Why the Fed won’t directly target exchange rates

I saw this comment over at MarginalRevolution:

On the AD front, Scott Sumner has been vindicated more than any other writer.  His best critic is Arnold Kling, especially with regard to whether there are only two kinds of inflation regimes, low or high and variable.  A related question is what a looser monetary policy would have done to financing the long-run debt burden and the use of the interest rate spread to recapitalize banks.

A few thoughts:

1.  It’s nice to be complimented.  BTW, did people notice that one of our commenters here (statsguy) had a post that Tyler Cowen named best post of the year?  Whatever success I’ve had is mostly due to the good fortune of being promoted by blogs like MR and Econlog.

2.  Regarding the impact of looser monetary policy, I put a lot of weight on the correlation between NGDP growth expectations and the severity of the banking crisis.  The estimated total losses to the US banking system got worse when NGDP growth expectations were declining, and have improved since NGDP growth expectations began improving.

3.  I am a huge fan of Kling’s posts, but I think his strength is micro/public policy/banking and the real side of macro.  I still don’t see a persuasive model of nominal shocks.  (Persuasive to me anyway.)  Of course I focus on nominal shocks, and mostly leave the real side of macro to others.   Since the time of David Hume, the best minds in the field have struggled with trying to explain why nominal shocks have real effects.  All they have come up with is some lame sticky wage/price models.  I won’t be able to do any better, although I suspect the profession slightly underestimates the relative importance of wage stickiness.  So I focus on explaining AD shifts, and assume the SRAS is upward sloping when in a recession.

4.  Kling also has some astute views on macroeconomic thought.  He was the one who noticed that my view should be the standard view of the recession, but for some strange reason isn’t.  I didn’t leave the profession, the profession abandoned me.  He and I also view the relative popularity of Keynesian and Austrian views as being cyclical.  But on purely monetary policy issues, I think Nick Rowe, Andy Harless, and Paul Krugman have been my toughest critics.

Speaking of Kling, here is a recent comment about my views:

Scott Sumner writes,

“The US can’t really use the exchange rate as a policy tool, it is too controversial.”

And so, we have to turn to less controversial tools, like pouring more wood on what the CBO says is a fiscal fire.

That is not what Sumner says, of course. He says that the Fed can just announce a target for nominal GDP, and the markets will obey.

I find that highly implausible for nominal GDP, but I do find it plausible for the exchange rate. If the Fed announced a policy of “20 percent weaker dollar or bust,” and proceeded to buy euros, yen, and other currencies, by golly, I do not think that private speculators would try to get in the way. And if foreign governments tried to get in the way, that would probably lead to some sort of worldwide monetary expansion that I imagine would make Sumner happy.

One point to make here is that this represents another reason to reject the notion of a liquidity trap. If the Fed runs out of T-bills to buy, it can always buy foreign currencies.

I agree about the liquidity trap; Svensson, McCallum and many others have pointed out that currency depreciation is a foolproof way out of liquidity traps.  And FDR showed it works.  I shouldn’t have said the Fed “can’t” do it; the problem is that they won’t because it will be (wrongly) viewed as a beggar-thy-neighbor policy.  There are two problems with that argument.  First, any expansionary policy, even QE, will depreciate the dollar.  Indeed the dollar fell sharply in March 2009 on the date that QE was announced.  But if the Fed specifically targets the exchange rate, the Europeans and Japanese will whine “beggar-thy-neighbor.”  The other problem is that under a fiat money regime, other countries can easily prevent any US currency depreciation from reducing their NGDP.  Of course if they offset the US action, their currencies will also depreciate.  All currencies cannot depreciate against each other, but they can all depreciate against goods and services.

I’m not sure why Kling doesn’t think NGDP targeting would work.  Remember, I want to target expectations.   Just eliminate interest on reserves and do enough QE so that NGDP expectations rise to the desired level.  You will also depreciate the dollar as a side effect.  Since he thinks dollar depreciation works, why wouldn’t other actions that have a side effect of depreciating the dollar also work?  BTW, I don’t claim announcing a target is enough; you must also accommodate the public’s demand for base money at that target.  Kling continues:

However, I cannot leave this issue without referring to the two-regime theory of monetary policy, which would say that this sort of policy risks moving the U.S. into a regime where the inflation rate becomes high and variable. Instead of keeping cash in mattresses, people will try to conserve on cash, and this will raise the velocity of money, even as the Fed is expanding the money supply. There is a risk that we will overshoot the inflation target. If higher inflation solves a lot of our unemployment problem, then, fine, Scott Sumner is a hero. If not, then, well, he is something else.

I’m not at all worried about being tarred and feathered, because I favor targeting expectations, and also level targeting.  That combination will prevent an outbreak of inflation.  If you need to drain a trillion in base money out of the system in one day—you do it.  Indeed if an outbreak of inflation were to occur, I could get rich by going long on CPI futures, with no risk.  I seriously doubt there will ever arise an economic scenario where I could become rich at no risk.

