Andy Harless has an excellent analysis of why the Fed is ignoring the seemingly obvious need for more monetary stimulus:

So why is the Fed so tight? Here are some possibilities:

1. Fed policy is better described by a rule that is non-linear in unemployment. With the unemployment rate so tremendously high, perhaps marginal increases in the unemployment rate affect the Fed less than they would if the rate were closer to normal. But given the Fed’s mandate to pursue high employment, wouldn’t the need for more aggressive monetary policy in response to higher unemployment rates be even more acute when the employment situation is already so obviously out of whack? And wouldn’t the unusually high unemployment rate, in and of itself, tend to eliminate the risk of pushing the unemployment rate too low and thereby free the Fed to pursue more aggressive policies than it otherwise would?

2. The Fed is anticipating dramatic declines in the unemployment rate and/or increases in the inflation rate. Except that we don’t see those in the Fed’s forecasts.

3. The Fed is correcting for its earlier overshoot, for being too loose in 2009. Except we’re not seeing much evidence that the overshoot (if there was one) needs to be corrected. There is no economic boom. The inflation rate has continued to fall. If the Fed did overshoot on the ease side, recent economic data suggest that, in retrospect, the overshoot was a good idea and not one that should be corrected by a reversal in subsequent policy.

4. The Fed is passing the buck to fiscal policy. But fiscal policy is tightening too now, in relative terms. It doesn’t seem likely that the Fed is irresponsible enough to base its policy on hypothetical fiscal policies that aren’t actually happening.

5. The Fed has “abandoned the Mankiw rule” and is now setting its policy stance according to very different criteria than it has used over the past 23 years. But is there any evidence that Ben Bernanke has had some sort of conversion experience? And is there any reason why the Fed would be interpreting its mandate differently than it has in the past?

6. The Fed has dramatically altered the parameters of its “Taylor Rule.” But why?

7. The Fed is uncomfortable with quantitative easing and would like to minimize its use and reverse it as soon as possible, irrespective of Taylor Rule considerations. I think we have a winner. The long term effects of quantitative easing are uncertain and could be seen as potentially dangerous. (What will happen if, at some point in the future, the Fed has to choose between liquidating its unconventional assets at a loss, exacerbating an inflationary environment, or raising interest rates high enough to risk a fiscal crisis?) So there is arguably reason for the Fed to be uncomfortable with it. But the implications are disturbing, if you believe in a Philips curve or anything like it. Faced with an excessively high unemployment rate and an excessively low inflation rate, the Fed is choosing to risk exacerbating the situation (i.e., to take the intermediate-term risk of deflation) rather than to risk a very different type of difficult situation in the distant future. Maybe it’s the right decision, but it’s an awfully scary one.

I think he is right.  And this reminded me of all the newspaper stories I read from the early 1930s.  Only a few people thought money was too tight–mostly monetary economists.  Most assumed policy was easy.  The Fed did take some steps that looked fairly aggressive—large increases in the monetary base and very low interest rates—but they seemed ineffective.  The Fed and many conservatives in the financial press became increasing fearful that all the monetary stimulus was a sort of time bomb waiting to explode into high inflation.  So the Fed became strangely passive even as the Depression got worse.  Does any of this sound familiar?

I know that no matter what I say most people will instinctively regard low interest rates and a rising monetary base as “easy money.”  And when this scenario occurs, people get a queasy feeling in the pit of their stomach.  The problem is that monetary economics is very counterintuitive.  When deciding to go with the gut, or go with what the brain is telling you, it is very important to always rely on logic, not instincts.  In the early 1930s the Fed went with their gut, and they seem to be doing so again (although thankfully their mistakes are far smaller this time.)

Here’s another example from Raghu Rajan:

My sense is that we do not know enough about the effect of ultra-low interest rates to state categorically that they are an unmitigated good for reviving the economy. But perhaps the most important cost of low rates is its effect on risk taking and illiquidity seeking. Remember that the United States Fed under Greenspan helped precipitate the recent crisis by keeping rates too low too long. That suggests we cannot be sanguine about the risks that are being taken now. Indeed, many of those who urged Greenspan to keep rates ultra low then are urging the Fed to keep rates ultra low now.

