Now that the multiple universe hypothesis is gaining increasing scientific acceptance, it’s time to soar beyond our own tiny universe and consider monetary policy in alternative worlds.  Consider a universe very similar to our own, but where central banks target zinc prices, not interest rates.

1.  They started with a “zinc standard,” maintained through open market operations.  It provided a sort of nominal anchor.

2.  Then an economist named Irwin Fisher noticed that the relative price of zinc is unstable, and hence the price level fluctuates even when nominal zinc price are constant.  Even worse, price level fluctuations seem to trigger fluctuations in output and employment.  He suggested lowering the price of zinc by 1% each time the price level rose by 1%, and vice versa.

3.  A few decades later a more sophisticated macroeconomist named Johan Tailor devised a more complex monetary rule, which tried to stabilize NGDP growth by adjusting zinc prices in response to both inflation and output deviations, according to an optimal rule estimated using state-of-the-art econometric techniques.  The zinc price that will stabilize NGDP was called the “Wicksellian equilibrium zinc price.”  The central bank was instructed to do OMOs until the actual free market price of zinc was equal to its Wicksellian equilibrium value.  It no longer even needed to hold stocks of zinc.  It bought and sold Treasury securities until the free market price of zinc moved to the right level.

4.   Then they decided to set up a NGDP futures market.  Now the central bank was instructed to adjust the monetary base until the price of zinc moved to a value that generated a NGDP futures price equal to the NGDP target.

5.  Eventually zinc price targeting started to wither away.  Zinc was increasingly viewed as a barbarous relic.  It played no important role in the monetary transmission mechanism, and the central bank began to directly target NGDP futures, without even bothering to use the intermediate step of zinc price targeting.  This brought about “the end of macroeconomics” as a separate field of study.  All “macro” analysis now had micro foundations.

In other universes other elements were used; cobalt, lead, chromium, etc.  Some used valuable compounds like H20, or NaCl.  In one universe zirconium was quite rare, and was the medium of account.  Diamonds were common, and used for small coins.   Oddly, the “zero lower bound issue” never arose in any of these universes.  Zinc prices can go as high as infinity (and also as low as you want in log terms, which is what matters.)  But in one poor benighted universe central banks adopted interest rates as an intermediate target.  Whenever the Wicksellian equilibrium nominal interest rate fell below zero, the central bankers didn’t know what to do—they ran around like chickens with their heads cut off.  Fortunately they too passed through that stage, and eventually moved to a system where OMOs were used to directly target NGDP futures prices (in the year 2037.)  But during the intermediate targeting period things sure were messy!

Mark Thoma recently asked the following question:

So, for those of you who are advocates of nominal GDP targeting and have studied nominal GDP targeting in depth, (a) what important results concerning nominal GDP targeting have I left out or gotten wrong? (b) Why should I prefer one rule over the other? In particular, for proponents of nominal GDP targeting, what are the main arguments for this approach? Why is targeting nominal GDP better than a Taylor rule?

The entire post is rather long, and Thoma raises issues that I don’t feel qualified to discuss, such as learnability.  My intuition says that’s not a big problem, but no one should take my intuition seriously.  What people should take seriously is Bennett McCallum’s intuition (in my view the best in the business), and he also thinks it’s an overrated problem.  I think the main advantage of NGDP targeting over the Taylor rule is simplicity, which makes it more politically appealing.  I’m not sure Congress would go along with a complicated formula for monetary policy that looks like it was dreamed up by academics (i.e. the Taylor Rule.)  In practice, the two targets would be close, as Thoma suggested elsewhere in the post.

Instead I’d like to focus on a passage that Thoma links to, which was written by Bernanke and Mishkin in 1997:

Nominal GDP targeting is a reasonable alternative to inflation targeting, and one that is generally consistent with the overall strategy for monetary policy discussed in this article. However, we have three reasons for mildly preferring inflation targets to nominal GDP targets. First, information on prices is more timely and frequently received than data on nominal GDP (and could be made even more so), a practical consideration which offsets some of the theoretical appeal of the nominal GDP target. Although 20 collection of data on nominal GDP could also be improved, measurement of nominal GDP involves data on current quantities as well as current prices and thus is probably intrinsically more difficult to accomplish in a timely fashion. Second, given the various escape clauses and provisions for short-run flexibility built into the inflation-targeting approach, we doubt that there is much practical difference in the degree to which inflation targeting and nominal GDP targeting would allow accommodation of short-run stabilization objectives. Finally, and perhaps most important, it seems likely that the concept of inflation is better understood by the public than the concept of nominal GDP, which could easily be confused with real GDP. If this is so, the objectives of communication and transparency would be better served by the use of an inflation target. As a matter of revealed preference, all central banks which have thus far adopted this general framework have chosen to target inflation rather than nominal GDP.

