Monetary Policy: The Naive View

Christina Romer is certainly consistent. In spite of her many years of experience in academia and policy circles, she consistently surprises me with her un-nuanced views on economic theory and empirical evidence and how they inform policymaking. Case in point: this NYT article.

Romer wants to make the case that the state of the world dictates more accommodation by the Fed. First,

By law, the Fed is supposed to aim for maximum employment and stable prices. But the unemployment rate is 8.2 percent — a good two percentage points above what even the most pessimistic members say is its sustainable level.

Second,

...right now, the inflation measure that the Fed watches is a bit below its target of 2 percent...

Third,

the Fed’s dual mandate doesn’t say it should care about unemployment only so long as inflation is at or below the target. It’s supposed to care about both equally. If inflation is at the target and unemployment is way above, it’s sensible to risk a little inflation to bring down unemployment.

The "dual mandate" specified in the Full Employment and Balanced Growth Act of 1978, or Humphrey Hawkins Act, is in fact quite vague. Under the Act, the Fed is supposed to be promoting maximum employment and price stability. But any creative central banker would find it easy to make an argument that his or her favorite policy fits well within the Act's guidelines. One could argue (I'm not saying this argument would necessarily be correct), for example, that "price stability" means constant prices (0% inflation) and that employment is lower than it was five years ago due to factors which the Fed cannot correct for. That would then imply that policy should be less accommodating. The set of policies consistent with the Act is so large that the dual mandate argument is not going to help in making Romer's case. She's going to have to make the case by appealing to sound economics.

So what about that? The inflation rate, as measured by the twelve-month percentage increase in the pce deflator, is indeed just below 2%, the Fed's inflation target. The unemployment rate is indeed historically high. Given the Fed's past behavior, one might think more accommodation would be appropriate, assuming of course that the Fed's past behavior was optimal. But what is the Fed supposed to do to be more accommodative? Romer says the alternatives are:

1. Nominal GDP targeting. Romer incorrectly refers to NGDP targeting as an "operating procedure." The operating procedure is actually a description of how the FOMC directs the open market desk at the New York Fed to act. The desk can only do one thing: conduct open market operations. The current fiction (in line with what is written in FOMC statements) is that the operating procedure is the same as before the financial crisis, i.e. the desk conducts open market operations to target the fed funds rate at a level specified by the FOMC. In fact, the fed funds rate is currently determined by the interest rate on reserves, as set by the Board of Governors (for the details, see this post). The desk currently just executes whatever the current quantitative easing (QE) program of the Fed is, without regard to the quantity of reserves that are held in the system overnight.

It would not have made any sense even in pre-financial crisis times for the FOMC to direct the desk by just telling it to hit a NGDP target. Nominal GDP is measured on a quarterly basis, and the National Income Accounts numbers are published with a lag. Currently, for example, it is June 10, and the last NGDP number we have is for first quarter of the year. The FOMC meets about every six weeks. If we were practicing NGDP targeting, how exactly would the FOMC translate the difference between actual NGDP and target NGDP in the first quarter into a directive to the desk at the next meeting? If, as in pre-financial crisis times, excess reserves in the system were essentially zero overnight, then presumably the directive to the desk would have to be in terms of a fed funds target. Under current conditions, and given how the Fed thinks about the monetary policy problem, the directive to the desk would have to be in terms of quantitative goals for the Fed's portfolio. Thus, the operating procedure under a NGDP target would necessarily have to be identical to what it is now.

NGDP targeting does not do anything other than specify the Fed's ultimate goals. As such, there are two problems with it. The first is the absence of a sound theory to justify NGDP targeting. It is unclear why an economy in which NGDP grows at a constant rate is an economy in which the central bank is doing what is optimal. Second, one can imagine circumstances under which particular NGDP targets will not be feasible. In fact, I do not think it would be feasible for the Fed to achieve 5% annual nominal GDP growth by the end of this year, for these reasons.

2. More QE. Romer and the FOMC are on the same page on this one, but I don't think QE does anything at all (again, see the last link above). At best, QE can signal future intentions of the Fed with regard to the policy rate (and thus move asset prices), but the Fed can do the same thing with "forward guidance," i.e. announcements about the future path for the policy rate. Like other people, including Miles Kimball, Romer seems to think that QE isn't doing much because the Fed hasn't done it right:

The previous rounds of quantitative easing may have done little to improve expectations because their size and duration were limited in advance. If the Fed does another round, it should leave the overall size and end date unspecified. Or, better yet, the ultimate scale and timing could be tied to the goals the Fed wants to achieve.

First, I'm not sure how you announce a policy without saying what it is. Second, the last sentence in the above quote is interesting. The Fed claims that, for example, purchases of long-maturity Treasuries will lower long bond yields. If they were confident about that, the FOMC would announce targets for long bond yields rather than quantitative goals. They don't announce the targets, therefore they must not be confident that QE does what they claim.

3. Forward guidance. As with QE, Romer likes it, but she does not like how the Fed does it:

Instead, the policy-making committee could adopt the proposal of Charles Evans, the president of the Federal Reserve Bank of Chicago, that the Fed pledge to keep rates near zero until unemployment is down to 7 percent or inflation has risen to 3 percent. Such conditional guidance assures people that the Fed will keep at the job until unemployment is down or the toll on inflation becomes unacceptable.

If you look through the FOMC minutes (a prize to the person who can find this), you'll find the FOMC's rationale for ditching Evans's suggestion, and I think that rationale was good. From what I remember, the reasoning was: (i) There are too many contingencies to worry about. You can't write them all into the FOMC statement. (ii) Making policy explicitly contingent on, for example, the unemployment rate, would be silly. The unemployment rate is determined by many factors, most of which have nothing at all to do with monetary policy. (iii) The relationship between monetary policy and real economic activity is imperfectly understood.

The important fight that is going on is not one involving the weapons of monetary policy against the poorly-performing US economy. The key struggle is in getting policy people, and those who write about policy, to use the best available economic tools and reasoning to address our current problems.