Thursday, September 22, 2011

Can You Push on a String? Should You?

It has been a commonplace observation about monetary policy for decades that "you can't push on a string." That is, while monetary policy can definitely slow down an economy during an inflationary period by using higher interest rates, it may no work as well to use low interest rates to stimulate an economy during a period of high unemployment. The problem is that although a central bank can make reserves available to banks, it cannot force banks to want to lend nor households and firms to want to borrow.

However, some would argue that we haven't yet pushed hard enough or long enough. As I will explain, I'm dubious about this argument. But for an example, Charles L. Evans, President and Chief Executive Officer of the Federal Reserve Bank of Chicago, gave a talk on September 7 advocating a more aggressively expansionary monetary policy in "The Fed's Dual Mandate Responsibilities and Challenges Facing U.S. Monetary Policy." Here is some of the flavor of his argument:

"Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market. ...

It is painfully obvious that the large quantities of unused resources in the U.S. are an enormous waste. And it’s not just the current loss—over substantial periods of time, the skills of long-term unemployed workers decline, their re-employment prospects for similar jobs fade, and these reductions in skills have a lasting effect on the future growth potential of the economy. ...

One way to provide more [monetary] accommodation would be to make a simple conditional statement of policy accommodation relative to our dual mandate responsibilities. ... This conditionality could be conveyed by stating that we would hold the federal funds rate at extraordinarily low levels until the unemployment rate falls substantially, say from its current level of 9.1% to 7.5% or even 7%, as long as medium-term inflation stayed below 3%. ... [I]t would not be unreasonable to consider an even lower unemployment threshold that would be enough progress to justify the start of policy tightening. There are other policies that could give clearer communications of our policy conditionality with respect to observable data. For example, I have previously discussed how state-contingent, price-level targeting would work in this regard. Another possibility might be to target the level of nominal GDP, with the goal of bringing it back to the growth trend that existed before the recession."

As I read it, Evans's argument is based on two claims: 1) A truly aggressive monetary policy could bring down the unemployment rate; and 2) The costs of continued high unemployment are enormous, and the risk of significantly higher inflation is low, so uncertainty should be resolved in favor of a more aggressive monetary policy. I am dubious of both these claims. 

Will a more aggressive monetary policy reduce unemployment? 

Evans implies that the Federal Reserve hasn't really done all that much to fight unemployment: he says that if inflation were up, central bankers "would be acting as if their hair were on fire," and says that similar urgency is needed in fighting unemployment.

It seems to me that the Fed has been acting as if its hair was on fire! If you had asked me, circa 1986 or 1996 or 2006, about how I would describe a Federal Reserve which dropped the federal funds rate to near-zero, held it there for three years (since late 2008), and promises to keep it there for another two years (as it did at its August meeting of the Open Market Committee), and at the same time creating money to buy a couple of trillion dollars worth of federal debt and mortgage-backed securities, I would called it an extraordinarily and unimaginably extreme monetary policy. I have supported that extreme reaction, given the extreme circumstances of the U.S. economy in late 2008 and into 2009. But to claim that the Fed hasn't been very aggressive in fighting unemployment is ridiculous.

Milton Friedman once famously said: "Inflation is always and everywhere a monetary phenomenon." At this point, the argument in favor of a more aggressive monetary policy comes close to making the extraordinary claim: "Unemployment is always and everywhere a monetary phenomenon." But is it always possible to fix unemployment with an appropriately strong dose of monetary policy? The answer seems obviously "no." Unemployment is sometimes rooted in structural characteristics of an economy as it slowly adjusts to a severe negative shock.
Evans talks about whether the Fed should move to targeting the price level, or to targetting a level of nominal GDP. Whatever the theoretical arguments for such steps, the Fed's extreme easing has been unable to push up inflation substantially. The central bank certainly seems to have been pushing on a string. And we have the looming example of Japan, where the central bank has been running a near-zero target interest rate for almost 15 years at this point, without successfully stimulating a higher price level. The Fed has already promised to extend the near-zero federal funds interest rate for two years. I just don't believe that promising to keep it there indefinitely, until unemployment falls, is the magic key to stimulating economic recovery.

