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

Pretty disappointing, but with one silver lining.  We pretty much know where the “Bernanke put” is, he drew a line at roughly 1% core inflation.  That means no more “depression economics.”  Let’s get costs down and we can get a faster economic recovery:

1.  Payroll tax cuts (at the margin, employer only.)

2.  Replace unemployment extended benefits with large lump sum payments to the unemployed.

3.  Temporary (two year) minimum wage cuts to $6.50.

Of course this won’t happen, but it would promote faster growth if it did.  They are things Obama could try.  Now for the speech:

Maintaining price stability is also a central concern of policy. Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee’s objectives.

Translation:  The Fed defines price stability as about 2% inflation, and it’s running around 1% (core inflation.)  Bernanke thinks that’s a bit lower than desirable.  But then there is also this:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability.

Aaaargh!!  So which is it?  Is inflation too low, or not?

I wish those prominent economists calling for 4% inflation had followed my advice.  Call for level targeting.  Draw a 2% trend line for core inflation from September 2008.  We are now 1.4% below that trend line.  Shoot for getting back to trend.  I know that doesn’t sound like much stimulus, but given the slack in the economy it would actually take pretty fast NGDP growth to get 3.4% core inflation over 12 months.  Or 2.7% over 24 months.  You’ll never convince the Fed to change its inflation target to 4%, and there is no need to try.

But Bernanke definitely does understand the logic of the argument I have been making in recent posts:

First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.  (italics added.)

Translation:  “Listen you inflation hawks, if things get even a tiny bit worse we will need more stimulus not just to boost growth, but to prevent further disinflation.”

I think we are already there, where more nominal growth is a win/win, and my hunch is that (to a lesser extent) Bernanke agrees.  After all, he basically said that in the first quotation I gave you, which I take to be his true feelings.  The hawks would never have said inflation is too low.  Bernanke is a patient man, but he is running out of patience.  Let’s hope the three new Board members push him hard this fall.

So if Bernanke wants to do more, why doesn’t he say so?  He explained why, if you read between the lines:

Central banks around the world have used a variety of methods to provide future guidance on rates. For example, in April 2009, the Bank of Canada committed to maintain a low policy rate until a specific time, namely, the end of the second quarter of 2010, conditional on the inflation outlook.4 Although this approach seemed to work well in Canada, committing to keep the policy rate fixed for a specific period carries the risk that market participants may not fully appreciate that any such commitment must ultimately be conditional on how the economy evolves (as the Bank of Canada was careful to state). An alternative communication strategy is for the central bank to explicitly tie its future actions to specific developments in the economy. For example, in March 2001, the Bank of Japan committed to maintaining its policy rate at zero until Japanese consumer prices stabilized or exhibited a year-on-year increase. A potential drawback of using the FOMC’s post-meeting statement to influence market expectations is that, at least without a more comprehensive framework in place, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality. The Committee will continue to actively review its communication strategy, with the goal of communicating its outlook and policy intentions as clearly as possible.

Translation:  We can’t communicate a clear objective because unlike in Canada and Japan, I can’t get those hawks to agree with my view of the appropriate “comprehensive framework.”  We will try to make our intentions as clear as possible, if we can ever agree on what they are.

[BTW, notice how in 2001 the BOJ promised to tighten policy as soon as inflation reached zero?  If you have deflation for years, and tighten the moment you hit zero (which was 2006) won’t you go right back into deflation?  The answer is yes.  So much for Paul Krugman’s theory that the BOJ is valiantly struggling to avoid deflation.]

What if more stimulus is needed, does the Fed have more ammo?

The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.

So Congress and the President are desperately looking for ways to boost demand, w/o ballooning the deficit.  The Fed has such tools, but sees no need to use them.  And what is the most likely tool?

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve’s holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC’s recent decision to stabilize the Federal Reserve’s securities holdings should promote financial conditions supportive of recovery.

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.

Another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations. (Of course, if inflation expectations were too low, or even negative, an increase in inflation expectations could become a benefit.) To mitigate this concern, the Federal Reserve has expended considerable effort in developing a suite of tools to ensure that the exit from highly accommodative policies can be smoothly accomplished when appropriate, and FOMC participants have spoken publicly about these tools on numerous occasions. Indeed, by providing maximum clarity to the public about the methods by which the FOMC will exit its highly accommodative policy stance–and thereby helping to anchor inflation expectations–the Committee increases its own flexibility to use securities purchases to provide additional accommodation, should conditions warrant.

Translation:  It worked last time (March 2009), there are a few minor problems, but we have addressed those problems.  He mentions other ideas like better communication and lower IOR, but you get the impression that he is much less enthusiastic about those ideas.  My guess is that he would only do a comprehensive stimulus with all three tools if things got really bad.  Actually things are really bad; I mean  if things got really, really bad.  If 3rd quarter NGDP growth comes in around 3% or lower, look for more QE in the fall (when the three new members are seated.)  BTW, I am less confident than Bernanke that QE worked last time.  But it is definitely better than nothing.

Mark Thoma has a response to my recent follow-up posts on the fiscal expectations trap.  Before getting into the details, let me just say that the “Paging Brad DeLong” post was meant to be sort of half-joking.  I would add that I don’t think anyone would deny that I have gotten beaten up for drawing what I thought was a clear inference in a Krugman post, which apparently wasn’t there.  So there’s some history there.  But I am thankful that Mark is taking my idea seriously enough to devote quite of bit of space to it in his very popular blog.

