Is Bernanke Just Taking Shots In The Dark?

by: Brad DeLong

Alan Blinder says "Ben Bernanke Deserves a Break":

Try putting yourself in Ben Bernanke's shoes, which by now must be feeling about two sizes too tight. The Federal Reserve chairman walked into last week's meeting of the Federal Open Market Committee (FOMC) knowing that:

  • The U.S. economy is extremely weak—certainly not growing fast enough to make a dent in the unemployment rate. And serious dangers lurk in Europe.
  • With the president and congressional Republicans at loggerheads as usual, it is unlikely that the economy will get much help from fiscal policy.
  • Financial markets were fully expecting some version of "Operation Twist," under which the Fed buys longer-term Treasury securities and sells shorter-term ones. (The objective of "twisting" is to flatten the yield curve by pulling down long-term interest rates relative to short ones.)
  • Market participants wanted the Fed to do even more than "twist," which they viewed (correctly) as a relatively weak weapon. If the FOMC didn't deliver some additional kicker, it risked a Bronx cheer from the markets.
  • The Fed's bag of tricks, while certainly not empty, didn't have any show-stoppers left in it. Any remaining influence of monetary policy on the economy was bound to be modest. Not zero, but modest.
  • Any proposal to ease monetary policy further would likely provoke dissenting votes from Federal Reserve bank presidents Richard Fisher (Dallas), Narayana Kocherlakota (Minneapolis), and Charles Plosser (Philadelphia), the same trio that dissented at the August FOMC meeting.
  • Four Republican leaders in Congress—Mitch McConnell, Jon Kyl, John Boehner and Eric Cantor—had just sent Mr. Bernanke an unfriendly and amazingly ill-timed letter, expressing "reservations" about any "additional monetary stimulus proposals" and urging the Fed to "resist further extraordinary intervention in the U.S. economy."

So as Chairman Bernanke convened the FOMC on Tuesday morning, Sept. 21, only two things were at stake: the health of the U.S. economy and the independence of the Federal Reserve. Does that seem like enough to worry about?

What did Mr. Bernanke decide to include in the package that will presumably be called QE3? Ignoring both the internal dissent and the clear hostility in the congressional letter (not to mention Texas Gov. Rick Perry's reckless accusations of treason), he went ahead with the "twist" idea... a slightly larger twist program than the markets expected. Between now and June 2012, the Fed will buy $400 billion of Treasury securities with maturities between six and 30 years, and sell an identical amount of shorter-term Treasurys.... For more than a year now, the Fed has been allowing its portfolio of agency debt (e.g., Fannie Mae and Freddie Mac) and mortgage-backed securities (MBS) to shrink naturally.... But starting "now" (the Fed's word), and continuing indefinitely, those proceeds will be reinvested in agency bonds and MBS instead....

I was a huge and enthusiastic supporter of QE1, which concentrated on MBS, but only a lukewarm supporter of QE2's Treasury purchases....

Mr. Bernanke has apparently decided that he can live with 7-3 votes on the FOMC—which, fortunately, seem not to have undermined market confidence in the Fed. Expect Messrs. Fisher, Kocherlakota and Plosser to dissent again, if policy is eased further: 7-3 is the new normal...

To look at the graph above and conclude that the Federal Reserve has strived mightily to boost aggregate demand may be the wrong way to look at it. The way the Fed affects the economy is by swapping assets that people have little inclination to try to trade away for currently produced goods and services for assets that people have more inclination to try to trade away for same. It puts more assets that people have an inclination to trade away in the hands of the private sector, and you boost planned spending.

To assess what the Federal Reserve's net position is, you have to multiply the size of the monetary base by the per-unit inclination to spend. What is the per-unit inclination to spend? We usually say that it is the three-month T-bill rate, in which case the per-unit inclination to spend is now zero. But that is not right, because the assets that the Federal Reserve's bond purchases have taken out of the private sector's portfolio are not all three-month Treasury bills.

Suppose that the center of gravity of the Federal Reserve's portfolio is roughly the interest rate of a 5-year Treasury bond. Then if you calculate the incentive to spend--the foregone interest from holding the monetary base rather than the assets the Federal Reserve has bought--you get a picture of the net monetary impetus from the Federal Reserve that looks like this:

Microsoft Excel

If this is the right way to do the calculation--and I am not at all sure that it is--we get a rather different story than the one usually told. Yes, monetary policy turns expansionary at the end of 2008 in response to the financial crisis:

Microsoft Excel 1

But since then the Federal Reserve looks as though it has allowed monetary conditions to tighten and loosen depending on what happens to interest rates--depending on the movements of "animal spirits"--rather than effectively leaning against the wind.