Sunday, July 28, 2013

Fed Fatigue

The Econ blogosphere has erupted over the apparently heinously inconceivable idea that Larry Summers might be the next Fed chair.

Here's Ezra on the situation:

As far as I can tell, there’s almost no one in the economics blogosphere who wants to see Larry Summers named as Ben Bernanke’s replacement. The bulk of opinion ranges from relative indifference between the two candidates (“as we know there’s no real daylight between Yellen and Summers“) to extremely strong anti-Summers opinions (“Larry Summers will destroy the economy“) — with much of the latter being driven by Summers’s record on financial regulation. Tyler Cowen is almost alone in holding up the pro-Summers end of the argument.

Personally, I'm a Bernanke guy. I think he did an amazing job in the height of the crisis and would love to see him take another term. But I'd be fine with Larry Summers (I'm sure Larry is breathing a sigh of relief now that he knows) as Chair. I'd be fine with Yellen too, though I worry that she thinks the Fed can do more than it actually can (at least such a belief is not likely to be very harmful in the near term at least).

But, all the commotion about who's going to be the next Chair is way overblown. It's just not that important, for two reasons. First, the Fed is not independent of politics and without big political change there is not going to be big monetary policy change. Second, the ability of monetary policy to reliably guide the real economy is much more limited than most people want to believe.

On the Fed and politics, you can start here, or here.

As a quick example, consider the "Volcker disinflation" in the early 1980s. Big Paul took office in 1979 and announced in October that the Fed would focus on monetary aggregates and lower their growth rates. However, the actual policy of lower money growth didn't happen until after the election in 1980, which installed a conservative Republican president and a Republican majority in the Senate. In the year between the announcement and the election, monetary growth was unchanged from the previous two years. In the year after the election, monetary growth was only half as fast.

On the limited power of monetary policy to control the real economy, you can start with Adam Posen's recent review essay. Here's a good bit:

Indeed, central bankers should be far humbler today than they were in recent decades, when some claimed credit for the so-called great moderation, the period of reduced economic volatility that lasted from the late 1980s to the early years of this century. It is now clear that the prosperity and stability much of the world enjoyed during those years were largely the result of good luck.

In my view, Posen, if anything is overstating the power of monetary policy over the real economy.

Consider post 2007 US monetary history. The Fed promptly took the policy rate to zero. We still had big problems. So the Fed started QE. We still had big problems. So the Fed did further rounds. We still had big problems. So the Fed tried forward guidance. We still had big problems. So the Fed tried outcome-based as opposed to calendar-based forward guidance. Guess what? We still have big problems (I know, counterfactuals are a b**ch, but the Fed clearly didn't fix things).

You may say, "but recoveries after financial crises are always slow". But people, that's just another way of saying that Central Banking is not that powerful when it's most needed!

You may say, "but they should have done more and that would have fixed things".

That's borderline epistemic closure. "The right monetary policy can do anything. The economy is not fixed, so the right monetary policy was not employed", is going to be pretty hard to ever disprove.

I think some of the Summers backlash is because Larry understands that the power of monetary policy for the real economy is rather limited.


Gordon said...

It's not a question of recoveries being slow. The market monetarists says it's expectations that matter. Suppose you're at a party being hosted by the Simpsons with Homer being the U.S. government and Marge being the Fed. If Homer is pouring the drinks, the expectations are that he'll go overboard trying to please people and many of the party goers will end up severely drunk. Some people think Marge's only role is to put out glasses and ice though people like Flanders believe that alone will lead to problems. If Marge is pouring the drinks but listening to the fears of Rev. Lovejoy to not pour too much, the party won't get going. If Marge finally convinces people that she'll keep the drinks flowing until the party takes off, THEN people will start committing to the party.

Patrick R. Sullivan said...

If you think monetary policy ain't potent, how do you explain Zimbabwe;

Makes Volcker look like Casper Milquetoast.

Wonks Anonymous said...

The Fed can have limited impact on the real economy, even while it is "omnipotent" over the nominal economy. So the Fed can still be faulted for falling below its inflation target.