Here’s how Mark Thoma concludes his post (he is discussing Woodford’s model):

Note that the source of the increase in expected inflation is the expected increase in government spending in the next time period. All that’s required for expected inflation to rise is that fiscal policy is expected to persist another period. However, the Fed won’t do anything in response to the rise in inflation expectations because under the assumptions of the model the target interest rate remains negative (and to go back to an earlier point in the discussion, the expected inflation is credible due to observable changes in fiscal policy in the present time period).

The bottom line is that despite recent claims to the contrary, when the economy is at the zero bound fiscal policy is still effective, i.e. it has a multiplier greater than one, even under strict inflation targeting.

If I’ve mischaracterized anyone, I’m sure I’ll hear about it.

I think Mark Thoma understands these models pretty well, probably on some levels better than I do.  But there are many levels to these models.  There are formal mathematical models, and then there are policy implications that require some sort of game theory guesswork.  The policy implications that come out of the models depend in part on the assumptions you make about how one policymaker responds to another.

I have been aggressive in pushing this idea because I am pretty sure that I will be shown correct in the end, it’s just a question of how correct.  If the Congress passes a $700 billion stimulus and the next day the Fed becomes terrified of inflation that they raise interest rates to 20% and put us in a depression, I think everyone agrees that there will be no “fiscal multiplier.”  And I agree that under some of the assumptions in the Woodford model you can get a much bigger fiscal multiplier at the zero bound than otherwise (assuming an inflation-targeting central bank.)  I would never have the courage to attack the nuts and bolts of the Woodford model–he knows much more about this than I do.  What I question is the sort of policy options that he considers.

Let’s return to the monetary expectations trap for a moment.  Woodford argues that if you fall into a deflationary liquidity trap, the right policy is to do price level targeting, not inflation targeting.  As long as the policy is credible, you can still lower real interest rates even after nominal rates hit zero.  I agree (although I’d prefer NGDP targeting to price level targeting, but put that aside.)

So I consider price level targeting to be the benchmark for a central bank that is serious about escaping a liquidity trap.  Bernanke also suggested price level targeting for Japan (around 2003, I believe.)  How could price level targeting fail?  Well suppose Bernanke said we are going to target a price level path that rises 2% per annum from September 2008.  This means prices will be roughly 20% higher in Sept. 2018 (plus compounding.)  The policy would fail if people thought Bernanke would go back on his word after we got out of the recession.  Why might they think that?  The argument is that central bankers don’t like inflation rates over 2%.  And if you fall below target (as we are doing now) the public won’t find promises to get back on target to be credible.   BTW, I don’t agree with this view, I think an explicit promise would be believed.  But put that aside and let’s assume the pessimistic case when the public didn’t think the Fed would allow prices to be 20% higher in 10 years.  That’s a monetary expectations trap.

What can fiscal policy do in a monetary expectations trap?  Fiscal policy is supposed to shift the AD curve to the right, and thus raise inflation.  Mark suggests that the Fed can’t easily stop this, as the fed funds rate is stuck at zero.  He might concede that they could raise rates to 20%, but how likely is that?  The point is that if the Fed keeps rates at zero, fiscal policy has a clear field.  But that’s where I disagree.  From a price level targeting perspective the Fed can tighten monetary policy without any change in short term nominal rates.  How?  By suggesting a lower future price level target.  Or even suggesting that they won’t allow inflation to rise, as it is already below the 2% target path.  Indeed I think the Fed is doing a bit of this with all its exit strategy talk.  They are sending out signals that they won’t allow the price level to climb back to that 2% trajectory.  They are suggesting that they’ll raise rates if necessary to prevent this from happening.  That’s contractionary right now, even if current interest rates stay at zero.  Don’t believe me?  Read Woodford.  He has made a career of emphasizing that changes in future expected monetary policy are far more important than changes in the current setting of monetary policy.  That’s why I’m so confident that I’ll be shown to be correct in the long run.  Woodford is on my side regarding the fundamental assumption required to drive my result; changes in future expected monetary policy are more important than changes in the current policy setting, fiscal or monetary.

The rest is game theory.  And I’m confident there as well.  It seems far more likely that the future Ben Bernanke would try to sabotage fiscal stimulus he thought excessive, than that the future Ben Bernanke would try to undercut an explicit price level target path objective set out by the current Ben Bernanke.  (Not that either is particularly likely.)

One final point.  I am not saying the fiscal multiplier is low at the zero bound, I am saying that the fiscal multiplier is low at the zero bound if you assume the sort of perverse central bank that would create an expectations trap for monetary policy.

It’s worth thinking about where we are in the Great Recession, relative to the same time period in the Great Depression:

1.a  October 1929, stocks crash on sharply falling expectations of NGDP growth.

1.b  October 2008, stocks crash on sharply falling expectations of NGDP growth.

2.a   Early 1931, stocks rise on signs of recovery

2.b  Early 2010, stocks rise on signs of recovery

3.a   May 1931, stocks fall as European banking/sovereign debt crisis begins

3.b  May 2010,  stocks fall, as European banking/sovereign debt crisis begins
Den ganzen Beitrag lesen…