That queasy feeling

Andy Harless has an excellent analysis of why the Fed is ignoring the seemingly obvious need for more monetary stimulus:

So why is the Fed so tight? Here are some possibilities:

1. Fed policy is better described by a rule that is non-linear in unemployment. With the unemployment rate so tremendously high, perhaps marginal increases in the unemployment rate affect the Fed less than they would if the rate were closer to normal. But given the Fed’s mandate to pursue high employment, wouldn’t the need for more aggressive monetary policy in response to higher unemployment rates be even more acute when the employment situation is already so obviously out of whack? And wouldn’t the unusually high unemployment rate, in and of itself, tend to eliminate the risk of pushing the unemployment rate too low and thereby free the Fed to pursue more aggressive policies than it otherwise would?

2. The Fed is anticipating dramatic declines in the unemployment rate and/or increases in the inflation rate. Except that we don’t see those in the Fed’s forecasts.

3. The Fed is correcting for its earlier overshoot, for being too loose in 2009. Except we’re not seeing much evidence that the overshoot (if there was one) needs to be corrected. There is no economic boom. The inflation rate has continued to fall. If the Fed did overshoot on the ease side, recent economic data suggest that, in retrospect, the overshoot was a good idea and not one that should be corrected by a reversal in subsequent policy.

4. The Fed is passing the buck to fiscal policy. But fiscal policy is tightening too now, in relative terms. It doesn’t seem likely that the Fed is irresponsible enough to base its policy on hypothetical fiscal policies that aren’t actually happening.

5. The Fed has “abandoned the Mankiw rule” and is now setting its policy stance according to very different criteria than it has used over the past 23 years. But is there any evidence that Ben Bernanke has had some sort of conversion experience? And is there any reason why the Fed would be interpreting its mandate differently than it has in the past?

6. The Fed has dramatically altered the parameters of its “Taylor Rule.” But why?

7. The Fed is uncomfortable with quantitative easing and would like to minimize its use and reverse it as soon as possible, irrespective of Taylor Rule considerations. I think we have a winner. The long term effects of quantitative easing are uncertain and could be seen as potentially dangerous. (What will happen if, at some point in the future, the Fed has to choose between liquidating its unconventional assets at a loss, exacerbating an inflationary environment, or raising interest rates high enough to risk a fiscal crisis?) So there is arguably reason for the Fed to be uncomfortable with it. But the implications are disturbing, if you believe in a Philips curve or anything like it. Faced with an excessively high unemployment rate and an excessively low inflation rate, the Fed is choosing to risk exacerbating the situation (i.e., to take the intermediate-term risk of deflation) rather than to risk a very different type of difficult situation in the distant future. Maybe it’s the right decision, but it’s an awfully scary one.

I think he is right.  And this reminded me of all the newspaper stories I read from the early 1930s.  Only a few people thought money was too tight–mostly monetary economists.  Most assumed policy was easy.  The Fed did take some steps that looked fairly aggressive—large increases in the monetary base and very low interest rates—but they seemed ineffective.  The Fed and many conservatives in the financial press became increasing fearful that all the monetary stimulus was a sort of time bomb waiting to explode into high inflation.  So the Fed became strangely passive even as the Depression got worse.  Does any of this sound familiar?

I know that no matter what I say most people will instinctively regard low interest rates and a rising monetary base as “easy money.”  And when this scenario occurs, people get a queasy feeling in the pit of their stomach.  The problem is that monetary economics is very counterintuitive.  When deciding to go with the gut, or go with what the brain is telling you, it is very important to always rely on logic, not instincts.  In the early 1930s the Fed went with their gut, and they seem to be doing so again (although thankfully their mistakes are far smaller this time.)

Here’s another example from Raghu Rajan:

My sense is that we do not know enough about the effect of ultra-low interest rates to state categorically that they are an unmitigated good for reviving the economy. But perhaps the most important cost of low rates is its effect on risk taking and illiquidity seeking. Remember that the United States Fed under Greenspan helped precipitate the recent crisis by keeping rates too low too long. That suggests we cannot be sanguine about the risks that are being taken now. Indeed, many of those who urged Greenspan to keep rates ultra low then are urging the Fed to keep rates ultra low now.

Again, this is much like the argument that conservatives used in the early 1930s.  They said “Look at the people calling for easy money.  They are the same people who supported easy money back in 1927.  And we all know that easy money blew up the stock market bubble and caused the Depression.  Now we must work off our excesses.”

Except that easy money didn’t cause the stock market bubble.  Indeed money wasn’t particularly easy (there was no inflation in the 1920s.)  And the stock market crash did not cause the Depression (as we discovered in 1987.)  And the Depression didn’t work off excesses; it created massive unemployment, which makes it look like every single industry was overbuilt (an  impossibility, unless we need more leisure.)  And almost everyone now agrees that the conservatives were wrong in 1932, we did need easier money.  In the years to come people will wonder why the Fed was so passive in 2009 and 2010.

HT:  Mark Thoma and Arnold Kling

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This entry was posted on June 11th, 2010 and is filed under Monetary History, Monetary Policy, Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.