Jackson Hole Conference

Ben Bernanke's job is not easy, though that's partly his fault. By speaking extensively to the "maximum employment" part of the dual mandate, he has defined success in a way that dooms him to failure. By embarking on unprecedented and aggressive policy programs - quantitative easing (QE) and forward guidance of various sorts - he has taken on some big risks.

In his Jackson Hole speech, Bernanke's job was to do the best he could in defending past decisions, and in arguing that the Fed is prepared to face whatever the future holds.

Bernanke wants you to think of the people running the Fed as mechanics with a large box of tools. If the economy is to run the way we want it to, all we need to do is find the right tool, and fix it. The more tools, the better. In his speech, Bernanke wants to tell us about "balance sheet tools" and "communication" tools - QE and forward guidance, respectively.

QE and forward guidance are "unconventional" central banking tools. Why do we need these unconventional tools? According to Bernanke, the economy needs fixing, and we can't use conventional tools - open market purchases of short-term government debt - as the overnight nominal interest rate is as low as the Fed is willing to push it.

How do we know that the unconventional tools work? As economists, we feel more assured if we have sound theory and empirical evidence that we can argue are consistent with particular policy actions. What's the theory behind QE? According to Bernanke:

One mechanism through which such [long-maturity asset] purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors' portfolios.

For most modern macroeconomists, that won't be very assuring. "Porfolio balance theory" was the stock and trade of James Tobin more than forty years ago. In this class of models, one specifies a set of asset demand functions - one for each asset, where the demand for an asset depends on the rates of return on assets and on wealth. In general, open market operations in any asset will be non-neutral in such a model. If the central bank purchases a particular asset, then its price will go up, and the rates of return on other assets will change, depending on whether these assets are substitutes or complements for the asset the central bank purchased.

What's wrong with portfolio balance theory? Principally, it ignores how assets are used in retail and financial transactions, and how assets are intermediated by financial institutions. As well, complementarity and substitutability among assets are in practice functions of financial regulation and government policy rules, and should not be treated as "structure." Further, Tobin's models were static, and dynamic elements are critical for studying the effects of monetary policy.

But, Bernanke may be one step ahead of us, as in a footnote, he states:

For modern treatments of the portfolio balance channel in a macroeconomic context, see Andrés, López-Salido, and Nelson (2004). The portfolio balance channel would be inoperative under various strong assumptions that I view as empirically implausible, such as complete and frictionless financial markets and full internalization by private investors of the government's balance sheet (Ricardian equivalence).

Standard frictionless models have no role for quantitative easing. Indeed, the Arrow-Debreu framework has no role for a central bank or for central bank liabilities. To start thinking about monetary policy and what it does, we need a model with "frictions," i.e. we need a formal description of how different assets are used in exchange and an explanation for why conventional and unconventional central banking actions might matter.

The Nelson et al. paper builds a model based on conventional representative agent macroeconomic frameworks, and adds to this some frictions, of sorts. It's certainly not in the New Monetarist spirit. Central bank liabilities are in the utility function, there are costs to adjusting money balances, and the frictions that will give a role for QE are transactions costs associated with purchasing long-maturity bonds, and "self-imposed reserve requirements." This paper did not teach me much about why QE may or may not work.

Basically, Bernanke does not have much to go on in the way of theory to justify the use of QE. What about empirical work? Plenty of this has been done by now, and Bernanke cites some of it, but without a theory, where are we? We can find plenty of people - most of them in the Federal Reserve System - who are now willing to vouch for the fact that QE announcements move asset prices in the "right" direction. But what of it? What do the announcements mean? How do we separate the forward guidance aspect of a QE announcement from the basic QE effect?

On forward guidance, Bernanke makes clear what the "2014" language in the FOMC statement means, in case you were confused:

As the language indicates, this guidance is not an unconditional promise; rather, it is a statement about the FOMC's collective judgment regarding the path of policy that is likely to prove appropriate, given the Committee's objectives and its outlook for the economy.

Thus, there is no commitment implied by the language in the statement. Bernanke wants us to interpret the forward guidance in the FOMC statement as a forecast for when the Fed is likely to raise its policy rate. Maybe this is not such a bad idea. Under normal circumstances, every FOMC meeting gives us more information on the Fed's implicit policy rule, and theory tells us that the more we know about the policy rule, the better. But at the zero lower bound, we don't get much information about what the Fed is up to. Forward guidance might help in this respect, though I doubt that the FOMC will want to keep the interest rate on reserves at 0.25% for the next two years.

Woodford
Woodford's paper from the Jackson Hole conference seems to be getting some attention. I wouldn't recommend reading all 96 pages of this tome unless the value of your time is close to zero. To get the general idea, read pages 82-87. Here's something I disagree with:

To the extent that central banks have been willing to make explicit commitments about the future conduct of policy, it has most often been to underline their commitment not to allow higher inflation than would correspond to their normal, long-run inflation target, even temporarily. Thus, in the case of the Federal Reserve, the introduction of more explicit forms of forward guidance and aggressive expansions of the Fed balance sheet have been accompanied by assurances that these policies should in no way suggest that there will be any relaxation of the FOMC’s vigilance when it comes to preventing any increase in inflation. Such assurances tend to contradict precisely the kind of signals that one would want such policies to send in order for them to be effective in providing people a reason to spend more.

A key problem for the Fed is that it needs to reassure people that it remains committed to controlling inflation, in spite of the unusual circumstances. The fact that inflation expectations - as reflected in TIPS yields, for example - remain subdued, reflects the Fed's efforts to maintain its hard-won credibility as being serious about inflation. I don't think Woodford, or anyone else, would like the results if the Fed were to abandon that commitment.

Woodford seems not to think much of QE, and goes off on an extensive discussion of forward guidance, most of which made me happy that Woodford is not in charge of forward guidance at the Fed. If he were, we would never understand what they are up to.