Tuesday, July 20, 2010

Yglesias Ponders why the Fed is Pondering What its Job is...

Yglesias smartly notes that Fed policy is not actually all that complicated. If inflation is below target, has been for some time, and is expected to be below target in the future, you loosen policy. Especially if you're at 9.5% unemployment and expect to have high unemployment for the foreseeable future. Rocket science this isn't.

Somehow, the Fed doesn't see it that way. They see their job as being a very complicated one which requires lots of waiting for new data to come in, and careful examining of various moments from esoteric indicators while not putting too much emphasis on inflation or employment. I think this is what happens when you put academic economists in charge of the Fed. These people are trained to think that Macro is a inherently a horrendously complicated and difficult subject when it isn't, really. Sure, it may look to a layperson that, for the past 15 months, the case for looser policy has been obvious, but, the Fed wants to say, it's actually really complicated.

The other thing which academic economists have, which is clear from the article Yglesias linked, is completely unrealistic expectations about what mere Fed signaling can do in the absence of any concrete action to change private-sector inflation expectations.

Harding reports that of the first two things the Fed might do in easing policy, "Neither is a drastic move but the Fed will expect quite a strong signaling effect from its first change towards looser policy."

But why would this be the case? If it has taken the Fed this long to take small steps, why wouldn't the market assume that once the Fed took these small steps, they are very unlikely to do anything more unless the market collapses again? It's really hard for me to see the Fed acting again until another six months of unemployment come in...

Here's a final exam for Macro at Princeton. (First thought was that it actually looks quite easy compared to some of the shit I've been subjected to...) Still though, the way economists are trained is very clear -- they are trained to do math, short proofs and fast algebra, and that's about it.

Given Bernanke's difficulty with setting rates, Sims might want to include a multiple choice question on future exams:

1. If inflation is below target, has been for awhile, and is expected to be below target for the next two years, while unemployment is expected to be above 8% for the next two years, should the Federal Reserve:
(a) do nothing
(b) raise the discount rate
(c) loosen
(d) engage in word games about the duration of how long we will have low rates under the misconception that all-important expectations will magically change.


  1. Help me out here TV. When I was taking economics back in the 1970s, we learned that the Fed could slow down the economy but if they slowed it down too much, they couldn't get it restarted again. The phrase was "pushing a string."

    So how is economics being taught differently so that you could believe that Fed policy could have any effect whatsoever in getting the country out of its current disaster--even if they had a LOT to do with causing the mess?

  2. Simple. As I've posted, there are roughly five or six things the Fed can do right now...
    (1) More QE -- just create money, and buy long-term bonds. This will reduce interest rates and borrowing costs, and will also reduce the value of the dollar. The most cutting edge research available says that yes, this will do something.
    (2) The Fed Funds rate is at .25, not zero, so it could still be cut slightly...
    (3) cut the discount rate, now at .75...
    (4) The fed could stop paying interest on reserves (which it should stop anyway). This is just free money for the banks, and encourages them not to lend out money.
    (5) Raise the inflation target to 2.5%.
    (6) Announce the Fed will do enough QE to actually hit its target.
    In addition, Bernanke could verbally support additional fiscal stimulus, or buy state government debt to make it easier for states to deficit spend...


  3. I am sure TV that everything you list would help a LITTLE. But to deal with the sort of structural problems we face--especially with unemployment--we are going need everything you want PLUS a fiscal stimulus of a LEAST $1 trillion a year for at least ten years.