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Blogs review: State-dependent monetary policy guidance

What’s at stake: The Fed announcement to move from a date-based approach to forward policy guidance to quantitative unemployment and inflation targets marks a major evolution in the practice of monetary policy. While there is still no consensus as to how effective this move will be, there has been wide recognition of its intellectual importance. And although similar moves appear to be in the making in the UK and Japan, the ECB has been singled out as behind the curve along this dimension of the crisis response.

By: Date: December 17, 2012 Topic: Global Economics & Governance

What’s at stake: The Fed announcement to move from a date-based approach to forward policy guidance to quantitative unemployment and inflation targets marks a major evolution in the practice of monetary policy. While there is still no consensus as to how effective this move will be, there has been wide recognition of its intellectual importance. And although similar moves appear to be in the making in the UK and Japan, the ECB has been singled out as behind the curve along this dimension of the crisis response.

Moving from a date-based approach to a state-based approach

Greg Ip writes that low inflation and full employment have been statutory goals of the Federal Reserve since 1977, but its officials always felt more comfortable with the first than the second. But the stubbornly weak economy of recent years prompted some at the Fed to question their historical neglect of the second half of their mandate. “The Fed’s dual mandate … has the force of law behind it,” Charlie Evans, president of the Federal Reserve Bank of Chicago, said in September 2011.  “So, if 5% inflation would have our hair on fire, so should 9% unemployment.” Mr. Evans’ argument was so powerful because it called on the Fed to do nothing more than apply orthodox economic policy reasoning to Section 2A of the Federal Reserve Act.

Michael Woodford writes in the Wonkblog that the statement provides important additional clarification of the conditions under which it will be appropriate to begin raising short-term interest rates, relative to the FOMC’s statements in September and October. Matthew O’Brien contrasts the Evans rule with what the Fed told us before. The Fed was saying it expected the economy to be crummy enough to justify zero rates until mid-2015. But what if the economy picked up before then? Would the Fed raise rates then?

Lawrence Ball writes that for the first time, the Fed clearly says it will be more dovish in the future than the pre-crisis Taylor Rule dictates. The pre-crisis TR is something like the following for the real interest rate r: r = 2.0 – (1.5)(u-u*) + (0.5)(pi-2.0). Let’s say u* is still 5.0. Then if u=6.5 and pi=2.5, the TR says r = 0, which implies the nominal interest rate is i = 2.5. Yet the Fed says that i will still be zero! Some argue that u* has risen above 5.0. That would raise the i implied by the TR, strengthening the conclusion that the Fed’s new rule is more dovish than the TR.

Paul Krugman writes that there is one fairly important wrinkle, however: the inflation criterion was couched in terms of the inflation projection, rather than past inflation. This would let the Fed hold rates low even in the face of a blip caused by, say, a sharp rise in commodity prices.

From the periphery to the mainstream: the Evans rule

Brad Plumer writes that the chart below, from Reuters, shows how members of the Federal Open Market Committee have become steadily more dovish over the course of this year.

Source: Wonkblog

Matthew O’Brien writes in the Atlantic that Charles Evans is the Man who occupied the Fed. He has gone from dissenter to intellectual leader in just a year. Greg Ip writes that by the conservative standards of the Fed, the Evans rule migrated with remarkable speed from the periphery to the mainstream. Karl Whelan writes that Evans deserves enormous credit for getting the Fed to adopt this new approach, which should help to convince U.S. citizens and financial markets that the Fed is serious about getting the U.S. economy back in shape.

Greg Ip writes that the Evans’ rule was a sort of watered-down nominal GDP targeting. But the Evans rule was much easier for the Fed to swallow than NGDP targeting because it required no radical remake of its operating framework.

The global momentum toward more monetary policy innovations

Robin Harding (HT Brad DeLong) writes that the move speaks of a quiet revolution that is sweeping over central banks. A day earlier, Mark Carney, currently governor of the Bank of Canada, soon-to-be governor of the Bank of England, became the most senior central banker to praise an even more radical policy: targeting the level of nominal gross domestic product. Brad Plumer (HT Scott Sumner) reports that Carney said that in major slumps: “To achieve a better path for the economy over time, a central bank may need to commit credibly to maintaining highly accommodative policy even after the economy and, potentially, inflation picks up. He added: “If yet further stimulus were required, the policy framework itself would likely have to be changed”.

