The upshot of Ben Bernanke’s speech at the economic symposium at Jackson Hole, Wyoming, at least to most interested observers, is that the Federal Reserve will enact a new round of quantitative easing at their next policy meeting the week of September 10. This may be dependent on the jobs numbers that come out this coming Friday, but that’s the general consensus. One regional Fed President hinted that a “package” of measures could be enacted by the Fed, although this probably includes an extension of the communication on how long interest rates would remain close to zero (extending through to 2015) along with the new asset purchases.
So this would suggest that the Fed will take some steps to ease monetary policy. The problem is that, at the same policy symposium, leading monetary policy theorist Michael Woodford argued in a paper that the steps under consideration would be the exact wrong ones to take.
Mr Woodford’s 97-page paper is deeply sceptical about the efficacy of quantitative easing and endorses the idea of a central bank target path for nominal GDP. From his conclusion:
“Central bankers confronting the problem of the interest-rate lower bound have tended to be especially attracted to proposals that offer the prospect of additional monetary stimulus while (i) not requiring the central bank to commit itself with regard to future policy decisions, and (ii) purporting to alter general financial conditions in a way that should affect all parts of the economy relatively uniformly, so that the central bank can avoid involving itself in decisions about the allocation of credit. Unfortunately, the belief that methods exist that can be effective while satisfying these two desiderata seems to depend to a great extent on wishful thinking.”
Woodford prefers a series of more unconventional steps that have mainly to do with communicating different targets for monetary policy, and a commitment to adhere to those targets in the future. Just buying up some securities in an attempt to flatten out interest rates, an extension of the type of policy you would do under normal circumstances (only the basket of assets purchases changes because of the near-zero interest rate lower bound), doesn’t get you anywhere, according to Woodford. And once again, this is not some random economist entering the debate; this is someone who worked closely with other Fed Presidents on the matter, someone who worked with Ben Bernanke at Princeton, someone who has advised the New York Fed. It represents a policy argument at the highest level.
Paul Krugman further explains this.
I think I was the first to make a point (pdf) that Woodford and Gauti Eggertsson greatly expanded in 2003, namely, that the central bank can still gain traction if it can convince the public that it will pursue a more inflationary policy than previously expected after the economy recovers. As I wrote way back then, the central bank needs to credibly promise to be irresponsible [...]
But that isn’t what the Fed has mainly done, at least not explicitly. Instead, it has relied on purchases of nonconventional assets (misleadingly billed as quantitative easing or QE), especially long-term debt. Has this been effective? Woodford parses the evidence, and concludes tentatively that most of the apparent effects of QE actually come through the expectations channel — that is, that QE works, to the extent it does, largely because markets see it as a form of forward guidance.
So what should the Fed be doing? Woodford concludes that it needs to make a change in its basic policy pronouncements, so as to make them “history-dependent” — that is, it needs to promulgate a view of its intentions that would lead it to be slower to raise rates following a big slump than it would in other circumstances. And let me repeat the past tense: following a big slump, not just when you’re in it.
One of the ways the Fed could do this is through Nominal GDP targeting, which is essentially targeting a GDP rate without adjusting for inflation. This would extend the time in which the central bank would hold off on raising interest rates, because it allows inflation to rise without entering their targeting consideration. Another option would be to take up Chicago Fed President Charles Evans’ idea, committing to doing anything to lower unemployment under 7%, unless inflation rises above 3%. Since the Fed has provided inflation an effective ceiling of 2%, this would allow it to rise above that.
Woodford essentially is saying that the Fed’s insistence that they will fight inflation during and immediately following a recovery ruins the potential positive effects of their own policy. Just purchasing a bunch of assets does nothing; it’s the expectations channel that must be employed. This completely contradicts Bernanke’s speech, which largely defended quantitative easing and set the table for more of it.
Joe Weisenthal writes that this paper “may change the future of economics.” It also suggests that Bernanke, who isn’t so dense as to not have an understanding of Woodford’s findings, may have an ulterior motive in mind in purchasing all these assets, mostly old and often toxic mortgage-backed securities. The recent scooping up of foreclosed properties at bargain-basement prices by hedge funds actually plays a role here – they are closing out the properties as prices that could be lower than what the market will actually bear, generating major losses for the trusts that hold these properties. Who ultimately takes these losses? The Fed, if they decide to buy up all the private-label MBS out there. So there’s a backdoor bailout quality to this as well.