10/23/10 5:46 PMThis Is Indeed a Gloomy Day: Department of Macroeconomic Policy - Grasping Reality with Both Hands

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Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 7080467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchAugust 11, 2010

This Is Indeed a Gloomy Day: Department of Macroeconomic

Policy

In a liquidity trap conventional monetary policy--the swapping of highly-liquid bankreserve cash for short-term government securities--is ineffective because themacroeconomic financial market imbalance is not a shortage of cash relative todemand but rather a shortage of high-quality (and perhaps long-duration) assetsrelative to demand. The private sector's finances are sufficiently shaky that it cannotcreate high-quality assets--if it could, we wouldn't have a problem. (And a privatesector that cannot create high-quality assets cannot create any long-duration assetseither--except for highly speculative ones.)

The government thus ought to take action--just as the government takes action in anormal monetary-policy episode by swapping cash for short-term Treasuries and thusalleviating the shortage of cash relative to demand that is causing unemployment.

What actions can the government take?

1. Diminish demand for high-quality financial assets and increase demand for realgoods by credibly announcing that the inflation tax on high-quality financial assetswill be a hair higher in the future--i.e., through quantitative easing and inflationtargeting.

2. Manufacturing more high-quality assets through fiscal policy, by issuing moreTreasury bonds and using the proceeds to pull government spending projectsforward in time and push taxes back into the future--i.e., through expansionaryfiscal policy.

3. Have the Treasury create additional high-quality assets by becoming the tail risk-bearing partner of the private sector, or possibly by expanding its own balance

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sheet--i.e., through financial markets policy.

4. Have the Federal Reserve alter the supply of high-quality assets by taking somelow-quality private-sector assets onto its own balance sheet and financing it byexpanding its own short-term safe nominal liabilities--through what it calls non-standard monetary policy and I call financial market policy.

Note in this context what the Federal Reserve said that it might do yesterday: as itsprivate-sector assets mature, it will buy long-term Treasury bonds--thus takingduration and some systemic but not default or other tail risk or other systemic riskonto its own balance sheet. This is very weak tea as far as a policy to remedy financial-market imbalances is concerned.

So I am disappointed.

I am also disappointed with senators 51-60 in the U.S. Congress, who in spite of amammoth educational lobbying effort by Christie Romer, Larry Summers, andcompany persist in their refusal to allow the Obama administration to create more jobsby (2).

And I am also disappointed by the Treasury--which could, I think, be using its existingTARP authority to do an awful lot more of (3) than it is.

Others are disappointed as well.

Felix Salmon:

The Fed gives up on tightening: The big market reaction following today’s FOMCstatement took place in the 10-year Treasury bond, where yields sank to 2.77%right after the statement came out, from 2.82% beforehand. That’s a big move byTreasury-bond standards, and constitutes the continuation of a longer trend: theyield was above 3% as recently as July 29, and we’re now well into yields not seenexcept during the very worst part of the financial crisis, when the flight-to-qualitytrade was in full force.

Today’s Treasury yields aren’t a function of flight to quality, necessarily, and theimmediate impetus for this move was the fact that the Fed has committed tobuying up more Treasury bonds itself:

To help support the economic recovery in a context of price stability, theCommittee will keep constant the Federal Reserve’s holdings of securities attheir current level by reinvesting principal payments from agency debt andagency mortgage-backed securities in longer-term Treasury securities.

In other words, the Fed’s balance sheet had been shrinking, up until now, but thatshrinking has now come to an end, and it’s going to remain at its current bloatedlevel for the time being. This is tantamount to a very modest rate cut — not a fullquarter-point, perhaps, but maybe half of that. Of course, when rates are at zero,basis points loom larger than they normally do, so these moves on the side ofquantitative easing become very important. And more important still is the signalthat the Fed is sending: we thought we were OK to tighten things up a little bit,but now we’ve changed our mind, and we’re getting a little bit looser instead. Therecovery, in other words, still needs Fed support in order to maintain anysemblance of sustainability or momentum.