Again, this is much like the argument that conservatives used in the early 1930s.  They said “Look at the people calling for easy money.  They are the same people who supported easy money back in 1927.  And we all know that easy money blew up the stock market bubble and caused the Depression.  Now we must work off our excesses.”

Except that easy money didn’t cause the stock market bubble.  Indeed money wasn’t particularly easy (there was no inflation in the 1920s.)  And the stock market crash did not cause the Depression (as we discovered in 1987.)  And the Depression didn’t work off excesses; it created massive unemployment, which makes it look like every single industry was overbuilt (an  impossibility, unless we need more leisure.)  And almost everyone now agrees that the conservatives were wrong in 1932, we did need easier money.  In the years to come people will wonder why the Fed was so passive in 2009 and 2010.

HT:  Mark Thoma and Arnold Kling

I didn’t have time to blog today, so here are some interesting posts that relate to issues I’ve been discussing.

James Hamilton on the implications of the oil spill:

I agree with Ed [Dolan] that intra-organizational incentives contributed to the problem in both cases, and that government policy allowed the firms that created the problems to pass some of the costs on to others in many details of the financial debacle. But I am less persuaded that limited liability explains BP’s decisions at the corporate level. The company’s market value has declined by over $75 billion since April. Here was an entity with more than just skin in the game and looking more than just flayed at the moment. And yet, the company opted not to invest $500,000 in a secondary acoustic shut-off switch, which is essentially required in Norway and Brazil, and which Royal Dutch Shell and France’s Total SA sometimes use even when not required. BP’s backup plans B, C, and D all seemed to come out of the playbook for dealing with the 1979 Ixtoc disaster— none of them worked that well there, either. So why did the company take such risks?

I think part of the answer, for both toxic assets and toxic oil, has to do with a kind of groupthink that can take over among the smart folks who are supposed to be evaluating these risks. It’s so hard to be the one raising the possibility that real estate prices could decline nationally by 25% when it’s never happened before and all the guys who say it won’t are making money hand over fist. And this interacts with the forces mentioned above. When the probability of spectacular failure appears remote, and moreover it hasn’t happened yet, it’s hard to set up incentives, whether you’re talking about a corporation or a regulatory body, in which the person who makes sure that the risks stay contained is the person who gets rewarded. When everyone around you starts thinking that nothing can go wrong, it’s hard for you not to do the same. It can become awfully lonely in those environments to try to be the voice of prudence.

And yet, prudent judgment is the thing I most desperately wish decision-makers had more of in these times of dazzling new technological capabilities.

That was the point I was trying to make, but Hamilton makes it much more eloquently.  Here is Ryan Avent:

After having a look at the Fed’s new Beige Book and at Ben Bernanke’s testimony to Congress, it’s impressive the extent to which the Fed acknowledges the economic headwinds facing the economy, only to basically repeat the forecast it’s been touting (with small nudges one way or another) for the past nine months””American economic growth of between 3% and 4% this year and next, settling down thereafter. I’m not sure if that’s reassuring or troubling.

The whole post is worth reading, but I’d like to comment on why I think the Fed’s view is troubling.  Given the current inflation rate of 1%, the Fed is essentially forecasting 4.5% NGDP growth as far as the eye can see.  That’s trend growth, if we assume that trend real GDP growth has fallen to 2.5% (a widely held view.)  OK, so what does trend NGDP growth mean?  It means the Fed is contributing nothing to the economic recovery.  AD expansion is at rates you’d expect if we were at full employment.  The entire recovery must be “financed” by below trend inflation.  Alternatively, by shifts in the SRAS curve due to wage and price cuts.  And recall that NGDP recently fell nearly 8% below trend.  Even if half that was a permanent real shock, surely with 9.7% unemployment there must be some slack?  Couldn’t the Fed just help us out a little bit?  A tiny bit?  Is there really nothing they can do?

