lower rates are triggering a wave of refinancings, which will lessen the cash drain of maintaining household balance sheets

TO BE NOTED: From Tim Duy's Fed Watch:

"TALF Disappointment and the Fed's Balance Sheet

Mark Thoma directs us to a Washington Post article detailing the slow start-up of the Federal Reserve's much discussed but little used TALF program. At this juncture, a critical constraint appears to be counterparty risk - no one trusts the US government to hold parties to their contractual obligations:

Sources involved in the program said private investors have been reluctant to work with the government, which they view as an unreliable business partner. ... There are restrictions on the business activities of participants in the program. ... But perhaps more significant ... is a fear that the government could retroactively change the terms, exacting new limits on what investors can pay their executives, for example, or trying to claw back profits that firms make in the program. ...

Perhaps TALF will gain traction in the months ahead. For now, however, I imagine that no amount of lipstick is able to conceal what must be official disappointment with the program. The question on my mind is will slow take up on TALF induce the Federal Reserve to step up its purchases of mortgage assets and longer term Treasuries. From the last Fed minutes:

Members expressed a range of views as to the preferred size of the increase in purchases. Several members felt that the significant deterioration in the economic outlook merited a very substantial increase in purchases of longer-term assets. In contrast, the potential for a large increase over time in the size of the balance sheet from the TALF program was seen as supporting a more modest, though still substantial, increase in asset purchases.

It looks like the expected success of TALF was a reason for moderating the size of the balance sheet expansion via longer term assets. It would stand to reason, all else equal, that TALF's slow start would trigger the Fed to step up purchases of other assets.

Also, one would think the Fed would take note that expanding their purchases of longer term assets has been a relatively successful policy, especially if the goal was to pull mortgage and Treasury rates lower. To be sure, the ultimate impact on spending in the near term is likely to be muted - the benefits of lower mortgage rates are limited to households that are not credit impaired or underwater on their homes, and we are not likely to see much equity withdrawal this time around. But lower rates are triggering a wave of refinancings, which will lessen the cash drain of maintaining household balance sheets, and free up some additional spending power. Overall, however, the Fed will be wary that the benefits of their last policy expansion will wane if Treasury rates pull above 3%, and thus will be induced to expand purchases of those assets, trying to offset the impact of the massive supply issuing forth from Treasury.

It is interesting that a relatively simply policy - one that does not require and army of lawyers and financial managers - has been much more successful and quick to execute than the exceedingly complex TALF program. If policymakers were not so blinded by the fetish of finance, they would see this as an example of the time honored KISS principle.

Another policy change to be watching for - when will the Fed commit to a quantitative goal for a sustained rate of expansion in the balance sheet? From Federal Reserve Vice-Chair Donald Kohn:

In gauging the effects of market interventions in the current crisis, one approach is to look to the size of increases in the quantity of reserves and money to judge whether sufficient liquidity is being provided to forestall deflation and support a turnaround in growth--an approach often known as quantitative easing. The linkages between reserves and money and between either reserves or money and nominal spending are highly variable and not especially reliable under normal circumstances. And the relationships among these variables become even more tenuous when so many short-term interest rates are pinned near zero and monetary and some nonmonetary assets are near-perfect substitutes. In our approach to policy, the amount of reserves has been a result of our market interventions rather than a goal in itself. And, depending on the circumstances, declines in reserves may indicate that markets are improving, not that policy is effectively tightening or failing to lean against weaker demand. Still, we on the Federal Open Market Committee (FOMC) recognize that high levels of Federal Reserve assets and resulting reserves are likely to be essential to fostering recovery, and we have discussed whether some explicit objectives for growth in the size of our balance sheet or for the quantity of the monetary base or reserves would provide some assurance that policy is pointed in the right direction.

What conditions could force the Fed from "credit" easing to "quantitative" easing, the latter being explicit policy guides for monetary expansion? The Fed could seek to force a firmer lid on longer-term Treasury rates. Another is that the Fed believes that setting a quantitative target is necessary to keep inflation expectations anchored in the face of the deflationary potential of persistently wide output gaps. Alternatively, the Fed could choose to forgo quantitative targets as they evaluate the durability of the green shoots emerging from the economic wasteland.

Bottom line: The challenges of setting in motion the complex TALF program suggests that the Fed will step up purchases of longer term Treasuries. The next policy line to cross is the formation of explicit policy objectives for the growth of a monetary aggregate. I would be looking for language in Fedspeak that points in that direction."

I think the Fed knows this; hence, they avoid the loaded term quantitative easing in favor of credit easing.