1.  I believe the federal government could estimate monthly nominal GDP numbers that are accurate enough to be useful for policy purposes.  However, even if they could not I’d still favor NGDP targeting, because like Lars Svensson I believe the Fed should be targeting the forecast, that is, setting policy in such a way that the Fed’s forecast of future NGDP is equal to their policy target.  I also favor level targeting (recently recommended by Woodford), and I think this would reduce the overshooting problem associated with futures targeting.

2.  It seem to me their second point (which isn’t really a criticism at all) was actually disproved during the recent crisis.  Between mid-2008 and mid-2009 NGDP fell over 8% below trend (or about 3% in absolute terms.)  On the other hand core CPI inflation fell only slightly below trend.  Because the Fed is an (implicit) inflation targeter, the slight slowdown in CPI inflation did not present an unambiguous signal (in their view, not mine) for aggressive stimulus.  Hence they waited until November 2010 to undertake QE2.  If they had been targeting NGDP along a 5% growth trajectory, it would have been immediately obvious that NGDP was coming in well below target, and would remain below target for many years.  In my view the QE2 program would then have been adopted much sooner and in larger amounts, and I think it retrospect it is clear that additional stimulus would have been welcome in late 2008 and 2009.

3.  The third point is where I most strongly disagree with Bernanke and Mishkin.  In the current crisis we’ve seen just how difficult it is to communicate the need for higher inflation.  The public interprets that as the Fed trying to raise their cost of living.  I’m not surprised the plan is unpopular.  I’d guess that in 1997 Bernanke and Mishkin were thinking about the central bank communicating the need for lower inflation, not higher inflation.  In contrast, NGDP is essentially nominal income.  The Fed can tell the public they are trying to raise nominal growth to 5%, because a healthy economy requires the incomes of Americans to grow by about 5% per year.  That’s much less negative sounding that trying to raise the cost of living.  Of course the opposite could be argued on the upside, but the Fed has shown a much greater ability to hold inflation down that increase it, as the zero rate bound has left them spinning their wheels when inflation has fallen below target.  I think it would be easy to explain to the public that an excessively rapid growth in nominal incomes could be inflationary, and raise rates when needed.  Especially given that they were widely criticized for not raising rates enough during the housing bubble.

4.  Regarding revealed preference, NGDP targeting is more desirable the larger and more diversified the economy.  If an economy is dependent on just a few industries, then a major price shock in one export industry might force a dramatic contraction in other industries under NGDP targeting.  Price level targeting might provide for a better macroeconomic outcome in that case.  Thus I wouldn’t expect small countries to be the first to adopt NGDP targeting.  And would I be out of line in noting that the BOJ and ECB haven’t become famous for creativity and boldness?

Update:  I just noticed that Bill Woolsey has a long and very informative reply to my discussion of NGDP futures, and also a response to some of the points made by Brad DeLong.  Bill knows my plan better than I do, so I usually defer to his judgment.  He’s correct that I cut some corners in selling the idea to the National Review’s readers, and that the actual plan is more complicated than I suggested.  Indeed, I believe he was the first to use the phrase “index futures convertibility.”

Here’s Arnold Kling’s response to my recent advocacy of NGDP targeting:

Because of a cold, I will be missing an invitation-only event featuring Scott Sumner. In the spirit of sharing my ideas without my germs, let me offer some thoughts on nominal GDP targeting.

That’s no excuse, I also had a cold.   🙂

Kling continues:

1. For the Fed, a target represents a justification for taking action. Some people may be upset with what your action does to the exchange rate or the interest rate. Having a target allows you to justify your action.*

2. I would like to see the Fed use a target to justify its actions.

3. If the Fed were to use a target, then future nominal GDP would be an excellent choice.

4. In the current environment, a target for future nominal GDP could be used to justify expansionary actions.

5. There are plenty of expansionary actions available. The Fed could charge a penalty for holding excess reserves. The Fed could be buy foreign bonds (this might require a change in current law). There still are plenty of long-term Treasuries out there for the Fed to buy.

