Time for the Fed to grab the top of the pole
Nick Rowe has an excellent metaphor for monetary policy—balancing a tall pole in one hand. If you want the top of the pole to go right, you move your hand to the left. By analogy, if you want to increase inflation (and perhaps interest rates in the long run) you reduce short term interest rates.
But Nick points out that this strategy doesn’t work if the pole balancer bumps up against a tall wall. Now it’s no longer possible to move your hand in both directions–only one direction is available. Similarly, once nominal rates hit zero, monetary policy can only use the interest rate to tighten, not loosen. Instead, they’d need some sort of unconventional policy, such as a higher inflation target. That would be the equivalent of directly grabbing the top of the pole.
But the Fed doesn’t want to do those sorts of unconventional policies, preferring instead to wait things out, hoping the wall will crumble away over time. Unfortunately, the wall is now growing rapidly taller, which means it is now more essential than ever to use unconventional policy tools. For instance, this morning the yield on 5 year T-notes fell to 1.28%, the lowest rate I’ve ever seen on 5 year bonds. This is the market forecast of future rates, and an implied prediction that rates will be at zero for much longer than Fed officials believe. Here are recent monthly averages from the St Louis Fred:
The markets are telling us that the current slowdown is not just a “pause” in growth. The Fed doesn’t realize that yet, and thus has remained passive. But they will eventually need to act if we aren’t to end up like Japan. The current 1.28% rate can be seen as a weighted average of the Japan scenario (in which case rates should even lower), and a more robust recovery generated by more Fed stimulus (in that case rates should be higher.) It will be interesting to see which road the Fed takes.
Growth is currently slowing all over the world. The new ISM numbers show sharply slowing growth and inflation in the US. Congress has just acted to remove some fiscal stimulus, and address the long term debt problem. In the next six months we’ll see if we have a Federal Reserve that understands its role in driving NGDP, or a passive Fed that pretends it can do nothing—like the 1930s Fed that Ben Bernanke spent years studying.
There are many ways of grabbing the top of the pole, but I believe Greg Mankiw’s recent proposal is the only politically feasible option at this point, much as I’d prefer NGDP targeting.
Prediction: If US and world NGDP growth is very weak over the next 12 to 18 months, then US and world RGDP growth will be very weak over the next 12 to 18 months. If not, then not.
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1. August 2011 at 08:45
All econ commentators: Please shut up and post this column in your place.
1. August 2011 at 09:20
So again, and again, and again until you answer the question… you say this:
“But the Fed doesn’t want to do those sorts of unconventional policies, preferring instead to wait things out, hoping the wall will crumble away over time.”
Ok, but first answer:
If a the President and the Congress are actively kissing the ass of the private sector, doing their bidding, lessening regulation, ending red tape, flattening taxes, forgetting about “social justice” forgetting about “green regs”…
Does the consensus view of the economists that inform the beliefs of the Fed CHANGE?
In practice, do you predict the Fed will be more likely to think looser money is an OBVIOUS GOOD?
1. August 2011 at 09:38
I really don’t understand how politics weighs in on this. The Fed is independent for a reason… Why does it have political restraints? There have been times that the Fed does something that the public and other politicians are upset with, and I’m pretty sure that’s why the Fed isn’t a ‘Monetary Policy Committee’ in Congress. The problem here is that the Fed doesn’t want to do anything unconventional. The problem here is that BB was perfectly comfortable criticizing the Japanese and then not doing anything when he has a chance to.
I suppose the purpose of this rant is to say that blaming poor monetary policy on ‘politics’ is, in my opinion, a pretty lame cop out. It may not be entirely BB behind Fed policy, but still most economists are for tight monetary policy, at least from the polls taken.
‘Politics’ isn’t holding back the Fed, the Fed is holding back the Fed. Watering down the right solution won’t do anything. Let’s remember to hold those with the ability to do something responsible, not just blame it on unpopularity.
Sorry about the rant, but I really think the Fed can make a difference and there’s nothing Ron Paul, Rand Paul, or the other goldbugs can do about it
1. August 2011 at 09:53
Please Mr. Bernanke-san, please, please read Scott Sumner.