TO BE NOTED: From Tim Duy's Fed Watch

"More on Inflation Expectations

Thinking about the issues raised in my piece last week, it is worthwhile to spend more time on actual inflation and inflation expectations within the context of the Fed's policy of "credit easing." Consider as a starting point the recent work by John Williamson at the San Francisco Fed who concludes:

This analysis highlights the central roles of economic slack and inflation expectations in the risk of deflation over the next several years. The evidence indicates that a substantial increase in slack can lead to deflation, but the depth and duration of the deflation depends on how well anchored inflation expectations are. Two policy implications can be drawn from this and other research on deflation. First, a central bank should take appropriate actions to stem the emergence of substantial slack in the economy and thereby reduce the risk of deflation. Second, it should clearly communicate its commitment to low positive rates of inflation. An example of such communication is the Federal Open Market Committee's recently released long-run inflation forecasts. Such words, backed by appropriate actions, reinforce the anchoring of inflation expectations and reduce the chances of a deflationary spiral.

Conventional wisdom of the Fed's policy describes quantitative easing as an effort to boost inflation expectations. This flows from the fact that the Fed Funds rates is at zero, therefore further decrease in the real rate can only be achieved by boosting inflation expectations. To me, however, the Fed has not committed to a program of raising inflation expectations. Instead, they are reiterating their existing commitment to a low, stable rate of inflation. Consider the most recent FOMC statement:

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.

There is some risk of suboptimal inflation rates, and therefore they will conduct policy conducive to raising inflation. But what rate of inflation? Is there any sense that the Fed is actually trying to change the expectations of their policy goals? Not in the minutes from the previous meeting, where they clearly define their expectations for inflation under appropriate monetary policy:

It would appear that the Fed is attempting to anchor inflationary expectations in a range consistent with conventional understanding of the Fed's implicit inflation target of 1.7-2% (note that this implied the Fed see a floor on the real rate of -2%). If actual inflation is substantially less than this target, the Fed would be expected to ease policy accordingly. Otherwise, they would be accommodating declining inflation, which would challenge their commitment to their target. Their commitment to stable inflation would not be credible, and expectations would become unanchored in a deflationary direction.

Consider this commitment further via the Fed minutes:

Many participants noted some risk of a protracted period of excessively low inflation, especially if inflation expectations were to move down in response to lower actual inflation and increasing economic slack, and a few even saw some risk of deflation. Several others, however, anticipated that longer-run inflation expectations would remain well anchored, supported in part by the Federal Reserve's aggressive expansion of its balance sheet and the resulting growth of the monetary base, and therefore thought it unlikely that inflation would decline below levels they saw as consistent with the dual goals of price stability and maximum employment.

Yes, there is a risk of deflation, so policymakers will expand the balance sheet accordingly to prove their commitment to low and stable inflation. Notice the theme - to maintain credibility, the monetary authority needs to behave consistent with their commitments. In this framework, the Fed had little other choice but to expand the balance sheet aggressively if they want to avoid expectations of deflation.

Has the Fed been successful in anchoring expectations? Deflation concerns stem in part from the sharp drop in year-over-year inflation:

The TIPS market, however, is now waiving off deflation concerns:

In the context of the above discussion, the widening of the 10 TIPS breakeven looks consistent with a successful Fed policy to anchor expectations, which, again, differs from changing where that anchor lays. Likewise, the public perception does not appear to be tilted toward deflation:

Interestingly, the public's near term inflation expectation is well above the drop experienced in the wake of 9/11. It is worth noting that the rapid disinflation of late last year has somewhat reversed in recent months:

It is also worth thinking about what would have happened if the Fed did not do this:

Given that the velocity of the monetary base did this:

Now, credibility cuts both ways. The above analysis suggests that the Fed has so far staved off deflationary expectations by acting in a manner consistent with its inflation target. But suppose inflation rises above that target - perhaps velocity explodes, so that inflation rises even if output remains at suboptimal levels (something akin to Johnson and Kwak's emerging market scenario). Then the Fed would need to maintain its commitment to the inflation target by contracting the balance sheet. From the minutes:

Moreover, some noted a risk that expected inflation might actually increase to an undesirably high level if the public does not understand that the Federal Reserve's liquidity facilities will be wound down and its balance sheet will shrink as economic and financial conditions improve.

