent disagreement over whether or not a determined central bank can boost aggregate demand, everyone in fact seems to agree that it can””but only if we agree to talk about exchange rates rather than “aggregate demand.”

I’d hope “everyone agrees.”  But here’s Paul Krugman (from last year):

Oh, and about the exchange rate: there’s this persistent delusion that central banks can easily prevent their currencies from appreciating. As a corrective, look at Switzerland, where the central bank has intervened on a truly massive scale in an attempt to keep the franc from rising against the euro “” and failed:

PS.  The other quasi-monetarists have had excellent posts on the Swiss move (Beckworth, Hendrickson, Glasner, Nunes, etc.)  I’m still jet lagged and struggling to catch up with all the news I missed, and what other bloggers have been saying.