6. In the best case, the Fed would hit a target for future nominal GDP, unemployment would fall fairly quickly, and we would live happily ever after.

7. In the worst case, we would begin to shift to a regime of high and variable inflation. The Fed would have to undertake strong contractionary measures in order to keep nominal GDP on target, while unemployment remains high.

I believe we would all live happily ever after, and that inflation would not become high and volatile.  In order for inflation to be high (on average), RGDP growth would have to average much less than 3%. Let me repeat; much less, not slightly less.  A trend rate of 1% or 2% RGDP growth will not get you high inflation on average, unless you think inflation was still high after Volcker brought it down to low levels.

Much more importantly, I don’t think high or variable inflation is a problem as long as NGDP growth is on target.  All of the problems that are widely believed by economists to flow from high and variable inflation; actually result from high and variable NGDP growth:

1.  Excessive taxation of capital in a non-indexed tax system results from high nominal rates of return, associated with high NGDP growth.

2.  Unfair borrower/lender redistributions actually result from volatile NGDP, not volatile inflation.

3.  Distortions to the labor market (when nominal wages are sticky) are caused by NGDP shocks.

4.  Even the “shoe leather” cost of inflation may be better described by NGDP growth, assuming real interest rates and real GDP growth rates are strongly correlated.

George Selgin has much more to say about the advantages of using NGDP.

In the end Kling argues the NGDP targeting is worth a shot, and he also has some interesting things to say about the possible reasons why the Fed hasn’t yet taken this step:

(a) They do not want to be embarrassed if they are unable to hit a target
(b) This is what Tyler Cowen would call a Straussian situation, in which the insiders must never reveal their true agenda, or horrible demons will be let loose, leading to social breakdown and bloodshed.
(c) They fear that announcing a target would create “lock-in” and cost flexibility.
(d) A target would make many of the departmental functions and rituals (such as FOMC meetings) long cherished at the Fed seem pointless.
(e) The Fed is institutionally more concerned with the stability and profitability of the banking system than with macroeconomic variables.

I would add that most private macroeconomists also prefer inflation targeting to NGDP targeting.  Or they favor flexible inflation targets, but don’t plump for NGDP targeting because it seems too crude.  I believe that is because inflation and RGDP play an important role in their macro models.  Unfortunately, the ‘inflation’ in their models bears little resemblance to real-world inflation indices.

I tried to leave a comment at Brad DeLong’s blog, but I just can’t figure out these newfangled comment sections.  So I’ll post it here.  (I did leave a similar comment at Tyler Cowen’s post)

I’m kind of amused to see Brad DeLong suggest I finally “plump” for NGDP futures targeting.  I’ve devoted my entire career to the idea.  Indeed I presented this idea at the AEA meetings in 1987, and have 6 publications on the futures targeting idea.

My 1995 JMCB piece is an inferior version of the plan, which I have pretty much abandoned.  I’m sticking by my 1989 version, as well as my 1997 version.  But my two most recent publications are probably best.  I have an Economic Inquiry article with Aaron Jackson, and a B-E Contributions to Macroeconomics article, both from 2006.  The latter is closest to what I have just described. Many others have published similar ideas (Thompson, Hall, Woolsey, Glasner, Dowd, Hetzel, etc.)  Milton Friedman once endorsed Hetzel’s proposal, which is actually inferior to the others.  Hall’s was in the JME.  Dowd’s was in the Economic Journal.  At least one of my publications was refereed (I’m almost sure) by one of the smartest macroeconomists in the universe.   I also mentioned the idea to John Cochrane last year, and a few months later he seemed to endorse a similar idea.  None of this makes it right, but there has certainly been a long literature on the subject.  Yet DeLong treats it like some wacky idea I dreamed up for the National Review.

Bernanke and Woodford wrote an article criticizing the concept in 1997.  (The critique doesn’t apply to the version discussed below.)  So did Garrison and White.  I’m embarrassed to admit that I forgot that Tyler Cowen had also done so.  I need to reread his article and think about it, but I won’t have time for quite a while, as I am travelling tomorrow.