Policymakers are already considering the removal of their liquidity injections. In other words, they have not committed to a permanent increase in the money supply. Indeed, I believe this is why Fed Chairman Ben Bernanke describes policy as credit easing not quantitative easing. The latter implies permanence. From the minutes:

Several participants indicated that they thought the FOMC should explore establishing quantitative guidelines or targets for a monetary aggregate, perhaps the growth rate of the monetary base or M2; in their view such guidelines would provide useful information to the public and help anchor inflation expectations. Others were skeptical that a single quantitative measure could adequately convey the Federal Reserve's current approach to monetary policy because the stimulative effect of the Federal Reserve's liquidity-providing and asset-purchase programs depends not only on the scale but also on the mix of lending programs and securities purchases. In addition, a few participants noted that the sizes of some Federal Reserve liquidity programs are determined by banks' and market participants' need to use those programs and thus will tend to increase when financial conditions worsen and shrink when financial conditions improve; the size and composition of the Federal Reserve's balance sheet needs to be able to adjust in response.

Again, the Fed has committed to nothing other than to maintain a balance sheet consistent with well-anchored inflation expectations. Note too that this does not imply a complete reversal of the balance sheet expansion; if the velocity of money remains low, then some part of the balance sheet expansion can be permanent and not lead to an increase in expectations of the Fed's inflation target.

The risk is that the Fed commits a policy error by not allowing the balance sheet to contract sufficiently to offset any increase in inflationary pressures. There is a reasonable risk of such an outcome. Consider the first half of 2008, when the Fed continued to ease policy even as inflation, and inflation expectations, was rising dramatically. Had that situation continued, the Fed would have been accommodating increased inflation expectations, thereby threatening their perceived commitment to low and stable inflation. Instead, the Fed got "lucky" and the global economy collapsed, sending inflation downward as commodity prices collapsed. Would the Fed get so "lucky" again?

I think, however, the more likely risk is that the Fed's independence is compromised and they politically cannot shrink the balance sheet in a timely fashion. As I have argued, policymakers understand this risk, and are vociferously reiterating their independence. This too helps keep expectations in check.

Another risk is that policymakers deliberately attempt to reset the inflation target to a higher rate. This may become the policy choice if policymakers believe they need to reduce real rates below the -2% floor implied by the current target (effectively, the Fed chooses the inflation solution to the debt overhang). Resetting the inflation target, I believe, would amount to a commitment by the Fed to a permanent increase in the money supply growth rate. But I doubt it would be easy - how could a new target be credible if the Fed abandons the current target? An attempt to set a new target, I fear, would lead inflation expectations to become fully unanchored. I think the Fed knows this; hence, they avoid the loaded term quantitative easing in favor of credit easing.

Bottom line: The conduct of Fed policy is consistent with a commitment to the existing inflation target. The increase in the monetary base, in this framework, was necessary to prevent expecatations from shifting in the direction of deflation. But credibility works both ways; they need to remain ready to withdraw liquidity should inflation pressures emerge. The repeated claims that the expansion of the balance sheet is not permament is consistent with credibly committing to the existing target. There remains, however, plenty of room for policy error, and not to mention the now omnipresent fear that the Fed has sacrificed its independence."

I had always assumed that the point of both monetary and fiscal stimulus was to boost AD.

TO BE NOTED: From The Money Illusion:

"What’s the point of fiscal stimulus and QE?

If you were to rely on the press, you’d think that the purpose of fiscal stimulus was to boost real output, to “get us out of the recession,” and the purpose of quantitative easing (QE) is to boost inflation, to “get us out of the liquidity trap.” I’m sure someone will tell me where I am wrong, but this seems like utter nonsense to me. I had always assumed that the point of both monetary and fiscal stimulus was to boost AD. And that in the short run both policies raise both prices and output. And that the way nominal GDP growth is partitioned depends on the slope of the SRAS curve, not on what caused AD to increase. Did I misunderstand my macroeconomics courses?

I suppose you could argue that fiscal policy also has supply-side effects, but in the current case those are almost certainly negative. There are no supply-side tax cuts in the recent bill (indeed implicit MTRs rise), and even if more spending on health care, energy research and education boost long run productivity, they do nothing to shift the SRAS to the right. It would make more sense to ask whether the fiscal stimulus will succeed in boosting inflation, and whether the QE will succeed in boosting real output.

What set me off was a recent piece in the Washington Post by Johnson and Kwak. Despite my exasperated tone, I am not trying to pick on these two fine economists. Their views are widely held, and I am certainly in the minority—a minority of one on some issues. All I can do is provide my subjective reaction to the following quotations:

After the double-digit inflation of the 1970s and early 1980s, why would anyone want to create inflation? Households and companies alike are trying to “deleverage,” or pay down their debts. But deflation makes it harder to pay down debts, because debts are fixed in dollars and those dollars are becoming worth more and more. Moderate inflation in the neighborhood of 4 percent, by contrast, makes it easier for borrowers to manage their debt loads, and stimulates the economy.