1. August 2011 at 12:33
“The markets are telling us that the current slowdown is not just a “pause” in growth”
And it’s also a slow seasonal time of the year. Monetary flows peak in JUL-AUG, then it looks like real-gDp literally crashes (while inflation holds its own). And that assumes the transactions velocity of money doesn’t slide again.
1. August 2011 at 12:35
I’ll be honest…I got this wrong. I thought Bernanke was saying he didn’t want to be More Aggressive unless Congress began dealing with Long Term Budget Problems ( By this, I mean possible problems. They aren’t inevitable. But it is prudent to deal with them earlier rather than later. ). Without this, he was arguing that the Fed had to be more cautious. Now that we have a deal ( What actually happens in the future is anyone’s guess. ), it doesn’t look like I was right. But I still read his earlier words in the same way, meaning he changed his mind or he can’t get it through.
1. August 2011 at 12:35
BTW–a small ray of hope. Martin Feldstein has op-ed in today’s WSJ calling for a cheaper dollar.
1. August 2011 at 12:50
I really don’t understand how politics weighs in on this.
The Fed needs political cover for these policies, because the Congress created the Fed and it can uncreate it, or at least smack it around pretty good. A creature of legislation is always subject to legislation. By pissing off everyone in Congress, the Fed creates the consensus that buries it.
The Fed will obtain political cover once a material section of the GOP or Democrats shifts its opinion. Right now, aggressive loosening has no allies and many enemies in the parties; the GOP/Fox News wing are inveterate inflation hawks and the Democrats prefer that “government” spending be channeled by them into their patronage/simony/vote buying machine (i.e., fiscal stimulus).
1. August 2011 at 13:07
Scott,
I know we’ve had this discussion before, but the Chicago School definition of Fed “inaction” always cracks me up. It’s like you guys need to open a dictionary and realize that inaction and failure are different words (respectfully).
It’s hard to debate you because I think you’re making the more subtle case that if the Fed decides to do something like dramatically cut interest rates, increase the monetary base by 100x, or buy trillions of dollars in treasury bonds before they pay a single coupon to a commercial bank (my definition of monetizing debt), then it was a sign of previous inaction or monetary “tightness”.
However, I’d still argue that you should at least drop the inaction part and talk about bad policy. Since the demand and supply of money is constantly changing, the Fed is always acting in the strict economic sense.
1. August 2011 at 14:38
Benjamin Cole
1. August 2011 at 12:35
” BTW-a small ray of hope. Martin Feldstein has op-ed in today’s WSJ calling for a cheaper dollar. ”
The U.S. Dollar Index really needs to fall below at least 65. However, which currency can take the strain on the other side by appreciating further? The strong CHF is badly harming the Swiss. The Bank of Japan must be getting ready to intervene and may have started today. The Euro? Currently, too strong for the periphery and too low for the core. A stronger euro is more likely to spell debt contagion problems for Italy and Spain leading to an appreciation of the dollar. The Canadian dollar? The problem is the dollar needs to depreciate at least 15%, and no one else wants a stronger currency.
1. August 2011 at 14:44
The Fed knows perfectly well that they have to use unconventional policy by now: this is what QE1 and QE2 were all about. They’re not easing more because (1) they want to keep inflation rates near 2%/yr, even though this will cause an AD shortfall (due to supply-side headwinds) and (2) they’re concerned about the possible costs of unconventional policies. Mankiw’s proposal seems like a good idea, but it will have very limited effects in the short run.
What will help is (1) making it clear that DeKrugman’s “depression economics” does _not_ apply given effective monetary policy: indeed, inflation- and price-level targeting boost the impact of supply-side policy through AD effects. (2) promoting effective neo-liberal reforms which can keep progressives mildly happy, even as they weaken existing interest groups. For instance, get rid of Taft-Hartley and promote European-style, ‘civil society’ unions. (3) if necessary, using cost-effective fiscal policy (investment subsidies) to take the Fed off the zero bound and ‘normalize’ monetary policy. This is the only acceptable use of fiscal policy, and then only as a last resort. No ‘stimulus’ or ‘pump-priming’.