Of course the National Review paragraph had to grossly simplify, and cut lots of corners.  The 3% interest Brad DeLong mentions is wrong, it doesn’t factor in at all.  But I can’t blame him, as I didn’t provide enough information.  There are three completely different ways of setting this up, but I prefer to think about the following thought experiment:

1.  Set a policy goal, say 2% inflation over the next year.

2.  Have each FOMC member vote on the monetary base setting most likely to achieve that goal.

3.  Set the actual instrument at the median vote.

4.  One year later have the doves (i.e. those voting for a more expansionary setting) pay the hawks a $1000 salary bonus if the CPI is above 2%, and vice versa.  This encourages accurate voting.

5.  Now expand the FOMC from 12 members to all 7 billion humans (excluding North Koreans, who might vote as a bloc).  Make voting voluntary.

6.  Switch from one-man-one-vote to one-dollar-one-vote.

7.  Make the reward/punishment proportional to amount by which the actual CPI misses the target.

8.  Require every voter (speculator) to have a margin account.  Pay interest on the margin accounts at a rate high enough to create a sufficiently liquid market.

9.  Now you have CPI futures targeting.

10.  Switch to a 5% NGDP target and you have NGDP futures targeting.

Here’s my challenge.  I started with something close to real world monetary policy (you could even use the fed funds instrument, unless up against the zero rate bound.)  I moved one step at a time to my preferred policy.  At which step did I make a mistake?

Of course there are lots of issues like the risk of someone moving the entire economy to make money on a side bet elsewhere, which can be dealt with using pragmatic fixes, like having the central bank take a position against a large and highly suspicious bet from a single individual or firm.

BTW,  I mentioned the idea to John Cochrane last year, and a few months later he seemed to endorse a similar idea.

Contrary to DeLong’s claim, there’d be no huge swings in the monetary base, as the real demand for base money is fairly stable when expected NGDP growth is on target.  But if there was a surge in the liquidity needs of the economy, so be it.

Regarding helicopter drops on bankers; banks need play no role in my plan.  The Fed could swap briefcases of $100 bills with private individuals who own bonds.

The point of this policy is not to provide a painless way out of this hole (there might be price risk on the assets bought by the central bank) but rather to prevent us from getting in the hole in the first place.

PS.   Ignore DeLong commenters like Waldmann, he completely misunderstood the proposal.  There are no arbitrage opportunities because the Fed only pegs the price of 12 or 24 month forward NGDP contracts.  Trading begins on a new contract long before the previous one matures.

PPS.  I have a cold, will be travelling, and have lots of grading to do.  Don’t expect comments to be answered anytime soon.

PPPS:  Here’s a blog post that discusses the idea in a bit more depth.

I’ve been asked to summarize my views on liquidity traps in one place, so brace yourself for a long post.  (Longtime readers will definitely want to skip this one.)

For simplicity, I’ll define the term ‘liquidity trap’ as a situation where a fiat money central bank with a freely floating currency is unable to boost nominal spending because nominal interest rates have fallen to zero.  There may be some cases where central banks are limited by laws regulating the sorts of assets they are allowed to purchase, but I know of no real world cases where that was a determining factor.  Indeed I know of no case where a central bank that wished to boost inflation and/or NGDP was unable to do so.  Nor do I think we need ever worry about that scenario actually occurring.

On the other hand, I do think the zero rate bound is a real problem for real world central banks.  Because central banks are used to using short term rates as their primary policy tool, policy may well become sub-optimal once rates hit zero.  But that would not be because an economy is “trapped” at a zero bound, rather it is because central banks are reluctant to aggressively use alternative policy tools, including tools that would be much superior to fed funds targeting even if the economy were not up against the zero bound.

Part 1.  Basic monetary framework

Unlike most economists, I don’t believe that changes in short term interest rates play an important role in the monetary transmission mechanism.  The liquidity effect is an epiphenomenon, having little impact on investment.  Woodford argues that what really matters is changes in the expected future path of interest rates.  I agree that policy expectations are a key, but find it more useful to think in terms of changes in the expected path of the supply and demand for base money.  Simply put, I believe that current and expected future increases in base supply relative demand cause expected future NGDP to increase.  This is because even if we are at the zero bound, and cash and T-bills are perfect substitutes, we are not expected to be there forever.

