In Which I Reiterate My Conclusion That Non-Explicit Regime-Shift Changes in Monetary Policy Cannot Summon the Inflation Expectations Imp: A Note on Our Post-2009 Failure to Achieve Equitable Growth
As we hear more and more that the Federal Open Market Committee has man on it who have no enthusiasm for additional Quantitative Easing, it is time to reiterate my conclusion that the Federal Reserve's announcement last December that it was switching from a time- to a state-based policy rule has not REPEAT NOT shifted expectations of the distribution of possible levels of prices and inflation over the next five, ten, or thirty years.
Perhaps this is because Federal Reserve communicators have spent a lot of time telling people that the shift to state-based policy does not mean that the Federal Reserve will tolerate higher inflation. Perhaps it is because people do not believe that the Federal Reserve's policy rule is truly state-based--or state-based in the way the Evans Rule is supposed to be state-based. Perhaps it is for other reasons. In any event, this is a powerful piece of evidence that it is much harder to summon the Inflation Expectations Imp than economists like Greg Mankiw had thought. It is a point for the expansionary fiscalists in their debate with the expansionary monetarists.
And it is a smackdown of me for my fit of enthusiastic expansionary monetarism last December, when I wrote:
Back in the middle of 2011, in the circles in which I traveled--policy-oriented macroeconomists who actually knew something about the world and about financial history--there was a rough consensus that we all ought to make one last charge for more aggressive policies to boost growth and reduce unemployment. We did not think there was much chance that we would actually influence policy: it was more to lay down a marker for the future, to make a demonstration that there were policies that could plausibly have gotten us out the fix of jobless recovery and slow growth--a kind of intellectual Charge of the Light Brigade, a "c'est magnifique, mais ce n'est pas la guerre".
We had, after all, worried in 2005 that the housing bubble might collapse and create a sticky macroeconomic situation. And we had been ignored. We had, after all, worried in 2007 that the major banks risk management structures were inadequate to the situation. And we had been ignored. We had, after all worried in 2008 that the Treasury and the Federal Reserve's focus On not enabling moral hazard meant that they were running enormous risks that they did not understand. And we had been ignored. In late 2008 and 2009 we were listened to. But by the end of 2009 when we were worrying about (a) the risk of a jobless recovery, (b) state-level fiscal contraction, and (c) the potentially poisonous interaction of the financial crisis with the structure of the eurozone in the context of southern Europe's policy imbalances--well, we were back to being ignored.
Thus in the summer of 2011 we expected to be ignored again.
We expected to hear about the limited efficacy of quantitative easing and the substantial risks associated with the expansion of the Federal Reserve balance sheet; about the importance of confidence and the necessity of the near-term down payment on long-run deficit reduction; and about how it all costs the US must not become Greece and was in some danger of doing so. And we expected policymakers worldwide to hunker down and stay the course.
And so some of us went out to make the case for more expansionary fiscal policy in the context of an extremely low interest-rate environment that essentially eliminated any medium-term or long-term drag from national debt along the expectations-consistent central case path. And others of us went out to make the case for massive quantitative easing and changing the strategy space of the Federal Reserve in order to summon the Inflation-Expectations Imp and boost the trajectory of nominal demand. I am thinking of, among many, many others: Woodford, Sumner, Eggertsson, C. Romer, Hatzius and Stehn, Krugman, et cetera. Hatzius and Stehn (2012) marks perhaps the outer limits of what in our wildest dreams we would have sought in terms of expansionary Federal Reserve policy: committing to returning nominal GDP to its pre-2008 path and takng the Federal Reserve's balance sheet up to $5 trillion along the way. We were not--at least, I was not--confident that it would work: as with the Digital Conveyor in "Galaxy Quest", successfully summoning the Inflation-Expectations Imp is hmmm hmmm more art than science. But the risk seemed very low, and the potential benefits very high.
And now--by Grabthar's Hammer indeed!--we have lived to tell the tale.
We have 2/3 of Hatzius and Stehn (2012), or a reasonable facsimile thereof. Under its current Evans Plan, the Federal Reserve is going to do $85 billion of quantitative easing a month, and the Federal Reserve will not even think about raising short-term safe nominal interest rates until unemployment falls below 6.5% or forecast core inflation rises above 2.5%/year. This is, admittedly, at least three years later than the Federal Reserve should have adopted such policies. And this is, admittedly, only 2/3 of what I at least would have liked to see. But it is much much more than I would have dared to seriously hope for back a year and a half ago.
Will it work?
Let us try to imagine a world in which it does not work--in which, three years from now, unemployment is still above 6.5% and forecast core inflation still below 2.5%/year. In that possible future world, the Federal Reserve will be holding $3 trillion more of long Treasury and MBS securities than it is holding today. The private sector (plus foreign governments) will be holding $2 trillion less of long-term Treasury and MBS securities than they are holding today. The private sector will be holding $3 trillion more of cash and $2 trillion more of zero-yielding short-term Treasuries than it is today. At the moment the private sector (plus foreign governments) are holding about $2.5 trillion in cash, $8 trillion of short-term Treasury and $5 trillion of long-term Treasury and MBS debt. Three years from now they will be holding about $5.5 trillion in cash, $10 trillion of short-term Treasury, and $3 trillion of long-term Treasury and MBS debt. The ratio of relatively safe debt--debt you could if you needed to say you were holding to maturity and thus were not exposed to risk on--that yields something to the amount of safe zero-yielding assets the private sector will be holding will thus go from 1-2 to 1-5. Financial institutions that want to report nominal earnings, let alone avoid real losses on portfolios that will then include $15.5 trillion of U.S. obligations that pay essentially zero, will be desperately reaching for yield and risk--and whatever risky assets they buy to get some yield into their portfolios will trigger somebody to then spend more on currently-produced goods and services.
That possible future world is not a future world in which unemployment is still above 6.5% and forecast core inflation is still below 2.5%/year.
Thus the possible future world three years from now in which the economy is still stuck more-or-less where it is now--and in which people then are really glad that they hunkered down, took no risks, and socked nearly all of their portfolios in zero-yielding safe Treasuries and cash--has, as of 12:30 PM yesterday--vanished from the spread of possible future worlds that can be rationally anticipated as of today. If investors and markets are rational, holding cash and short-term Treasuries is no longer a way of insuring yourself against the nominal-stagnation lower tail. As of 12:30 PM yesterday, holding cash and zero-yielding short-term Treasuries is a risky bet that markets and investors will--irrationally--fail to recognize that the nominal-stagnation lower tail three years out is no longer there, or a risky bet that the Federal Reserve will reverse course and abandon its Evans Rule policies in the near future.
Will investors and markets be willing to bet on those risks? Or will they try to hedge by dumping short-term zero-yielding Treasuries and cash for equities backed by and for positions in currently-produced goods and services?
If they do the second, the Inflation Expectations Imp will shortly be summoned and our lost decade will be ended after only seven years.
If they do the first, then believers in the potency of monetary policy even at the zero lower bound will have a great deal of explaining to do, and sane policymakers will turn to carefully studying DeLong and Summers (2012), "Fiscal Policy in a Depressed Economy".