Saturday, September 15, 2012

QE3--One Step in the Right Direction

Finally, the FOMC has adopted QE3.    From the Market Monetarist perspective, the new policy is an improvement, but it could be better.

The key element of Market Monetarism included in the new Fed policy is a program of open ended open market operations until a macroeconomic goal reaches a desired level.    Market Monetarists favor open-ended open market operations until nominal GDP reaches a specific target growth path.    What the Fed proposes is purchases of  $40 billion of mortgage-backed securities each month until labor markets improve.

Until labor markets improve?   That is extremely vague.    We could imagine an appropriate labor-oriented nominal variable--a growth path of nominal wage income.   But that isn't what the Fed has proposed.   Unemployment, employment, or maybe the employment-population ratio seem to be the focus. And what is the proposed level? Whatever the Fed decides is appropriate at some future time.   Still, employment is something that is traditionally given a level-type goal.   (Of course, the Fed might use growth in employment which would be a growth rate target.)

Targeting real variables is a potential disaster.    Expansionary monetary policy seeking an unfeasible  target for unemployment was the key error that generated the Great Inflation of the Seventies.   Employment or the employment/population ratio could have the same disastrous result.

Given  the potential for inflationary catastrophe, that the Fed stated that this improvement in the labor market must be done in the context of price stability is better than nothing.   The Fed mentioned its 2 percent target for inflation.

However, an inflation target remains the wrong nominal target.    It is a growth rate rather than a level target. I saw nothing in the Fed's statement that suggested any room for allowing the price level to catch up to its previous growth path, which would imply more than 2 percent inflation (though not much for very long.)

On the other hand, in response to questions at the press conference, Bernanke said that because both employment and inflation are part of its mandate, if recovery in employment was associated with a temporary increase in inflation, that would  be acceptable, as long as inflation returns to its target in the long run.

This is exactly what would happen with a target growth path for the price level.   For example, if the price level were on a 2 percent growth path, and a recession caused the inflation rate to slow, perhaps even to the point of deflation, then returning to the previous growth path would temporarily require more than 2 percent inflation.   Once the price level recovered to its previous growth path, then the "target" for inflation would return to 2 percent.  

Unfortunately, Bernanke is actually saying that slightly higher inflation will be tolerated for a time if it would result in improved labor conditions.    Perhaps it is best to simply understand this in the context of the Taylor rule.   If the weighted negative output gap is greater than weighted excess inflation, then monetary accommodation is appropriate.

Now, if the Fed were seeking to return nominal GDP to a target growth path, then the more rapid growth in nominal GDP could result in higher inflation as well as more rapid growth in real output, and so, employment.   A willingness to tolerate higher inflation along with improvement in employment appears consistent with an upward shift in the current, excessively low, growth path for nominal GDP.  

The way Market Monetarists would put it is that the Fed should commit to return nominal GDP to a higher growth path (closer to the trend of the Great Moderation if not that very trend.)    The Fed should make it clear that it will follow this policy whatever happens to inflation or employment.   While it is true that lower inflation and more employment would be better, what will happen, will happen.  The Fed's should see its task as keeping nominal GDP on a stable growth path, which includes reversing any deviations of spending on output from that path.   How spending splits between inflation and production is not the Fed's responsibility.

The other "problem" with the Fed's policy is that it has specified that it will be purchasing mortgage backed securities.   Since these are all "agency debt," that means they are already guaranteed by the U.S. taxpayer for credit risk.

Generally, Market Monetarists (like Traditional Monetarists) do not worry much about what particular assets the Fed purchases.   It is the impact on the Fed's liabilities--the quantity of base money--that is important.     However, this policy certainly has an odor of credit allocation--the Fed is trying to encourage people to obtain home mortgages and buy houses.    Bernanke reinforced this view at the press conference by explaining how the policy is supposed to work.   It is supposed to lower interest rates on home mortgages and so more mortgage lending and more spending on housing.

Market Monetarists believe that the way monetary policy works, and the way it should work, is primarily by expectations of spending on output in the future, and the last thing we would like to see is the central bank direct credit to preferred sectors.   The key for this process to work is that people now must believe that the Fed will expand base money enough in the future to get nominal GDP to the target level at some future time.  This process has nothing to do with getting people to borrow more now or in the future.

Now, if people already believe that (which we insist would be better done by an explicit nominal GDP target rather than a commitment to  improve labor market conditions and a willingness to tolerate temporary above target inflation,) then many Market Monetarists would agree that increasing base money now by purchasing assets with a zero nominal interest rate would not do anything more to immediately raise spending on output. And so, the Fed would need to purchase some financial asset that has a positive yield.   Mortgage backed securities do have a positive yield, and so they should work.

Still, Market Monetarists generally favor a more systematic approach of purchasing assets with progressively more duration and risk.   While we see no real harm in purchasing extra amounts of short and safe assets, it seems plausible that using open market operations, of perhaps heroic magnitude, to generate a prompt recovery of spending on output, would require purchasing assets with a positive yields.   Agency securities are usually included on our lists--right after the thirty year government bonds.

More importantly, Market Monetarists reject the notion that an expansionary monetary policy will necessarily lower nominal or real interest rates.   In particular, the key pathway through which an expansion in the quantity money works--changes in expected future spending on output, will tend to raise both real and nominal interest rates.

Still further, Market Monetarists insist that an expansionary monetary policy does not require that people choose to borrow more to fund spending on output.   It is entirely possible that such a policy could work entirely by households and firms choosing to lend less.   Households and firms can sell off current holdings of bonds and use the money raised to purchase consumer and capital goods.   This is not more borrowing.  It is less lending.   If households and firms sell more bonds than the Fed buys, then this can occur with higher nominal interest rates.

