Ryan Avent on Fed policy failure

Ryan Avent discusses a speech by Fed Board member Jeremy Stein:

Early on, Mr Stein noted:

“If the federal funds rate were at, say, 3 percent, we would have, in my view, an open-and-shut case for reducing it.”

I suspect the issue has been long-since resolved in the minds of many observers, but it is increasingly clear that there is a discontinuity in the Fed’s reaction function when rates fall to zero. Now in my view, that fact ought to seriously change the way we think about long-run Fed policy goals, including the appropriate inflation target. It also leaves open the possibility that we ought seriously to rethink the case for countercyclical fiscal policy. It may suggest that in a world of very low inflation and very low inflation expectations, the odds of ZLB events are higher than widely understood, such that fiscal multipliers might well be higher than often estimated (as the IMF is coming to appreciate).

This is a very good point, but it’s even worse than Ryan indicates.  When the Fed is asked about raising the inflation target to 3% or 4%, they suggest it is a very bad idea.  But when you ask why, they are not able to come up with any powerful reasons.  That’s not to say there aren’t costs of raising the inflation target one or two points (there are) but they are utterly trivial compared to the cost of this recession.  So if the choice is between 4% inflation (as under Volcker) and a continuation of the Great Moderation on the one hand, and a Great Recession on the other, then it’s a complete no-brainer—go for the 4% inflation.  So the Fed actually has no defense for its current policy stance.

But we should not raise the inflation target, as there are much better options that would allow us to preserve a roughly 2% inflation rate (or something close.)  We could go to a 4% NGDP target, level targeting, and start using the monetary base as the policy instrument.  And combine that with a Svenssonian policy of targeting the forecast.  That would also avoid the zero rate trap and it would keep inflation close to 2% on average.  But the Fed also refuses to do that, as they are too attached to using the interest rate as a policy instrument.

Some people make the following bogus argument:  They claim is that use of the base as an instrument doesn’t solve the zero bound problem, as OMOs have almost no impact at the zero bound.  That’s true, but it’s also true of adjustments in the fed funds rate.  Roughly 99% of the impact of a change in the fed funds target is from the signals it sends about future monetary policy.  The same is true for changes in the base.  In any case, everyone agrees that a large enough increase in the base would be effective; the real debate is over whether the Fed would have to buy other (riskier) assets.  But this just shows how confused the Fed is about policy.  If you want to minimize the risk of the Fed running out of T-securities to buy, and being forced to buy riskier assets, you need a higher trend rate of growth in NGDP (than the 2% of the last 4 years.)

The Fed doesn’t realize this, but they are implicitly asking for the impossible.  This is what they demand:

1.  The Fed insists on a low inflation target.

2.  The Fed insists on targeting inflation by adjusting the fed funds rate.

3.  The Fed insists it prefers to buy Treasury securities, and feels squeamish about a scenario when they run out of T-securities to buy, and must buy other riskier assets.

Unfortunately we don’t live in a universe where the Fed’s wishes can be granted.  In a world that is becoming increasingly like Japan, with low real interest rates as far as the eye can see, the Fed’s low inflation goal conflicts with it’s preferred operating procedure.  Do we really want to have a Great Recession every 10 years because every time the nominal rate hits zero the Fed starts spinning its wheels and the markets lose confidence?  Eventually the Fed will recognize the problem and adjust their policy accordingly.  I just wish they’d put us all out of our misery by deciding sooner rather than later.

Ryan also had this to say:

If the Fed’s motivation is to reestablish a cushion against the ZLB, then it is effectively expressing a desire for the economy to run hot for a little while, long enough to get inflation up and influencing nominal rates. Now perhaps the motivation is not to achieve higher inflation in order to lower the real interest rate and speed up the recovery. But I don’t think that matters. The message markets, firms, and households ought to hear and understand””if in fact this view is gaining adherents within the FOMC””is that the Fed wants a faster recovery in order to achieve higher inflation and it is prepared to keep buying assets until it gets it.

I understand that when in France one must speak French, and when talking to the Fed one must speak in terms of inflation expectations.  But the message would be both more accurate and less controversial if stated in terms of NGDP growth.

PS.  And fiscal policy doesn’t even come close to solving this problem.  What good does it do to discuss Simpson-Bowles-type long term debt solutions, if every 10 years we are going to run $4 trillion in deficits over 4 years to deal with recessions that drive rates to the zero bound?  Fiscal policy shouldn’t even get any serious consideration, it’s so much worse than 3% or 4% inflation it’s ridiculous.



15 Responses to “Ryan Avent on Fed policy failure”

  1. Gravatar of Asdasdasd Asdasdasd
    13. October 2012 at 15:30

    Awesome blogging as ever, thanks.

