Tyler Cowen wrote an excellent column on the dilemmas faced by our monetary policymakers. Tyler understands that it isn’t even 100% clear who our monetary policymakers actually are, or for that matter, who they should be. Should Congress set monetary policy, and have the Fed implement their policy? Should the President? Or should the Fed set policy?
Given my fanatical views on monetary policy, I’ll find plenty of little things to nit-pick, and one big thing to praise (which many readers might tend to gloss over.)
Tyler’s strength is his ability to translate complex ideas into simple and clear exposition. While reading the article I occasionally came across statements that I thought oversimplified the issue, or were perhaps slightly misleading. In each case, however, I couldn’t think of any other way to present the idea, without going way over the heads on the NYT readers. But you guys are much smarter, so I’ll present a few examples and ask you what you think:
Here’s the problem: The economy needs help, but monetary policy, which is the Fed’s responsibility, has not been very expansionary. This is true even though the Fed has increased the monetary base enormously since the onset of the financial crisis.
How can this be? Supplying more money did not actually result in enough additional spending. The debilitating financial shock of the last few years convinced many consumers and businesses that they needed to save more. So they are holding on to much of the new money.
Given this problem, there is a logical and seemingly simple move available to the Fed: just make people believe that it is seriously committed to increasing the rate of inflation. Traditionally, the Fed has focused on restraining inflation, not stoking it. But these are unusual times.
If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year.
I’d put it slightly differently. Almost all the new money created by the Fed is now held by banks (as excess reserves.) So it’s not quite right to say that the problem is that consumers and businesses are sitting on their wallets. Does this simplification do any harm? Perhaps not, but I do get a lot of conservative commenters complaining that I am trying to get Americans to save less and spend more. Not true. Keynesians are trying to get Americans to save less and spend more. I am trying to get Americans to consume more and save more. But most of all, I want them to reduce their demand for base money. I want them to hoard less cash, not save less income. That would increase NGDP, allowing both more saving and more consumption.
I’d be thrilled if people and banks started taking all that base money out from under cushions, or out from excess reserves, and started buying assets like bonds, stocks, commercial REITs, etc. Of course this “spending” isn’t consumption, it’s saving. But it would boost asset prices and increase investment in the economy. And that would be great. So I do have a slight fear that talking about the need for Americans to save less will send out the wrong message, especially to conservatives who have a well-justified instinctive feeling that one of America’s problems is that we don’t save enough. There’s never a bad time to save more, as long as you don’t increase your real demand for base money.
Tyler’s at his best when considering the issue of credibility:
In a self-fulfilling prophecy, the Fed could stimulate spending and the economy, and at no cost to the Treasury. Of course, if no one believes the Fed’s commitment to price inflation, spending and employment will not go up. The plan will fail, and people will view their skepticism as vindicated.
In other words, one of our economic problems can be solved, but only if we are willing to believe it can.
In a way this is true, but it tends to create an excessive sense of pessimism. The reader is left wondering how likely it is that Americans would expect higher inflation, merely because of an announcement by the Fed. But there’s more to it than that, as proponents of monetary stimulus also favor specific actions, such as negative IOR (Alan Blinder, me), quantitative easing (many of us), qualitative easing (Krugman), etc. There’s trillions of assets that the Fed could purchase. It is extremely unlikely that an aggressive move by the Fed would be met by indifference on Wall Street. And it is Wall Street’s reaction that matters most, not the views of a housewife in Dayton, Ohio. So the Tinkerbell-like comment “only if we are willing to believe it can” might be misunderstood by the average reader.
Just a few paragraphs later Tyler discusses a much more serious version of the credibility problem:
Part of the credibility problem stems from the political environment, especially in Congress. Imagine the day after the announcement of a plan for 3 percent inflation. Older people, creditors and workers on fixed incomes — all connected to powerful lobbies — would start to complain. Republicans would wonder whether they had found a new issue on which to campaign, namely, opposition to inflation. And Democrats would worry about what position to take. Presidents of some regional Fed banks would probably oppose the policy publicly.
Although the unemployed might prefer such a policy, they are not well-mobilized politically. And President Obama is himself politically weak at the moment, so he cannot offer the Fed much cover.
Can the Fed walk down this path without blinking? Perhaps not.
This is a good point, but it also highlights why we absolutely must stop talking about inflation targeting. Suppose the Fed were to say:
For several decades the total income of Americans rose by just over 5% a year, and we had a healthy economy. In the last two years there has been almost no growth in the total income of Americans. We are going to adopt a more expansionary monetary policy with the goal of faster growth in aggregate incomes. If Americans have more income, then they will be better able to service their debts, and the banking system will be in better shape. Because the economy current has a lot of slack, we believe that we can achieve 7% annual income growth over two years, and 5% thereafter, without pushing inflation above the 2% to 3% norm of recent decades.”
