Note: This began as an effort to tie together various themes in my writing. Unfortunately, short and succinct did not work. So I apologize in advance for the length of this post.
There are certainly trends in my writing. One is that the Federal Reserve spent much of this year behind the curve by failing to adapt their large scale asset purchase program or their communication strategy to the reality of a persistently weak economy. The Federal Reserve effectively dealt with that issue at the last FOMC meeting.
To be sure, I can quibble with some of the specifics, such as a lack of more explicit economic targets and a clear commitment to near term-irresponsibility by allowing inflation to rise above 2 percent when (or if) the economy gathers steam. On the first issue, I am coming around to the thinking that while explicit targets (other than inflation or nominal GDP) might sound good in theory, in practice trying to tie policy to a constellation of price and output targets risks becoming a communications nightmare. The Fed needs to tread very carefully on this point; it may be best for them to fall back on that old adage about pornography. We will know a “sufficient and sustainable” recovery when we see it.
The second issue, a promise to be irresponsible on inflation, remains unlikely as long as the Fed continues to stress it will take actions “in the context of price stability.” I don’t view a temporary increase in inflation as necessarily undermining neither the Fed’s long-term inflation targets nor a nominal GDP target. And I think that the failure to make such a promise could very well disrupt a reversion of the economy to pre-recession trends. This I will discuss further later.
Another trend in my writing is that there needs to be some coordination between fiscal and monetary policy. Putting aside what I believe will be an aberration in the third quarter, authorities are already engaged in some degree of fiscal austerity:
and have effectively promised to do more. Should it even be reached, a compromise to the fiscal cliff will likely still be further austerity. I think that we should be wary about underestimating the impact of such austerity, especially as it is increasingly evident that multipliers are larger than expected at the zero bound. Fiscal austerity would likely be a key factor in maintaining the relatively tepid pace of the recovery into 2013. Moreover, fiscal austerity wastes the opportunity provided by a low interest rate environment. The Federal Reserve has already promised to buy a steady stream of assets from the financial markets. All Congress needs to do is sell debt into that stream. No explicit coordination necessary.
Another issue that I can’t run away from is the potentially negative impacts of a sustained zero interest rate environment. It would be a mistake to believe that monetary policy does not have distributional impacts. Low interest rates obviously hurt savers:
Moreover, we should be concerned about distortions to the capital allocation process. Encouraging excessive risk taking now will come back to haunt us later. That said, it is necessary to balance such negative impacts against the positive impacts. Nor is it clear that the Federal Reserve is driving this train; the absence of an aggressive monetary policy might very well weaken the economy such that interest rates fall further. In any event, I am challenged to see how a different monetary policy would be effective; tightening policy at this juncture would likely be disastrous for the economy.
Finally, another issue to which I have already alluded is a belief that the US economy is on a suboptimal path:
This is obviously controversial. For example, St. Louis Federal Reserve President James Bullard has repeatedly said there is only one path, and we are on it. The appropriate monetary and fiscal reaction functions are obviously different in a such a world. In such a world monetary policy leads only to potentially greater inflation with little impact on growth.
Jumbled as it might seem due to the nature of blogging, somewhere in the background I have a framework that ties this altogether. And I was reminded by a colleague that I had seen that framework presented by another colleague, George Evans. The associated paper, “The Stagnation Regime of the New Keynesian Model and Recent US Policy” is here.
Evans begins with a New Keynesian in which expectations are formed by adaptive learning. An outcome of the model is that a sufficiently large negative shock can push the economy into a deflationary trap. Interestingly, agents learn their way into the trap by forming pessimistic expectations of future economic outcomes. My interpretation is that agents learn to live in what is often called the “new normal” and as a consequence make decisions that ensure the the new normal is a stable equilibrium.
The model is subsequently modified to account for nominal wage rigidities such that the low equilibrium trap, the stagnation regime, has an inflation floor. Another characteristic of the regime is low levels of output and consumption in which welfare is potentially much lower than the preferred equilibrium.
How can we break out of the stagnation regime? A temporary increase in government spending that is sufficiently large to allow a self-sustaining process to take over. The economy reaches an escape velocity such that agents learn there way allow a dynamic path to the preferred locally stable, higher equilibrium. At such a point, government spending can revert to normal without threatening a recession.
Monetary policy can also come into play, but Evans is less optimistic that the Federal Reserve is capable of breaking the US economy out of the trap. He notes that even promises of low rates forever may not be enough if the economy has suffered a sufficiently large negative shock. Evans adds that quantitative easing can support the economy via lowering long-term rates and stimulating demand, but also warns:
An additional problem, however, is that there are some distributional consequences that are not benign. Households that are savers, with a portfolio consisting primarily in safe assets like short maturity government bonds, have already been adversely affected by a monetary policy in which the nominal returns on these assets has been pushed down to near zero. A policy commitment at this juncture, which pairs an extended period of continued near zero interest rates with a commitment to use quantitative easing aggressively in order to increase inflation, has a downside of adversely affecting the wealth position of households who are savers aiming for a low risk portfolio.
There is a lot to digest in a short paper, but I encourage making the effort.
