Sunday, September 11, 2011

Is the Fed out of bullets? Can/Should it do more?

a friend asks...

First off, I certainly do believe the Fed is by no means out of bullets. This is, of course, a longstanding debate -- originally it was Keynes vs. Milton Friedman -- on whether monetary policy can be effective in a liquidity trap. The demand for money has increased a lot, which means declining velocity and a money multiplier less than one. More monetary stimulus in the form of quantitative easing tends to wind up back at the Fed in the form of excess reserves. This clearly makes the going more difficult, and since the Fed is not used to managing the economy except by using the Federal Funds rate, any economy that is very nearly liquidity-trapped could benefit from fiscal stimulus. Yet, the impact of QE is clearly greater than zero -- every time it has been announced, in the US and elsewhere, it has made an impact on markets -- exchange rates and bond yields, which is enough evidence to know that it "works". Recently, even when the Fed has merely hinted at doing more, the markets have responded in a big way. In addition, the Fed has a number of other options at it's disposal, virtually all of which have already been proven to move the dial. I.e., they could cut the discount rate. (When they foolishly raised this rate to .75 in the beginning of 2010, the dollar strengthen and borrowing costs rose...) They could cut the Federal Funds rate all the way to zero (everyone agrees this works...). They could target the longer rates instead of doing QE. And they could promise to keep the Federal Funds rate at zero through the middle of 2013 -- no matter what (the recent language, far weaker, had a big impact on markets...). They could, and should, announce that their inflation target is 2% (not at or just below 2%), and that they will do whatever necessary to hit that rate. They could raise their inflation target to 2.5% (or higher). They could set a nominal GDP target. Or announce that they, like the Australians, will do "price level targeting" where, if inflation is below there target, as it has been for years, they will try to overshoot it so that on average they hit their target. They could try to flatten the yield curve "Operation Twist", or trade their short-term treasuries for agency/sub prime debt. They could target a weaker dollar (although this is usually thought to be Treasury's job, and I wouldn't necessarily recommend this, but it's a clear option). And they could cut the interest rate they pay to banks to hold reserves at the Fed, or even go negative. That's already 14 different things the Fed could do, and all of them are more-or-less proven. Now, this may all seem fairly obvious, and it is, but you'd be surprised at how many top economists, including, unfortunately, those on the FOMC, do not grasp this, and equally surprising how often you read that the Fed is almost out of bullets, with no actual evidence in support of such a thesis:

Re: Do we want the banks to lend? In short, yes, we do. A related question is: Do we really want consumers to spend? Obviously, consumers borrowed too much and need to pay down their loans. But when they all try to save at once, no one is spending, and then incomes are falling and consumers need to increase their savings rate even more... Same holds true for the banks. If none of the banks are lending, then consumers aren't taking out loans to buy houses, and then the economy is depressed and more houses are underwater and more mortgages are in foreclosure... Paying interest to banks on Fed holdings was probably meant as a back-door bank bailout. This isn't quite as atrocious as it sounds -- good banking regulations usually give banks both carrots and sticks -- easy, but limited profits but stiff regulations to ensure the stability of the system, and this is probably meant to be one of the carrots. Given the macro benefits, I don't think cutting the rate paid to banks would necessarily be negative on net for the banks, but I also think the Fed should do a range of things at once -- use language, cut the Federal Funds rate to zero, cut the discount rate, announce an inflation target of 2.5%, promise to hit that target, etc. If the Fed stimulated the economy, and inflation became a problem, the Federal Reserve, once again, has no shortage of weapons with which to fight inflation. Worrying about inflation now is exactly like having your house catch fire and worrying about the carpets getting wet when the fire trucks show up... For example, one thing the Fed could do, if the banks start to lend out too much of their excess reserves, is simply for the Fed to raise its reserve requirements. This would stabilize banking and reduce inflation. But thinking about exit strategies now seems premature... We're Japan, and just like Japan we are likely to have a depressed economy indefinitely, unless monetary policy suddenly gets better, which just isn't in the cards for this group of FOMC members.