NGDP targeting is probably a good idea in the long run., but adopting it now would be inflationary and cause policy uncertainty. It makes sense to wait until the current headwinds subside and real growth increases, so that policy is not abruptly affected.
1. August 2011 at 16:21
Thanks Ben,
Morgan, But most economists are Dems.
Marcelo, Much of the politics I referred to are within the Fed itself.
flow5, But I don’t think seasonal factors affect the business cycle.
Donald, I’m guessing Bernanke is getting to where he personally would like to move–but that’s not the same place as where he’s ready to push the Fed hard to move.
Bababooey, That’s a good point, and I’d add this. We know that 2/3rds of economists are Dems, and yet it’s hard to find polls where even 10% are calling for easier money. That’s a big problem.
Ben, That’s good to hear from Feldstein, although the exchange rate isn’t really the optimal tool.
John, I agree that the Fed is always acting, and just did a post on that recently. I suppose I meant inaction in the sense of being willing to let NGDP growth expectations fall, without trying to arrest the decline.
Richard, That’s the issue–they all need to fall, which means fall against goods and services, not each other.
anon, You said;
“Mankiw’s proposal seems like a good idea, but it will have very limited effects in the short run.”
I think you’d be surprised how fast NGDP would have to rise to keep inflation from falling below 2% (I’m talking core inflation here). I’d think you’d have to have at least 6% NGDP growth. Even more if Obama took the opportunity to do supply-side reforms.
I agree with your second paragraph.
1. August 2011 at 17:15
Scott, wrong:
http://blogs.wsj.com/washwire/2007/12/10/economists-go-for-republicans/
1. August 2011 at 18:42
With the House going on a month long recess and the Senate probably also going on a significant one, there might well have been an opportunity for Obama to make some recess appointments if he had nominated two people for the vacancies that the Republicans would have obstructed, giving him a rationale for recess appointing them. He should have nominated full employment hawks that the Republicans would never have approved. But in failing to do so Obama has once again failed to move monetary policy toward getting the Fed to comply with its mandate to achieve maximum employment. He could recess appoint Diamond, if Diamond is willing to accept a position on that basis. While he is not a full employment hawk he would move the FOMC toward a somewhat more stimulative policy.
1. August 2011 at 19:38
I can see where this going.
First it’s: “time of the Fed to grab the top of the pole.”
Next it’ll be: “Bernanke must grab the pole”
Then we’ll get: “time for Bernanke to dance with the pole”
Finally, we arrive at: “Bernanke pole-dancing at the FOMC!”
1. August 2011 at 20:13
Lee
I admit the title sounded WORSE to me (pole, etc) than your suggestions.
1. August 2011 at 20:37
Another monetary tool that might work politically: credible, specific commitments to keep interest rates low for a long time.
One of the goals of QE was to lower long-term interest rates (implemented by buying lots of long-term bonds). However, long-term interest rates are also based on the average expected path of short-term interest rates.
Thus, if the Fed could (say) promise to keep short-term interest rates at 0.25% for 5 years, presumably 5-year bond rates would also immediately drop to 0.25%. This must surely have a stimulative effect.
I don’t propose this as an optimal solution – for one thing it is still not controlling the top of the pole – but it might at least give us a handhold partway up.
And it would probably be politically quite easy – the Fed already gives signals in its press releases that rates will be held “for an extended period” and similar language. This language is explicitly recognised as a tool of monetary policy in itself – for instance listen to former Kansas Fed president Hoenig’s comments in a recent Planet Money podcast, when he relates his attempts to get that language removed as a mild tightening measure.
1. August 2011 at 21:05
“I believe Greg Mankiw’s recent proposal is the only politically feasible option at this point”
If congress actually does recess and does not keep itself open to prevent recess appointments, filling the two vacancies on the BOG with full employment hawks would have been politically feasible if Obama had nominated two of them so that the Republicans would have obstructed them, providing with a justification for recess appointments.
