"The Debate That’s Muting the Fed’s Response"

Christina Romer:

The Debate That’s Muting the Fed’s Response, by Christina Romer, Commentary, NY Times: ...Monetary policy makers are all hawks now. Even those who most emphasize the Fed’s role in fighting unemployment oppose policies that would raise inflation noticeably above the Fed’s implicit target of about 2 percent.

The real division is not about the acceptable level of inflation, but about its causes, and the dispute is limiting the Fed’s aid to the economic recovery. The debate is between what I would describe as empiricists and theorists.

Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal. ...

Theorists, on the other hand, emphasize economic models that assume people are highly rational in forming expectations of future inflation. ... For theorists, any rise in an indicator of expected or future inflation, like the recent boom in commodity prices, suggests that the Fed’s credibility is at risk. They fear that general inflation could re-emerge quickly, despite high unemployment.

Now, not every monetary policy maker fits neatly into these categories. ... But the main division is between the empiricists who say “inflation is unlikely at 9 percent unemployment” and the theorists who say “inflation could bite us at any moment.” ... Although the Survey of Professional Forecasters ... shows virtually no change in long-run inflation expectations since the start of the program, the theorists hold fast to their concerns.

As a confirmed empiricist, I am frustrated that the two sides have been able to agree only on painfully small additional aid for a very troubled economy. For a sense of how much more useful monetary policy could be, one can look to the Great Depression.

By 1933, short-term interest rates were near zero — just as they are today. As I described in a 1992 academic article, Franklin D. Roosevelt took the United States off the gold standard in April 1933, and rapid devaluation led to huge gold inflows and a large increase in the money supply. ... Expectations of deflation, which had been enormous, abated quickly. As a result, with nominal rates at zero, real interest rates ... plummeted. The first types of demand to recover were ones that were sensitive to interest rates. ...

The Fed could engage in much more aggressive quantitative easing, both in size and in scope, to further lower long-term interest rates and value of the dollar. It could more effectively convey to markets its intentions for the funds rate, which would also lower long-term rates. And it could set a price-level target, which, unlike an inflation target, calls for Fed policy to take past years’ price changes into account. That would lead the Fed to counteract some of the extremely low inflation during the recession with a more expansionary policy and lower real rates for a while.

All of these alternatives would be helpful and would retain the Fed’s credibility as a defender of price stability. And any would be better than doing too little just because some Fed policy makers believe in an unproven, theoretical view of how inflation works.

Since my views on monetary policy haven't always been reflected accurately when other people have characterized them, let me make them clear once again. I have never argued that monetary policy won't work at all when the economy is near the zero bound. What I have said is that monetary policy alone cannot close the output and employment gaps in severe recessions, and that fiscal policy has an important role to play in aiding monetary policy in spurring a recovery. I have called for more aggressive QE -- I was very clear that I did not think that QE2 was large enough or that is was done soon enough, e.g. I complained about the Fed waiting until the election was over before announcing the policy -- and I have also called for more aggressive fiscal policy. When I respond to those who call solely for monetary policy, it is not because I think that monetary policy won't work at all, it's because monetary policy alone is likely to be insufficient. We shouldn't take that chance.

From the very start of this crisis, I have called for a portfolio of policies as a response to our considerable uncertainty over both monetary and fiscal policy multipliers. My view is that fiscal policy is more powerful than monetary policy in severe recessions, but we don't know all that much about these multipliers in normal times, and we know even less about how they work in severe recessions (most estimates of monetary and fiscal policy multipliers come from models that don't connect the financial and real sectors very well, and hence miss a key transmission mechanism in this recession, and the studies use data that mostly come from normal times). The portfolio approach is useful when there is so much uncertainty over the effectiveness of policy because if one of the policies doesn't work as well as hoped, perhaps another will fill the void. In addition, to me it was also a case of asking which error is worse, overstimulating the economy and putting too many people to work too fast, or doing too little and enduring an "agonizingly slow recovery" to repeat a phrase I used often. I think the costs are asymmetric, that doing too little is a bigger error, so the response should be aggressive and it should involve all the tools at our disposal, i.e. it should involve both monetary and fiscal policy. We haven't done enough of either type of policy, and what we have done has been put into place much later than would have been optimal.

However, while I don't think we did enough, or did it fast enough, I also believe that what has been done on both the monetary and fiscal policy fronts has helped. The empirical evidence isn't all in and won't be for some time, but my reading of the evidence to date is that these policies helped to avoid a much worse outcome. (Even if, when summed across federal, state, and local levels, the net fiscal stimulus was relatively small, as appears to be the case, things still would have been worse without the federal stimulus offsetting the losses at the state and local level.)

Right now, we could use more of both types of policy, it's not too late to do more given the expectation that full recovery of employment is years away. Thus, I am also frustrated with the "painfully small additional aid for a very troubled economy," but my frustration is not just with monetary policymakers. Fiscal policymakers have also failed to do enough.