I ask you, which target would be easier to sell to the American people? Higher inflation, or higher incomes?
Here’s my favorite part of Tyler’s column:
Sadly, although Mr. Bernanke clearly understands the problem, the Fed hasn’t been acting with much conviction. This is understandable, because if the Fed announces a commitment to a higher inflation target but fails to establish its credibility, it will have shown impotence. It would be a long time before the Fed was trusted again, and the Fed might even lose its (partial) political independence. All of a sudden, the Fed would end up “owning” the recession.
I love that last sentence. I think the Fed is afraid of “owning” the business cycle, and always has been. But I’m not sure that it is merely because they have a fear of failure. Indeed before I thought about this issue, I might have expected exactly the opposite of what Tyler wrote. In an earlier post I pointed out that the Fed faced a very similar decision in late 1937. At the time there was criticism that the doubling of reserve requirements had reduced the money multiplier and triggered a recession, now there is criticism (by me and David Beckworth) that interest on reserves has reduced the money multiplier and triggered a recession. In the minutes of the November 1937 Fed meeting, one member all but admitted that the Fed was reluctant to reverse the increase reserve requirements, because that would be tantamount to admitting the Fed was guilty of triggering the recession. So they put their own reputation ahead of the public interest. (Yes, I know that powerful people often have trouble distinguishing between the two.)
I already believe the Fed “owns” this recession, but most people don’t. Suppose the Fed did everything I wanted, and it worked exactly as I thought it would work. Wouldn’t that cause more people to go back and re-examine what the Fed did in 2008? Perhaps a few people might start muttering ”perhaps Hetzel, Congdon, Sumner, Beckworth, Thompson, etc, were correct about 2008.”
So that was my initial reaction to Tyler’s comment. But on further reflection I think it may even be worse, Tyler’s interpretation might also be correct. Indeed I can see two arguments in his favor:
1. The mere fact that the Fed announced an intention to boost inflation, would suggest that the Fed thought they always had the power to do so, but were reluctant to pull out the “nuclear option” because they didn’t think the recession was that bad. Maybe (people would mutter) the Federal Reserve elite don’t personally know anyone who is unemployed.
2. And suppose the policy fails to boost inflation, would that let the Fed off the hook? I doubt it. Does anyone believe a determined central bank couldn’t produce Zimbabwe-style inflation, if it bought up the entire world stock of wealth? In all probability the Fed would fail without playing all their cards. They wouldn’t have done level targeting, or negative IOR, or unconventional QE (qualitative easing), or something. They’d be mocked; “What, are you guys so incompetent that you don’t even know how to debase your own currency? Even the Zimbabweans can to that!" No, failure would not be an option.
As much as I hate to admit it, I fear Tyler is right. The more aggressive the Fed’s move, the more “ownership” they’ll take for the recession. And that’s true whether they succeed or not. Indeed the only way it wouldn’t be true is if they did succeed in creating 3% inflation, but unemployment remained high. I think that’s very unlikely, and I’m pretty sure they do as well. So they are in a tight spot—just like in the 1930s. I hope they show more courage than the 1937 Fed.
And finally, Tyler’s column raises a very difficult political problem:
The Federal Open Market Committee, which votes on monetary policy, has three open seats — a situation that may be hindering the taking of decisive action. The Senate has not been willing to hold a confirmation vote on Mr. Obama’s nominations. But filling the seats is not enough; somehow, Fed officials have to believe that Congress is firmly on their side.
In failing to push harder for monetary expansion, is Mr. Bernanke a wise and prudent guardian of the limited discretionary powers of the Fed? Or is he acting like a too-hesitant bureaucrat, afraid to fail and take the blame when he should be gunning for success?
We still don’t know which narrative is more accurate, but the Fed is not receiving enough signals of support from Congress.
The very fact that Congress and the President are ignoring this issue, pretty much tells me that they are clueless on monetary policy. On the other hand, both groups do favor more AD, so their “heart” is in the right place. And of course I’m a big believer in democracy. So who do I favor making the decisions; the clueless or the heartless? I’m tempted to say “Whoever agrees with me; first tell me the target Congress would set.” But of course that’s cheating. The honest answer is that I don’t know. But it is becoming increasingly clear that we won’t get good policy until this dilemma is resolved.