The bigger picture, however, is one of the Fed largely having run out ofammunition. Most of what it’s doing now is symbolic: the real national response,as Mohamed El-Erian says, needs to come from the government rather than the

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central bank, and needs to be structural rather than monetary in nature. Giventoday’s decision, though, we can at least assume that any moves from the WhiteHouse to try to bolster the national economy will be met with the strong supportof Ben Bernanke...

Alex Frangos:

Is the Fed making the same mistakes Japan did when it comes to quantitativeeasing?

Macquarie Asia economist Richard Jerram says the Fed’s move Tuesday toreinvest maturing bonds rather than absorbing the cash reminds him of the“incremental policy shifts” the Bank of Japan made over the last decade that failedto convince markets of the bank’s intentions. “There are echoes of BOJ policy from2001-04 in the Fed’s move. The BOJ made repeated incremental policy shifts, butstruggled to explain why they were necessary or how they would affect financialmarkets or the real economy. There is a worryingly similar lack of clarity from theFed,” Jerram writes in a note Wednesday morning Tokyo time.

Jerram figures maintaining the size of the Fed’s expanded balance sheet in thisway might not have much of an impact on the economy anyway. “The idea thatmoderate and temporary debt purchases by the central bank affect bond yields iscontroversial. A survey of the BOJ’s experience found that most of the impactcame from the commitment not to raise rates until inflation was positive (similarto the Fed’s “extended period”). They struggle to find a direct impact on bondyields from the balance sheet expansion.”

Ryan Avent:

Monetary policy: Small stuff: ONE of the most hotly anticipated Federal OpenMarket Committee statements has just come out, and it doesn't fail to disappoint.After acknowledging that recovery has slowed and, "is likely to be more modest inthe near term than had been anticipated", the Fed opts to:

[M]aintain the target range for the federal funds rate at 0 to 1/4 percent andcontinues to anticipate that economic conditions, including low rates ofresource utilization, subdued inflation trends, and stable inflationexpectations, are likely to warrant exceptionally low levels of the federal fundsrate for an extended period. To help support the economic recovery in acontext of price stability, the Committee will keep constant the FederalReserve's holdings of securities at their current level by reinvesting principalpayments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the FederalReserve's holdings of Treasury securities as they mature. The Committee willcontinue to monitor the economic outlook and financial developments andwill employ its policy tools as necessary to promote economic recovery andprice stability....

The Fed is keeping the "extended rate" language to which Kansas City Fedpresident and inflation hawk Tom Hoenig objects... the Fed has opted to take a"symbolic" step in reinvesting the proceeds from maturing mortgage-backedsecurities... it is adjusting the composition of its balance sheet away from MBSand toward long-term Treasuries. It's not quite clear what's behind that; perhapsthe Fed simply wants to reduce its intervention in mortgage markets. The long andshort of it is that the Fed has taken the minimum possible non-contractionary

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action. I am struggling to understand it. Perhaps the Fed is wary of doing toomuch at once. Perhaps it is interested in demonstrating that it is aware of theeconomic risks but not yet convinced that further action is warranted. For now,though, it seems as though the Fed has acknowledged risks but refused to doanything substantive about them.

And:

Monetary policy: The day after: READERS won't be surprised to hear me expressdisappointment with the Fed's decision. I'm not alone in my dismay. Marketscontinue to swoon in the wake of the decision; American indexes opened offaround 2%. Commodity prices are sinking as well, in response to signs fromaround the globe that economic activity is likely to slow through the end of 2010.This morning, Census reported a significant increase in America's trade deficit, upfrom $42 billion in May to $50 billion in June, as exports declined slightly whileimports increased. Fed activity won't help; the news that a new round ofquantitative easing isn't immediately forthcoming boosted the dollar.

Macroeconomic Advisers try to find the silver lining:

We read today's statement as signaling that the Committee may have rapidlymoved from a tightening bias to an easing bias, in which case a restart oflong-term asset purchases is on the table. This could partly reflect a move to a"risk management" approach, in addition to the apparently significantdowngrade in the FOMC's forecast....

