Too Little, Too Late?

The FOMC, after over four years of overly tight monetary policy, seems to be feeling its way toward an easier policy stance. But will it do any good? Unfortunately, there is reason to doubt that it will. The FOMC statement pledges to continue purchasing $85 billion a month of Treasuries and mortgage-backed securities and to keep interest rates at current low levels until the unemployment rate falls below 6.5% or the inflation rate rises above 2.5%. In other words, the Fed is saying that it will tolerate an inflation rate only marginally higher than the current target for inflation before it begins applying the brakes to the expansion. Here is how the New York Times reported on the Fed announcement.

The Federal Reserve said Wednesday it planned to hold short-term interest rates near zero so long as the unemployment rate remains above 6.5 percent, reinforcing its commitment to improve labor market conditions.

The Fed also said that it would continue in the new year its monthly purchases of $85 billion in Treasury bonds and mortgage-backed securities, the second prong of its effort to accelerate economic growth by reducing borrowing costs.

But Fed officials still do not expect the unemployment rate to fall below the new target for at least three more years, according to forecasts also published Wednesday, and they chose not to expand the Fed’s stimulus campaign.

In fairness to the FOMC, the Fed, although technically independent, must operate within an implicit consensus on what kind of decisions it can take, its freedom of action thereby being circumscribed in the absence of a clear signal of support from the administration for a substantial departure from the terms of the implicit consensus. For the Fed to substantially raise its inflation target would risk a political backlash against it, and perhaps precipitate a deep internal split within the Fed’s leadership. At the depth of the financial crisis and in its immediate aftermath, perhaps Chairman Bernanke, if he had been so inclined, might have been able to effect a drastic change in monetary policy, but that window of opportunity closed quickly once the economy stopped contracting and began its painfully slow pseudo recovery.

As I have observed a number of times (here, here, and here), the paradigm for the kind of aggressive monetary easing that is now necessary is FDR’s unilateral decision to take the US off the gold standard in 1933. But FDR was a newly elected President with a massive electoral mandate, and he was making decisions in the midst of the worst economic crisis in modern times. Could an unelected technocrat (or a collection of unelected technocrats) take such actions on his (or their) own? From the get-go, the Obama administration showed no inclination to provide any significant input to the formulation of monetary policy, either out of an excess of scruples about Fed independence or out of a misguided belief that monetary policy was powerless to affect the economy when interest rates were close to zero.

Stephen Williamson, on his blog, consistently gives articulate expression to the doctrine of Fed powerlessness. In a post yesterday, correctly anticipating that the Fed would continue its program of buying mortgage backed securities and Treasuries, and would tie its policy to numerical triggers relating to unemployment, Williamson disdainfully voiced his skepticism that the Fed’s actions would have any positive effect on the real performance of the economy, while registering his doubts that the Fed would be any more successful in preventing inflation from getting out of hand while attempting to reduce unemployment than it was in the 1970s.

It seems to me that Williamson reaches this conclusion based on the following premises. The Fed has little or no control over interest rates or inflation, and the US economy is not far removed from its equilibrium growth path. But Williamson also believes that the Fed might be able to increase inflation, and that that would be a bad thing if the Fed were actually to do so.  The Fed can’t do any good, but it could do harm.

Williamson is fairly explicit in saying that he doubts the ability of positive QE to stimulate, and negative QE (which, I guess, might be called QT) to dampen real or nominal economic activity.

Short of a theory of QE – or more generally a serious theory of the term structure of interest rates – no one has a clue what the effects are, if any. Until someone suggests something better, the best guess is that QE is irrelevant. Any effects you think you are seeing are either coming from somewhere else, or have to do with what QE signals for the future policy rate. The good news is that, if it’s irrelevant, it doesn’t do any harm. But if the FOMC thinks it works when it doesn’t, that could be a problem, in that negative QE does not tighten, just as positive QE does not ease.

But Williamson seems a bit uncertain about the effects of “forward guidance” i.e., the Fed’s commitment to keep interest rates low for an extended period of time, or until a trigger is pulled e.g., unemployment falls below a specified level. This is where Williamson sees a real potential for mischief.

(1)To be well-understood, the triggers need to be specified in a very simple form. As such it seems as likely that the Fed will make a policy error if it commits to a trigger as if it commits to a calendar date. The unemployment rate seems as good a variable as any to capture what is going on in the real economy, but as such it’s pretty bad. It’s hardly a sufficient statistic for everything the Fed should be concerned with.

