"Krugman on negative insider trading
If markets are efficient then the expected loss on Fed purchases of long term debt is roughly zero. On the other hand if the Fed has inside information about its future policy, then the Fed could use that information to make expected profits or losses. In a post today, Krugman argues that the Fed may be using the inside information in a perverse way, to generate expected losses. His argument (which is technically correct and which I discussed here in an earlier post) is that the Fed might actually persevere and produce more inflation (and I would add more real spending growth as well) than the markets currently expect. Because markets are skeptical about the ability or willingness (probably the latter) of the Fed to carry through on a reflationary policy, long bond yields do not currently price in the sort of inflation or nominal spending growth that the Fed presumably wants. What do we make of this?
1. My initial thought a few weeks ago was that the Fed should buy assets that are likely to appreciate if they are successful, which they would insure by announcing a nominal target and doing whatever was necessary to hit the target. Who cares if traders who doubted the Fed’s word lose money? It’s a good way to build credibility.
2. The Fed may think my idea is too risky, and they may be right. The markets may actually know the Fed better than it knows itself. I.e. the markets may be able to predict future Fed behavior better than the Fed. Think of the Fed as like a powerful but lumbering woolly mammoth, surrounded by agile saber-tooth tigers. The markets are very good at sensing which policy targets are credible. In Japan, the markets correctly sensed that the BOJ’s promise to end deflation was a sham, and deflation got priced into bond yields. And they were right; the BOJ tightened policy twice while deflation was still occurring.
3. Neither Krugman nor Bernanke seems to have noticed yet that we could get by with far less QE than is currently being discussed. The proposal for negative interest on reserves that Bill Woolsey and I have been discussing for months has finally been discovered by Harvard University (according to a recent post in Mankiw’s blog–and with a wacky idea for negative interest on cash that is not a part of our proposal here.) It would end the problem of excess reserve hoarding, which has been by far the biggest factor in boosting demand for base money (and hence limiting the effectiveness of QE.) Let’s see how long it takes for the idea to get to Princeton (Krugman and Bernanke’s University.)
4. On a serious note, I actually do agree with Krugman:
a. QE is worth trying.
b. By itself QE may not work (in my view due to positive interest on reserves.)
c. And if it does work it may expose the Fed to some capital losses.
The reason that I have been prodding people like Mankiw and Krugman in recent posts is to try to raise the visibility of the proposal for negative interest on excess reserves. I strongly believe this issue is important, and hope to attract the attention of someone who can publicize the issue much more effectively than I can."Me:
Don, Thanks for the link, I need to link to that blog, as he has the same idea as I do. The FT idea of interest on cash, however, is probably a nonstarter. If I understand your idea, it is for negative rates on T-bills (once nominal rates had fallen to zero.) Is that right? If so, I am afraid that Nick Rowe is right, it wouldn’t work because of private currency hoarding. It is the same logic as my idea, and is a good idea, but here is the difference. The Fed cannot police the public and prevent them from hoarding cash as a way of avoiding negative rates. But the Fed can police commercial banks and prevent them from hoarding vault cash as a way of avoiding the tax on bank reserves.