Jackson Hole is Here

Always dangerous to make a prediction of an event which is very close to happening, but I think Krugman has it correct -- whatever Bernanke announces today it will be too little. And, the underwhelming nature will be be immediately apparent. If I were Fed Chair, I would announce that short-term rates would stay at zero through the middle of 2013 no matter what, that I would allow temporary (but only very mild) overshooting of the 2 percent inflation target, that I would cut the Federal Funds rate all the way to zero, that I would cut the discount rate to .5. And none of this involves the "controversial" QE, which Bernanke could, and should, also adjust upward.

I disagree with Krugman on the importance of political pressure from the right. Here's a revelation: although obviously the criticism of Bernanke coming from the right is backwards, the criticism actually comes because Bernanke has done a poor job guiding the economy. If the economy were increasing at a 4 percent annual rate, I think we would find generally less criticism of Bernanke, and more support and pushback on fringe critiques from the media at large. And deservedly so.

What really is holding back Ben Bernanke is the five other Republicans on the FOMC, and the even the Democrats on the committee, not all of whom have been vocal supporters of less passive monetary policy -- even in private.

Also, I think the Woodford opinion piece in the FT was a bit off-base. If doing more QE were a mistake, it really would be only for political reasons, and Woodford is profoundly wrong to suggest otherwise.

Look, QE works, in part, because market participants see that if the Fed is being more aggressive buying more bonds over the next six months, then it's unlikely that they will raise rates anytime soon to fight inflation. In other words, it affects expectations about the future. The logic that more QE "just ends up as excess reserves" may sound true, but is deeply flawed. Look, Treasuries are just assets -- like any other assets. Suppose the Fed were to buy up all the Treasuries on the planet. Doing so would almost certainly lead to negative interest rates. As yields fell, yes, more money would be held at the Fed as excess reserves, but also some of it would slosh over into corporate bonds, the stock market, and other assets, such as real estate. And lower long-term yields would reduce borrowing costs.

In addition, as this blog has stated repeatedly, whenever QE has been announced, it has made an impact on prices. This is evidence that QE works.

Woodford writes that "The problem is that, for this theory [QE] to apply, there must be a permanent increase in the monetary base." But of course, that isn't literally true. If the Fed started now buying up all of the Treasuries on the planet, yields would fall -- probably the moment such a plan was announced. The need for such purchases to be irreversible is a purely imaginary need born of Woodford taking his play economic models too seriously, but more probably misunderstanding them. The guy might be a great theoretician, but his insights do not transfer to the conduct of real world economic policy.

To show QE "doesn't work" he writes about how Japan's experiment failed because it wasn't permanent. But Japan never actually did much QE at all -- just $300 billion, and then reversed it when their economy got better. Now, although I am a major proponent of QE, I think they did too little for it to have worked, but as soon as they reversed it, their economy did slip into recession. Hence, there's absolutely nothing you can point to from the Japanese dealings with QE which would lead you to conclude that QE doesn't work.

Woodford also sees harm in more QE: "But a further round of easing could actually do harm, by giving policymakers an excuse to avoid taking actions that would do more to help the economy." I think this ignores the political dynamic in the Congress -- the Republican party has every incentive to see that economic growth is dismal next year.

Instead, Woodford tells us that what we need is "clarity" from the Fed. But the Fed has already been clear -- it will act if we face an actual recession. Decades of Japan-style slow growth are just fine. I don't really agree with Woodford that the Fed's become harder to read... they've been pretty predictable thus far. Perhaps Bernanke will prove me wrong?