If Only Bernanke Had Volcker's FOMC

Former FOMC president Volcker, like Bernanke, is overly reliant on  the creditism view of monetary policy.  Take this past week's comments at the Atlantic magazine news conference.

Higher inflation would backfire by causing interest rates to rise. "You are not going to get any stimulus and you are going to make it much harder to restore price stability,"

Volcker is implying that the higher interest rates that would accompany a higher inflation target would be contractionary.   At first glance, his analysis appears correct, a higher interest rate would seem to suppress already weak aggregate demand.  Yet with today's current low levels of inflation and interest rates at their lower bound, a higher interest rate stemming from a higher inflation target would be a by product of an improved economic outlook.  To understand why this counter intuitive conclusion is correct, we need to look at David Glasner's recent research on deflationary expectations at the zero lower bound, my bold:

Krugman Again

I'm starting to think my co-worker (and loyal reader) Alexander just likes to link me Krugman articles for the sake of an argument when work is slow. The article in question today was Krugman's Sunday headliner comparing government spending during the "Morning in America" Reagan recovery and today's current recession. Krugman rightly points out that Reagan's government actually increased spending more than Obama's if state and local spending are included.  What Krugman neglects to mention is that the majority of difference comes only AFTER the federal reserve turned on the monetary spigot, increasing NGDP growth to above 12% over the course of a single year.  For comparison sake, here is the government spending graph that Krugman links to followed by NGDP and RGDP growth following both recessions.

The NGDP Effect of Devaluation or Why Exports Don't Matter

Lars Christensen effectively argues that during a currency devaluation, the primary transmission mechanism for monetary policy has little to do with restoring competitiveness, but instead works through the money supply on one hand and velocity on the other.  In equation form, MV=PY=NGDP.   The purpose therefore of the currency devaluation in a depressed economy is not to increase competitiveness in order to boost exports (although he concedes that it is one effect of the devaluation) but to increase nominal spending through the expansion of the money supply and increased velocity.   Lars provides the concise example of Argentina, who abandoned its dollar peg in 2002, resulting in a rapid increase in the money supply, velocity, therefore boosting NGDP and consequently real GDP.

While Argentina provides an informative example of the benefits of devaluation on an economy in stagnation, I thought it would be important to look at a country that used monetary policy to avoid crisis all together.   Poland, as shown by Marcus Nunes last February, provides a unique example of the use of monetary policy to stabilize the broad economy in a time of international economic malaise.  Under normal circumstances, Poland’s continued economic expansion would be of little note, but the world economies since 2007 have been anything but normal.  What makes Poland remarkable is that outside of a minor decrease in RGDP growth in late Q4 2008 (-0.4%), the economy has continued to expand at the same level as it did prior to Lehman’s demise.   A close examination of Poland reveals that competitiveness plays little importance in the transmission mechanism for monetary policy in maintaining Poland's impressive rise....

The Real Story Behind the 1983 Recovery

I was underwhelmed by Krugman’s recent interpretation of the V-shaped recovery from the 1981-2 recession.  I have written about briefly about the 1983-4 recovery before but this post will be a bit longer.  First is NGDP, GDP, inflation, and 10 year inflation expectations from 1982-1987.

Pretty simple, NGDP is at 4% in 1982, the result is a Fed induced recession to fight inflation.  1983 to 1984, NGDP raises to 12 percent a year, the result is a robust recovery.  Let's compare that with the current recession.

Speaking Bernankian

It is becoming utterly frustrating to listen to communication from the Federal Reserve.  This one is from Yahoo finance:

Fed considers more clarity on interest rate policy

A panel headed by Vice Chairman Janet Yellen is exploring ways to provide more information on future central bank moves. More clarity on interest rate policy could help reassure investors and businesses that rates will stay low.

Interest rate policy?  Has they simply given up hope in communicating outside of the interest rate channel?  

The Federal Reserve has two massive communication problems right now, the first is there choice instrument in expressing changes in monetary policy is deeply flawed and the second is when they do enact a policy change, there is no direct, explicit target that they wish to accomplish.  

There is hope however, take this quote from the latest Fed minutes:

It was noted that any such accommodation would likely be more effective if it were provided in the context of a future communications initiative, and most of these members agreed that they could support retention of the current policy stance at this meeting. […]

With the Committee in the process of reviewing its monetary policy strategies and communication, and no additional accommodation being provided at this meeting, a few members indicated that they could support the Committee’s decision even though they had not favored recent policy actions.

NGDP was discussed thankfully, but I am not convinced that the FOMC understands anything outside of interest rates, take this quote:

More broadly, a majority of participants agreed that it could be beneficial to formulate and publish a statement that  would elucidate the Committee’s policy approach, and  participants generally expressed interest in providing  additional information to the public about the likely  future path of the target federal funds rate. 

So there we have, once the three fed dissenters leave in January I expect another round of $600 Billion in QE in order to 'push down long term interest rates.'  Instead, Bernanke should switch away from Bernakian and simply say the fed will enact QE until NGDP is growing at 6 percent.

Handcuffed by a Policy Tool with a Zero Lower Bond

I googled 'Fed Minutes' this morning and the first hit was this headline, Futures Flat Ahead of Fed Minutes.  It is such a shame we must scour the Fed Minutes in order to find a hint of direction in our current monetary policy.  Scott Sumner, Nick Rowe and Lars Christensen have several terrific blog posts on the subject the Federal Reserve's communication policy.  They call for a Chuck Norris style central bank, where markets react to the directly communicated 'threats.'  The thinking being that if a central bank is credible and clearly a communicate a policy target, then the markets will do the heavy lifting and facilitate the change in the expected variable (inflation, NGDP, r, etc).  The beauty is that if the fed is credible, they likely won't even have to carry out on their threat, just like any reasonable person would run away if Chuck Norris announced in five minutes he would be back to round house kick you into the upper atmosphere.

I am skeptical about Ben Bernanke's ability to use the the communications channel of monetary policy effectively, not because a Chuck Norris style would not be effective, it would, but because Bernanke's choice of policy instrument tells us little about the expected direction and stance of monetary policy.  It all comes down Bernanke's countenance to use interest rates and the credit channel of monetary policy.  Here is the Nov 2 statement:

"To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to continue its program to extend the average maturity of its holdings of securities as announced in September......The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013"

My bold, this is exactly why the markets eagerly await the fed minutes.  This style of communication tells us very little about monetary policy.  In the 1970's the federal funds rate was at record high levels.  Today it sits at all time lows for the foreseeable future, but does anyone make the claim that monetary policy was tighter in 1978 then it is today?  That is exactly why solely focusing on interest rates as a stance for monetary policy is a mistake.

Let's say tomorrow the PIIGS bond yields soar in anticipation of a Eurozone break up.  If Bernanke's only communication mechanism is interest rates, what more can he say that will prevent the collapse of domestic demand from failing as well?  The answer is not much as we have already hit the zero lower bound, his best case scenario is to say we will hold interest rates low indefinitely and try and push the yield curve down lower.  But without alternative measures taken, that will do little to stop the decline GDP as the rush for liquidity passively tightens monetary policy.

It is unlikely however, that Bernanke will allow a deflationary collapse.  Throughout his reign BB has shown little problem using unconventional monetary policy to prevent deflation, but if Bernanke were to choose a more suitable target and clearly communicate his expected monetary policy, these unconventional QE's and twists would not be necessary in the first place.

P.S. I think Bernanke views interest rates as the native tongue for his central banking language and he is worried that if he switches to a foreign language, either he will misspeak or the markets won't understand.  The response to that is as long as you have a clear target and are fully committed to meeting your target, the markets will start speaking your language.