Here is Tim Duy:

To summarize, the Fed believes we are facing another threat to demand, either via financial or real trade linkages, at a time when lending activity continues to fall, suggesting that monetary policy is too tight to begin with.  But the Fed stance is to believe that monetary policy is on the verge of being too loose, and, if anything, planning needs to be made to tighten policy.  At the same time, Fed policymakers also believe fiscal policy needs to turn toward tightening as well. Meanwhile, unemployment hovers just below 10%, nor is it expected to decline rapidly,  and inflation continues to trend downward.

All of which together suggests that the Fed’s policy stance is seriously out of whack with policymaker’s interpretation of actual and potential economic developments.  And I have trouble explaining the disconnect.

As I read Duy’s entire post, I tried to imagine what a Fed official might say in their defense.  Usually I can do that, even when reading something with which I disagree.  For instance, people often send me Krugman articles they object to.  Even when I agree with Krugman, I can usually imagine how he could defend his argument against a critique.  Tim Duy’s post seemed so persuasive that I can even imagine a credible counterargument.

Arnold Kling has some of his usual excellent posts on the housing crisis (here and here.)  I learned that my anti-Fannie and Freddie views are considered racist among some members of the liberal elite.  Ah yes, the racism accusation.  The McCarthyism of the left.  My reaction?  Only a left-wing  pinko commie would make that kind of accusation.

BTW, the McCarthy era was already ancient history by the time I was a teenager in 1970.  I have to think we are rapidly approaching the time when people who recklessly throw out the charge of “racism” will look just as silly as those who accuse Obama of being a communist.

From today’s Bloomberg:

Audits Avoided

The Senate bill contains most of what Fed officials sought. In addition to preserving their bank-supervisory powers, it maintains a ban on congressional audits of interest-rate decisions that some lawmakers had sought to strip away. Ensign joined most Republicans in opposing the final legislation, saying in a floor speech that it failed to deal with Fannie Mae and Freddie Mac, the housing-finance companies seized by the government in 2008, and “does nothing to address real reform.”

The outcome puts Fed Chairman Ben S. Bernanke in a stronger position to withdraw record monetary stimulus as the economy recovers from the deepest recession since the 1930s, said Senator Claire McCaskill of Missouri, a state that is home to the Federal Reserve banks of Kansas City and St. Louis.

‘Not as Informed’

“They’ve done a good job of educating without lobbying,” said McCaskill, 56, a first-term Democrat who spoke with Kansas City Fed President Thomas Hoenig and St. Louis’s James Bullard during the debate. “A lot of members of Congress were not as informed as they should have been about what the Federal Reserve is and how it works.”

Well it’s good to know that they have now been “informed” by the Fed of just how important it is that Congress not go poking around as the Fed prepares to tighten monetary policy.

Let’s see if you commenters can come up with more clever retorts.

Last year I spent a lot of time emphasizing that the real problem was the profession, not the Fed.  The Fed represents the consensus of opinion among economists.  Unless we can change that consensus, it is unlikely that we can change Fed policy.

Paul Krugman is also pulling his hair out over attitudes toward monetary stimulus.  He recently linked to a 2008 post that criticized Ken Rogoff for advocating tight money to slow the commodity price boom of 2008.  Krugman responded (in 2008):

Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen “” which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to “trend”?

Presumably there’s some implicit argument in the background about why a sharp rise in the relative price of oil is more damaging than leaving labor and capital underemployed. But that argument isn’t there in Ken’s recent pieces. Model, please?

I agree that

“Dollar bloc countries have slavishly mimicked expansionary US monetary policy”

and that’s a real issue: the Fed is pursuing very loose policy to deal with a US financial crisis, and that’s inflationary in countries that are pegged to the dollar without facing our problems. But that’s an argument for breaking up Bretton Woods II; it’s not an argument for tighter Fed policy.