Thinking in terms of this model, it is immediately clear that one should be very concerned with impending fiscal austerity unless you believed the economy had already reached escape velocity (I don’t). Moreover, you should be concerned about austerity even in context of the evolution of monetary policy into QE3 as it is not clear that the Fed can by itself push the economy to escape velocity. The Fed is literally stuck between a rock and a hard place, with the stimulative force of lower rates for borrowers traded off against lower income for savers, a point that Ed Harrison often makes. And the more we lean on monetary policy, the tighter that space gets. Yet we have little choice with a political environment that favors austerity over stimulus.
In addition, one should be concerned about the fragility of any recovery based upon a Fed-induced effort to achieve escape velocity. This is especially the case if the Fed has not promised (and whether such a promise is credible is another question) to be irresponsible in the transition to the higher equilibrium. Consider that the CBO projection for GDP growth is 4.8% in 2015. This, I suspect, is the kind of number needed to achieve escape velocity. But consider the Fed’s reaction function in the face of such growth in the context of 1.) price stability and 2.) internal concerns about the ability to unwind quantitative easing. I think under those circumstance policymakers would error on the of tighter, faster rather than allowing a temporary acceleration of inflation.
The last paragraph brings up an interesting question. Even if the Fed promised to allow inflation to accelerate and did so, eventually they would tighten policy just the same. Which means the same recession, just a year later. 2015 or 2016. 2017 at the latest.
The problem is that the recovery is pretty much held together by debt refinancing, cheap mortgages and higher asset prices; by such measures, monetary policy has been successful! To be sure, there has been some debt reduction on the part of households:
But it is limited in comparison of the ability of households to utilize lower interest rates to reduce the cost of financing that debt:
I think in the near-term those who believe the monetary authority is the only answer will appear correct as the recovery progresses. Indeed, Annie Lowrey at the New York Times reports that household debt is now increasing for the first time since the Great Recession began. From a broad macroeconomic perspective, this is a near-term positive, and creates reason to believe that monetary policy will cushion the impacts of whatever flavor of the fiscal cliff we experience.
But I don’t think this will be a stable long-term result. Obviously, I could be wrong, but it seems to me that we are using the same trick we have been using since the mid-1980’s – lowering debt financing costs, thus allowing for a greater debt burden. This trick will continue to work as long as there is room to push interest rates further down. Now that we are at the zero bound in short-term rates and the Fed has been forced to move quite far out the yield curve to implement monetary policy, it is likely this is the last time that trick will work. There will not be much room to refinance our way out of trouble the next time around. Hence why I concerned about still being at the zero bound when the next recession hits.
Moreover, I would find it unlikely that we pass through another two or more years of zero interest rates without seeing capital mis-allocations, assets bubbles, and excessive risk taking. In such an environment, I don’t think the Fed is going to be particularly successful in moving the economy off the zero bound without triggering a fresh recession.
Now, it would be easy to take this as criticism of the Federal Reserve. It isn’t. The Fed should have moved to open-ended QE long ago to end the problem of arbitrary end dates to policy and needed to clean up its communication strategy to make clear the economic outcomes would define when QE would end. And, probably most importantly, the Fed is compensating for a dysfunctional US political process. I know there is one view (see Raghuram Rajan) that the Fed is simply enabling that process. Perhaps Congress would do the “right” thing if push comes to shove. But what is the “right” thing? If Congress were left to its own devices, would it take us down the road of fiscal stimulus sufficient to spring the economy from the stagnation trap? Or would they continue down the road of additional fiscal stimulus, driving the economy deeper into the trap? My sense is that Congress would find additional austerity to be the path of least resistance. Pete Peterson has won. The Congressional deck is stacked against the economy. And I think Federal Reserve Chairman Ben Bernanke knows this.
Putting all the piece together, I tend to think that neither fiscal nor monetary policy by itself will support a sustained recovery in which the interest rate environment normalizes and fiscal stimulus can be eliminated without fear of renewed recession. The two need to work hand in hand; the Federal Reserve has provided the monetary environment conducive to additional fiscal stimulus. Congress and the Administration now need to take advantage of the environment. Or, alternatively, if the fiscal authorities are not issuing sufficient new financial assets such that there is upward pressure on interest rates, they need to be issuing more.
In conclusion, the above framework both praises the direction of monetary policy without discounting concerns about the dangers of the permanent zero bound policy. A framework that allows for both accepting near-term growth on the back of monetary policy but also concern about the sustainability of that policy. A framework that decisively rejects additional austerity on a simple basis that it will not help normalize the interest rate environment. If nominal rates were 8% then yes, fiscal austerity would help normalize the interest rate environment. But that simply isn’t the current situation. Perhaps, if we are lucky, it will be a problem in the future.
I realize that it would probably be easier if I could find myself either advocating the primacy of monetary policy in determining the level of output or deriding the Federal Reserve for the evils of the quantitative easing. Or if I could fully embrace fiscal stimulus as the only solution or austerity as the only solution. Picking one of those quadrant and defending it absolutely would probably make me more friends that straddling all four quadrants at once. But absolute devotion to one quadrant is probably not the right answer. I tend to believe that the right answer is a more complicated mix of monetary and fiscal policy than is currently employed. And don’t think we can get to that right mix if we lock ourselves into an ideological box. Hence why I try to avoid such boxes.
Again, sorry for the long post.
This post was originally published at Tim Duy’s Fed Watch and is reproduced here with permission.