(2)This is a bad precedent to set, for two reasons. First, the Fed should not be setting numerical targets for anything related to the real side of the dual mandate. As is well-known, the effect of monetary policy on real economic activity is transient, and the transmission process poorly understood. It would be foolish to pretend that we know what the level of aggregate economic activity should be, or that the Fed knows how to get there. Second, once you convince people that triggers are a good idea in this “unusual” circumstance, those same people will wonder what makes other circumstances “normal.” Why not just write down a Taylor rule for the Fed, and send the FOMC home? Again, our knowledge of how the economy works, and what future contingencies await us, is so bad that it seems optimal, at least to me, that the Fed make it up as it goes along.

I agree that a fixed trigger is a very blunt instrument, and it is hard to know what level to set it at. In principle, it would be preferable if the trigger were not pulled automatically, but only as a result of some exercise of discretionary judgment by the part of the monetary authority; except that the exercise of discretion may undermine the expectational effect of setting a trigger. Williamson’s second objection strikes me as less persuasive than the first. It is at least misleading, and perhaps flatly wrong, to say that the effect of monetary policy on real economic activity is transient. The standard argument for the ineffectiveness of monetary policy involves an exercise in which the economy starts off at equilibrium. If you take such an economy and apply a monetary stimulus to it, there is a plausible (but not necessarily unexceptionable) argument that the long-run effect of the stimulus will be nil, and any transitory gain in output and employment may be offset (or outweighed) by a subsequent transitory loss. But if the initial position is out of equilibrium, I am unaware of any plausible, let alone compelling, argument that monetary stimulus would not be effective in hastening the adjustment toward equilibrium. In a trivial sense, the effect of monetary policy is transient inasmuch as the economy would eventually reach an equilibrium even without monetary stimulus. However, unlike the case in which monetary stimulus is applied to an economy in equilibrium, applying monetary policy to an economy out of equilibrium can produce short-run gains that aren’t wiped out by subsequent losses. I am not sure how to interpret the rest of Williamson’s criticism. One might almost interpret him as saying that he would favor a policy of targeting nominal GDP (which bears a certain family resemblance to the Taylor rule), a policy that would also address some of the other concerns Williamson has about the Fed’s choice of triggers, except that Williamson is already on record in opposition to NGDP targeting.

In reply to a comment on this post, Williamson made the following illuminating observation:

Read James Tobin’s paper, “How Dead is Keynes?” referenced in my previous post. He was writing in June 1977. The unemployment rate is 7.2%, the cpi inflation rate is 6.7%, and he’s complaining because he thinks the unemployment rate is disastrously high. He wants more accommodation. Today, I think we understand the reasons that the unemployment rate was high at the time, and we certainly don’t think that monetary policy was too tight in mid-1977, particularly as inflation was about to take off into the double-digit range. Today, I don’t think the labor market conditions we are looking at are the result of sticky price/wage inefficiencies, or any other problem that monetary policy can correct.

The unemployment rate in 1977 was 7.2%, at least one-half a percentage point less than the current rate, and the cpi inflation rate was 6.7% nearly 5% higher than the current rate. Just because Tobin was overly disposed toward monetary expansion in 1977 when unemployment was less and inflation higher than they are now, it does not follow that monetary expansion now would be as misguided as it was in 1977. Williamson is convinced that the labor market is now roughly in equilibrium, so that monetary expansion would lead us away from, not toward, equilibrium. Perhaps it would, but most informed observers simply don’t share Williamson’s intuition that the current state of the economy is not that far from equilibrium. Unless you buy that far-from-self-evident premise, the case for monetary expansion is hard to dispute.  Nevertheless, despite his current unhappiness, I am not so sure that Williamson will be as upset with what the actual policy that the Fed is going to implement as he seems to think he will be.  The Fed is moving in the right direction, but is only taking baby steps.

PS I see that Williamson has now posted his reaction to the Fed’s statement.  Evidently, he is not pleased.  Perhaps I will have something more to say about that tomorrow.

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7 Responses to “Too Little, Too Late?”

  1. 1 JP Koning December 13, 2012 at 10:45 am

    Good post, David.

    “However, unlike the case in which monetary stimulus is applied to an economy in equilibrium, applying monetary policy to an economy out of equilibrium can produce short-run gains that aren’t wiped out by subsequent losses.”

    Just to add some food for thought, here’s an old comment by Stephen Williamson on the out-of-equilibrium concept:

    “Some people had what I thought were confused notions of equilibrium. In other cases, as in the link you mention, there are people concerned about disequilibrium phenomena. These approaches are or were popular in Europe – I looked up Benassy and he is still hard at work. However, most of the mainstream – and here I’m including New Keynesians – sticks to equilibrium economics. New Keynesian models may have some stuck prices and wages, but those models don’t have to depart much from standard competitive equilibrium (or, if you like, competitive equilibrium with monopolistic competition). In those models, you have to determine what a firm with a stuck price produces, and that is where the big leap is. However, in terms of determining everything mathematically, it’s not a big deal. Equilibrium economics is hard enough as it is, without having to deal with the lack of discipline associated with “disequilibrium.” In equilibrium economics, particularly monetary equilibrium economics, we have all the equilibria (and more) we can handle, thanks.”