In fact, many Market Monetarists would insist that the best scenario today is that firms, currently holding huge portfolios of short term to maturity securities, will sell off some of those securities and buy capital goods.  Again, if firms sell more bonds than the Fed buys, then short term nominal interest rates can rise while spending on current output and employment rises.   The motivation for purchasing the capital goods now would be higher expected sales of products in the future.

So, rather than promising to lower interest rates, the Fed needs to be committed to raising spending on output now and in the future.   How much?   They need a specific target growth path for spending on output.

Open ended purchases of mortgage backed securities to lower interest rates to encourage people to borrow and buy housing until labor markets improve though only if inflation doesn't rise too high for too long...

Well, open ended purchases of something is a move in the right direction.   But the Fed has a long way to go.


  1. I agree with all the words you write.

  2. In a mostly service sector economy like we have today in the West, what are the "capital goods" you'd like to see bought? Restaurant ovens? Shopping malls? iPads for lawyers?

  3. I suppose by describing a "best scenario," I am opening myself up to that question. What capital goods exactly should firms buy? Well, I don't have an answer to that. And if there are no capital goods for firms to buy, then additional spending on consumer goods would be appropriate. (But I don't think having lawyers buying ipods is first best. For efficient rent seeking--definately, a mixed bag.)

  4. The notion that using monetary policy to spur unproductive consumption on housing and housing-related purchases is very much at odds with the broader classical idea that growth comes from investment in productivity-increasing capital and entrepreneurial innovation. It seems crudely keynesian in a rough way. It's as if the credit allocation towards housing is aimed at addressing housing market "slack", even if the actual composition of consumer demand for housing doesn't support re-employing all of that so-called "slack" anyway.

    Say's law definitely doesn't have any fans at the Fed.

    1. You sound a bit Keynesian there John - consumption doesn't need to be productive, it's production that serves the end of consumption. Actually, Market Monetarists don't see monetary policy as needing to "spur" anything. What's happened is that the flow of the medium of exchange through the economy has dried up (collapsing NGDP). This means there are people wanting to work for employers and contribute to producing goods for sale, and then exchange their claims on that output with those of other workers and investors, to feed their families etc. who are now unable to do so, as money is not flowing through to market participants (by which I mean ordinary households) to resolve the coincidence of wants problem of exchange. Mass unemployment is what we're seeing, the result of the fact that workers have to be paid these claims in money wages, but their wage rates can't fall (for a number of reasons) along with the fall in the total flow of money-spending.

      So it's wrong to say, as people often do, that there is a lack of "demand". Ask any unemployed worker - there's plenty of demand for more production . What we have is a lack of spending, the expression of demand through money payments. We MArket Monetarists are simply trying to get money flowing through the economy at a level consistent with the current wage rates and full employment - that every worker should have the exchanges of their labor for goods which they want to make, facilitated by money flowing through to them. This is expressed more formally as "restoring the NGDP trendline".

      But yes, Bernanke is wrong about targeting the housing sector per se. And of course we want to see a recovery in investment, along with every other unnecessarily depressed sector of the economy, through the facilitation of the exchange of output via money. We need to get the money flow up to just the right level - of course too much money-spending causes its own problems, as we saw in the 70's.

  5. I'm not an economist so I probably missed the boat somewhere. But while this all sounds like great theory, it also seems to presuppose a key input to growth: that everything *else* growth needs is already in place, and all we have to do is get the money policies right.

    As a grunt way down in the trenches, it sure looks to me like the growth of government regulation over the past five years has been a major downer on the economy.

    So does monetary policy have some magic way of getting around the increasingly onerous costs of complying with new government regulations? Because I really need to know about this magic.

    1. No, it doesn't, but as Scott Sumner says bad monetary policy creates a fertile climate for bad government policies. We've had bailouts, , extended UI, Dodd-Frank and even Obamacare thanks to the climate created by the Fed's failures. Even the debt has ballooned thanks to "Bernanke's Depression", and the risk of monetization is far greater when you can't grow your way out of it. As the examples of both Argentina and Nazi Germany show, radical governments really come to power not during hyperinflation but during deflationary depressions. Granted, we've only had a disinflationary recession here, but still...

  6. I still think you guys are playing with fire, but this is the best Market Monetarist response to QE3 I've seen, Bill. (Sent here by David R. Henderson.)

  7. Thanks for your insightful post. You write: “Still further, Market Monetarists insist that an expansionary monetary policy does not require that people choose to borrow more to fund spending on output.” Absolutely true; spending on output has to increase, but borrowing/lending is totally irrelevant. B might borrow from A to spend on output, but it would be just as good, for the success of expansionary monetary policy, if A himself spent the money on output instead of lending it to B for B to spend.
    But you go on: “It is entirely possible that such a policy [viz., expansionary monetary policy] could work entirely by households and firms choosing to lend less.” There are two things wrong with this sentence: (1) ‘by’ and (2) ‘lend’. (1) As noted above, borrowing and lending are irrelevant; the policy works simply by inducing more spending on output, not *by* anything having to do with borrowing/lending. (2) It is misleading to talk of the decision to lend less, without mentioning borrowing: borrowing/lending is a two-sided transaction, with a decision being made by both parties, so there is just as much *deciding not to borrow* going on as there is *deciding not to lend*.

    1. I can't really disagree with your criticisms. In fact, the most obvious way monetary expansion can work is that when the central bank purchases securities, the person selling the securities uses the funds received to purchase output. And those selling the output spend the money received on other output, and so on. That the person who initially sold the security is "lending less" isn't essential.

      However, my point remains that a shift to a nominal GDP level target, and his a change in expectations about what will happen in the future, could result in people choosing to sell off securities and buy consumer and capital goods. They are lending less, tending to raise real and nominal interest rates.