Archive for the Category Quantitative Easing


Do or do not. There is no try.

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

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

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

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

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

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

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

1.  Higher NGDP growth may fail to boost RGDP.

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

But it will boost NGDP.

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

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

Further thoughts on Switzerland

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

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

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

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

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

Tyler Cowen had this to say about the action:

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

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

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

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

In another post Tyler Cowen makes this comment:

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

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

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

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

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

Here’s Matt Yglesias:

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

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

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

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

Lindsey and DeLong discuss me

Well that’s certainly something I’d never expected to see, some prominent pundits talking about my ideas on

Brink Lindsey is sympathetic to my argument.  Brad DeLong suggests that my plan would require the Fed to do twice as much bond buying as under QE2, and keep doing it month after month.  (I.e. about $200 billion/month in bond purchases.)  I’m not sure where he got those figures, but I won’t criticize him.   After all, right after QE2 I said it was roughly half of what the Fed needed to do.  He may have been referring to that comment, or perhaps that’s just his own take on what would be needed.  Brad made the quite reasonable point that it’s politically difficult for the Fed to do enough to end the recession.   I agree; if it weren’t difficult they probably would have already done it.

And yet, I’m not willing to give up so easily.  Here’s a few other possibilities.

1.  There are things the Fed could try that don’t involve printing money, and hence might be less controversial.  The most obvious is a lower IOR.  Interest on reserves is seen as a subsidy to fat cat bankers, and it’s opposed by many on both the left and the right.  Of course if you believe the banks control the Fed, you will tell me this can never happen.  But if the banks control the Fed, why would they let NGDP expectations fall so sharply in 2008, and again recently, badly hurting bank balance sheets.

2.  The Fed could try Greg Mankiw’s suggestion of level targeting.  That’s not a cure-all.  But I’m convinced core inflation is likely to remain below 2% for some time.  And 2 and 1/2 year TIPS spreads are only 1.3%.  This would give the Fed room to ease.  It would provide even more room if that started the level targeting from the point at which rates hit zero—which is the theoretically appropriate point in time, according to Woodford, et al.  We are now well below that trend, according to either the core or headline rate.

3.  The Fed could try for 5% NGDP targeting.  This might be acceptable to the right, as it would take “hyperinflation” off the table.  In addition, throughout history I’d guess that at least 75% of the economists who advocated NGDP targeting were right of center (Hayek, McCallum, quasi-monetarists, etc.)  They could tell Barney Frank that unlike a strict inflation target it addresses the Fed’s dual mandate.  I’d actually prefer slightly higher than 5% during the catch-up period.  But things are so bad now that even 5% would be an improvement.

DeLong might argue that those alternative policies would also require the Fed to buy up lots of bonds.  But that isn’t necessarily the case.  Indeed if the policy were credible, it’s very possible that we could get by with a reduction in the currently bloated base, which includes trillions of excess reserves that are doing nothing.

So even though Brad DeLong’s skepticism about the politics of monetary stimulus is quite persuasive, I’m not willing to throw in the towel.  There are things the Fed can do that are less controversial than QE2 on steroids, and surprisingly, might be even more effective.

HT:  Dennis and Brito

Why the Fed’s policy won’t lead to high inflation

Stephen Williamson has an excellent observation about the Fed’s new commitment to hold rates near zero for 2 years:

Further, it seems the outcome the Fed would hope for is one where inflation increases, the interest rate on reserves increases commensurately, and the Fed proceeds to sell off assets so as to normalize the state of its balance sheet, with zero excess reserves. Committing to IROR = 0.25 for two years risks two outcomes that seem equally bad (if we believe that 2% inflation is optimal). One is the too-high-inflation outcome: People anticipate high inflation, reserves start to look much less desirable, and the high inflation is self-fulfilling. The other is too-low-inflation: People anticipate low inflation, the reserves look more desirable, and low inflation is self-fulfilling. The first scenario is something that I have been worried about. The second scenario was a concern of Jim Bullard, and Narayana Kocherlakota.I think both are possibilities, i.e. there are multiple equilibria.

Fed officials like to talk about “anchoring expectations.” In this circumstance, the kind of FOMC statement that would anchor expectations would be something like: “We anticipate raising the fed funds rate target (actually the IROR target, but what the heck) as observed and anticipated inflation warrants. Currently, we think we are on a path on which inflation will increase.”

George Selgin made some similar criticisms in the comment section of this post and this post (where Nick Rowe also makes comments.).  I completely accept their analysis.  Interest rate pegging is a really bad idea.  But I am not particularly worried that the high inflation outcome will occur, for two reasons:

1.  Consider Stephen’s comment “Currently, we think we are on a path on which inflation will increase.”  You would think that is the view of the Fed.  That would certainly be their view if Lars Svensson (of targeting the forecast fame) were running the place.  But alas, Svensson is in Sweden, the land of negative IOR (and the only western European country expected to achieve rapid growth during 2009-12.)  The Fed probably expects core inflation to slow a bit over the next year.  Why don’t they adjust one of their policy levers?  Why not more QE, or lower IOR?  Your guess is as good as mine.

2.  The Fed still has plenty of anti-inflation credibility.  And thus it’s widely understood that if inflation exceeded the Fed’s comfort zone, they’d slam on the brakes in mid-2013.  But what about the period before mid-2013?  It turns out that many New Keynesian models suggest that current NGDP is strongly affected by future expected NGDP.  Although I’m not exactly a NK economist, my intuition tells me they are correct on this point.

