The Fed was surprisingly bold with its latest move. Theoretically, there was a bit of everything
The US economy is in a funk, it needs stimulus. More evidence has come out recently that the great rise in unemployment is mostly cyclical rather than structural. This is a good thing, as it means that there is room for stimulating aggregate demand to restore economic growth and bring down the unemployment rate. It will also help to prevent any more long term damage to economic growth and human capital that was discussed in DeLong and Summers.
With the interest rates effectively at the zero lower bound, and the congress in gridlock until at least December, all eyes were on the Federal Reserve. And they did not disappoint. Before we get to what they did announce, let’s take a quick look at what some prominent economists have been calling for. What we’ll see is that this week’s announcement is a real blend of all these ideas.
What theory & academics have called for
At Jackson Hole, the annual gathering of central bankers and economists, Michael Woodford, the highly respected monetary economist, presented an exhaustive review of monetary policy at the zero lower bound. Woodford’s analysis suggested that large scale asset purchases, by themselves, will achieve little, and what matters instead is the Fed’s communication of its future intentions – forward guidance. Woodford presents a detailed analysis of how forward communication can move interest rates in such areas as Overnight Interest rate swaps. His analysis of the minimal effects of large scale purchases is also engaging, but there is mixed evidence on this as pointed out by Econbrowser.
From this exhaustive analysis, Woodford ends up at a point where he endorses nominal GDP targeting as a new form of monetary policy. Not a new idea, see Ryan Avent’s blog post here , but a powerful one nonetheless. The key to this policy, from Woodford’s point of view, is that the policy is history dependent, not just forward looking. The logic is as follows: the Fed can assess where nominal GDP is at present and compare this to where it would have been had it continued on its pre-crisis trend. Thus, if it has an explicit NGDP target, it will commit to easing monetary policy until that gap is removed, making it dependent on historical trends. Woodford also believes that a shift to this policy is even possible straight away, in that it would not take much of a shift in public communications to articulate this new framework.
Such a major shift was always unlikely, at least for the time being, but modifications on NGDP targeting have been suggested. Charles Evans, of the Chicago Federal Reserve, has proposed that forward guidance should be employed in relation to both inflation and unemployment. Evans believes that the Fed should make it clear that the interest rates will not be raised until unemployment falls below 7% or inflation rises above 3% on a medium term basis. This 7/3 guidance frames monetary policy with targets in mind, even if it not history dependent like that of NGDP targeting.
Finally, Adam Posen, ex member of the UK Monetary Policy Committee, has suggested that monetary policy should target those areas of the financial system that are the most impaired at present. This might be targeting small business by encouraging credit for SMEs, or buying Mortgage backed securities (MBS) to unblock the housing mortgage market. Paul Krugman has suggested that the Fed needs to commit to be ‘credibly irresponsible’ when facing the zero lower bound and a liquidity trap. This implies that the Fed commits to keeping policy loose even when the economy recovers, thus ignoring their policy rule for a period of time when the economy is out of the liquidity trap.
What they have just announced
The Fed has announced that it will buy $40bn of MBS each month, as well as signalling that rates will remain exceptionally low until 2015. More importantly, however, they signalled that this framework will continue until there is substantial improvement in the labour market. This is quite extraordinary, even if it will be pursued within the bounds of ‘price stability.’
This approach has it all from the four academics discussed above. It is not quite NGDP targeting as advocated by Woodford, but it is clear that they have taken his work on forward guidance very seriously. It is also not quite Evans 7/3 policy, but it is very close as all that is missing are the explicit targets. It is targeted at the MBS market, which is very Posen and Krugman’s notion of ‘irresponsibility’ is implicitly there too.The following is taken from the FOMC statement:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.
By stating a substantial improvement in the labour market as it’s primary goal, it has signalled that it is willing to endure higher inflation than previously thought – thus, it will take on some irresponsibility to achieve its mandate on unemployment.
It really is a remarkable policy move.