Michael Woodford, one of the top monetary theorist in the world, has an Op-Ed today that does a great job explaining why the Fed’s policies have failed to gain traction in the economy. His key point is that the Fed has failed to clearly communicate the path of future monetary policy. In so doing, the Fed has failed to shape expectations forcefully enough to make a dent in nominal spending. In other words, the problem is not that the Fed cannot do anything, but that the Fed has failed to act properly. Woodford says a price level target would solve the problem (and by implication so would a nominal GDP level target) of properly shaping nominal expectations.
Here is Michael Woodford making his point by showing the flaws with the Fed’s QE programs:
The economic theory behind QE has always been flimsy…The problem is that, for this theory to apply, there must be a permanent increase in the monetary base. Yet after the Bank of Japan’s experiment with QE, the added reserves were all rapidly withdrawn in early 2006. The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves permanent and also to allow the temporary increase in inflation that would be required to permanently raise the price level in that proportion.
The one time QE did work was for FDR during the 1933-1936 period. The big difference between then and now is that FDR’s QE program was supported by an explicit price level target that FDR himself promoted. Also, the monetary base creation supporting FDR’s QE program was permanent as can be seen by the figures in this post. FDR knew how to do QE right.
Michael Woodford also addresses the portfolio channel of monetary policy that been used as an argument to support the Fed’s QE programs (my bold below):
A more recent argument for QE stresses not the increase in reserves, but the change in the composition of assets held by the Fed. But asset trades of modest size by a central bank are unlikely to affect prices, unless the markets in question have seized up.
Once again, the point is not that portfolio channel does not work but rather that the Fed has to be fully committed to using it. The Fed needs to unload both barrels of the gun. By only engaging in asset trades of modest size, the Fed is not doing enough to meaningfully shock and shape nominal expectations. Here too an explicit price level or nominal GDP level target would be useful. For such a monetary policy target would tell the public that the Fed intends buy up as many assets as necessary to hit the level target. It would not stop at some arbitrary amount like it did with the $600 billion of QE2. Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its level target would cause the market itself to do much of the heavy lifting. Investors would adjust their portfolios in anticipation of the higher inflation and nominal spending. This seems to have worked in Sweden where larger asset purchases (25% of GDP versus the Fed’s 15% of GDP) combined with an explicit inflation target (that works more like nominal GDP level target) has brought a robust recovery.
Michael Woodford ends his piece with these recommendations:
Mr Bernanke can and should use his speech today to explain how his policy intentions are conditional upon future developments…A clarification could help the economy in two ways. First, he could signal that a temporary increase in inflation will be allowed, before policy tightening is warranted. This would stimulate spending by lowering real interest rates. Second, specifying the size of any permanent price-level increase would avoid an increase in uncertainty about the long-run price level. This in turn would ward off an increase in inflation risk premiums that might otherwise counteract the desirable effect of the increase in near-term inflation expectations.
In other words, he thinks the Fed should adopt a price level target. I wonder what he thinks about a nominal GDP level target.
This post originally appeared at Macro and Other Market Musings and is reproduced here with permission.