Technically the preceding argument assumes that the price level doesn’t wildly gyrate around the 2% growth trend (if we assume 2% inflation is the Fed’s target.)  I suppose you could have 12% inflation one year and negative 8% the next.  But the volatile part of the CPI is commodities like food and oil, and intertemporal arbitrage prevents that sort of response to monetary shocks.  The bigger (core) part of the CPI is mostly driven by wage growth, and is very inertial.  Believe me, if you keep price level expectations in the TIPS markets growing along a 2% upward sloping trend line, the actual CPI is not going wildly fluctuate above and below that level, unless there are some pretty big supply shocks that have nothing to do with monetary policy.  Ditto for NGDP targeting.

Fear of overshooting toward a high inflation scenario is common among economists, but represents 1970s thinking.  There were no TIPS markets warning us about rising inflation expectations back then.  If it happens again, we will be able to watch the accident in slow motion, hour by hour in the TIPS markets, and will have no one to blame but ourselves.  I’ll refuse to take the rap.

There are dozens and dozens of developed countries.  How many have experienced double digit inflation in the past 20 years?  There’s a reason for that.



16 Responses to “Why the Fed won’t directly target exchange rates”

  1. Gravatar of Kent Willard Kent Willard
    31. July 2010 at 14:49

    Interesting insights. With a bit of editing your posts could be half their length but say just as much. Your ideas would be more widely read and better understood. Sometimes that means more but smaller posts, with a more specific topic.

  2. Gravatar of Bonnie Bonnie
    31. July 2010 at 15:21

    “There is a risk that we will overshoot the inflation target. If higher inflation solves a lot of our unemployment problem, then, fine, Scott Sumner is a hero. If not, then, well, he is something else.”

    What I think is missing from the argument is the tradeoff between disinflation/deflation or an inflation rate that is too low, leaving us vulnerable to exogenous shocks, and inflation from overshooting by some degree. And by real, I am suggesting the state of the economy today versus that of 2006 to early 2007 when inflation was just a tad too high. I can only speak for myself, but I was far more hopeful for the future than I am today. Inflation that is not kept in check can be bad, but so too is the condition we now have.

    It takes skill and strong leadership for the Fed to be able to walk the tightrope, keeping it all in balance so that we can have that most important portion of the ingredients to a well functioning economy. I don’t think that anyone could argue that we have that today and the question becomes one of justification. I really don’t think that terror of overshooting the mark is justification enough to hold the economy in such a state that many many lives are being financally destroyed unnecessarily. Is that really why the Fed was created? If so, then I think we need to revisit that choice and make some other kind of arrangement.

  3. Gravatar of Doc Merlin Doc Merlin
    31. July 2010 at 15:24

    ‘There are dozens and dozens of developed countries. How many have experienced double digit inflation in the past 20 years? There’s a reason for that.’

    Well, causing a hyperinflation takes a hell of a lot of work. Zimbabwe had to issue currency with literal expiration dates on it and have an official policy of hyperinflation for it to work. Germany did something similar, just ran the presses 24/7. Hyperinflation doesn’t happen by accident…

    But double digit inflation? Your 20 year time period is a bit short, lets look at the last century.
    The USA.

    Anyway, I suggest you read the book “This Time Its Different” which covers currency crises as well as debt crises.

  4. Gravatar of Bonnie Bonnie
    31. July 2010 at 16:02

    I just wanted to add to my previous comment that the arrogance of the powers that be over this whole predicament, the Fed and some in the economics profession who are willing to defend the indefensible without so much as being able to explain why this state of the economy is preferable to one with a little more inflation is simply breathtaking. Is a simple justification of why ~1% inflation is preferable to 2-3% too much to ask? I think all those people who have been destroyed in this recession or are facing financial ruin in the very short term as a result of continued contractionary policy deserve at least for them to come out of their ivory towers and explain it. We don’t want to hear after having the worse recession in 80 years that things have to get worse before the Fed will use the additional tools in its shed. Can’t afford bread? Have some cake instead.

  5. Gravatar of scott sumner scott sumner
    31. July 2010 at 17:04

    Kent, Thanks.

    Bonnie, I agree that we were better of in 2006-07. If we target NGDP, we can better absorb price shocks like the oil price run-up.

    Doc Merlin, My point is that double digit inflation used to be a problem, but under modern monetary policy practices you just don’t see it anymore. Your list shows just how dramatic the change has been. It used to be common, now it’s almost unknown.

    Bonnie#2, I agree.

  6. Gravatar of Benjamin Cole Benjamin Cole
    31. July 2010 at 17:18

    Scott–The old newsman in me has to say it is “complimented” not “complemented” in the first thought. If you ever had you rear end chewed out by a copy editor, you would know about knee-jerk reactions….

    I thoroughly agree with Sumner’s sentiments about “fighting the last (previous) war.”