Increases in expected future NGDP (my preferred policy indicator) raise current asset prices (foreign exchange, stocks, commodities, commercial real estate, etc.)  Because wages are sticky in the short run, production of corporate fixed assets, exports, commercial and residential real estate, commodities, etc, increase as their prices increase.  The resulting higher real incomes also boost consumption.  The reverse is true during tight money, as in late 2008.

I don’t like the interest rate transmission mechanism because interest rates often move in the “wrong” direction in response to monetary surprises.  An unexpectedly small cut in the fed funds target in December 2007 sharply depressed equity prices at 2:15pm.  The fed funds futures market confirmed that the decrease was smaller than expected.  Keynesian theory says T-bond yields should have risen on the news.  Instead, yields fell from 3 months to 30 years, as investors (correctly) understood that the Fed’s pathetic response to the sub-prime crisis would slow economic growth, and hence future fed funds rates would have to be cut sharply.  (And they were in January 2008.)  The action slowed the economy, but not because interest rates rose.

The powerful monetary stimulus of 1933 (dollar depreciation) had little effect on interest rates or the current money supply, but sharply raised future expected NGDP.  This sharply raised current asset prices, and led to rapid growth in output.

If you buy my argument that changes in expected future NGDP (what Keynes probably meant by “business confidence”) is driving current asset prices and aggregate demand, then the next question is whether monetary policy can influence future expected NGDP at the zero bound.

Part 2.  Unconventional policy tools.

My favorite example of an unconventional policy tool is the 1933 dollar devaluation.  In 1932 the Fed had tried open market purchases to boost the money supply, but the policy failed as fears the US would be forced to devalue led to gold outflows, which negated most of the effect of the asset purchases.  This is the only example of a liquidity trap cited in the General Theory.  Unfortunately, Keynes confused two closely related problems.  A liquidity trap is where an increase in the money supply fails to boost NGDP.  In 1932 the constraints of the international gold standard meant that purchases of assets failed to substantially increase the money supply.  That’s gold standard economics 101, having nothing to do with liquidity traps.  As soon as we left the gold standard in March-April 1933, FDR was able to easily create rapid inflation despite 25% unemployment, near zero T-bill yields, and much of the banking system shutdown for many months.

FDR’s policy of raising the price of gold can be seen in one of two ways.  In one sense it was a devaluation of the dollar in the forex markets, as most countries did not follow his action by raising their purchase price of gold.  But even if the US had been a closed economy the Fed could have depreciated our currency by reducing the weight of gold in one dollar.  In ancient times this was called “debasing coinage” and no one worried about the zero rate bound preventing central banks from inflating.  As far back as 1694 John Locke used a reductio ad absurdum argument to criticize monetary ineffectiveness claims.

Another approach is to do quantitative easing.  But printing money (even under a fiat money regime) will not be very effective unless the currency injections are expected to be permanent.  Why would people bid up asset prices if the central bank was expected to pull the money out of circulation in the near future?  This is why the QE done in Japan around 2003 did not do much, and it is why Paul Krugman is skeptical about QE.  The other problem is that it is hard to make a credible promise to permanently increase the money supply by X%, because once you exit the zero rate bound the velocity of base money will rise sharply, and unless the base is reduced you will get hyperinflation.  Markets know this, and hence don’t expect QE to be permanent.

The solution is to adopt an explicit nominal target such as the price level, or better yet NGDP, and then do level targeting.  This is essentially a promise by the central bank to leave enough base money in circulation long term to allow for a modestly higher price level of NGDP.  For instance, they might want to target 5% NGDP growth.  Even if we are at the zero bound and monetary policy appears to be spinning its wheels, a commitment to higher future NGDP will tend to raise current AD.

The Fed made two mistakes.  First, they did not engage in level targeting.  It has long been understood that once nominal rates hit zero the central bank must adopt a level target.  Indeed Bernanke lectured the Japanese on exactly this point back in 2003.  So in September 2008 the Fed should have switched to level targeting, indicating that they wanted core inflation to grow along a 2% path until we were out of the recession, promising to later make up for any near-term shortfalls.  Instead they allowed core inflation to fall well below 2%, and then (implicitly) indicated that they were going to continue inflation targeting, allowing bygones to be bygones.  There was to be no above 2% inflation to catch up for the shortfall.  This actually made their job much more difficult, as it resulted in a more severe recession than necessary in 2009, and then plunging investment pushed the Wicksellian equilibrium nominal rate below zero.  They could no longer use their traditional policy instrument and they were reluctant to aggressively employ alternative measures, because they didn’t know how strong the effect would be.  For instance, when banks needed more liquidity in late 2008 the Fed neutralized the effects of the large monetary base injections by paying interest on reserves at a rate higher than T-bill yields.  Only when the recession drove stock prices to extremely low levels in March 2009, and deflation appeared on the horizon, was the Fed willing to do QE1.  And only when the recovery faltered during mid-2010 (as European troubles increased the value of the dollar) was the Fed willing to do QE2.

