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Thursday, August 27, 2020

Fed Rearranges Deck Chairs On Monetary Policy Titanic

The Federal Reserve has announced some changes to its description of the long-term objective of policy (link). From an operational perspective, this change is entirely cosmetic, and accomplishes nothing useful. It is really a distraction from the reality that the Fed is pushing on a string. The only way forward for monetary policy is for it to be transformed into fiscal policy.

The meat of the change is as follows:
In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.
This is  policy commitment that has all the robustness of a paper bag that has been left out in the rain for a few weeks. Since there are no numerical dimensions to the statement, a single print of 2.1% inflation is enough to satisfy the criteria before the Fed launches a rampage of rate hikes.

This change only makes sense as a political maneuver to deal with neoclassical economists who are obsessed with monetary policy. A tiny change was made to allow the Fed to claim it "did something," while ignoring the questionable calls for level targets.

(Note: For an alternative take on this issue, I recommend Skanda Amarnath's article on doubling down on inflation targeting. The article discusses an issue that I did not cover here -- the tendency for the Fed and fixed income markets to continuously over-react to rising inflation. Of course, other markets are worse -- gold market commentators have correctly predicted the last 20 of the past zero hyperinflations in the United States. )

If the Fed Can't Hit 2% Inflation, It Isn't Going to Hit 2.5% Either

Although a certain amount of grudging respect has built up for the Zero Lower Bound (or more accurately, The Effective Lower Bound), neoclassical economists are still all-in on the belief that monetary policy can be used to micro-manage the trajectory of the economy.

One needs to view the conventional consensus on interest rates with skepticism. Observed economic outcomes can be explained by the possibility that interest rate policy is a very weak tool, and its effectiveness lies in rapid rate hikes engineering a crisis and recession. Stimulating faster growth is not easily done -- the "pushing on a string" problem.

Mainstream academics and central bankers are spending a good deal of time arguing about the optimal design of monetary policy, while ignoring the "pushing on a string" elephant in the room.

Level Targeting -- Oh Dear

The idea of nominal GDP level targeting (NGDPLT) is popular in some circles. Instead of announcing a target rate of growth, a specific level of nominal GDP is targeted, with the target growing at a fixed rate (typical suggestion of 5%).  In an ideal world where deviations from target are small -- and monetary policy can fine-tune the economy -- it sounds reasonable.

Unfortunately, we no longer live in that world. If there is a massive downward deviation in nominal GDP, policymakers are stuck with three choices.
  1. Try to have nominal GDP grow slightly above target (5.5%) for a decade. This is largely indistinguishable from just saying the central bank wants nominal GDP growth to be "around 5%."
  2. Engineer (somehow) a massive overshoot of 5% nominal GDP growth, so that the target level is hit. The question then arises -- how does the economy transition back to 5% growth from something like 9%? In that environment, why would inflation expectations be anchored? (This ignores the entire "pushing on a string" concern.)
  3. Or just go "whoops" and revise the target to be closer to current level of nominal GDP, and have the target grow at 5%  year from there. This ends up being identical to a framework that wants "nominal GD growth to be round 5%."
Things are obviously worse if we somehow got a major inflationary overshoot of the target. Are policymakers going to engineer a depression out of fealty to some target level, or just revise the level? 

(The interesting thing about neoclassical economists is the compartmentalisation of thinking. Time consistency is only applied to show that fiscal policy has an inflationary bias. This is viewed as an extremely important result. Meanwhile, no attempt is made to ask whether new proposals for monetary policy are time consistent.)

Turn Monetary Policy into Fiscal Policy

To get around the "pushing on a string" problem, various proposals to turn what are obviously fiscal policy tools over to the central bank. Since Ricardian Equivalence is generally not taken seriously, there are few doubts that fiscal policy can (eventually) stimulate faster nominal growth (e.g., real growth, or inflation otherwise).

Neoclassical economists are still stuck in the 1960s optimal control mindset, and believe that technocrats can micro-manage the cycle. To be fair, almost anybody could do a better job than the current legislative branch of the United States government. However, this fecklessness reflected the consensus that fiscal policy was ineffective, and only monetary policy was needed to guide the cycle. The neoliberal consensus got exactly what they asked for, and the result was a failure (as they were told at the time).

However, this political quick fix could easily fail. Hard money ideologues would howl if the unelected central bank started spending money. Furthermore, there is no free lunch. No matter whether one is a MMTer or conventional economist, there are constraints on fiscal policy. The central bank engaging in fiscal policy is infringing on the policy space of the legislature. It would be completely unsurprising if fiscal conservatives announced cuts to social programmes to counter-act fiscal actions taken by the central bank. Given that considerable effort is made by legislatures to target spending, having those programmes dismantled to compensate for the central bank firing money out of a firehouse would most likely result in worse outcomes for society.

(c) Brian Romanchuk 2020


  1. I think the point of the AIT announcement is to signal the Fed is not going to preemptively hike based on some theoretical Phillips Curve model.

    1. They could just say that they exaggerated inflation risks for the last three cycles, and leave it at that. Some regional Fed presidents will probably go full ZeroHedge about inflation risks anyway, no matter what the framework document says.

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