    Re “That’s not to say there aren’t costs of raising the inflation target one or two points”

    What are the welfare costs of inflation?

    Lucas (2000) argued they were very small:

    “This paper surveys research on the welfare cost of inflation. New estimates are provided, based on U.S. time series for 1900-94, interpreted in a variety of ways. It is estimated that the gain from reducing the annual inflation rate from 10 percent to zero is equivalent to an increase in real income of slightly less than one percent. Using aggregate evidence only, it may not be possible to estimate reliably the gains from reducing inflation further, to a rate consistent with zero nominal interest.”

    Are there better refs for the welfare effects of inflation?

    What is your back of the envelope estimate of the welfare effects of increasing inflation from 2% to 4% in terms of a percent of real incomes?

  2. Gravatar of Morgan Warstler Morgan Warstler
    13. October 2012 at 16:25

    Banks don’t lower mortgage rates, they keep the profits…

    So… the time line for QE3 takes longer?


  3. Gravatar of Major_Freedom Major_Freedom
    13. October 2012 at 21:29


    When the Fed is asked about raising the inflation target to 3% or 4%, they suggest it is a very bad idea. But when you ask why, they are not able to come up with any powerful reasons. That’s not to say there aren’t costs of raising the inflation target one or two points (there are) but they are utterly trivial compared to the cost of this recession.

    This statement shows a misunderstanding/ignorance of the concepts of “costs” and “gains”. As is usual for “central planning / collectivist / monetarist / aggregate” thinkers, the concepts are imputed as relating to groups of people, rather than what actually takes place in reality: relating to individuals only.

    There is no such thing as social costs or social gains. All costs and all gains only exist at the individual level. When one person loses $10, and another gains $11, then it is a false inference to conceive of any collective gain of $1. The only reality that exists is one person losing $10 AND one person gaining $11.

    The fallacy present in such statements is called the reification fallacy, or, in short, hypostatization.

    The typical reason why such reification fallacies take place is due to the fact that with a particular statist action X, some individuals are harmed, while other individuals are benefited, and in order to reconcile such disparate outcomes, in order to give a singular argument that statist action X is justified, individuals are treated as merely cells, as centers of pleasure and pain, of a greater, larger organism that allegedly has the true reality, and the claim is made that the gains exceed the costs, and so in general, in the aggregate, the statist action X is justified.

    This is an extremely crude and sloppy approach to understanding human life, because the reality of human life is that each individual is an end in themselves, each individual has their own unique value scales, and thus each individual has their own unique cost and gain schedules.

    Central planning intellectuals seem to always ignore the individuals who are harmed, and they pretend these individuals don’t exist, or if they do accept they exist, they are treated as sacrificial means to promote some fuzzy and undefined “greater good”. Fascism and communism are BASED on this very idea, propelled to the extreme. In the area of money, the principle is no less present. The philosophy is there, and the contradiction between that philosophy and traditional anglo-saxon property rights, is glossed over, and ignored.

    It is absolutely revolting that so much garbage ethics is being taken for granted in mainstream/monetarist economics. So sloppy, so crude, so devoid of intellectual rigor, and so utterly sociopathic towards those who are harmed.

  4. Gravatar of Major_Freedom Major_Freedom
    13. October 2012 at 21:36

    To be more specific, with 3% or 4% price inflation, for all those who are employed and earning profits, whose incomes will not rise as fast as the prices of the goods they buy, THEY will be harmed by the inflationary policy. They are going to be sacrificed for the sake of others.

    Why don’t market monetarists just be more honest and direct, and advocate for taking wealth outright at gunpoint from those who have more, for the sake of those who have less? The same friggin principle is present. Why the stealthy, underhanded inflation tax method? To much of a coward to do it otherwise?

  5. Gravatar of Benjamin Cole Benjamin Cole
    14. October 2012 at 00:00

    Superb blogging.

    Japan is the role model, although the USA perhaps will do a Japan-lite, as the USA Fed targets 2 percent inflation, and Japan’s central bank targeted 0 percent.

    Major Freedom: A marginally higher, or lower, rate of inflation will distribute incomes in unpredictable ways.

    A zero percent inflation rate–if you can even measure that accurately–will also redistribute incomes in some way. If maintained, it will make borrowing cheap, and transfer wealth to borrowers from creditors. Likely, it will transfer wealth from owners of gold to non-owners, too.

    BTW, some hard-core right-wing scholars, such as Dan Boudreaux of George Mason University, have postulated that the CPI overstates inflation by a percent or two. If true, we are at zero percent inflation now. I tend to think with rapidly evolving good and services, the CPI does overstate inflation–government bureaucrats have no hope to keep up with such a rapidly evolving landscape.