Several points.  If the CPI is a much worse indicator than NGDP, then the price of oil and other commodities are far worse than even the CPI.  Krugman’s also right about the exchange rate issue.  BTW, China sharply revalued the yuan between 2005-08, and thus avoided high inflation.

On July 29, 2008, the very same day that Rogoff penned his infamous call for tighter money, I received a rejection letter for a paper I had submitted to Contemporary Economic Policy.  (Please don’t take this as a criticism of that journal, two other journals didn’t even think my paper was worth evaluating.)  Here is one of the two referees who didn’t like the paper (a third loved it):

The author assumes that the Fed will not repeat the mistakes of 1979-80.  The current environment looks very much like 1980.  The monthly CPI rose 14 a.r. in June and expectations in the Michigan survey rose from 4 to 7% for the year inflation with the June report.  The dollar is at all time lows and commodity prices are soaring to record heights.  With the fed funds rate negative the New Keynesian model is predicting a rapid rise in inflation.

Hey Mr. Anonymous referee; how’s that New Keynesian model prediction working out for yah?

So that’s where we were on July 29th, 2008, on the eve of the Fed’s Great Mistake.  With mindsets like those being the norm, is it really at all surprising that we ended up where we did?  If you are wondering what they should have been focusing on in 2008, my answer is NGDP forecasts for the US inferred from various real output indicators plus TIPS spreads.  This might not have called for easier money yet, but certainly not tighter money.

Part 2.  Krugman and Thoma vs. Rajan.

Krugman (and Mark Thoma) also criticize Raghuram Rajan’s recent article calling for tighter money.  Although I agreed with Rajan in his recent dispute with Krugman about Fannie and Freddie (and prefer his more polite writing style to Krugman’s), I’m afraid I find this column even more discouraging than do Krugman and Thoma.  Here is Rajan:

Regardless of the true explanation, the US is singularly unprepared for jobless recoveries. Typically, unemployment benefits last only six months. Moreover, because health-care benefits are often tied to jobs, an unemployed worker also risks losing access to affordable health care.

Short-duration benefits may have been appropriate when recoveries were fast and jobs plentiful, because the fear of losing benefits before finding a job may have given workers an incentive to look harder. But, with few jobs being created, a positive incentive has turned into a source of great anxiety. Even those who have jobs fear that they could lose them and be cast adrift.

Then he criticizes fiscal stimulus, before turning to monetary policy:

Equally deleterious to economic health is the recent vogue of cutting interest rates to near zero and holding them there for a sustained period. It is far from clear that near-zero short-term interest rates (as compared to just low interest rates) have much additional effect in encouraging firms to create jobs when powerful economic forces make them reluctant to hire. But prolonged near-zero rates can foster the wrong kinds of activities.

For example, households and investment managers, reluctant to keep money in safe money-market funds, instead seek to invest in securities with longer maturities and higher credit risk, so long as they offer extra yield. Likewise, money fleeing low US interest rates (and, more generally, industrial countries) has pushed up emerging-market equity and real-estate prices, setting them up for a fall (as we witnessed recently with the flight to safety following Europe’s financial turmoil).

Moreover, even if corporations in the US are not hiring, corporations elsewhere are. Brazil’s unemployment rate, for example, is at lows not seen for decades. If the Fed were to accept the responsibilities of its de facto role as the world’s central banker, it would have to admit that its policy rates are not conducive to stable world growth.

Policy would still be accommodative if the Fed maintained low interest rates rather than the zero level that was appropriate for a panic. And this would give savers less of an incentive to search for yield, thus avoiding financial instability.

Politicians will not sit quietly, however, if the Fed attempts to raise rates. Their thinking – and the Fed’s – follows the misguided calculus that if low rates are good for jobs, ultra-low rates must be even better.

Emerging studies on the risk-taking and asset-price inflation engendered by ultra-low policy rates will eventually convince Fed policymakers to change their stance. But, if politicians are to become less anxious about jobs, perhaps we need to start discussing whether jobless recoveries are here to stay, and whether the US safety net, devised for a different era, needs to be modified.

