In an October 1 speech to the Economics Club of Indiana, Chairman Ben Bernanke addressed the risk that the Fed's latest round of quantitative easing (QE) could lead to inflation. Here is his resolutely reassuring answer, as quoted by Dave Altig on the Atlanta Fed's Macroblog:
I'm confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way. …
Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to 'take away the punch bowl' is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools. I can assure you that my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions.
I wonder, though, if there is such a thing as being too reassuring. This conclusion, although a bit unconventional, comes from combining two ideas about monetary policy that are increasingly mainstream.
The first idea is that if QE works at all, it works mainly through the forward guidance channel. That is one of the central findings of Michael Woodford's much discussed Jackson Hole paper. The point is that just expanding the Fed's balance sheet when interest rates are already effectively at the zero bound has little direct expansionary effect. All we have to do is look at the following chart, which I have posted before. Notice how the nominal GDP (NGDP) line barely wiggles despite the huge leaps in the monetary base. The Fed, to use the well-worn expression, is pushing on a string.
Instead of pushing, someone should be pulling, but the Fed itself does not have arms long enough to reach the far end of the string. The solution is to persuade private-sector market participants to pull it by raising their expectations of the future strength of the economy. The Fed does that not just by expanding its balance sheet, but by signaling that it will keep it expanded until the real economy gets moving again.
The second idea is that the Fed should be targeting not inflation and unemployment separately, but NGDP, a variable that rolls the two parts of the dual mandate into one. NGDP level targeting, endorsed with caveats by Woodford and much more enthusiastically by others, would allow inflation to rise well above 2 percent during the recovery and then fall back to some such rate once the output gap closes. The whole point of NGDP level targeting is that by temporarily relaxing the inflation target, the output gap will close much faster.
In practice, though, inflation expectations seem to have hit a sort of glass ceiling. Altig provides the following chart, which shows that expectations have risen with each round of QE, but then flattened out just below 3 percent. NGDP targeters would say 3 percent is still too tight a cap.
Instead, they would like to see forward guidance that is much stronger than Bernanke's anodyne assurance that "my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions." Instead, they would like him to say that the Fed will keep its foot on the gas until NGDP reaches its long-run target path, inflation be damned.
Well, they are not going to get that out of Bernanke, not at this point in time. The inflation hawks would tear him to shreds if he said that-not just those with seats on the FOMC but those with seats in Congress as well.
Given this undeniable political constraint, is there anything Bernanke could do to speed the recovery? In my view there is. He could just shut up.
I suggest that the next time someone asks him whether the Fed's exit strategy is adequate to control inflation, he should just say, "Next question, please." Wow. Think what the Wall Street Journal would do with that quote! They would put it on the front page in large type.
Of course, it would be even better if he said something like this: "Well, guys, we think we have an exit strategy - raising the deposit rate on excess reserves, reverse repos, and all that - but frankly, these are theoretical ideas. They have never been tested in battle. We are not really sure they would work."
If that didn't send inflation expectations through the 3-percent ceiling, what would?
In fact, the ultimate in forward guidance would be for the Fed to have no exit strategy at all. A no-exit monetary policy would mean that the Fed would never add to the monetary base unless it were committed to leave the money in the system permanently.
Here is how Woodford puts it:
Finally, some would argue that the well-established principle of the long-run neutrality of money implies that an expansion of the monetary base must eventually result in a proportional increase in the general level of prices (though with no real effects, in that long run), and hence must eventually be able to increase aggregate nominal expenditure, to whatever extent may be desired. But this argument concerns the effects of a policy of permanently increasing the monetary base. The "irrelevance results" of Krugman and Eggertsson and Woodford instead pertain to a policy that increases the monetary base only during a period over which the zero lower bound prevents the central bank from achieving its usual targets, while the central bank is expected to return to its usual (purely forward-looking) approach to policy once it is no longer constrained - for example, by returning to the pursuit of its long-run inflation target, or by following a Taylor rule consistent with such a target.
If, instead, one were to assume a permanent increase in the size of the monetary base, and assume that it is immediately understood by everyone in the economy that such a permanent change in policy has occurred, then such a policy would be predicted to have an immediate positive effect on economic activity.
Of course, the Fed could not abandon its exit strategy now. A hypothetical no-exit monetary strategy would already have gotten inflation expectations up and NGDP growing long before the Fed's balance sheet had grown to where it is now. Promising never to reduce the base below its current size would put us on track well above what even the most ardent NGDP targeters would advise.
So there is the paradox: The bigger the Fed's balance sheet grows, the more it has to emphasize the efficacy of its exit strategy, but the more it talks about the exit strategy, the less real kick it gets out of further increases in its balance sheet.
How do we break out of this trap? Next question, please.