  2. 2 Benjamin Cole December 13, 2012 at 10:05 pm

    Thoughtful blogging.

    I do not see how QE can only cause inflation. That just does not make sense.

    It first has to cause growth (given a reasonable amount of competition).

    When the Fed prints (digitizes) money and buy bonds, the bond-sellers must either spend the money (good) or invest in other assets (good).

    If they put the money into banks, and banks hide it, then we are wiping out trillions in national debt without any inflationary costs. Good.

    The scare story is that suddenly banks lend out al the money they have stored up, and boom-boom we have inflation and no growth. This does not make sense. You first have to get accelerated growth.

    I don’t understand what Stephen Williamson wants.

    Where is the downside to QE?

    The problem with the Fed’s QE program is that it is too timid, as David G. says.

  3. 3 Benjamin Cole December 14, 2012 at 3:45 am

    Some more thoughts.

    Seems like the Fed’s outright buying of another $45 billion a month in Treasuries is more expansionary than just net zero selling and bonds of different maturities.

    Added onto the MBS buying, we are at $85 billion a month in Fed buying, or roughly $1 trillion a year. That used to be considered serious money.

    If this “accomplishes nothing” as many say, then the Fed is wiping out $1 trillion a year in debt, at no cost to taxpayers (eventually, the MBS has to be sold or held to maturity, reaping gains for taxpayers).

    As I have argued, it seems better government at this point to place the Fed into the Treasury Department. For one, it has become a huge revenue generator, and may be for decades. No one knows how long QE will replace lower interest rates as the Fed policy tool of default. Japan’s case suggests decades is not impossible.

    For two, the voters are mystified by this opaque, independent agency that is governing their lives. Public agencies always want to be independent and opaque. That is a recipe for bad government. Indeed, this is the result.

    By placing the Fed within he Treasury, and making the Fed Chief’s terms coterminous with the President’s, we revert back to democratic control of our most powerful microeconomic policy making body.

    FOMC should be televised on CSPAN, and have a moderated one-hour Q/A session to cap.

    The voters then could demand clarity on Fed policies and intentions, or not, as they choose.

    We would (I hope) see presidential aspirants in campaigns reveal their monetary policies. In this last cycle, one would have thought there was no such thing as monetary policy.

  4. 4 phil December 14, 2012 at 7:46 am


    In another post (“The Money Multiplier, RIP?”) you said:

    “Every deposit is a promise to pay the bearer something else outside the control of the creator of the deposit. That something is base money. Under a fiat money system, it is a promise to pay currency. Under a gold standard, it was a promise to pay gold, coin or bullion. This distinction is captured by the distinction between inside money (deposits) and outside money (currency).”

    I agree with this but am having difficulty convincing someone else that this is the case. They have some very odd ideas about money.

    Do you know where I might find another ‘authoritative’ statement/explanation of this fact (that deposits are promises to pay currency)?


  5. 5 David Glasner December 15, 2012 at 6:31 pm

    JP, Thanks for your comment and for providing the quotation from Williamson which provided the basis for my next post.

    Benjamin, Just to take Williamson’s side for a brief moment, I think that he has said that he worries that that once inflation starts, the Fed will be unable or unwilling to respond decisively to nip it in the bud. He also makes a slippery slope argument that once you accept a little bit of inflation, you will always face a tradeoff between a little bit more inflation and little more unemployment and once you set the precedent of choosing inflation over unemployment, you will never be able to stop, or at least not until inflation reaches socially intolerable level as it did in the late 70s and early 1980s. I think that is a legitimate concern, but not when we have 1-2% inflation and 8% unemployment.

    About bringing the Fed under the control of the government, you make a good argument. It goes against the dogma of an independent central bank, which many of us have learned to accept as foundational. Perhaps we need to rethink it. As I suggested in my post, an unelected Fed official may be unable to take the really daring steps that are called for in a crisis to avoid a prolonged depression. On the other hand, do we want monetary policy to become a matter of partisan politics? That could also lead to a nasty state of affairs. We need to think more about this.

    phil, I discuss this in my book Free Banking and Monetary Reform. The distinction goes back at least to a book by Gurley and Shaw Money in a Theory of Finance. There is also a recent short paper by Richard Lagos “Inside and Outside Money,” prepared for the New Palgrave Dictionary of Economics (2nd edition).

  1. 1 Thursday Morning Links | Iacono Research Trackback on December 13, 2012 at 5:07 am
  2. 2 What Kind of Equilibrium Is This? « Uneasy Money Trackback on December 14, 2012 at 9:55 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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