Hamilton: The Fed Needs a New Plan

Jim Hamilton says it's time for change:

Time for a change at the Fed, by Jim Hamilton: Plan A didn't work. Plan B didn't work. I suggest the Fed get going on Plan C.

The Bureau of Labor Statistics announced last week that the seasonally adjusted consumer price index fell by 1% during the month of October, implying an annual deflation rate around -12%. That's the biggest monthly drop in the CPI since publication of seasonally adjusted changes began in February 1947. The core CPI (excluding food and energy) saw its first decline in a quarter century.

Does this mean that deflation is now upon us? Mike Bryan argues that despite the indication from the headline and core CPI, actual decreases in prices were not that widespread in October. ...

So maybe everything's OK? I think not. Two forward-looking indicators are profoundly troubling. First, the yields on inflation-indexed Treasuries for medium-term maturities are actually higher than those for regular Treasuries. If taken at face value, that means investors anticipate an average deflation over the next 5 years at a -1.29% annual rate. Perhaps one might dismiss this as another indication that the usual arbitrage activity is completely absent in current markets, so that the nominal-TIPS spread is no longer a meaningful indicator. ...

But a second and equally troubling suggestion of expected deflation is the extremely low yields on short-term Treasury bills. Again there may be those who interpret this not as a harbinger of deflation but instead as a reflection of the astonishing (and equally frightening) flight to quality that we have been witnessing.

Even if you don't interpret the October CPI, TIPS yields, and nominal T-bill yields as warning flags of deflation, they nonetheless raise what is to me the core question: If the Fed wanted to use monetary policy to stimulate the economy at the moment, as I believe it should, what would it do?

The traditional answer would be to lower the fed funds target. But surely further cuts in the target rate can accomplish nothing in the current environment. ... If you're counting on another couple of rate cuts as the last arrows in your quiver, I'm afraid to report that continuing this battle rather desperately calls for a Plan B. ...

Nor should there be any enthusiasm for yet another lending facility. What started as a few billion dollars is now in the trillions, and credit spreads continue to widen. If we keep doing the same thing we've been doing for the last year and a half, why should we expect any different result?

So here's my suggested Plan C. The goal of monetary policy should be to achieve a core inflation rate of 3.0% (at an annual rate) over the next 6 months. That's something that can be accomplished without rate cuts or lending facilities, and here's how.

Step 1 is for the FOMC to form a clear determination that a 3% core inflation rate is indeed their immediate goal. ...

Step 2 is to communicate the goal to the public. Bernanke and Kohn should state clearly that they're worried by the October fall in the CPI,... and that they will now be adopting quantitative easing with the goal of preventing further declines in the overall price level.

Step 3 is to start creating money and use it to buy up assets until the goal set out in Step 1 is achieved. What sort of assets? My answer here would be the exact opposite in philosophy of the kind of purchases and loans that the Fed has been implementing over the last year. The Fed has been trying to sop up the illiquid assets that nobody else wants. But I think what the Fed should be doing is instead acquiring assets of a type that would allow it to quickly reverse its position if a sudden shift in perceptions causes inflation to come in above the intended 3% target. The Fed can't afford to dump the illiquid securities it's been taking on recently, and that leaves it with substantially less flexibility... My goal would therefore be to buy assets for the Fed that won't lose their value with a reversal of expectations and whose sell-off by the Fed wouldn't be itself an additional destabilizing force.

What specifically would such assets be? I'd start with those clearly undervalued TIPS. Next I'd buy short-term securities in the currencies relative to which the dollar has been appreciating. Here again if the Fed has to sell these off in a sudden change in perceptions, the Fed will have both made a profit and, by selling, be a stabilizing force. If we're still seeing no improvement, the Fed can start to buy longer-term Treasuries.

What if the policy is unsuccessful, and we still get severe deflation despite the 3% inflation target? In some ways, that's the best outcome of all, since, as I explained previously, in that scenario the Fed has solved the nasty problem of all that debt owed by the Treasury.

Targeting inflation is not just another arrow in the quiver; it's a bazooka, at least for purposes of preventing deflation. Time to take aim and fire.