The addition of two full employment hawks to the FOMC would greatly change its composition and its policies. But, once again, Obama has dropped the ball on this.
2. August 2011 at 01:36
Scott,
Completely agree -more New-Keynesians on the FOMC understanding monetary policy and from Republican stock. But, what about the conflict between this and Humphrey-Hawkins? My old problem with serious monetary policy in the US..
Short of making a credible commitment to permanent inflation targeting (impossible), I would guess that the Fed will do whatever it can to compensate before the economy adapts to stagnation..
2. August 2011 at 01:44
Anon,
Curious proposal, though with potentia:
)” promoting effective neo-liberal reforms which can keep progressives mildly happy, even as they weaken existing interest groups. For instance, get rid of Taft-Hartley and promote European-style, ‘civil society’ unions.”
Assuming it would not be costless, how do you think spending on your promotions would fare in the upcoming expenditure pruning process? And what about the incumbent unions? Want the president to shoot his last friends???
2. August 2011 at 01:44
Anon,
Curious proposal, though with potential:
)” promoting effective neo-liberal reforms which can keep progressives mildly happy, even as they weaken existing interest groups. For instance, get rid of Taft-Hartley and promote European-style, ‘civil society’ unions.”
Assuming it would not be costless, how do you think spending on your promotions would fare in the upcoming expenditure pruning process? And what about the incumbent unions? Want the president to shoot his last friends???
2. August 2011 at 05:53
“Proof by analogy is fraud.” -Bjarne Stroustrup
2. August 2011 at 05:54
Seasonal analysis refers to monetary flow’s normal pattern. And the calculations for MVt precede the result for nominal gDp. The best reasoning may assume otherwise, but the evidence is incontestable.
2. August 2011 at 09:16
Contemplationist,
Yes, it was either that or the other; I decided to go the more amusing and less disgusting route. One might call it a toss-up. Hardee haha.
3. August 2011 at 06:16
Rien Huizer, yes, my proposal was somewhat provocative. It was meant to prove that not all neo-liberal reforms are “pro-business” in nature, and show how overall labor market deregulation could be made more politically palatable.
In fact, TH is widely considered an “anti-labor” law, yet more importantly it also restrains freedom of contract by disallowing a vast range of negotiation tactics (which are commonly used in other OECD countries)–such as “work to rule”, which helps reveal the extent of workers’ influence on overall productivity–and secondary actions, which require negotiation among unions comprising a supply chain and help ensure that a single union does not capture undue rents by decreasing overall efficiency.
Basically, it is quite likely that current labor laws (restricting negotiation tactics to strikes and collective bargaining, requiring unions to be ‘certified’ with the NLRB, requiring binding arbitration of grievances etc.) have influenced the character of US unions as largely rent-seeking organizations rather than voluntary associations pursuing the broader interests of “rank and file” workers.
3. August 2011 at 11:01
[…] Sumner’s blog The Money Illusion has two provocative posts today that argue that Federal Reserve policy is currently too tight, despite the near-zero fed […]
3. August 2011 at 22:04
Anon,
No doubt there is plenty pof room for improvements, but would they be costless (expenditure and political capital) . I doubt anyone would want to pay for that.
In a tabula rasa setting of course (like Scott’s NDGP targeting) different labor ralations (why are the OECD countries with the highest labour productivity of the “collective bargaining” type). And yes, anglosaxon unions (and Japanese) tend to be rent seeking. NOt unique to the US..
3. August 2011 at 22:06
Sorry, I left something out here:
In a tabula rasa setting of course (like Scott’s NDGP targeting) different labor ralations (why are the OECD countries with the highest labour productivity of the “collective bargaining” type ) would be worth a try, because there would be no transition costs and losers to be compensated. And yes, anglosaxon unions (and Japanese) tend to be rent seeking. But NOT unique to the US..
12. August 2011 at 09:38
Morgan, I guess the forecasters are more conservative than the academics.
Leigh, It might work, but in more recent posts I explain why I’m skeptical.
FEH, I agree about the appointments.
anon, I favor abolishing all labor law.