Christina Romer: We Need a Regime Change at the Fed

Christina Romer does the Five Books interview and one of her recommended reads is a famous article by Peter Temin and Barry Wigmore titled “The End of One Big Deflation.” This is a great choice since it shows that even in a “balance sheet recession” facing a binding zero percent lower bound, monetary policy can still be very effective by managing expectations. The key is to radically shift expectations. Here is Romer discussing the implications of this article for today:

What we learned from the Temin and Wigmore paper is that one way out of a recession at the zero lower bound is by changing expectations. To do that, often what is needed is a very strong change in policy – something economists call a “regime shift”. The most effective way to shake an economy out of a terrible downturn when we’re at the zero lower bound is an aggressive change in policy that makes people wake up, say “this is a new day” and change their expectations. What the Fed has done since early 2009 is much more of an incremental change.

In other words, the Fed has failed to appropriately manage expectations and so we are stuck in a slump. And I am not convinced that it is now doing any better with its new long-run forecasts of the federal funds rate. So what in the current environment would rise to the level of a “regime shift”? What would change expectations enough to catalyze a broad-based recovery in aggregate demand? Here is Romer’s answer:

I think that what the Fed needs instead is a regime shift. A number of economists have suggested that the Fed adopt a new framework for monetary policy, like targeting a path for nominal GDP. If the Fed adopted such a nominal GDP target, they would start in some normal year before the crisis and say nominal GDP should have grown at a steady rate since then. Compared with that baseline, nominal GDP is dramatically lower today. Pledging to get back to the pre-crisis path for nominal GDP would commit the Fed to much more aggressive policy – perhaps more quantitative easing and deliberate actions to talk down the dollar. Such a strong change in the policy framework could have a dramatic effect on expectations, and hence on the behavior of consumers and businesses.

Such a regime shift would require Bernanke to man up and have his own Volker moment, as previously noted by Romer. It would be a huge change and that is the point. A big shock to public expectations, one that would meaningfully change the expected path of future aggregate nominal spending, could be created by a public commitment to a nominal GDP level target. This is just the medicine the U.S. economy needs right now.

P.S. No, a nominal GDP level target would not unmoor long-run inflation expectations and it would not depend on a bank lending to work.

P.P.S. Yes, there is evidence for nominal GDP expectations mattering for subsequent NGDP growth. Here is how I think it would actually unfold.

This post originally appeared at Macro and Other Market Musings and is posted with permission.

4 Responses to "Christina Romer: We Need a Regime Change at the Fed"

  1. Crimson-blue   February 20, 2012 at 9:11 pm

    I agree, but you have our current candidates for the President of the US running campaigns proposing exactly the opposite. They want to move back to a gold standard, move to a single mandate (inflation), or abolish the Fed altogether.

    One (probably oversimplified) explanation is that inflation is perceived to adversely affect savers, senior citizens and the wealthy are the savers and they vote consistently and Republican. Unemployment affects the young who don't vote consistently.

  2. B.B   February 21, 2012 at 8:07 pm

    Please explain how the Fed's monetary policy can achieve anything in the real economy without credit growth – except for much confusing arm and wand-waving. Romers, please revert to money-and-banking 101 – thank you. As you no doubt remember, this economy is being supported by the US Government – not the Fed.

  3. sierra7   February 22, 2012 at 11:46 am

    I do like the "change in expectations" delivered to the whole of USA……..To believe or to construe thru any "policies" that we can just go back to the very, very unhealthy of debt bubble that got us into this mess in the first place is utterly ridiculous on its face….but that's what the FED and the gov (both parties by the way) wish to do.
    Being more honest with the public would be a first step……, bust up the major banks (not nationalize)…get back to a modern concept of Glass/Steagall, show the ordinary working stiff that out government truly has the needs (not the lifestyles) of the common folk in mind.
    There is much more downside to this mess; nothing will proceed in an orderly manner until ALL financial positions, from the maniacal consumer to the largest financial institution are unwound.
    Everything else will be illusory.

  4. EEB   February 25, 2012 at 5:55 am

    This notion is absolutely absurd. It is just another variant of the Confidence Fairy. I can bloviate all I want to about how inflation "should" be x% per annum, but how are you to make that happen when both aggregate and effective demand are deeply depressed. Wild bears do not shit in pay toilets!!! If you really want to "change expectations", then you would be well- advised to revive WPA. Alternately, we could have Helicopter Ben drop pallets of $100 bills on the middle of Bedford- Stuyvesant. That would surely produce some results.