    Inflation? Where? Yes, I lived through the 1970s inflation, and it left an impression. I can also remember my father, who lived through the Great Depression, always buying the cheapest apples in the store—50 years after the Great Depression ended. Though safely ensconced into the American middle-class, he could not change his habits.

    But Sumner is pointing out we cannot let our hunches and emotions–perhaps so worthy in personal situations–dictate economic policies.

    This regrettable intuition to fight the last war seems to be compounded by people like Dallas Fed Chief Richard Fisher, who boldly state that price stability is the ultimate goal. Price stability–not economic prosperity?

    Sometimes I think the whole nation is re-fighting the 1960s-70s. The left-wing seems to think it is forever Selma, Alabama 1962, and the right-wing ever expects a Cuban Missile Crisis (1961?) or a nearly hot Cold War.
    The slightest provocation–a dreadfully edited video of Sherrod, or the panty-bomber, or some punk terrorists in the hills of Afghanie–is enough to send the left-wing and right-wing klaxons for weeks.

    And so it is with the Fed and inflation. Now they have Fed chieftains saying neither deflation or inflation is the goal but absolute price stability. I am not sure this makes any sense.

    As our society becomes richer, certain assets might get bid up in price, such as real estate. It is a reflection of the greater disposable income. The always hard-to-measure health care costs might rise also, again reflecting people’s desires and higher incomes. One would have to cause balancing deflation in other areas to balance these two categories–which together form a huge portion of the CPI.

    We have a Fisher, down on his knees slavishly worshipping a price totem, rather than economic prosperity.

  7. Gravatar of Carl Lumma Carl Lumma
    31. July 2010 at 22:19

    Which statsguy comment is that? (link maybe?)

  8. Gravatar of scott sumner scott sumner
    1. August 2010 at 05:09

    Benjamin, I meant that Tyler and I complement each other pretty well. 🙂

    Seriously, you wouldn’t believe how bad my spelling would be if not for the computer’s automatic spellcheck.

    I agree about refighting battles of the 1960s. In 1930 they were thinking back to the post war inflation and (brief) depression, but this time we didn’t just have a one year depression. As time moves on, people need to adapt and figure out what are the real problems.

    Carl, It wasn’t a comment, it was a post over at Baseline Scenario. Tyler Cowen linked to it 2 or 3 days ago.

  9. Gravatar of Philo Philo
    1. August 2010 at 09:25

    “Whatever success I’ve had is mostly due to the good fortune of being promoted by blogs like MR and Econlog.” Such promotion is only a first step; more important to the success of TheMoneyIllusion is the excellent content.

  10. Gravatar of Bob O’Brien Bob O'Brien
    1. August 2010 at 10:46


    You mention in 4) above that interest in Austrians is cyclical. I find that the ideas I am reading about the Austrians are very complimentary to your ideas. For example I recently read this article:


    On page 6 Roger Garrison writes “Hayek argued that the ideal policy was to keep MV – and hence PQ – constant by increasing the money supply just enough to offset declines in money’s velocity (M) of circulation.”

    In general I find the Austrian writers usually focus on the why’s of the micro aspect of the economy while your blog focuses on the big picture of Fed Monetary policy and that these two areas address different aspects of the economy and both you and the Austrians seem to be spot on with your ideas.

  11. Gravatar of Carl Lumma Carl Lumma
    1. August 2010 at 19:01

    @Scott Gee, thanks for the intriguing clue.

  12. Gravatar of Carl Lumma Carl Lumma
    1. August 2010 at 19:04

    Here, apparently:

  13. Gravatar of scott sumner scott sumner
    2. August 2010 at 04:47

    Thanks Philo.

    Bob, Yes, I have read about how Hayek also favored NGDP targeting.

    Carl, Thanks for the link

  14. Gravatar of Philo Philo
    3. August 2010 at 10:01

    Of course, the excellent content is the reason Marginal Revolution and Econlog started referring to The Money Illusion.

  15. Gravatar of Defennder Defennder
    4. August 2010 at 23:55

    Hi Prof Sumner, I hope you’re still reading comments for this post.

    I noticed your explanation above as to why the Fed won’t target exchange rates (ie. depreciate the dollar). I recently came across this concept of the inconsistent trinity in international economics that it’s not possible for any central bank to do all of the following three:

    Maintain a fixed exchange rate.
    Free movement of capital
    Set interest rates.

    Greg Mankiw wrote a op-ed in the NYT recently on this concept:

    So perhaps unless the Fed were to give up the goal of restricting capital or setting interest rates, there doesn’t seem to be any way in which they could deliberately depreciate the dollar. Or at least that’s my understanding.

  16. Gravatar of scott sumner scott sumner
    6. August 2010 at 06:20

    Thanks philo.

    Defennder, Yes, but they have essentially given up on interest rates, which have been stuck near zero for 20 months. That’s why exchange rates are a potential alternative

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