The Fair, by Tim Duy: A man takes his son to the county fair; the lights and sounds of the amusement rides are like a magnet to the boy. The boy, however, is penniless. His father, seeing the longing in his son's eyes, hands the boy a dollar for the rides, but quizzically adds "if it looks like you are about to have any fun with that dollar, I will take it back from you." The boy is puzzled. First, a dollar only buys three tickets, and the least expensive ride is four tickets. Plus, Dad said he would take the dollar back if he went to buy tickets. So what is the point of even trying to buy any tickets?
Consequently, the father and son stand at the edge of the midway, the father wondering why his son simply stands there while the son wonders why his dad doesn't want him to have any fun. They are soon joined by the boy's grandfather, who, assessing the situation, says that the father should never have given the son a dollar in the first place. "He will just buy candy, which will cost you more later when you have to take him to the doctor to treat diabetes." The father neither agrees or disagrees. Along comes a trusted uncle, who says to give the boy another dime, but " then if he looks like he will have any fun, take back a quarter."
The grandfather and uncle start bickering, loudly, in public, about what to do with the boy and his dollar. Soon another uncle rushes into the fray, proclaiming it is pointless to give the boy a dollar because all the workers are already busy helping other fairgoers. "He can't buy anything anyway, and if he tries, he will just drive up prices for all his cousins." The discussion becomes increasingly heated, drawing the boy's cousins away from the rides. The lights and noise of the fair fade as lines dwindle and the rides grow silent.
All the while, the confused boy is wondering why his father just stands there, refusing to criticize the grandfathers and uncles even as the argue increasingly silly positions. Finally, the father, realizing the boy's confusion, turns to him and says "Reaching consensus in the family is always more important than the fair." The arguing continues as employees begin to turn off the rides, one by one.
This, I believe, is an apt analogy of the current state of monetary policy. A policy that is supporting disinflationary expectations simply because it lacks a credible commitment to any other outcome.
Why does policy lack a credible commitment? First, as I think has been clear from day one of the Fed's quantitative easing policy, policymakers eagerly await the opportunity to reduce the balance sheet - the expansion of the balance sheet was never intended to yield a permanent increase in the money supply, and as such should have had little impact on long run expectations. As recently as Federal Reserve Chairman Ben Bernanke's July Congressional testimony, policymakers were stressing the ability of the Fed to reduce the balance sheet, clearly much more concerned about the inflationary potential of their actions than the ongoing disinflationary impact of being stuck at a subpar equilibrium. Only recently has attention turned to the possibility of additional action, and then only under critical pressure. When additional action is taken, it will almost certainly be in the context of a temporary action, the Fed will stand ready to withdraw the stimulus should it look like economic agents are having any fun with that infusion of cash.
Moreover, I do not believe the swelling of the balance sheet - albeit massive in the eyes of policymakers - sufficed to convince market participants that the Fed was committed to maintaining inflation expectations. St. Louis Federal Reserve Chairman James Bullard, in his "Seven Faces" paper, claims that the suggestions that the appropriate Federal Funds target should have been negative 6% are "nonsensical." And, of course, in a sense they are - zero is indeed the lower bound. But economists also suggested estimates of the quantitative equivalent of negative 6%, perhaps something on the order of a balance sheet expansion to $10 trillion, far beyond what Fed policymakers found tolerable. And I think that big number was important - it gave an indication of the size of monetary commitment consistent with previous policy response. The failure to meet that commitment could reasonably be interpreted by market participants as an indication the Fed was willing to accept the disinflationary impact of the Great Recession, perhaps so far as seeing the event as another opportunity for opportunistic disinflation.
Moreover, any sense that the policy action to date was acceptably insufficient was reinforced by the Fed's own forecasts, which undeniably reveal an expectation that policymakers anticipate an agonizingly long recovery, yet decline to add additional stimulus. Recall that the most recent FOMC decision only prevents premature tightening of policy, not a stimulus boost. Moreover, consider Bullard's remarks Friday:
“The consensus is developing in the forecast community that we’ve got a slower economy in second half of this year,” said Bullard, who is known to be an outspoken hawk on monetary policy. “But we will pick up in 2011, probably back to trend growth, or even better.”
Note that this is this forecast remains in the context of current policy:
“I think we have to be prepared to move, and I think the committee is much closer to being prepared than we were, say in June, or May of this year,” Bullard said, although he added, “I don’t think it will be necessary to take additional action.”
It is important to note that a return to potential growth does little more than prevent the output gap from expanding further, little more than absorbing the natural expansion of the labor force, with little hope of reemploying the millions who lost their jobs in 2008 and 2009.
In short, policymakers feel no urgency to engineer a V-shaped recovery, to return output to potential. They won't provide enough to buy tickets for the rides, and they know it.
Now, Bullard is currently one of the most rational policymakers, and is at least willing to intellectually entertain the need for additional stimulus. But even here, he is not willing to offer policy of the magnitude necessary to rapidly return to potential. From his response to my earlier piece:
When we make 25 basis point moves on the federal funds rate, those are small viewed in isolation, but they have important effects for macroeconomic stabilization because they imply an expected interest rate path over the coming years. The same is true for QE. A move on a particular day may seem small, but it implies a path for future policy, and a series of smaller moves may add up to a very large move if the incoming data are consistent with such an outcome. The "shock and awe" view, if applied to interest rate targeting, would suggest very large interest rate movements in response to relatively small changes in incoming data, a policy that most would view as destabilizing for the macroeconomy. The same is true for QE. So the point is that QE moves should be commensurate with the incoming data (a.k.a. "state contingent"). Of course we can argue about the incoming data--and I know you have strong views on that--but I think my position on a "disciplined" QE program is correct and that the dangerous policy is to make destabilizing moves out of line with the incoming data.