I see the Fed as failing in two key ways. Policy... is too tight. (And it's somewhatbizarre; as Paul Krugman says, what are the odds that the current size of the Fed'sbalance sheet, which the Fed has opted to preserve, was right for last year'sscariest moments, this spring's optimism, and the current period of nervousness?)But perhaps more distressing, the Fed's communication has been simplymiserable. It hasn't explained why its outlook has changed enough to alter policybut not enough to alter policy meaningfully. It continues to emphasise pricestability while inflation expectations decline. It's all very unhelpful. But perhapsthe members of the Federal Open Market Committee are watching today astraders bid down stocks and commodities and bid up the dollar andunderstanding that they have reinforced the economy's disinflationary, pessimisticmood. The question is: come September, what are they going to do about it?

And:

Trade: A perfect storm: Leaders in America and China are very nearly withoutoptions; America's Congress is too paralysed to pass stimulus or deficit reductionplans, and China is squeezed between international pressure to rebalance anddomestic pressure to maintain growth. Against this backdrop, America's recoverylooks ever weaker, joblessness is rampant, and elections loom. The ground couldhardly be more fertile for protectionist populism, and politicians are beginning torise to the occasion.

Matthew Yglesias:

Matthew Yglesias » Overselling vs Doing Nothing: Right now the inflation rate isbelow-target and the price level is below trend. There’s some greater-than-zeroquantity of currently idle resources that could be mobilized before a higher level ofaggregate demand pushed the price level above trend. Does that mean 6 percentunemployment or only 8.5 percent unemployment? I have no idea, but there’s

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only one way to find out and that’s to go see.

In terms of structural issues, I think that all countries at all times feature some ofthese and could and should be working on improving the fundamentals.Recessions tend to turn minds out of cheerleading mode and draw attention tothese issues, but they’re not necessarily propitious moments for dealing withthem. The tendency is for all incumbents and all policies they promote to becomeunpopular during recessions, which makes it hard to build support for anythingaimed at reaping long-term benefits.

The Fed should do its job, and then everyone will get off their cases and go back toignoring monetary policy. If it doesn’t, people like me are going to have to startpublishing tedious articles complaining about the absurd governance structure ofthe FOMC.

Brad DeLong on August 11, 2010 at 05:12 PM in Economics, Economics: Finance,Economics: Fiscal Policy, Economics: Macro, Obama Administration | Permalink

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Comments

Badtux99 said...Some of us are being shrill today, I see. Ph'nglui mglw'nafh Delong R'lyeh wgah'naglfhtagn!!

Sigh. It's like we're shouting into the teeth of a hurricane that, err, this boat is goingthe wrong way. And the collective captains of this ship of state *still* are just blitheringstraight ahead into the very eye of the storm...

Reply August 11, 2010 at 05:29 PMhoward said...it appears at a minimum that fisher and hoenig don't believe in the dual mandate.

and i can't figure out what bernanke believes any more: he obviously no longer believeswhat he believed as an academic.

Reply August 11, 2010 at 05:49 PMTJ said...Sigh. It's like we're shouting into the teeth of a hurricane that, err, this boat is goingthe wrong way. And the collective captains of this ship of state *still* are just blitheringstraight ahead into the very eye of the storm...

10/23/10 5:46 PMThis Is Indeed a Gloomy Day: Department of Macroeconomic Policy - Grasping Reality with Both Hands

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Me: Economists:

PaulKrugmanMark ThomaCowen andTabarrokChinn andHamiltonBrad Setser

Juicebox

Mafia:

Ezra KleinMatthewYglesiasSpencerAckermanDanaGoldsteinDanFroomkin

Moral

Philosophers:

Hilzoy andFriendsCrookedTimber ofHumanityMarkKleiman andFriendsEricRauchwayand FriendsJohn Holboand Friends

I believe you'll find they think they are piloting the Disco Volante, and they think theycan tool off in the hydrofoil part when the rest sinks.

Reply August 12, 2010 at 07:56 AMComments on this post are closed.

Procrustean Economics (Wonkish)New York Times (blog) - Sep 30, 2010Brad DeLong manfully takes on the efforts of various commentators to define awaythe paradox of thrift and redefine our current problems as somehow wholly ...Related Articles » « Previous Next »

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