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



11 Responses to “That queasy feeling”

  1. Gravatar of Mattias Mattias
    11. June 2010 at 07:14

    What if feds QE assets lead to big losses for the fed? Are they real losses if they don’t cause inflation or have any other effects in the world outside the fed?

  2. Gravatar of Lord Lord
    11. June 2010 at 08:07

    I agree. I just hope if growth falls to zero or goes negative they will relent and not fear there is nothing they can do, but I doubt they will do anything otherwise.

  3. Gravatar of Jon Jon
    11. June 2010 at 09:16

    The Fed needs to reboot.

    – get the treasury to buy out that portfolio of MBS.

    – stop paying interest on excess reserves, assess a penalty instead.

    The concern that the current policy mix is unstable is genuine.

  4. Gravatar of ssumner ssumner
    11. June 2010 at 09:56

    Mattias, Losses to the Fed are basically losses to the Treasury (i.e taxpayers.) They can reduce the risk greatly by ending the program of interest on reserves.

    Lord and Jon, I agree with both of you. But I doubt they will do much.

  5. Gravatar of Christian Debt – Economic Update: Bubble Burst March 16 2010 Christian Debt - Economic Update: Bubble Burst March 16 2010
    11. June 2010 at 11:53

    […] TheMoneyIllusion » That queasy feeling […]

  6. Gravatar of Mike Sandifer Mike Sandifer
    12. June 2010 at 09:54

    You mention low inflation during the roaring 20s, just as inflation is seen by many to have been low during the 2000s. But, what of the claim that housing prices should have been integrated into inflation indices during the last boom? And could a similar case be made for the 20s and stock prices?

  7. Gravatar of ssumner ssumner
    13. June 2010 at 10:12

    Mike, I didn’t say low inflation during the 1920s, I said no inflation. Prices fell during the 1920s.

    No, stock prices shouldn’t be included, because stock booms and crashes have no effect on GDP, as we saw in 1987. What you should do is target NGDP, which I beleive grew about 3%/year during the 1920s. That’s certainly a very conservative monetary policy.

    The problem is that they stopped doing that in late 1929.

  8. Gravatar of marcus nunes marcus nunes
    13. June 2010 at 10:33

    Is the Bank of England acting deiffrently from the Fed/ECB? Were they saying that future MP would be expansive?

  9. Gravatar of ssumner ssumner
    14. June 2010 at 06:35

    Marcus. Thanks for the link.

    I’d break that down into two questions, one nominal and one real. The high inflation is explainable in terms of the 20% to 30% devaluation of the pound. (Were there VAT increases as well?)

    The question is why didn’t the nominal expansion have more real effect? There are several possible explanations. In recent years the Brown government moved away from neoliberalism and back toward a more high tax/big government model. In addition, the British economy depends heavily on finance, and thus was hit by a much bigger real shock than a manufacturing country like Germany. From that perspective, if there recession was similar to Germany’s, that could be considered a mild success, all things considered.

  10. Gravatar of Is it time to crank up the printing presses… again? | Is it time to crank up the printing presses… again? |
    30. June 2010 at 06:49

    […] Sumner have been arguing persuasively for some time, monetary policy can and should do more (see here, for instance). In other words, the fact that nominal Fed funds is just about nil isn’t […]

  11. Gravatar of Crank Up Those Printing Presses Crank Up Those Printing Presses
    30. June 2010 at 07:32

    […] Sumner have been arguing persuasively for some time, monetary policy can and should do more (see here, for instance). In other words, the fact that nominal Fed funds is just about nil isn’t […]

Leave a Reply