Another even more famous University of Chicago professor (Milton Friedman) pointed out that low interest rates are usually a sign of tight money, not easy money.  Tight money produces a weak economy and disinflation.  That drives nominal and real rates to very low levels.  Second, Brazil is not even in the dollar bloc.  So I don’t see how one can imply that easy money in the US is making economies like Brazil overheat.  They can revalue.  And the proposal to extend unemployment benefits seems puzzling for two reasons.  First, I thought it had already been done.  Maybe Rajan thinks even the extended benefits are not enough.  But second, studies show that this sort of policy creates more unemployment.

Hoover’s Fed raised interest rates from very low levels to somewhat less low levels in 1931.  FDR made labor markets much more rigid.  Between the two of them they produced a 12 year depression.  Rajan’s proposals obviously wouldn’t be anywhere near as harmful, but I still think it would be a step in the wrong direction.

Part 3:  Paging Banksy and Fairey

Maybe we need some sort of guerrilla street art campaign to change attitudes through subliminal indoctrination.  Outside of every economics conference, FOMC meeting, G-20 meeting, etc, we need street artists to plaster enigmatic images like this one, but with ‘obey’ replaced by 9/08+2%.  Then people might start asking what it means.

(I.e., target the core price level on a 2% growth track from Sept. 2008.)

It occurred to me that perhaps much of what I have been discussing recently is a bit too esoteric for normal people who don’t live and breathe Woodfordian monetary theory.  So today I’m going to try to explain the basic ideas in a very simple way.  Then in part 2. I’ll try to explain how I can use the same Woodfordian model that people like Thoma and Krugman use, and reach different conclusions.

I’ll start where Nick Rowe left off yesterday.  Nick spent a lot of time discussing all the perplexities of trying to control the economy by controlling real interest rates.  Unfortunately my brain is not wired properly to understand monetary policy based on manipulating real interest rates.  I see the new Keynesians as taking a peripheral stylized fact (prices are sticky), exaggerating to the point of inaccuracy (prices don’t change at all in the short run), and then making it centerpiece of their model.  But Nick ends on a more hopeful note, which is where I’ll pick up:

Tinkerbell and framing aside, this reveals another critique of our thinking about monetary policy as setting interest rates. Why did we ever think that cutting real interest rates would increase demand permanently, as Old Keynesian models suggest? Cutting real interest rates merely shifts demand towards the present, and away from the future. That won’t work if both present and future demand are too low. Maybe monetary policy is about the supply and demand for money?

I’ll start with the last line of Nick’s post.  The only knowledge I am going to assume that you have is an understanding of the Quantity Theory of Money—the idea that if you double the money supply, the price level will also double over time, leaving every real variable in the economy unchanged.

I want you to imagine that everyone understands and believes in the QTM.  Imagine you live in a country where a typical 3 bedroom ranch house sells for $200,000.  Also assume the money supply has been stable for years.  Now the Fed suddenly doubles the money supply.  What will happen to the price of that house?  Keynesians will say “nothing”; prices are sticky.  If they are right, I plan to buy up as many houses as I can, right after the money supply doubles.  And then sell them again when the house prices double later on.  But I actually think it more likely that the sellers will also understand this implication of the doubled money supply, and won’t hand me a $200,000 profit on a silver platter.  They’ll immediately demand higher prices.  The Keynesians are right that in the real world many prices rise more slowly, but in any case they do eventually rise.

So far there is nothing controversial in my application of the QTM.  But now let’s assume that as the Fed doubles the money supply, they announce that 4 months later they plan to withdraw the extra money from circulation.  Does the price level still double in that case?  Or, if you are a sticky-price Keynesian, does the expected future price level still double?  If we think about that $200,000 house, I think the answer is clear.  Who in their right mind would pay $400,000 for a house expected to be worth only $200,000 very soon, after the monetary injection is withdrawn in 4 months?  Indeed we would expect almost no increase in the price of the house, despite the doubling of the money supply.  And the reason is simple, the efficient markets hypothesis is far more fundamental than the QTM.  It’s simply not plausible that house prices would rise from $200,000 to $400,000, if people expected them to return back to $200,000 in the near future.