Sam said...

I'm confused.

One of the things I learned in Econ 101 (we used Greg Mankiw's intro text) was that there is a short-term trade-off between inflation and unemployment.

Inflation over the past 5 years has been extremely low, while unemployment has been extremely high.

I remember Milton Friedman taught that the Fed always controls inflation.

Doesn't this mean the Fed has failed to do its job?

Anonymous said...

I don't think market monetarists are exclusively resorting to theory. They have plenty of real world examples on their side E.g. the devaluation of the dollar in 1933; also Sumner and others have praised the monetary policies of Australia and Israel. Maybe Canada too?\

Saturos said...

The market monetarist argument is that the Fed has been clearly and continually communicating intentions which are quite contrary to those it needs to - i.e., setting policy so that the median inflation forecast is sub-2%, even whilst Bernanke has admitted that the Fed is perfectly capable of targeting above 2% inflation, and Woodford has said that level targeting is the most powerful thing at the ZLB, and Bernanke has said that only NGDP and inflation can reliably tell you the stance of monetary policy, and employment has been well below the Fed's own estimate of the natural rate, and no one has explained why the costs and risks of formally announcing a more expansionary target for the level of spending (or even just signalling that intent obliquely through more QE) has more "costs and risks" than doing nothing. I don't see how that's epistemic closure - for a real example of epistemic closure, see people who insist that real interest rates are the only way of judging the stance of monetary policy, insist it's been ultra-easy since '08, and aren't even aware of the fact that they *rose* in late '08. Or who insist that the Fed is powerless at the ZLB, then complain of runaway inflation if the Fed announces an intent to buy an arbitrary quantity of assets until (the demand side of) the economy looks good again. And insist they had the Japanese situation right all along whilst saying it's in a liquidity trap and ignoring how Abe depreciated the yen just like that.

Mark A. Sadowski said...

"Consider post 2007 US monetary history. The Fed promptly took the policy rate to zero. We still had big problems. So the Fed started QE. We still had big problems."

For three months after Lehman's collapse on September 15, 2008, the federal funds rate stayed well above zero. In that period, the Fed found the time to provide dollar swaps for foreign central banks, instituted a policy of interest on excess reserves, and started QE1 with $700 billion in Agency MBS. Finally, on December 15, 2008, the Fed decided to lower the target federal funds rate to zero.

It is important to remember the exact sequence of these events. It is a false memory to think that the Fed immediately took the policy rate to zero in response to the financial crisis. There was not one, not two, but three separate FOMC meetings between Lehman's bankruptcy and the ultimate decision to take the policy rate to zero where each time the FOMC failed to seize an opportunity use its main policy instrument to fight back against the collapsing economy.

The Fed's sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in 2007. The decision to wait three months to lower interest rates to zero in late 2008 was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history.

Mark A. Sadowski said...

"I know, counterfactuals are a b**ch, but the Fed clearly didn't fix things."

It might be useful to compare the US with another large currency area that is also up against the zero lower bound in policy interest rates and has done no QE at all. That would be the eurozone. Since August 2008 the Fed has increased its monetary base by 260% and the ECB by only 43%.

According to Econ 102 there are primarily two ways that policymakers can regulate aggregate demand (AD): fiscal and monetary policy. And by definition aggregate demand is nominal GDP (NGDP).

The best way of measuring fiscal policy stance is by changes in the cyclically adjusted primary balance. The April 2013 IMF Fiscal Monitor projects that between 2010 and 2013 the cyclically adjusted primary budget balance as a percent of potential GDP will increase by 4.0% in the US and by 3.8% in the eurozone.

The IMF WEO projects that from 2010 to 2013 that NGDP will increase by 12.0% in the US and by 4.6% in the eurozone. The IMF also projects that from 2010 to 2013 that real GDP (RGDP) will increase by 6.0% in the US and by 0.5% in the eurozone. So AD increased by nearly three times as much, and real output 12 times as much, in the currency area that actually did QE, and nevertheless contracted its fiscal policy stance more.