Wonky Fed Post (hip waders advised)Posted: April 29, 2011
The Fed’s been doing some pretty nontraditional things recently under Ben Bernanke. A lot of this was not unexpected given his record of academic research on the subject of the Fed trying to be more public about its actions and the role of Quantitative Easing in Japan’s lost decade recovery. I thought I’d put a few things up about both. I’m going to have to use some monetarist jibber jabber so please ask questions if the jargon is overwhelming! It’s easier to explain the jargon downthread than write a long run on post with explanations included.
The Roosevelt Institute held a Future of the Federal Reserve Event. Here’s video via RortyBomb of Joseph Stiglitz discussing QE2 among other Fed issues. I mentioned something yesterday down thread about the effectiveness of transmission of monetary policy through the traditional interest rate channel into the real economy and Stiglitz has a fairly succinct comment on that. There is some debate on how much the Fed can actually do much at this point–with zero bound interest rates–to get at unemployment and even the inflation coming from higher oil and food prices. We know it can happen, it’s just we don’t have empirical evidence under similar situations–other than from Japan–to know the degree to which stuff can happen right now. So it could be an infinitesimally positive effect even thought it’s a positive effect.
There’s been some discussion of this on economists’ blogs since the Bernanke Presser a few days ago. Mark Thoma tweeted this critique of both him and Brad Delong on the Bernanke Presser from a monetarist’s site from blogger economist Stephen Williamson. My first masters was in Monetary Economics so I’m well-steeped in monetarist theory.
In standard form, Mark Thoma’s heartgoes out to the unemployed, as mine does. However, Mark is much more certain than I am that the Fed can actually help these people out. Here is what Mark would have asked Ben about, if he could:
The main question I wanted to hear Bernanke answer is, given that inflation is expected to remain low, why isn’t the Fed doing more to help with the employment problem? Why not a third round of quantitative easing?
In retrospect, more aggressive action by the Fed was warranted in every instance. Perhaps this time is different — I sure hope so — but the recovery has been far too slow to be tolerable. Green shoots require more than hope, they require the nourishment, and with fiscal policy out of the picture it’s up to the Fed to provide it.
Well, the answer to the question: “Why not a third round of quantitative easing?” should be: “Because it does not do anything.” (see here). In retrospect, the Fed could not have done any more than it did, even if you think that sticky wages and prices matter in a big way. Mark may think that the level of employment is intolerable, but the Fed has to tolerate it in the same way I have to tolerate the soggy weather outside.
I wanted to put this up before I linked to Krugman’s Op-Ed today which argues that Bernanke may be unduly influenced by inflationistas and Ron Paul, of all people called “The Intimidated Fed” and that he can do more. Because, I’m not so sure the FED can do much more or if it’s Ron Paul that’s the dragon needing slaying. First, I think it more like that Bernanke is being influenced by two Fed Presidents sitting on the Board of Governors right now than by Ron Paul. But, I’m not a DC or FED insider so it’s pure speculation on my part.
Some background: The Fed normally takes primary responsibility for short-term economic management, using its influence over interest rates to cool the economy when it’s running too hot, which raises the threat of inflation, and to heat it up when it’s running too cold, leading to high unemployment. And the Fed has more or less explicitly indicated what it considers a Goldilocks outcome, neither too hot nor too cold: inflation at 2 percent or a bit lower, unemployment at 5 percent or a bit higher.
But Goldilocks has left the building, and shows no sign of returning soon. The Fed’s latest forecasts, unveiled at that press conference, show low inflation and high unemployment for the foreseeable future.
True, the Fed expects inflation this year to run a bit above target, but Mr. Bernanke declared (and I agree) that we’re looking at a temporary bulge from higher raw material prices; measures of underlying inflation remain well below target, and the forecast sees inflation falling sharply next year and remaining low at least through 2013.
Meanwhile, as I’ve already pointed out, unemployment — although down from its 2009 peak — remains devastatingly high. And the Fed expects only slow improvement, with unemployment at the end of 2013 expected to still be around 7 percent.
It all adds up to a clear case for more action. Yet Mr. Bernanke indicated that he has done all he’s likely to do. Why?