So let’s review.  If you double the money supply, and the increase is expected to be permanent, speculators will rapidly bid up the prices of houses.  And even the prices of sticky goods will be expected to rise as their prices are readjusted over time.  But if you double the money supply, and the monetary injections are expected to be withdrawn in the near future, then house prices will barely budge, and sticky prices won’t be expected to eventually rise upward.  This is an incredibly powerful insight.

What does this all mean?  It means that the effect of changes in current monetary policy on current aggregate demand and prices is utterly trivial compared to the effect of changes in the future path of monetary policy on AD and prices.  Change the current money supply and leave all future money supplies unchanged, and almost nothing happens.  Leave the current money supply unchanged and change all future money supplies for year 2, 3, 4, etc, and you have a powerful and immediate effect on AD and prices.  The current price level basically depends on the future expected path of monetary policy.  Woodford didn’t discover this idea, but it forms the centerpiece of his model.

OK, but how does all this relate to the “Tinkerbell principle?”  And why do we only hear about this principle during “liquidity traps?”  The reasons are complicated.  One reason is that Keynesians like Woodford and Krugman think of monetary policy in terms of the path of interest rates.  This leads to very different assumptions from using the money supply as your policy instrument.

Let’s redo the previous example with interest rates.  The Fed cuts the interest rate this year, but leaves all future expected interest rates unchanged.  Unlike with the monetary base, the expansionary effect of today’s action is not completely negated by the fact that future monetary policy is unchanged.  Those who trust me can skip the next paragraph.

[You can think of this in two ways.  Assume the current expansionary cut in rates boosts the economy this year.  Because AD is higher at the end of the year, even an unchanged level of future interest rates means an effectively lower policy rate in the Wicksellian sense.  The rate has fallen relative to the natural right (which is higher in a stronger economy.)  If this makes no sense here is another explanation.  To cut rates this year the Fed must increase the monetary base.  This boosts NGDP.  If they plan to keep all future rates unchanged, then they must keep a higher monetary base at the end of the year when interest rates return to their normal level.  This is because with more spending in the economy, you have more demand for base money, and hence must supply more base money to keep rates at the predetermined level.  So a one-time cut in short term rates leads to a permanent rise in the monetary base.  That’s why even temporary monetary policy changes can have an effect if you use interest rates as your policy tool.  but even there, future expected changes are far more powerful.]

What about the “liquidity trap?” Recall that Keynesians think that monetary policy becomes ineffective once rates hit zero.  (Modern Keynesians use short term rates, but Michael Belongia reminded me that Keynes actually was thinking in terms of long rates.  So we aren’t actually in a Keynesian liquidity trap, as the Fed’s QE in March 2009 did substantially affect long rates.)  You might wonder; “Why don’t the Keynesians think a permanent doubling of the monetary base would raise prices, even if interest rates were zero today?”  After all, my initial example with the $200,000 house and doubled money supply seems very straightforward.  The answer is that smart Keynesians like Woodford and Krugman and Thoma do understand that a permanent doubling of the money supply would raise prices.  Their argument is different from Keynes’s original liquidity trap argument.  They fear that any monetary injection would not be expected to be permanent.  More specifically, they fear that the Fed would not be able to convince the public that the increase would be permanent.  And if they can’t do that, then they can’t convince them that the price rise would be permanent.  And if that $200,000 house is only expected to temporarily rise to $400,000, then it will never rise in price in the first place.  So to create current inflation you have to believe the inflation will be permanent.  “If we believe we can inflate, then we can inflate.”  That’s Tinkerbell.

Part 2.

