Tuesday, November 16, 2010

QE2 Complaints

Post-financial crisis, most economists appear to have been supportive of the Fed. Of course, one of the potential costs for the Fed of doing unusual things is that they are going to find more people disagreeing with what they are up to. Yesterday, a number of economists signed on to a public statement criticizing the Fed, which reads:
We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.

We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.

We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.

The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.
The signatories of this document include Michael Boskin (Stanford), Charles Calomiris (Columbia), and John Taylor (Stanford), but these academic types (who in some cases have done time in Republican administrations) are in the company of people like William Kristol. What unites these people seems mainly to be the Republican party, so we can interpret what they are up to in that light.

I have some sympathy for what these people are saying, but I think that the Fed should be doing what it can to increase the rate of inflation. The Fed's implicit inflation target has been 2%, and Fed officials, including Bernanke, have actually made that target explicit in public statements (though not in the FOMC statement itself). By any measure, the current inflation rate is below 2%, and the Fed should then do what it can to increase it, to make good on its commitment. Under current circumstances, with a large stock of excess reserves in the financial system, it is widely recognized that conventional open market operations (purchases of T-bills) will have no effect, and the interest rate on reserves is close to zero. Thus, there is no other option available but purchases of long-term assets. Purchases of private assets by the Fed is a dangerous game, so the Fed needs to purchase long-term Treasuries, which is what it has proposed to do. How much Treasuries should it purchase? That is the million-dollar (or six hundred billion dollar) question, and I don't know of anyone who has a good answer.

The key problem is not that the Fed is engaging in purchases of long-term Treasuries, but how much of it they are doing, and the level of commitment implied by announcing specific quantities to be purchased over a specific period of time. I think a better approach would have been to say that purchases were going to be made to achieve a particular inflation target (say 2%), or a target for the price level path. Given the announced purchases, the Fed will have to do some talking if they want to deviate from what was announced in the last Fed statement, and that could be costly in terms of their credibility.

An odd feature of the document criticizing the Fed's policy is that John Taylor appears to have played a prominent role. Taylor's rule, which plays a central role in New Keynesian economics, is explicitly interventionist. It formalizes the Fed's "dual mandate" in a rule that sets the fed funds rate target in response to actual inflation and the "output gap." Implicit in the Taylor rule is the idea that the Fed can and should intervene to smooth the path of real GDP over time. Taylor has stated (see this) that: "To establish Fed policy going forward, the best place to start is to consider what has worked in the past." Indeed, some people, including Glenn Rudebusch, have used Taylor rule predictions, which tell us, for example, that the fed funds rate should currently by -6%, to justify quantitative easing. They use this justification in spite of the fact that typical New Keynesian models with Taylor rules do not capture the effects of purchases of long-term Treasuries by the Fed. Now, how John Taylor thinks QE2 works is a mystery. One might expect that he thinks like a typical New Keynesian, but it seems like most of those people want to give QE2 a shot, so apparently Taylor's views are different. Maybe his ideas have changed, but it's unclear how or why.

Some Fed officials have made public statements supporting QE2, and these statements appear to be respones to criticism coming from other countries. Here, Discussing QE2, Janet Yellen says:
The purpose of it is not to push down the dollar. This should not be regarded as some sort of chapter in a currency war.
As well, as reported here, New York Fed President William Dudley "said that the Fed’s move was not intended to affect the value of the dollar..." Right. This sounds like what happens when your 8-year-old is clowning around and spills her milk ("I didn't mean to do it.") By their nature, monetary expansions tend to make the currency depreciate. I know it, Ben Bernanke knows it, Janet Yellen knows it, and so does William Dudley. If the FOMC was not thinking about the international repercussions of QE2, it should have been.


  1. Hi Steve,
    Nice post.
    JT talks about this a bit in his blog (Economics one). One of the posts is titled "The Taylor Rule Does Not Say Minus Six Percent"

  2. Steve,

    "If the FOMC was not thinking about the international repercussions of QE2, it should have been."


    Sure, QE2 will lead (other things equal) to a dollar depreciation just like lowering the fed funds rate would. So what?

    If the FOMC decides -- based on a Taylor rule, dual mandate, inflation target or whatever -- that expansionary policy is called for, then that's what they'll do. The goal is inflation at target/full employment/price stability/whatever. What happens to the exchange rate will happen, or not, but is not a goal of policy. Are you arguing for including the exchange rate in a version of the Taylor rule?

    BTW, I don't remember where I read this, but re Taylor's opposition to current Fed policy, a useful paraphrase is "the Taylor rule means whatever the hell John Taylor says it means."


  3. To generate a higher price level, the quantity of money supplied must exceed the quantity of money demanded. Couldn't we discourage banks from holding such large quantities of excess reserves by lowering the interest rate paid on reserves (maybe making it negative by taxing them)?

  4. Pete,

    I didn't explain that, did I? I don't think that the consequences of an exchange rate depreciation are that important. But obviously some people in the world (and some policy makers, including Tim Geithner) think they are. Since QE2 likely leads to an exchange rate depreciation, the Fed should have thought about how to sell that to the world. Now, maybe they did, and maybe Janet Yellen is part of the marketing, but it seems like the international reaction came as a surprise.

    Anonymous: Yes, the Fed could reduce the interest rate on reserves to zero, but likely that would have little effect. Bernanke is on record as not wanting to do that, for reasons that made no sense to me. I haven't heard anyone suggest taxing reserves. Maybe you have an idea there.

  5. Steve,

    My take is that part of the job description of Treasury Sec is to "promote a strong dollar policy," whatever that means, and whether or not it makes any sense. Except of course for John Snow, who described t-bills (in the social security trust fund) as "worthless iou's." So Geithner has a constraint that doesn't apply in normal-land.

    Re taxing reserves, see Sweden, Bank of: http://acrossthecurve.com/?p=8285


  6. On the Bank of Sweden: Interesting. It's possible that the law does not permit this in the US. Also, the law does not permit paying interest on the reserve accounts of GSEs. Could you charge them negative interest though? Or could you charge the banks negative interest but be stuck in a situation where the GSEs do better at zero?