The best way to avoid the zero rate bound is to create and subsidize trading in a price level or NGDP futures market, target the futures price, and let the money supply and interest rates respond endogenously.  The Fed should be willing to supply an unlimited amount of reserves in order to keep NGDP futures prices rising along a 5% growth trajectory.   Because there is no zero bound for NGDP futures prices, the Fed will always be able to keep NGDP expectations on target.

The flaw in the Keynesian model is that it assumes sticky wage and prices, whereas only T-bond prices are flexible.  But there are lots of other asset prices that are also flexible, and that don’t have a zero lower bound.  These include commodities like gold and silver, stocks, and foreign exchange.  Unfortunately, all of those asset prices have drawbacks as targets for a major central bank like the Fed.  And the asset price that would work best (NGDP futures prices) doesn’t yet exist.

[BTW, it’s a disgrace that the government has not yet set up and subsidized trading in a NGDP futures market.  Contrary to popular impression the Fed isn’t trying to create more inflation; they are trying to create more NGDP.  For any given increase in NGDP, the Fed would actually prefer less inflation and more RGDP growth.  We desperately need a real time measure of market NGDP growth expectations in order to know whether AD is likely to exceed or fall short of the target.]

In this imperfect world the best the Fed can do is to focus on TIPS spreads as a crude measure of expected inflation, and a whole range of indicators for expected RGDP growth, such as the relative prices of stocks and commodities, as well as other indicators or real output trends.  The Fed needs to do enough QE to increase expected NGDP growth (using all these imperfect indicators) up to the desired level.  Since we are below trend, they should probably target slightly above 5% NGDP growth for a few years, then 5% thereafter.

Part 3.  Fallacious arguments in favor of the liquidity trap

There are so many, I hardly know where to begin.  One common argument is that swapping cash for zero interest T-bills is useless, because they are perfect substitutes.  I don’t view them as perfect substitutes at all.  When I get in the car to go shopping at Walmart I don’t think “Hmmm, should I take cash or T-bills.”  At this point people will say “Yes, but zero interest bank reserves and T-bills are near perfect substitutes.  And all the recent base injections are going into excess reserves.”  Yes, but there is no zero lower bound on interest paid on reserves (and yes I’m including vault cash in “reserves.”)

But let’s suppose cash and T-bills were perfect substitutes.  Even in that case a permanent injection of new base money would still be expected to raise the future level of NGDP, as liquidity traps don’t last forever.  (If they did we should legalize counterfeiting.)   Yes, a temporary currency injection wouldn’t do anything, but that’s almost equally true when rates on T-bills are positive.  Temporary currency injections don’t matter, permanent ones do.  It makes little difference whether rates are at zero or not.

The second fallacious argument is that monetary policy was ineffective in the Great Depression.  Actually, when the government got serious about inflating they left the gold standard, and then they had no difficulty in raising prices sharply.

The third fallacious argument is that monetary stimulus would not be effective at the zero bound because central banks are conservative and no one would believe their promises to inflate.  In fact, no one can provide an example of a central bank that tried to inflate but failed because they were stuck in a liquidity trap.  Some cite Japan, but that example doesn’t meet any of the criteria for a liquidity trap:

1.  The Bank of Japan has frequently expressed opposition to a positive inflation target.  Because they are not trying to produce inflation, it’s no surprise they have failed to produce inflation.

2.  It’s true that they pay lip service to avoiding deflation, but every time the inflation rate rises above zero percent they tighten monetary policy and go right back into deflation.

3.  Some point to the large QE the BOJ did around 2003.  But their promise to keep prices stable meant the QE was going to be temporary.  The public knew this and quite rationally refused to bid up prices.  Sure enough, when 1% inflation threatened to rear its ugly head in 2006, they promptly reduced the monetary base by 20%.

