The GEM Project has generated a set of specific policy recommendations on how best to prevent future Great Recessions or worse. In the most important of these, the Federal Reserve is tasked to substantially strengthen, with respect both to the content of its toolkit and to the perceptions of global investors/lenders, its capacity to manage total nominal spending.
This post elaborates on that central recommendation and is divided into two parts. The first reprises the Project’s message that monetary authorities seeking to a more powerful toolkit must avoid innovations rooted in market-centric SVGE thinking. The second part, largely given over to Stanley Fischer, summarizes the positive agenda on what needs to be done. The veteran central banker and macro theorist provides an experienced-based look at the monetary-policy toolkit that is consistent with coherent generalized-exchange macroeconomics. Most crucially, he returns analytic and policy attention to the centrality of total nominal spending.
Misleading consensus. Mainstream theorists in the academy, mired in the stabilization-irrelevant market-centric DSGE model class, unsurprisingly reduce the Fed’s Great Recession problem to managing zero (or negative) interest rates. In coherent consensus thinking, the real interest rate always dominates the equilibration of desired saving and investment. Saving is increasing, and investment decreasing, in the inflation-adjusted rate. The proper inflation adjustment is to deduct expected price change from the nominal interest rate, with rationally expected inflation equaling the monetary authority’s credible price regime.
Given their credulous faith in timely, effective market adjustments, Eggertsson and Woodford (2003) and Evans (2011) have argued that the central bank can effectively stimulate investment and overall spending, even if the operational (nominal) interest rate is zero-bound, via announcing a temporary increase in its inflation regime, thereby reducing the real interest rate that they believe centrally governs capital outlays. In a generalized-exchange economy, such a strategy encounters debilitating problems. Most important, the empirical/rational fact of meaningful wage rigidities chronically restricts markets’ capacity to clear, compromising the ability of real interest rates to equilibrate desired saving and investment. In the broad range of circumstances, expectations of nominal demand growth will dominate interest rates in optimal choices to invest versus to hoard liquidity. Even if the announcement effect actually lowered expected real interest rates, the reduction would be ineffective in reversing investor reluctance in circumstances of (widely anticipated) contracting or chronically slow nominal demand growth. Didn’t macroeconomists used to know this?
Moreover, in the context of zero-bound restrictions, the announcement effect would not reduce relevant real interest rates. Given contracting or weak aggregate demand, the efficacy of the proposed increase in the established inflation regime would be damaged by both its promised temporary status and its lack of credibility. The latter is largely rooted in the absence of companion policies that would actually stimulate total spending, reduce excess supply, and eventually put upward pressure on price inflation. Finally, the problem of dubious benefits is compounded by the transparently significant costs of the announcement policy. Credibility for an inflation regime has been hard won and requires careful maintenance. A temporary upward-violation of the established regime reintroduces the time-inconsistency problem into central-bank policymaking and its management of expectations throughout the economy. The result must be some weakening of the credibility of the monetary authority’s commitment to low inflation.
Insights from Fischer. Stanley Fischer (2013, p.2) first identifies “… the policy of quantitative easing – the continuation of purchases of assets by the central bank even when the central bank interest rate is zero. Although these purchases do not reduce the short-term interest rate, they do increase liquidity. Further, by operating in longer term assets, as in QE2, the central bank can affect longer term interest rates, which may have an additional impact on the private sector’s demand for longer term assets, including mortgages and corporate investment.
“Second, there is the approach that the Fed unsuccessfully tried to name ‘credit easing’ – actions directed at reviving particular markets whose difficulties were creating serious problems in the financial system. For instance, when the commercial paper market in the United States was collapsing, the Fed entered on a major scale as a purchaser, and succeeded in reviving the market. Similarly, it played a significant role in keeping the mortgage market alive. In this regard, the Fed became the market maker of last resort.” In particular, the various market breakdowns critically aggravated the collapse in total nominal spending that, via meaningful wage rigidity, generated involuntary lost jobs and income along with its associated multipliers. Financial-market failures were a central part of the acute-instability mechanics in 2008-09.
Fischer elaborates on his policy-making message, citing an interesting intervention channel (considered in Chapter 6) that has never been used by the Fed. “In a well-known article, James Tobin in 1963 asked in which assets the central bank should conduct open market operations. His answer was the market for capital – namely the stock market…. Although central banks have occasionally operated in the stock market – notably the Hong Kong Monetary Authority in 1997 – this has not yet become an accepted way of conducting monetary policy.” (pp.2-3) While the GEM emphasis on credibility and uncertainty takes a limited view of Tobin’s argument, it still informs the larger message of a Fed toolkit capable of reversing collapsing demand in the most difficult circumstances. The search, especially in circumstances of acute instability, for effective monetary interventions in total spending is far from complete.
Blog Type: Policy/Topical Saint Joseph, Michigan