Petition for Monetary Stimulus

We, the undersigned economists are concerned that inflation and nominal growth are likely to fall short of the Fed’s policy goals under the current stance of monetary and fiscal policy.  We believe that monetary policy can do more than it has, and without significantly impacting the the national debt.

Goal: Increase inflation expectations to about 3%, or nominal GDP growth expectations to roughly 5%.

Policy can be more effective in three areas:

1.  Reduce the demand for base money:

A.  Charge an interest rate penalty on excess reserves.  If combined with positive interest payments on the level of reserves that the Fed considers desirable for liquidity purposes, such a system need not reduce bank profits.

B.  Set an explicit CPI or NGDP target for at least 5 years, commit to do whatever it takes to hit that target, and promise to make up for any shortfall or overshooting (“level targeting.”)

2.  Increase the supply of base money:

A.  The preceding proposal for reducing the demand for excess reserves may give monetary policy “traction,” allowing the Fed to boost cash holdings of the public through ordinary open market operations in short term government debt.

B.  If not, commit to buying however much medium, and then long term debt is required.  Fed officials should  try to purchase assets that are not likely to fall sharply in value when inflation expectations return to normal.

3.  Monitor inflation expectations closely:

The Fed should rely on a mix of internal forecasts and market indicators.  No market indicator is perfect, but nominal/indexed bond yield spreads provide some indication of inflation expectations, and should help the Fed avoid sharply overshooting its inflation target.  Other markets can provide some indication of real growth expectations, if the Fed chooses to target nominal GDP.

Summary

We are not proposing a cookie-cutter approach that relies on a mechanical formula.  The Fed itself is best able to decide the difficult problems of how to limit excess demand for bank reserves, and what assets to purchase.  Difficult decisions must be made where trade-offs are involved.  For instance, buying indexed debt might reduce the Fed’s risk of future capital losses as inflation expectations recover, but also may reduce the information content of the yield spread.  Despite the very real risks of unconventional monetary policy, we believe that an aggressive multifaceted initiative could quickly turn expectations around, making the actual size of asset purchases required quite manageable.

We would also point to the very real benefits of faster nominal growth, which go far beyond the traditional social welfare benefits of reduced unemployment:

1.  Faster nominal growth would reduce the budget deficit, which is expected to reach worrisome levels.

2.  Faster nominal growth would reduce debt defaults, and this would make it both easier and less costly to rescue the banking system.

During crises it is sometimes the case that an aggressively bold move can achieve results where traditional measures seemed ineffective.  In 1932 traditional open market operations failed to have much impact on confidence in the financial markets or the economy.  Then output and prices began rising rapidly almost immediately after Roosevelt’s dollar devaluation policy was adopted in early 1933.  And this occurred despite near-zero short term rates and in an economy where much of the banking system was shutdown.  Although fiscal stimulus and bank rescue operations may be able to help, nominal growth and inflation are fundamentally monetary problems.  And although FDR’s dollar devaluation policy would not be appropriate during this worldwide slump, we believe than an equally vigorous and unconventional set of steps could stimulate the financial markets and the broader economy relatively quickly.

Scott Sumner  (Bentley College)

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