4.  They passively sat by and allowed the yen to appreciate strongly, even as deflation was accelerating in recent years.

5.  If it walks like a duck . . .

Some point to the alleged failure of the Fed to inflate, despite trying hard.  Yet a few months back when Brad DeLong asked Bernanke why the Fed didn’t adopt a 3% inflation target, Bernanke said that would be a horrible idea.  The Fed had worked so hard to bring inflation down to low levels.  If you heard an answer like that, would you expect the Fed to produce higher inflation?  It’s no surprise inflation expectations have remained low.  Admittedly the Fed doesn’t want deflation either.  My view is that when core inflation falls to about 1%, warning bells go off and the Fed grudgingly does some QE to boost inflation a bit closer to 2%.  If that’s not what they are trying to do, I’d love to know their policy goal.

There’s another problem with the view that QE is ineffective at the zero bound.  Even if the Fed couldn’t reduce nominal rates, they could always reduce real rates.  Indeed Mishkin’s textbook suggests about 10 different transmission mechanisms other than nominal rates.  Yet liquidity trap proponents ignore them all.  Even worse, when the mechanisms are shown to work they go into denial, asserting that it just can’t be true because their theory says it’s impossible.  So for instance during September and October there were more and more rumors of aggressive QE (and possibly even level targeting) emanating from various Fed officials.  Mishkin’s text says this should boost stock prices, it should depreciate the dollar, it should raise commodity prices, it should raise inflation expectations in the TIPS markets, and it should lower real interest rates.  And all of those things happened.  For years Paul Krugman has been arguing that what the Fed really needed to do was to raise inflation expectation.  Well they did it.  And his response seemed to be incredulity, as if the markets were nuts in thinking QE could actually raise inflation expectations.

Although Krugman and Robert Barro are poles apart ideologically, they both suffer from one weakness–relying too much on what their models tell them.  Both expressed skepticism about whether QE would do very much, because they looked at QE from a mechanistic perspective.  But QE is much more than that;  it is an implicit commitment by the Fed to seek (slightly) higher inflation.  Of course they need to do much more, but they did succeed in terms of their very conservative goals.  They did generate about 0.5% higher inflation expectations over 5 years.  The reason QE worked was not the operation itself (which I agree does little or nothing) but rather because it tells the market that the Fed is now more serious about boosting long term prices and NGDP.  In other words they are now willing to leave that base money out there long enough to get closer to their implicit inflation target.  The Fed was afraid to directly call for higher inflation (something Krugman thinks could work) so they spoke in code, hoping the markets would understand them but Sarah Palin would not.  Unfortunately for Bernanke, Sarah Palin has advisers who know exactly what the Fed was up to.

Part 4.  Reductio ad absurdum arguments

I can’t take anyone serious who actually believes in a complete liquidity trap–i.e. that no amount of monetary base injections would be inflationary.  Taken literally, that would imply the Fed could buy up all of Planet Earth without creating any inflation.  Among serious economists the debate is over magnitudes.  The skeptics will say that the amount of QE required would be unacceptable, it would expose the Fed to excessive risks if they later had to resell assets in order to prevent runaway inflation.

In fact, there are all sorts of reasons why this “risk” argument is bogus.  First of all, the high base demand is itself a product of the Fed’s contractionary policies, which allowed NGDP to fall in 2009 at the sharpest rate since 1938.  That’s why banks hoard reserves.  A much more aggressive monetary policy would mean less real demand for base money.  Second, the demand for base money has been artificially bloated by the IOR policy; the public is not hoarding much cash and they certainly would not do so if the Fed set a much higher inflation or NGDP target path.  Most importantly, any capital losses suffered by the Fed would be tiny compared to the gains the Treasury would get from much faster NGDP growth.  Remember that the big drop in NGDP is the number one reason the deficit ballooned in 2009—more important than even the fiscal stimulus.  Furthermore, many of the Fed’s purchases have been medium term T-notes, for which price risk is not that significant.  If people are actually worried about this issue, the Fed could buy equities and foreign bonds, which would appreciate with an expansionary monetary policy.  But in my view those (controversial) steps would not be necessary, as the risks are greatly overblown.

Maybe I should stop there—I feel like I am beating a dead horse.  Does anyone still believe in liquidity traps?  Is there even anyone still reading this post?