Consider the following analogy.  Suppose the Fed said it would let the dollar/euro exchange rate float for two years, and then peg it at 1.40.  Also suppose this announcement was credible.  In practice, the spot rate would show very little variation over the next two years, even though the Fed was taking no explicit actions to stabilize rates (until mid-2013.)  The same intuition applies to NGDP.

Keynes understood this at an intuitive level, which is why he always talked about the importance of business “confidence.”  Whenever reading Keynes, just substitute the term “expected NGDP growth” for “confidence” and the meaning will be much clearer.  Of course other factors such as regulation can also affect business confidence, but Keynes focused on AD.

So although I agree with the criticism of Williamson and Selgin, as a practical matter I focus on the fact that the Fed’s action is almost certainly going to be too little, not too much.  (And obviously the 3 year T-note market agrees.)  I hope I’m wrong, as I’d much rather see the Fed trying to rein in 4% inflation in 2013, than trying to boost up 0% inflation in 2013

Selgin and Williamson are also correct that what the Fed really needs to do is commit to a nominal target, and let interest rates move as necessary to hit that target.  Because they failed to do so, a two year interest rate commitment is likely to be meaningless.

Freaked out by Freakonomics

I have great respect for the work of Justin Wolfers, so it pains me to write this post.  But if you read the following, I think you’ll see why I couldn’t let it pass:

Typically, the Fed does this by reducing the Federal Funds Rate, which is an interest rate on overnight loans. Unfortunately, that short-term interest rate is now pretty much at zero, and can’t go any lower. The thing is, no-one actually cares about the Fed Funds Rate. You and I and the businesses we work for don’t borrow using short-term interest rates.  Instead, we finance our investments with longer-term loans.  The Fed Funds Rate only matters to the extent that it reduces long-term interest rates.

So the key is for the Fed to reduce long-term rates.

Recently, the Fed has been doing this by “Quantitative Easing.”  It’s a terrible name for a simple solution. Just as the Fed adjusts short-term interest rates by buying and selling overnight government securities, it can adjust long-term interest rates by buying and selling long-term government securities. That’s what QE2 did.

Many market commentators are disappointed that the Fed didn’t announce “QE3″””a renewed round of quantitative easing. But they shouldn’t be. The Fed still chose to reduce long-term interest rates, they just decided to do it with a different tool. They figured that if you can’t reduce short-term interest rates further, you should reduce ’em for longer. That’s what the Fed was promising, when they said they expect to keep their short-term rate at “exceptionally low levels for the federal funds rate at least through mid-2013.”  What does this do? Keeping short-term interest rates lower for longer will also reduce long-term interest rates. And that’s the main game. It has already worked””perhaps even more reliably than following QE2. The interest rate on two-year bonds is down to virtually zero, and the 10-year interest rate is down to 2.2 percent.

So yes, we got lower long-term interest rates.  That’s what matters. And it doesn’t really matter how we got there.

I certainly agree that the fed funds rate is unimportant.  But I’m afraid Wolfers has violated one of my favorite maxims: Never reason from a price change.

It does matter why rates fall.  In December 2007 the cautious Fed announcement so discouraged investors that the stock market crashed and long term interest rates fell (on expectations of recession–which turned out correct.)  Obviously I can’t say for sure that this explains the current movement in the long term bond market.  But consider the following:

1.  When AD is severely depressed, stocks react very positively to monetary stimulus.

2.  When AD is severely depressed, stocks tend to move in the same direction as bond yields.

3.  QE2 rumors seemed to clearly boost stock prices in the fall of 2010.

4.  In recently weeks both stock prices and bond yields have fallen sharply, and the falls have been highly correlated.

Put all those facts together and it seems much more likely that the recent decline in yields is due to fears that the Fed will allow NGDP to plunge, rather than the belief the Fed has adopted a truly stimulative policy.

Wolfers’ mistake is to forget that interest rates can change for many reasons.  It might be more demand for T-bonds from the Fed (expansionary) or more demand for T-bonds from people frightened that the Fed will do nothing to prevent a double dip (contractionary.)

HT:  JTapp

Update:  JTapp told me that Justin Wolfers made the following comment in Twitter:  “Scott Sumner failed to read my piece closely: I didn’t reason from a price change but from a Fed demand shock.”

I understand that Wolfers was assuming the fall in interest rates was in response to a Fed demand shock, but I’m arguing he had no basis for drawing that inference.  The Fed did not announce a policy of increasing its purchases of bonds by more than the market expected—if anything, just the reverse.  All we really know is that markets are responding to the Fed.  We don’t know exactly why.   Indeed the Fed’s action was so confusing that the markets initially didn’t even seem to know how to react, gyrating wildly up and down several times in the hours after the 2:15 announcement.  And recall that in December 2007 a contractionary surprise caused bond yields to plunge–why is this different?     So I’m afraid my criticism stands.

We really, really need a NGDP futures  market, which would eliminate all these debates about whether Fed actions are expansionary and contractionary.  And who is one of the two most famous proponents of prediction markets?  Justin Wolfers.  I’m sure Justin and I agree on that issue.

Update#2:  I just got an email from Justin Wolfers.  Perhaps I created the wrong impression in my “never reason from a price change” comment.  Justin certainly understands the distinction between supply and demand shocks, and I didn’t mean to suggest otherwise.  But monetary economics adds another degree of complexity.  The same action (buying bonds) can raise or lower bond yields, depending on expectations.  A one time open market purchase may well lower bond yields.  But an announcement that the Fed will buy enough bonds to create Zimbabwe-style inflation will raise bond yields.  So even if one knows it’s a demand for bonds shock (and we don’t know in this case) it’s still dangerous to draw inferences from interest rate changes.