So far I agree, but now let’s look where I disagree with the standard Woodfordian approach to monetary policy traps.  To do that we need to think more about what the Fed is really doing.  Recall that the most important thing the Fed does is not to set the current value of the money supply (or interest rates), but rather to signal intentions about future policy.  But how do they do this?  There are many ways.  They could change the monetary base, and let the public guess what that meant.  They could announce permanent changes in the money supply.  They could adjust the exchange rate.  They could announce that they are targeting the expected inflation rate in the TIPS markets.  And so on.  In practice, most central banks send signals by changing short term nominal interest rates.

Unlike all the other options that I mentioned, nominal interest rates have an Achilles heel.  They might need to go significantly below zero, but cannot.   This means that if rates fall to zero, and the Fed wants them to be lower, and the Fed is incapable of communicating with the public in any way other than interest rate changes, then the Fed becomes literally dumb (in the sense of speechless, although I’d argue that slang for ‘stupid’ also applies here.)

[Note, here and in a few other places I am shamelessly stealing ideas from Nick Rowe’s brilliant “social construction of monetary policy” post.]

So the markets look to the Fed for direction, and they have nothing to say.  During the first 10 days of October, 2008, the markets saw that the short term rate needed to go well below zero to prevent a severe recession.  They looked to the Fed for some signal that it was switching out of interest rate “talk” and into some other language like price level targeting.  But like most big bureaucracies, the Fed is not as nimble and quick as Tinkerbell.  They remained mute—and the asset markets understood that this meant future monetary policy would be constrained by the zero rate bound on short rates, and would be far too contractionary.  Asset prices crashed.

Modern central banks don’t just have one language, they have two.  In addition to signaling short term intentions with interest rates, they signal long term policy goals with inflation targets.  So even when rates hit zero, the Fed could have signaled a higher inflation target.  Indeed Krugman and Woodford both recommended this.  This would be a signal that once we exited the liquidity trap, the Fed would keep monetary policy more expansionary than usual, so that prices could rise by more than the normal 2%.  Here’s where the expectations trap comes in.  Once we have exited the liquidity trap, the Fed might not want the high inflation to actually occur.  It makes sense to promise inflation, as that will lower real interest rates today and help us recover.  But once the deflation and recession have ended the Fed might renege on this promise, because they are conservative central bankers who don’t like high inflation.

Here’s an analogy.  A mom promises a child that she’ll get a lollipop if she finishes her homework.  After homework is finished, the mom reneges on her promise, because lollipops are bad for the child’s teeth.  And after all, the homework is done so the inducement has achieved its purpose–even if it was all a lie.  I hope you can see the problem here.  This sort of thing almost never happens.  Moms do give the lollipop, and for two very good reasons:

1.  Moms are not evil witches.

2.  Moms may have to promise lollipops in the future.

So although the “expectations trap” is a nice clever theory, it almost certainly has no implications for the real world.  If the central bank publicly promised a certain inflation or price level path in an emergency, they would almost certainly carry through with the promise.  Why then was this silly theory developed?  Because I think people gave far too much respect to the Bank of Japan protestations of innocence in the 1990s, and focused far too little on the fact that the BOJ was unwilling to actually promise inflation.  So it looked like the BOJ was stuck, unable to move AD and prices, when in fact they weren’t really trying.  Even worse, the BOJ actually did eventually do a temporary currency injection somewhere around 2001-02, and then withdrew the money in 2006.  And remember, the whole expectations trap idea is based on the insight that temporary currency injections have almost no effect.  So when the temporary currency injection had almost no effect, it seemed to support the model.  It does support the model that temporary currency injections don’t have much effect, but doesn’t support the assumption that the central bank can’t signal inflation.  After all, they never tried to signal inflation.

So why does the Woodford model seem to suggest that fiscal policy can work when monetary policy is stuck in an expectations trap?  This is very complicated, as (I am pretty sure) it rests on two dubious assumptions:

1.  The Fed can only signal short term policy by targeting short term rates.

2.  The Fed targets inflation at 2%, come hell or high water.

If you buy both assumptions, then it is indeed true that when short term rates are zero, the Fed can do nothing.  They can’t cut short rates and they won’t change their long run 2% inflation target.  And it’s also assumed that if they did promise higher inflation, no one would believe them.