First let’s be very clear about one thing, the Fed can create inflation only by boosting AD, not reducing AS. So Johnson and Kwak are essentially asking “why would anyone want to boost AD?” My response is; why would anyone even ask a question like this? When restated in terms of AD, the answer is simple, because NGDP is now falling at a 7% annual rate and is expected to be far below the Fed’s implicit target for many, many years. Just imagine a discussion of fiscal policy along similar lines: “Hmmm, I wonder why the fiscal authorities see a need to stimulate the economy? Aren’t they worried that NGDP growth is likely to be excessively rapid going forward? Don’t we need to slow down AD growth?” I’m going to go out on a limb and assume that no one has been asking that sort of question recently. But they are asking analogous questions about monetary policy. (BTW, their answer to the question is perfectly fine.) They then ask:

But is the United States really a normal advanced economy anymore? We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of “slack;” there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.

First of all this is a perfect illustration of why it makes more sense to talk in terms of NGDP growth, not inflation. Monetary and fiscal expansion will raise NGDP growth in all sorts of countries, under all sorts of conditions. That is the Fed’s policy goal. In addition, the Fed has made it clear that they want low inflation, not high inflation, a point acknowledged elsewhere by Johnson and Kwak. We’ve had positive inflation in every recession of my lifetime (except the last 6 months), so why would we expect anything different from a monetary expansion today? In the next paragraph they assert:

If the United States is indeed behaving more like an emerging market, inflation is far easier to manufacture. People quickly become dubious of the value of money and shift into goods and foreign currencies more readily. Large budget deficits also directly raise inflation expectations. This would help Bernanke avoid deflation, but there is a great danger that unstable inflation expectations will become self-fulfilling. We do not want to become more like Argentina in 2001-2002 or Russia in 1998, when currencies collapsed and inflation soared.

What great danger? Why are inflation expectations at record lows in the long term bond market, if there is a great danger of inflation? And if those expectations started to rise, couldn’t the Fed just pull the money back out of circulation to keep inflation expectations in check? (By the way, I’d much rather be like Argentina after inflation “soared,” than Argentina before inflation soared–although I would prefer to avoid both options.)

At the other extreme is Tim Duy, who worries that we won’t be able to get any inflation at all. I’ll use Mark Thoma’s post, as it nicely explains all the competing views. (Be aware of the Russian doll problem, lots of quotations within quotations within quotations.)

The key paragraph in Johnson and Kwak that I [Tim Duy] take issue with is:

“Then in March, the Fed said that it will begin buying long-term Treasury bonds on the open market, hoping to push down long-term interest rates (by increasing the amount of money available for long-term lending) and thereby stimulate borrowing. The implication is that the Fed will finance these purchases by creating money. Not only that, but Bernanke wants us to know exactly what the Fed is doing; he hopes to push up our expectations of future inflation, so that wages and prices will nudge upwards, not downwards.”

The implicit assumption is that the Fed is expanding the money supply via a policy of quantitative easing with the explicit goal of raising inflation expectations. First off, as Bernanke said once again today, he does not describe policy as quantitative easing:

“In pursuing our strategy, which I have called “credit easing,” we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices.”

Pay close attention to Bernanke’s insistence that the Fed’s liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment - a commitment to contract the money supply in the future. Is this any way to boost inflation expectations?

So Tim Duy draws the opposite conclusions from Johnson and Kwak, the danger is no inflation at all. Obviously in terms of likely outcomes, I agree with Duy. But I also think that in this particular exchange Johnson and Kwak’s interpretation of Fed intentions is just as plausible, perhaps more so.

The Fed clearly doesn’t intend the reader to interpret “stable prices” literally, rather they are referring to the Fed’s inflation target, which is more like 2% inflation. So you have one side warning of high inflation if the monetary base remains at the current high levels, and others saying we won’t get any inflation at all if the money is pulled out of circulation later. In a sense both sides are right. So why doesn’t the Fed clearly say that it plans to leave just enough money in circulation to keep long run price levels 2% or 3% (per year) higher than current price levels? Isn’t that what the Fed wants?