    For me, I want prosperity, more so than price stability, if price stability can even be measured.

  6. Gravatar of Saturos Saturos
    14. October 2012 at 00:19

    Scott, really need a response to this paper: http://mungowitzend.blogspot.com.au/2012/10/whats-your-super-power.html

  7. Gravatar of Saturos Saturos
    14. October 2012 at 00:20

    Oops, wrong link: http://mungowitzend.blogspot.com.au/2012/10/calvo-we-have-problem.html

  8. Gravatar of Saturos Saturos
    14. October 2012 at 00:21

    I’m not too worried as yet, since Michael Woodford just endorsed the idea that the authors are rejecting, but still…

  9. Gravatar of Bill Woolsey Bill Woolsey
    14. October 2012 at 03:01


    I didn’t get past the introduction.

    The policy of holding interest rates at some fixed level for a fixed period of time was always stupid.

    Calvo pricing models are “bad.”

    With rational expecations and Calvo pricing, holding interest rates too low (rather than varying them according to a Taylor type rule) is going to give the Wicksellian cummulative process pretty soon. (Two years in the simulations they did.)

    A nominal anchor is essential. Woodford’s approach of keeing interest rates low until nominal GDP reaches a target growth path would not be subject to the same problems as keeping interest rates low for a specific period of time regardless of what happens. Woodford was criticial of such a policy in the Jackson Hole paper.

  10. Gravatar of Bill Woolsey Bill Woolsey
    14. October 2012 at 03:23


    The answer to Avent’s musings is to fire the central bankers.

  11. Gravatar of Max Max
    14. October 2012 at 06:17

    “In any case, everyone agrees that a large enough increase in the base would be effective; the real debate is over whether the Fed would have to buy other (riskier) assets.”

    Eh…didn’t you just recently call this view a straw man that no monetarist believes:


    I’m confused, unless you meant “…a large enough *permanent* increase in the base…”

  12. Gravatar of StatsGuy StatsGuy
    14. October 2012 at 06:19

    “In a world that is becoming increasingly like Japan, with low real interest rates as far as the eye can see, the Fed’s low inflation goal conflicts with it’s preferred operating procedure.”

    That’s one of the most succinct and biting points you’ve ever made.

    The Fed’s policy response, btw, consists primarily of talking a lot and really hoping that the real interest rate increases. Right…

    In any case, the remaining MBS market is actually fairly secure, and that can absorb a fair bit of liquidity. They could probably move into investment grade corporate debt as well with minimal risk, and without excessive political opposition (though voices will be raised). I think the bigger issue is going to be when and if they go into equities. Politically, I question whether this will be allowed.

    At the end of the day, the crisis seems to be more political than anything.

  13. Gravatar of StatsGuy StatsGuy
    14. October 2012 at 06:24

    Also, just one quick note on the Fed taking a “loss” on its book.

    It’s important to note that the Fed is ONLY concerned about a nominal loss, because it has zero financing, and that really means default risk – which is quite low on the assets it’s absorbed.

    The only other risk is if it’s forced to sell assets back into the market to bring inflation down by decreasing demand – in other words, we have a demand glut.

    BUT IF THAT HAPPENS, the Fed can just increase RATES (which become an effective policy instrument again), and hold the remaining assets until maturity (at zero financing costs – BECAUSE THEY ARE THE FED). As my grandmother would say, ‘if only we could be so lucky’.

    I seriously get sick of hearing this argument from the mainstream financial press.

  14. Gravatar of Greg Ransom Greg Ransom
    14. October 2012 at 07:32

    Scott, there is an argument.

    The argument is that an unsustainable disequilibrium is created via expansion of credit and money expansion and the inflating of shadow money liquid asset money substitutes at within particular domains of the economy — and what is required is ever accelerating money and credit and shadow instruments to sustain the disequilibrium, which exists also in the real structure of the economy.

    And ever accelerating money & credit & shadow money is unsustainable.

  15. Gravatar of ssumner ssumner
    14. October 2012 at 08:18

    Asdasdasd, One percent of GDP is HUGE! I’d expect much smaller welfare loses from moving from 2% to 4% inflation. But I’d still prefer NGDPLT.

    Saturos, I think we know from the Japanese experience that low rates don’t necessarily lead to inflation. What else is the paper saying?

    Max, Any attempt to buy up all of planet Earth would be interpreted as at least partly permanent.

    Statsguy, Buying equities would be almost as silly as doing fiscal stimulus. Not quite, but almost.

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