Scott Sumner  

Dr. Strangelove at the Fed

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Breaking Conformity Equilibria... Eichengreen on Market Failure...

Perhaps you recall this classic line from Dr. Strangelove:

The whole point of the doomsday machine...is lost if you keep it a secret!
I thought of that line when reading a recent Bloomberg piece on monetary offset of the widely expected Trump fiscal stimulus. (Amusingly, it mentions Paul Krugman as a proponent of the idea, but doesn't mention any market monetarists. But that's good if it means the idea is going mainstream.)
This offset should not necessarily be construed as a negative development, he added, as it would ultimately allow monetary policy to regain its traditional effectiveness as the Federal Reserve moves away from the lower bound.

However, the central bank has also recently discussed the potential benefits of allowing the economy to run hot, which include reversing the supply-side damage done in the wake of the financial crisis and allowing the natural rate of interest to rise, which in turn would enable the Fed to raise its policy rate to loftier heights in the future. After years of hoping for a more active role for the government in facilitating an acceleration in growth, it would be curious development if monetary policy makers were to dampen such an expansion.
In that sense, "Trump may find an unlikely ally in Yellen," argued Neil Dutta, head of U.S. economics at Renaissance Macro Research, as she's a Fed Chair that doesn't seem too inclined to counteract the promised fiscal boost.

"Will overheating the economy pull capacity off the sidelines? Maybe or maybe not," the economist said. "But Yellen will make the case for maybe."

An extended period of low levels of market-based measures of inflation compensation and the disinflationary effects of a stronger greenback -- ahead of the implementation of any protectionist measures -- suggest the Fed to forego a more aggressive pace of tightening, Dutta added.

Moreover, if the Federal Reserve wants to act like a price-level targeting central bank -- effectively making up for sluggish inflation since 2012 -- then it can allow PCE inflation to run a full percentage point above 2 percent for several years, as New River Investments Portfolio Manager Matt Busigin observed.


There's a good argument for either of those ideas (running hot and price level targeting). But the good argument was to be made in 2009 when unemployment was 10%, not 2016, when unemployment is already down to 4.9%

Were the Fed today to retroactively adopt a policy of price level targeting, it would represent almost criminal negligence. The whole point of the policy is to make downturns like 2009 less severe, by creating higher inflation expectations. If you deny throughout 2009, and 2010, and 2011, and 2012 that you plan any such catch-up, and then suddenly announce it in 2016 or 2017, it's like building a (mutual assured destruction) doomsday machine and keeping it secret.

I already have a rather low opinion of Fed policy in 2008-2014. If this article turns out to be correct then my evaluation of the Fed's actions during the crisis will be even lower, indeed much lower.

One other point. People who criticize the idea of monetary rules need to really think about the implications of this article. Yes, we don't know that this will happen, but just the fact that it's being contemplated is frightening.

If you are the kind of person who says, "I don't care about this regime stuff, just tell me what the Fed should do now", then you are not part of the solution, you are part of the problem.

HT: Benn Steil

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COMMENTS (10 to date)
bill writes:

I recall the Fed saying they needed or wanted fiscal "help" on a few occasions. So if they immediately offset it, fully, that would be problematic (on that score). So I think you are right to be frightened. Meanwhile, the balance sheet stays big and the Fed is busy trying to calibrate its IOR dial.

John Hall writes:
Market Fiscalist writes:

If the govt decided to run a huge unfunded deficit (like Zimbabawe a few years ago) then how would monetary offset work ? The CB could sell off all its bonds, increase IoR etc - but could that truly stem an inflationary tide caused by govt deficit-funded money creation?

Brent Buckner writes:

If the Fed committed to on-going level targeting I think the benefit of the regime over the longer term would outweigh the costs of the Fed announcing that at the start it was about 4% below its desired level.

Thaomas writes:

You do what is right when you can. If the political pressure on the Fed was too great to have price level targeting in 2009 well that's too bad, but If you can do it now, why complain. It is politically "unfair" if Republicans in Congress will not invest in high return projects while a Democrat is President, but that's no reason not to invest in them now.

Scott Sumner writes:

Bill, They've said so many contradictory and incoherent things that I don't know what to believe, all we can do is look at their forecast of inflation. How will this change them.

Market, I think they could if they were independent. Of course that would mean default.

Brent, I'm afraid I don't agree. Just the act of doing that would create credibility problems about the long term. Now if they started with the current price level as the benchmark, that would be different.

Thaomas, You said,

"You do what is right when you can."

That's how we create instability. The Fed needs to think in terms of a regime that will create a stable monetary environment.

And there were certainly no outside insurmountable pressures stopping the Fed from doing the right things in 2009.

bill writes:

I recall the Fed saying they needed or wanted fiscal "help" on a few occasions. So if they immediately offset it, fully, that would be problematic (on that score). So I think you are right to be frightened. Meanwhile, the balance sheet stays big and the Fed is busy trying to calibrate its IOR dial.

Lorenzo from Oz writes:

Regarding

(Amusingly, it mentions Paul Krugman as a proponent of the idea, but doesn't mention any market monetarists. But that's good if it means the idea is going mainstream.)

David Friedman's point that, when you are a young man, you worry that people will steal your ideas and when you are older, you worry that people won't comes to mind.

Thaomas writes:

Scott,

When I said do the right thing when you can, I meant adopt level targeting.

Scott Sumner writes:

Bill, I think they wanted fiscal help so that they did not have to do so much themselves.

Lorenzo, In fairness, I didn't really invent the idea.

Thaomas, OK, but that's a very different policy than what I described in the post, which involved catch-up.

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