By the way, here is another case where NGDP growth makes far more sense than inflation. Most liquidity trap models talk about reducing real interest rates through expected inflation. But if you look at the logic of these models, it is clearly NGDP growth that matters, not inflation. Don’t believe me? Then consider a scenario where the Fed generates 5% NGDP growth expectations, but negative 1% inflation expectations. Do we stay in a liquidity trap? Obviously not, with 6% real growth expectations the Wicksellian natural rate (in real terms) will rise well above 1%, so you don’t have to worry about that problem. And even if you stayed stuck in a liquidity trap, would that be so bad with 6% real growth?

Why doesn’t the Fed simply communicate its inflation target so people aren’t playing this zero inflation/hyperinflation guessing game? They don’t have to tell us exactly how much money they will later pull out of circulation; just tell us that it will be enough to produce X percent inflation. Perhaps the problem is that Congressmen like Barney Frank get upset when the Fed hints that it might ignore its “dual mandate” and focus solely on an inflation target. I have a suggestion for the Fed, it’s a nominal target that gives equal weight to inflation and real growth. Anyone want to guess what I’m thinking?

While I am in a grouchy mood let me get one more thing off my chest. Consider the following quotation from Johnson and Kwak:

If he succeeds in restarting growth while avoiding high inflation, Bernanke may well become the most revered economist in modern history. But for the moment, he is operating in uncharted territory.

First let me reiterate that I don’t blame just Bernanke for the crisis, I blame the Fed and all the macroeconomists who refused to strongly criticize the stance of Fed policy in October 2008, when growth forecasts fell far below any reasonable policy objective—in other words, just about everyone. But Bernanke was chairman of the Fed at that time, and they did refuse to cut rates to zero. Admittedly they did inject a lot of reserves, but then they paid interest on those reserves at rates higher than alternative assets, insuring that almost all the extra reserves would be hoarded. And this was done when financial markets and private forecasters were (correctly) forecasting falling NGDP. So when I see people talking about the potential heroism of Bernanke, I can’t help thinking of the fireman who started fires so that he’d have a chance to become a hero putting them out. Yes, this is almost certainly a bad analogy, Bernanke is both well-intentioned, and a much better than average fireman. But if it is a bad analogy, then it’s a pretty sad comment on the state of our profession.

Update 4/6/09, Despite my disclaimer before the first J&K quotation, a commenter mentioned that my tone was not very polite. That was certainly not my intention, but I can see how people might read it that way. So let me be a bit clearer about this point. Since early October I have been extremely frustrated with about 99% of macroeconomists; who I blame for the worldwide recession/depression. I think they have almost everything backwards. I believe they are looking at totally meaningless “indicators” of monetary policy like interest rates and the money supply, and ignoring the only variable that matters, the expected growth in the central bank’s target variable. So in the unlikely event that J&K come across this post, just assume you are surrounded by 99% of other macroeconomists, including all the greatest minds in the field, and consider me an eccentric economist at a small school taking potshots from the sidelines. I was just venting my frustration with the entire tone of the ongoing debate over macro policy, and picked your piece at random.

I’d like to thank the invaluable Dilip for the links used here. I should probably be paying him for his assistance. But I won’t, unless someone will pay me for doing this blog. With a bunch of new links, I will probably not post for a few days, returning later in the week with a piece on international monetary issues."

Me:

1. Don the libertarian Democrat
   5. April 2009 at 21:01

   Here’s a quote from a paper that I like:

   http://www.princeton.edu/svensson/papers/jep2.pdf

   “The problem is, again, why an expansion of the monetary base today should be viewed as a
   commitment to increased money supply in the future. While the liquidity trap lasts and the interest
   rate is zero, the demand for monetary base is perfectly elastic and excess liquidity is easily
   absorbed by the private sector. However, once the liquidity trap is over and the nominal interest
   rate is positive, demand for money will shrink drastically, in most cases requiring a drastic
   reduction of the monetary base. It is difficult to assess how much the monetary base would have to
   be expanded before inflation expectations and inflation take off. Beyond some unknown threshold,
   deflation may be quickly replaced by hyperinflation.”

   Now, I’m not an economist, but, although Sevensson doesn’t like the idea, he does seem to be talking about QE and inflation together. Am I wrong?

And:

Don, Yes, Svensson thinks QE can raise inflation but he prefers currency depreciation as it is easier to estimate the impact. He may be right in Japan’s case, although as he says it doesn’t apply to the world economy. Svensson favors using internal Fed forecasts, not market forecasts as I prefer, so he worries more about overshooting than I do.

In other words, they are explicitly committing to a temporary increase in the money supply.

