Friday, December 14, 2012

The Fed's great experiment

So now you have it. QE4. The Fed will buy $85 billion of long term government bonds and mortgage backed securities, printing $85 billion per month of new money (reserves, really) to do it. That's $1 trillion a year, about the same size as the entire Federal deficit. It's substantially more each year than the much maligned $800 billion "stimulus." Graph to the left purloined from John Taylor to dramatize the situation.

In addition, the Fed's open market committee promises to
"..keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored." [Whatever "anchored" means.] 

This is a grand experiment indeed. We will test a few theories.

First, just how much of the labor market's troubles are the result of an ill-advisedly long maturity structure of government debt? How much is the result of 2% long term rates (negative in real terms) being too high and strangling credit? (If, in fact the Fed's purchases have any sustained effect at all on long rates, which I doubt.) At zero interest rates does the split between reserves (which are, in the end, nothing more than floating-rate, overnight, electronic-entry US government debt) and other forms of government debt mean anything at all? In short, is monetary policy of the buy-bonds, print-money sort completely ineffective at zero rates, yes or no? At a trillion bucks a year we will soon find out. I bet no. (The WSJ calls this the "more cowbell" approach to policy.) But nobody can say it wasn't big enough to test the theory.

Second, just how much is the economy suffering from a lack of promises from appointed officials? "Oh, well, sure, now I'll build that new factory and start hiring people. I just wanted to hear that Bernanke 'anticipates' that he will think low rates are appropriate until until unemployment hits 6.5%, not just into the 6th year of the Biden administration."

Fashionable new-Keynesian models give a big role to such pronouncements. I'm dubious.  Does the average Joe understand the difference between, say, the Administration's promises that sure, next year we'll cut entitlements, and the Fed's promises?

One big hole in the argument:  Charlie Evans (Chicago Fed president) calls this "Odyssean" policy, after Odysseus who had himself tied to the mast so as to hear the sirens. But notice a big difference between Odysseus and Bernanke. Odysseus did not "anticipate that remaining near the mast will remain appropriate so long as the call of the sirens is not too beautiful, the sea not too rough, the sailors manning the rigging doing their jobs, and no other ships we might crash in to."  Odysseus made an irreversible decision. Cortez burned his ships.

If you want people to believe you about the unemployment trigger, you have to remove the discretion to change your mind tomorrow if, say, the dollar crashes, Spain defaults, long term interest rates spike, the Chinese dump their bonds or whatever.  Otherwise, we know it is all hot air. If they can decide in this meeting 6.5% is the right target, they can decide in the next meeting, "whoops, no, we'll print money until China starts buying Chevys." (Sorry, that will be mumbo jumbo about "illiquid conditions in sovereign credit markets and global imbalances..")

I'm not such a fan of new-Keynesian models (here, with hard academic article warning) so this lack of real commitment doesn't trouble me that much. I don't think we would get immediate benefit even from a completely credible tied-to-the-mast commitment to buy trillions of dollars until unemployment hits 6.5%. (I do think rules-based policy in general is a good idea, not this sort of discretionary commitment-making. But  I can think of a lot better rules, like "the price level shall be CPI=130 forever, period.")

But we certainly will test whether this kind of open-mouth operation has any effect. My forecast: continued sclerosis, and, whatever happens, no evidence that these policies had any effect whatsoever.

Which puts me rather less critical of the Fed than many skeptics. I think money and bonds are perfect substitutes at the moment, so "no effect" means no hyperinflation either. The problems are not monetary, so the Fed is just trying to seem important though it's powerless. The major damage that I see in current policy is the implied shortening of the maturity structure of debt: If markets force interest rates to rise to 5%, the deficit doubles due to interest payments, and the US experiences a Greek death spiral. But nobody is even talking about that.