I haven’t had a chance to fully digest yesterday’s Fed action. However since I have received many comments from people who think I should be enthused, I feel obligated to throw a little cold water on the celebration.
Yesterday the Fed announced that they would engage in quantitative easing, which is one of the three major steps that I had hoped they would take. Unfortunately, it is the least important of the three. Just to review, I suggested that a multipronged approach was essential:
1. An interest penalty on excess reserves.
2. A clearly spelled out target path for NGDP or the price level.
3. Quantitative easing, if necessary.
4. Keep expanding until market expectations signal NGDP growth is likely to hit the Fed’s target.
If the Fed had done both one and two, I don’t think the QE would even be necessary, without those other two steps, my fear is that we’ll just get more of the same—banks hoarding lots of interest-bearing reserves, which are now essentially T-bills in all but name. So this “monetary policy” is essentially swapping one type of government debt for another. (I’m sounding like Paul Krugman here.)
On the other hand the S&P did jump 2% on the news, and since it was partially anticipated (I wish I knew the odds) we can infer that the actual impact was substantially larger. But the level of the S&P suggests that we are far from where we should be, and an indicator I put even more weight on, inflation expectations in the TIPS market, barely budged at 5 and 10 year maturities. The five year figure is a mere 0.69%. I’m not an expert on forecasting, so these observations are very tentative, but I certainly didn’t see the sort of strong market reaction one would expect after a credible policy announcement.
I also don’t know what to make of the numbers—$300 billion in Treasury notes, and even more in purchases of other types of debt. Does this mean the monetary base will go up by this amount? If so, when? And if QE is such a good idea, why has the Fed reduced the monetary base by $250 billion over the past 10 weeks? Will the $300 billion merely reverse that decrease? My hunch is that all these questions miss the point. Hamilton has a post where he says:
The Fed has declared pretty loud and clear that it is not going to allow deflation. So here’s my personal investment advice: don’t bet against the Fed.
My first reaction was that Hamilton was wrong, that the TIPS market had bet against the Fed. And recall that I view market expectations (however imperfect) as the best we have. The more I thought about it, however, the more I concluded that Hamilton is exactly right, the market read this as an indication that the Fed will do whatever is necessary to prevent outright deflation. Instead we are likely to get continued below target inflation, and NGDP growth that is far below target. For that the stock market was thankful. But having spent so much time studying market reactions to truly effective stimulus in the Great Depression, I was underwhelmed by yesterday’s response. A policy that was expected to boost NGDP growth up to 5% would have had an explosive impact on equity prices, and might well have driven long bond yields up, not down.
I hope this post doesn’t sound too negative. The Fed is moving (slowly) in the right direction. The market reaction was positive. However, it is also important that we keep pressing the Fed to undertake a truly credible policy initiative, which would also include limits on bank hoarding of reserves, an explicit target path for one of the nominal aggregates, and a promise to target the forecast (whether internal or market-based.)
By the way, in Mankiw’s blog today I noticed that he described how a “clever grad student” had proposed a negative interest rate on base money. I wonder if this clever student reads my blog. Or the two short papers I published this year in The Economists’ Voice. To be fair, he also proposed that the plan be applied to cash, but the method was so convoluted (invalidating currency with certain serial numbers, chosen randomly, at certain dates) as to be totally impractical. And of course Gesell proposed a similar idea back in the Depression. But the plan is very easy to implement for reserves, and almost all of the base hoarding has been in reserves. Why hasn’t the Fed done this already?
The idea in the Mankiw column is not politically or practically feasible, as it would turn Federal Reserve Notes into a giant Keno game. But there are more pragmatic solutions to the worldwide crisis that might actually work, like charging interest on excess reserves.
P.S. Dilip just sent me a post by Yves Smith, who knows more than I do about the details of the Fed plan. I would just add one point; some of the discussion focuses on whether long bond yields might rise. If you told me today that long bonds would be yielding 5 or 6% a year from now, I’d be thrilled, just as I’d be thrilled to hear that oil would be back up to $100.