From Tim Duy's Fed Watch:

"Johnson and Kwak vs. Bernanke

Simon Johnson and James Kwak of the Baseline Scenario argue in today's Washington Post that the Fed risks triggering an inflationary spiral despite the current gaping output gap (see also Mark Thoma's comments here). I believe that Johnson and Kwak are perpetuating a misunderstanding about Federal Reserve Chairman Ben Bernanke's policy intentions, namely boosting inflation expectations. This is an understandable extension of the widely cited policy of quantitative easing. But despite the widespread use of the term quantitative easing, I still believe this is not Bernanke's understanding of the Fed's policy stance (see also David Altig). And, I would argue, if this is indeed the Fed's policy, Bernanke is doing a very bad job at implementation.

The key paragraph in Johnson and Kwak that I take issue with is:

Then in March, the Fed said that it will begin buying long-term Treasury bonds on the open market, hoping to push down long-term interest rates (by increasing the amount of money available for long-term lending) and thereby stimulate borrowing. The implication is that the Fed will finance these purchases by creating money. Not only that, but Bernanke wants us to know exactly what the Fed is doing; he hopes to push up our expectations of future inflation, so that wages and prices will nudge upwards, not downwards.

The implicit assumption is that the Fed is expanding the money supply via a policy of quantitative easing with the explicit goal of raising inflation expectations. First off, as Bernanke said once again today, he does not describe policy as quantitative easing:

In pursuing our strategy, which I have called "credit easing," we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices.

Pay close attention to Bernanke's insistence that the Fed's liquidity programs are intended to be unwound. If policymakers truly intend a policy of quantitative easing to boost inflation expectations, these are exactly the wrong words to say. Any successful policy of quantitative easing would depend upon a credible commitment to a permanent increase in the money supply. Bernanke is making the opposite commitment - a commitment to contract the money supply in the future. Is this any way to boost inflation expectations? See also Paul Krugman:

In that case monetary policy can’t get you there: once the interest rate hits zero, people will just hoard any additional cash – we’re in the liquidity trap. The only way to make monetary policy effective once you’re in such a trap, at least in this framework, is to credibly commit to raising future as well as current money supplies.

If Bernanke really intends to raise inflation expectations, he is making an elementary error by reiterating his intention to shrink the Fed's balance sheet in the future. The current increase in money supply is thus transitory and should not affect future expectations of inflation. I can't see him making such an elementary error, which suggests that Bernanke's word should be taken at face value; he intends policy to be "credit easing," not the oft-cited "quantitative easing."

To be sure, the Fed is setting the stage for inflation if the price for their efforts to stabilize the financial system is monetary independence. The Fed is very, very aware of this risk; expect policymakers to keep reiterating Bernanke's intention to maintain independence. Note that he made this point in the quote above, and makes it again later in the same speech:

The FOMC will continue to closely monitor the level and projected expansion of bank reserves to ensure that--as noted in the joint Federal Reserve-Treasury statement--the Fed's efforts to improve the workings of credit markets do not interfere with the independent conduct of monetary policy in the pursuit of its dual mandate of ensuring maximum employment and price stability. As was also noted in the joint statement, to provide additional assurance on this score, the Federal Reserve and the Treasury have agreed to seek legislation to provide additional tools for managing bank reserves.

Johnson and Kwak also attempt to deal with the central criticism of inflation worries: How can inflation emerge given the gaping output gap? They solve this puzzle by analogizing the US to an emerging economy:

But is the United States really a normal advanced economy anymore? We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of "slack;" there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.

The challenge in my mind is that institutions in the US, primarily the relationship between management and labor, are not conducive to sustained inflation as they are in emerging markets. Desperation among workers is more likely to take hold. From today's Wall Street Journal:

Despite what objectives they may have put atop their resumes, when asked to describe the work they really wanted, the job seekers largely had the same goal: "I'll take anything right now."

In many cases, that desperation means that even educated workers must trade down to jobs below their potential and with lower pay. That results in painful, long-term effects, from hurting their own career advancement to displacing those with less education or experience.

Frankly ,I don't see a clear transition mechanism within the US economy to generate sustained inflation in this environment. I am somewhat more sympathetic to another threat Simon and Kwak identify:

We do not want to become more like Argentina in 2001-2002 or Russia in 1998, when currencies collapsed and inflation soared.

If the US Dollar cracked - a frequent fear of mine during the past year - and commodity prices surge, and the Fed effectively accommodated that price increase by easing policy further to counter the negative demand effect, which would effectively be a permanent increase in the money supply, then I can tell a story about an inflationary spiral. Such a story did not look ridiculous last year as oil was heading toward $150. Now, however, it is a lot harder to tell. Too many "ifs" and "maybes." A story that hangs together much better after a six-pack than my recent snack of sugar and caffeine.

