Wonky Fed Post (hip waders advised)

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?

And:

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.

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