It doesn't seem pragmatic to say that highly expansionary Fed policies for about four years, since late 2007, haven't worked to reduce unemployment or to create a higher price level, so we must continue those same policies of near-zero interest rates indefinitely. In a previous blog post about a month ago, "Can Bernanke Unwind the Fed's Policies?" , I offered an overview of what the Fed has done and raised some of these issues.

Is there little risk to pursuing an even more aggressive monetary policy?

Sustained high unemployment is a terrible social illness. If it's true that an aggressive monetary policy might help, and at least would be unlikely to harm, then there would be a case for proceeding. But there is at least some chance that harm is being done. Here are three possible risks:

1)What if inflation remains bottled up for some time, but then arrives very quickly over a few months? Or what if the U.S. dollar begins to sink in value very rapidly? After all, we have no real experience with the kind of monetary policy we are conducting. A burst of high and sustained inflation would mean that all the banks and financial institutions which have been holding low-interest debt from the last few years would face huge losses on their portfolios. The Federal Reserve would face such losses on its holdings of debt, too.

2) When the Fed engages in quantitative easing, it is essentially using its power to create money as a way of financing federal government borrowing and mortgage-backed lending. In the middle of the financial crisis in late 2008 and early 2009, this step made sense to me. But if this policy is extended over a period of years, well after the actual financial crisis has ended, surely these trillion-dollar interventions have some possibility of creating lasting distortions in the housing market or in markets for government debt?

3) Perhaps most concerning, the aggressive monetary policy of near-zero interest rates may be locking the economy into slow growth. James Bullard is president and CEO of the Federal Reserve Bank of St. Louis, wrote about this about a year ago in an article called "Seven Faces of `The Peril'".

Bullard argues that there may be two stable equilibria with regard to monetary policy: One equilibrium involves an inflation rate around 2-3% and a nominal interest rate that is slightly higher. This was the situation in the U.S. economy for much of the 2000s, before the financial crisis. The other equilbrium involves an inflation rate of near-zero and nominal interest rates of near-zero. This has been the situation of Japan in the last 15 years or so, and arguably, it is the situation in which the U.S. now finds itself.

Bullard argues that in this situation, the central bank never raises the interest rate, because inflation is low, but it also can't lower the interest rate, because that rate is already near-zero. Thus, the interest rate stops being a tool of monetary policy, and instead is passive and useless. He writes of this situation: "The policymaker is completely committed to interest rate adjustment as the main tool of monetary policy, even long after it ceases to make sense (long after policy becomes passive), creating a second steady state for the economy. Many of the responses described below attempt to remedy the situation by recommending a switch to some other policy when inflation is far below target. The regime switch required must be sharp and credible— policymakers have to commit to the new policy
and the private sector has to believe the policymakers."

Bullard's suggested policy response is to expand quantitative easing by having the Fed purchase additional Treasury securities, but also to get the interest rate back up. He writes:

"The United States is closer to a Japanese-style outcome today than at any time in recent history. In part, this uncomfortably close circumstance is due to the interest rate policy now being pursued by the FOMC [Federal Open Market Committee]. That policy is to keep the current policy rate close to zero, but in addition to promise to maintain the near-zero interest rate policy for an “extended period.” But it is even more than that: The reaction to a negative shock in the current environment is to extend the extended period even further, delaying the day of normalization of the policy rate farther into the future.
Promising to remain at zero for a long time is a double-edged sword. ... Under current policy in the United States, the reaction to a negative shock is perceived to be a promise to stay low for longer, which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities."
 I haven't figured out whether I believe the Bullard-style model. In the U.S., we don't have enough experience with a near-zero federal funds interest rate to be highly confident about what will happen. But it is at least possible that those who advocate extending near-zero interest rates are doing more to trap the U.S. economy in Japan-style stagnation than to stimulate a robust recovery.