Bottom line: I reiterate my concerns that the media and market participants are using the term "quantitative easing" too loosely. I understand that this complaint falls on largely deaf ears. If Bernanke is using quantitative easing to boost inflation expectations, then I think we need to seriously address the likely ineffectiveness of any such policy when Fed officials repeatedly promise to shrink the balance sheet in the future. In other words, they are explicitly committing to a temporary increase in the money supply. There is no reason to believe this will meaningfully impact inflation expectations. Such expectations, however, could be generated via a policy error. The error the Fed fears the most is they lose independence, the increase in money supply becomes permanent, and that political pressures force sustained increases in the money supply. Consequently, look for officials to consistently repeat their intentions to remain independent."

Me:

"And we will take all necessary actions to ensure that the unwinding of our programs is accomplished smoothly and in a timely way, consistent with meeting our obligation to foster full employment and price stability."

"Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior).8"

"In pursuing our strategy, which I have called "credit easing," we have also taken care to design our programs so that they can be unwound as markets and the economy revive. In particular, these activities must not constrain the exercise of monetary policy as needed to meet our congressional mandate to foster maximum sustainable employment and stable prices."

"Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes. In particular, credit spreads are much wider and credit markets more dysfunctional in the United States today than was the case during the Japanese experiment with quantitative easing. To stimulate aggregate demand in the current environment, the Federal Reserve must focus its policies on reducing those spreads and improving the functioning of private credit markets more generally."

I seem to be reading him differently than you are. He seems to be saying that Credit Easing includes QE, and attempts to do essentially the same thing. But, in our crisis, the Fed has been asked to do more than simple QE. These extra tasks are not normal tasks for the Fed, as QE would be, and it is these tasks that he wants to unwind going forward.

Also, since I take him to be worried about deflation, how can he not be attempting to cause inflation?

As to the balance sheet, I take him to be saying that he doesn't want to constrain himself, given these other tasks, to a narrow QE, or any constraints on what he plans to do within the normal bounds of Fed policy until these other tasks, adding to the balance sheet temporarily, are wound down.

Posted by: Don the libertarian Democrat | 04/03/2009 at 10:07 PM

"So when does Fed policy truly become inflationary? "

Here's someone who would consider me crazy. Tim Duy on the Economists's View:

"Fed policy has been directed at improving credit market functioning, thereby acquiring assets, of which the expansion of liabilities is simply a side affect of the policy, not the policy itself. The Fed apparently views deliberate expansion of liabilities – a commitment of x% percent growth in some monetary aggregate via Treasury purchases – as quantitative easing. A commitment to increase the balance sheet at a steady pace (the first derivative) rather than maintain a high level. We are not there yet.

Is this distinction important? Or just semantics? I believe it is important, as the latter, a move to target the liabilities side of the balance sheet, would imply that the Fed is deliberately trying to stoke an inflationary fire. This may become the future policy, but for now the Fed is simply trying to keep the financial system from collapsing ( OKAY ). Inflation would be an accident, not a deliberate policy effort, at least from the Fed’s point of view ( OKAY ). For the moment, the policy remains insufficient to ward off deflationary pressures long as the rest of the world refuses to accept the burden of global adjustment.( HOW SO? )

The problem, in my mind, is that the rest of the world either refuses or is simply incapable of shouldering some of the burden of global adjustment. This inability to adjust appears to be the end result of almost thirty years of global acceptance and US indifference to external imbalances. Global consumption and production patterns, both spacially and intertemporally, are so misaligned that it looks like we are all now in a race to the bottom together. An amazing global policy failure. So, so depressing. ( WHAT'S THE RACE? )

So when does Fed policy truly become inflationary? Currently, I am thinking it becomes inflationary when policymakers become desperate enough to attempt to use monetary policy to entirely offset the headwinds blowing against economic activity ( WHY? ). When they truly attempt to target asset prices to “fix” the housing market( THIS ISN'T WISE ). When they decide the easiest answer to the excessive build up of debt is to inflate it away( IT'S FINE WITH ME ). At that point, policy will shift from the asset side of the balance sheet to the liability side. That is when Treasury and the Fed will risk ( HOW SO? ) a disorderly adjustment of the Dollar. Hopefully we will not get there. But I suspect that is when the tide will turn for the Fed."

Is it hyperinflation? Where is the dollar going? And why?

