1 Small Step For Macro Policy, 1 Giant Leap For The Fed

by: Scott Sumner

The blogosphere (including my comment sections) is full of commentary on the likely effectiveness of the recent Fed policy initiative. I've already offered my opinion, but I'd like to use some analogies here, as it's hard to grasp how a policy can be both a big deal, and also way too little. Imagine a general was sending his troops into battle with bow and arrows, and having no success. Then he returns the next day with submachine guns. That would be a pretty effective change in strategy, wouldn't you say? But suppose that he still has cruise missiles and tactical nuclear warheads back at the base. You'd still say the general had brought less than 10% of his firepower into battle.

The Fed hasn't even come close to pulling out the big guns, which would include:

1. Level targeting, to make up for shortfalls.

2. Targeting the forecast; doing very aggressive QE until NGDP expectations are right on target.

On the other hand they seem to have taken at least two important initiatives. And just as guns are much more powerful that arrows, these Fed tools are much more powerful than previous policies:

1. Making the size of QE conditional on actual progress on the jobs/inflation front.

2. Promising to keep policy expansionary for an extended period, even after the economy has recovered.

I speculated that the second policy is a sort of "dog whistle" to the markets-trying to convince them that the Fed would allow slightly above 2% inflation, without formally stating that goal (for fear of setting off the Tea Party.) Baby steps toward level targeting. Obviously that's a tricky maneuver, and I have no idea if it will work. Bernanke was asked how the Fed would react to above 2% inflation, and indicated that they would bring it down gradually, in a way consistent with their high employment mandate. They aren't aiming for high inflation, but they won't get overly excited if it exceeds 2% for a modest period of time. Sort of like when the government said they weren't trying to assassinate Saddam, but wouldn't be overly concerned if he happened to die in a bombing raid.

Ryan Avent suggested that this policy is a test of the ideas that market monetarists have been promoting. I agree. Where I'd differ is that in my view the results are already in on the NGDP front. The policy succeeded in raising NGDP expectations, but failed to raise them enough to make a dramatic impact on the business cycle. (I'd guess 0.3% to 0.5% as a ballpark figure for the boost to NGDP expectations.)

There's another aspect to market monetarism, the claim that more NGDP would lead to more RGDP. Although we have pretty good proxies for NGDP expectations, I don't think our RGDP expectations proxies are nearly as good.

[Which is a disgrace. If we had both types of futures markets, both the MMTers and John Cochrane's macro views would be refuted within 10 minutes of the Fed announcement.]

So we'll have to wait on that one. If NGDP does accelerate sharply (which I don't expect), and if all the increase comes in the former of higher prices, then I will have been wrong in claiming it's mostly a demand-side problem. Oddly, I actually consider that failure much more likely than finding out that the Fed can't boost NGDP (which I consider extremely unlikely.) And yet I think most policy pundits would regard the failure to boost AD, or NGDP, as being the more likely "failure." For some reason there are lots of economists who don't think the Fed can boost AD (NGDP) and yet also think that if they succeeded it would almost certainly boost RGDP. I.e. there are still lots of old-style Keynesians.

I have no fear at all of the policy "failing" in the direction of high inflation. It won't happen.

PS. I knew I shouldn't try to list names in the previous several posts. I forgot David Eagle, who has worked for many years on NGDP targeting. And people like Doug Irwin, Niklas Blanchard, Kantoos, and many others. And of course there's Paul Krugman, who's 1998 paper started the ball rolling on the expectations approach to the zero rate trap.

PPS. The Washington Post mentioned my views on QE3.

PPPS. I was asked whether the new Fed policy will enable Obama's big spending plans for his second term. I doubt it. The policy initiative is too small to decisively impact growth or the deficit, but large enough to take away support for further fiscal stimulus. Obama will be forced to adopt Simpson/Bowles-style austerity during his second term. There's no longer any point in even wasting keystrokes on Mitt's plans. He's done-put a fork in him.

PPPPS. I was brought back to Earth after fantasies of saving the world economy yesterday, as I revised a NGDP targeting paper for the Mercatus Institute. There were so many grammatical (and content) suggestions from George Selgin and the other referees that I had to virtually re-write the paper. Only by putting them side-by-side can I see just how appalling my writing style really is. George speaks extemporaneously better than I can write. The good news is that it will probably be my best paper, but I really should make the referees my co-authors.

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