This sounds like the uncle who advises giving the boy another dime. Still not enough to buy tickets for the rides, and with the explicit warning that what was given will soon be taken away.
The problem here, I have come to realize, is that Bullard and I are talking across each other, not to each other. In the context of the Fed's forecast, his position is reasonable. He is looking at incremental changes, give some here, take some back there, to manage expectations along the current trajectory, one that everyone acknowledges will only reduce the output gap at an agonizingly slow pace. Whereas I feel an urgency to close that gap, policymakers, in my opinion, exhibit a sense of complacency about the gap.
But the gap itself is important to managing disinflationary expectations. By not specifically targeting the gap, the Fed is implicitly accepting the disinflationary consequences. If the US falls into a Japan-style malaise in the wake of this, or what I think is more likely, the next recession, I believe it will be attributable a clear unwillingness of Fed policymakers to view potential output as a relevant policy objective
Instead of making incremental changes to the level of the balance sheet, I would prefer incremental changes to the rate of growth of the balance sheet. Make an explicit promise to keep feeding the kid at the fair quarters until it looks like he's about to throw up while riding the Ferris wheel.
And, next, we come to the issue of consensus - the public bickering of the boy's elders. I do believe consensus is important, or that at least in private, all decision makers believe they have had adequate opportunity to define their positions. I do not, however, believe it is conducive to good policymaking to air vast policy differences in public. Seriously, we have a regional Fed president running around loose claiming that low interest rates will only entrench deflationary expectations, seemingly unable to grasp the concept that those deflationary expectations are driving rates lower. And has any Fed official offered an explicit response?
Talking points exist for a reason. They are important. They help manage expectations. They provide at least a veneer of policy consistency. Federal Reserve Chairman Ben Bernanke appears to see no need to enforce a set of talking points. This, I think, is a mistake, as it lets policy expectations be driven by the likes of Minneapolis Fed President Narayana Kocherlakota , Dallas Fed President Richard Fisher, and Kansas City Fed President Thomas Hoenig.
Coming clean, I admit that basic public consistency was something I appreciated during the reign of former Federal Reserve Chairman Alan Greenspan. I recall an incident, back in the day, when a regional Fed president made a comment that was decidedly out of line with the public stance of policy at the time. The press grabbed it, as they should have. I can't remember the comment itself, and it really is not important now. What was important was that a few days later, former Governor Edward Gramlich made a countervailing remark that was particularly notable because it was out of context with his presentation. It was a clear effort to reinforce expectations around the current policy. Soon thereafter I had an opportunity to talk with Gramlich, and ask him if he had been asked by Greenspan to set the record straight. He indicated that this was indeed the case.
Some would call this dictatorial; I just think it is good policy. Particularly good for an agency that claims managing expectations is an important element of conducting policy.
Finally, I would add that it is not clear the father should even given the boy money to buy tickets. Why not just cut out the middle man and give the boy tickets directly? Quantitative easing is arguably simply trading one ultra safe asset for another, hoping to induce others to acquire riskier assets. Unfortunately, the avenues by which the Federal Reserve can acquire riskier assets, like an outright portfolio of equities, are limited. The Fed, however, could buy foreign sovereign debt, thereby driving down the value of the Dollar. Predictably, Bullard dismisses the notion:
Bullard also noted large countries with very low interest rates and weak pricing environments, like the U.S., Japan, Europe and potentially the U.K., cannot use their exchange rates to boost inflation away from deflationary levels. He said such an action “might not be prudent, and it might not be possible.”
Bullard also noted that in this time of anxiety about currency levels, the evidence on the effectiveness of central bank interventions is “mixed,” even though those are the sort of moves “traders seem to pay attention to.” Bullard also added, “The dollar, obviously, is and will remain a reserve currency for a long time.”
Policymakers always revert to the "interventions are not effective" straw man when discussing currencies, ignoring the elephant in the room - China appears perfectly capable of targeting very specific levels of the exchange rate. And we seem to believe that such a policy contributes to inflation in China. Yet the same is not true for the US?
The issue is simply one of commitment. In the absence of crisis, Federal Reserve policymakers refuse to look at policy via any lens beyond interest rates and the most simple exercise of balance sheet expansion. They could very well anchor inflation expectations against a steady depreciation of the dollar or other assets prices. They could stop thinking of foreign exchange purchases as one-time events, and instead acquire at a fixed rate, say $1 billion a day. Virtually every other nation believes prudence demands the establishment of large foreign currency reserves. Why should the US differ?
Bottom Line: Although the Federal Reserve is poised for another round of quantitative easing, it is important to recognize their ultimate objective. It is not to pursue an a rapid return to potential output in order to rapidly alleviate unemployment. It is simply to maintain policy expectations in the context of a return to potential growth. Thus, one should expect the actual easing to be commensurate with such a policy. In other words, pay attention to what Bullard is saying - "measured" policy action. This, in my opinion, will be too little too late, as I am more concerned with an aggressive assault on unemployment and believe that using potential growth as a policy reference effectively locks the US into a suboptimal equilibrium.