"Any acknowledgement that stable dollar adjustments are a policy priority should help prevent a dollar run. "

Free Exchange with two points about earlier posts. First, the Tim Duy point that using the Great Depression as a guide in our current crisis might be of limited use, especially where Quantitative Easing is concerned:

"And Tim Duy speculates that because of the lingering current account deficit, America's shaky dollar could be approaching a dangerous adjustment. Enough downward pressure on the dollar could begin to affect Treasury rates. And the Federal Reserve, focused like a laser beam on preventing deflation and depression, might simply work to hold those rates down by buying Treasuries and plowing still more money into the economy. And then? Well, America could begin to have trouble financing its borrowing, and could then face the need to either pursue strongly pro-cyclical fiscal policies or hyperinflationary monetary policies.

There are a lot of ifs in all of that. It would be nice to have a probability distribution for all of the different potential catastrophic outcomes facing the global economy, in order to know which lesser evil to aim for. Had we one, I suspect this concern would turn up in far fewer die rolls than the standard depression outcome. Still, it seems worth paying attention to the conflict underlying the whole thing—that America's optimal policy choices now are not quite the same as they were in the 1930s, since America's role in the global economy has changed.

Because once that conflict is understood, American leadership can be proactive. Any acknowledgement that stable dollar adjustments are a policy priority should help prevent a dollar run. And more importantly, Barack Obama's economic team should begin to consider how best to cajole large creditor nations with current account surpluses to spend heavily on stimulus and boost domestic consumption.

There's no particular reason that America has to make policy in a vacuum, just hoping that trading partners don't do anything radically destabilising. Leaders globally need to understand that they have a mutual self-interest in unwinding global imbalances while also providing coordinated stimulus. And leaders among those leaders need to lead."

I've said much the same thing, only with less expertise.

Now, about Germany and the EU Stimulus:

"Jean-Claude Trichet, head of the European Central Bank, argued today in favour of European fiscal discipline and adherence to the Stability and Growth Pact. A noble sentiment, but one that's potentially troublesome given Mr Trichet's recent signals that the ECB is ready to pause in its rate cutting, and given Germany's reluctance to pursue bold fiscal stimulus. Germany said last night that no new stimulus plans would be forthcoming until it was clear what stimulus policies Barack Obama might pursue in office. Just why isn't clear. Mr Obama's stimulus is likely to be at least $500 billion in magnitude, and it's hard to know why the structure of the plan—tax cuts or local budget grants or infrastructure investment—would influence German choices."

I suspect that the wait for President Obama's Stimulus Plan is actually aimed more at domestic politics, since I concur in finding Germany's wait puzzling. But it is true that the amount of the US Stimulus might have an impact on how necessary a coordinated stimulus plan is, and how much each nation should spend. It could simply be prudence.

"The risk that this is not the relevant analogy for the US, and that policymakers are not prepared to accept such a possibility."

After saying that mining the Great Depression for clues on how to get us out of this current problem is of minimal use, I find this post by Tim Duy on the Economist's View interesting:

"But to be a real Dollar rout, we would expect to see Treasuries come under severe pressure, which has not exactly been a recent trend. So perhaps there really is nothing to fear. Indeed, I have argued that that if the stimulus is too excessive, that excess should reveal itself in the Treasury market, and policymakers can simply back off. No problem – ease away. Build those bridges.

This assumes that policymakers back off. What if rising Treasury rates encourage the Fed to double down, expanding quantitative easing to hold rates low and stimulative. What if years of research on the Great Depression have left even the best and the brightest with tunnel vision such that they could not accept that they were wrong?

Bottom Line: The Fed is headed to the zero mark, with another 50bp almost certain this week. It is widely expected that they will give some guidance as to their next steps, pointing us in the direction of an explicit policy of quantitative easing. Fed policy, as well as fiscal policy, assumes that the Great Depression is the most accurate analogy. This assumption ignores the external position of the US, which stubbornly refuses to adjust. If that failure to adjust is relevant, then recent Dollar stability was simply a head-fake. We should see pressure on the Dollar and, ultimately, Treasuries. Policymakers could adjust, but would they? With pursuit of the Great Depression case as the baseline scenario, it seems prudent to keep in mind the risk that this is not the relevant analogy for the US, and that policymakers are not prepared to accept such a possibility."

I think that Printing Money is simply the clearest option that we have. It has little to do with the Great Depression. The problems this could lead to are serious, and we'll be in for a rough ride. But the fact that the policy of Printing Money is Assessable makes it a good choice. I doubt that anyone in this mess is going to hold to a failing policy for too long. Rather, I would fear that we do not give these policies a chance to be assessed.

As to the point about the usefulness of the Analogy with the Great Depression, I agree.