Here’s my problem with that view.  The term ‘trap’ suggests there is nothing they can do.  But in fact this “trap” is completely self-inflicted.  They can target some other variable, such as the money supply, or long term interest rates, or exchange rates, or TIPs spreads, and signal a more expansionary policy in that way.  They aren’t dumb (well, at least in the “mute” sense.)  And even Woodford himself has argued that if they are at the zero rate bound, their long run target should be the price level, not inflation.  Either changing the short run policy indicator or changing the long run policy goal would allow them to boost AD.

A skeptic might say:  “But you haven’t really addressed the expectations trap.  Suppose they set a higher price level target, and no one believes them?  Then we are still stuck.”  I have three problems with this view:

1.  They would be believed.

2.  Even if they weren’t they can use other short term tools like currency depreciation or TIPS spread targeting.

3.  If there is still a problem it is even more applicable to fiscal policy.

And now we have come full circle to my post that raised such a fuss.  I argued that if you take the Woodfordian view that future expected monetary policy has a far greater impact than changes in current monetary policy (which I accept) then it is equally true that changes in future expected monetary policy can have far more effect than changes in the current stance of fiscal policy.

And if you go on to assume that heartless future monetary policymakers will sabotage current attempts by the Fed to boost the future expected price level, then they would be even more likely to sabotage current fiscal policymakers, for whom that have a far greater distaste.  So why didn’t Woodford get this result?

In the Woodford model once rates hit zero the monetary authority is literally speechless, except if they can signal changes in the future path of interest rates, i.e. promise to hold them at zero for an “extended period of time.”  (Sound familiar?)  But if they have a 2% inflation target (which is assumed) they have no incentive to do this after they have exited a liquidity trap.  And the public understands this and hence doesn’t believe Fed promises to inflate.

Fiscal policy is different.  They can do something meaningful right now.  Even if short term rates stay at zero, fiscal expansion can boost AD in the normal Keynesian way (or by boosting velocity in the monetarist approach.)  The fact that the inflation target stays at 2% in the long run doesn’t sabotage current fiscal policymakers, as current fiscal expansion it least is able to get you out of the deflation much sooner, and back on to that long run 2% inflation track.

So what’s wrong with this approach.  Technically, there is nothing wrong with it.  But it’s not what I consider an expectations trap.  Monetary policymakers (especially Bernanke) know all this.  They know that if they want to escape the liquidity trap quickly, they need to target the price level, not inflation.  Bernanke said as much when he recommended that Japan do this.  Woodford recently recommended a price level targeting approach.  So at a minimum, a Fed that really wanted to be more expansionary would adopt a price level target, aka ‘level targeting’.  They would promise to catch up for shortfalls.  But if this is their promise, and they are assumed to renege on the promise, and sabotage current monetary policy, then fiscal policy is equally screwed.

If fiscal policy is to work, then it must raise AD, and hence the future expected price level.  If the Fed won’t let them do that, then it won’t work.  It doesn’t even matter if the short term rate is stuck at zero right now, and there is nothing the Fed can do right now to sabotage fiscal policy.  Just the expectation that in the future they will act to prevent the price level from rising as the fiscal authorities hope, is enough to sabotage current fiscal policy.  That’s why I started this entire overlong essay with the thought experiment about house prices, to try to convince you that what drives current assets prices, and current AD, is future expected monetary policy.

To summarize; future expected monetary policy is what drives AD.  Fiscal policy may be effective, but only of the future Fed is expected to allow it to be.  Current monetary policy may be effective at the zero rate, but only if the future Fed is expected to allow it to be.  And there is almost no reason to expect that a future Fed (probably headed by Ben Bernanke) would try to sabotage and humiliate a current Fed that made a very public and explicit price level target in the midst of a severe crisis.  Won’t happen.  Period.  End of story.