Second, I’m not sure Bernanke (i.e. The FED) is in a very strong position to do much that can influence the real economy right now. The QE stuff really only shifts the FED portfolio around between long and short term debt which can influence yield curves, but, at the zero bound, there’s still a limited impact on real interest rates. You really can’t go lower than zero in nominal terms. Also, the FED’s bought all this crap from every one from Belgian cities to AIG to give them more liquidity and for the most part, that money’s not channeling back into the US economy in the forms of loans. Monetary policy is never very effective when an economy is in a liquidity trap (extremely low interest rates) and its transmission channel–the way the policy gets to the real economy where GDP lurks–morphs during various economic conditions. We’re not seeing anything resembling 20th century economic conditions.
What I mean by ’20th century economic conditions’ is this. We’re experiencing an incredible outflow of jobs, investment funds, lending, etc to other parts of the world where frankly, the economic outlook is much better. Plus, their cheap stuff is flooding our market here. So, the first question to ask is whose economy is actually getting the stimulation? China and other ASEAN+3 places are experiencing inflation and their policies as well as ours are most likely at the root. We may very well be exporting the inflation as well as the investment dollars and jobs. Second, we’ve never had interest rates so close to zero (i.e. at the zero bound). This is still relatively new territory and we don’t have the empirical evidence to estimate the size of things like the money multiplier or the shape of the Money Demand curve changes shape around a liquidity trap. (I warned you this would be wonky.) A liquidity trap basically means that interest rates are so low that who ever really wants to borrow has already done so. That means you can’t urge any more people to borrow just based on interest rate manipulation. Again, the rate of change along demand curves means things can change by leaps and bounds or hardly at all even though the basic relationship stays positive or negative.
This brings me back to the ‘real’ sector of goods and services. We have a lot of householders who don’t feel that we’re out of a recession. There’s the psychological effect too of having lost your wealth via lower house prices and you’re still watching the high unemployment rate. Then, there’s businesses who aren’t about to expand and borrow whatever the tax rates or the interest rates because they don’t have enough customers to generate a decent, reliable cash flow. Believe it or not, it’s still customer purchases that drive businesses!
The problem at the moment is not the monetary policy. It’s the fiscal policy. Krugman says that “Goldilocks has left the building”. Well, in terms of fiscal policy, the three bears never came back to the building. We had a bit of stimulus in the Obama stimulus of 2009 that stopped some of the future hemorrhaging of federal and state functions. That’s gone. The rest of it was nonsensical tax cuts which we just got more of in December, 2010. It’s not completely translating into madcap household spending because–again–see the point above. This isn’t the 20th century US economy and this wasn’t your father’s Great Depression. People are nervous and worried, they’ve lost wealth, and they’re still madly unsure about their jobs. Plus, they now are paying more for food and gas. They also have less faith in the last two governments than the ever did under FDR. I’m going to sound like a old-school Keynesian, but those animistic spirits matter!
So, I don’t think we’ve reached a point where the Fed can basically maintain a course. This doesn’t exactly let Bernanke off the hook, believe me. What my arguments should do is put those responsible for fiscal policy–the White House and Congress–back on the hook. We’ve had miserable fiscal policy for about 10 years now. As a result, we’ve had two miserable recoveries and shameful job markets. We’ve also had an explosion of exotic investments in nonstandard markets and financial institutions that have caused high risk, market instability, and incredible variation in financial returns. The biggest thing that the Fed could do right now is push for better laws that give it better ability to regulate this mixed up set of financial institutions that we now have with their opaque, information-asymmetric riddled grab bag of financial innovations. They need to offset the banking lobbyists who are pushing to remove what little was done in Dodd-Frank.
There’s something to be said for arguing that banking is really like a public utility and not like other types of businesses. If we’re going to bail them all out like they’re so important to the economy they can’t fail, they we need to start regulating them in that same way with that same realization. It might be time to force lenders to lend and get them out of the business of casino-like speculation. It’s also time for Congress and the President to go to fiscal policy school and learn what’s what about basic economics.
Just a wonky bunch of thoughts from a bayou dwelling economist.
Oh, and if you want to read something else on the Fed’s Options, here’s one I just found: For the Fed, a Narrowing of Options. The squeezin’ is not making the eagle grin …
This week, even as the Fed was lowering its forecast for economic growth in 2011, it was also lowering its expectations for unemployment. It had no choice. Back in January the consensus among Fed officials was that the unemployment rate would be 8.8 to 9 percent in the final quarter of 2011. It has already fallen to 8.8 percent, and the new consensus, of 8.4 to 8.7 percent, could be far too pessimistic if companies mean what they say about hiring.