Gavyn Davies writes that Mark Carney’s thinking on the future of unconventional monetary easing appears to be different in several important respects from that of the Bank of England’s current governor and the monetary policy committee. The current BoE line on forward guidance is largely hostile, on the grounds that the central bank cannot possibly know what it is likely to want to do in future, and should not pretend to do so. The Carney philosophy on the next steps on unconventional monetary easing is more Ben Bernanke than Mervyn King in flavor, though it goes even further than the Fed chairman in embracing nominal GDP level targets if circumstances warrant it.

Brad Plumer also reports that in Japan the Liberal Democratic Party, which won the parliamentary elections on Sunday, has said it might require the central bank adopt a 3 percent nominal growth target.

Why Oh Why Can’t We Have a European Charles Evans?

Karl Whelan wonders who is willing to be the ECB’s Charlie Evans? Are any members of the ECB’s Governing Council willing to consider new and innovative approaches to monetary policy? Or are they happy with the status quo of the euro area drifting along in a seemingly endless slump? Twice before in the current crisis, in 2008 and 2011, the ECB has embarked on rate-hiking cycles driven by the perception of inflation threats.  Twice they have had to reverse course but there are few signs that lessons were learned from these mistakes.

Karl Whelan writes that watching these developments from across the Atlantic, it’s impossible not to feel an uneasy contrast between the Fed’s new approach and the complacent and inertial approach of the European Central Bank.

Simon Wren-Lewis writes that the ECB has also had an innovative year, but from a different starting point. OMT was a big deal not in terms of central bank practice – it just allows the ECB to do what others are doing already, but with a much more limited remit and under conditionality – but it was a big deal in terms of the mindset of the ECB. However, whereas I think the Fed has been consistently building one innovation on top of another, it seems as if OMT was such an effort for the ECB that they want a rest for at least a year or so. But the Eurozone is starting a new recession, while the US is at least growing. So in terms of what is needed, the ECB is looking at least as out of touch with reality as they did a year ago.

The end of sterilization, the size of the Fed’s balance sheet and uncertainty

Matthew O’Brien writes that the Fed’s other (slightly less) big announcement was that it will continue its $85 billion of monthly asset purchases, albeit with a slight, um, twist. Here’s what hasn’t changed: the Fed will buy $45 billion of Treasury bonds and $40 billion of mortgage bonds each and every month until unemployment "substantially" improves. What has changed is how the Fed will pay for its $45 billion of Treasury bond purchases. Before, the Fed had been selling $45 billion of short-term bonds to pay for the $45 billion of long-term bonds it was buying, which went by the dramatic name of "Operation Twist". It was a way to lower long-term borrowing costs without printing money, back when more Fed members were worried about potential inflation. But with its supply of short-term Treasuries running, well, short, the Fed will turn Twist into QE. In other words, it will now print money to pay for the $45 billion of Treasuries it buys. The Fed’s balance sheet will grow more than before, though its monthly flow of purchases remains the same.

John Taylor writes that the Fed policy requires a completely unprecedented increase in reserve balances as illustrated in this chart below. The risk is two-sided. If the Fed does not draw down reserves fast enough during a future exit, then it will cause inflation. If it draws them down too fast, then it will cause another recession.

Source: John Taylor

Mohamed El-Erian writes that the Fed’s growing involvement is ultimately inconsistent with the proper efficient functioning of a market economy. With a market share that will end 2013 between 30% and 45% depending on the securities, the Fed is heavily involved in markets as both a referee and player. As such, it distorts their functioning, the price discovery process and the allocation of capital.

Brad DeLong writes that El-Erian appears to be working in a model in which there are "fundamental" prices of assets, in which the market approximates those fundamentals via some "price discovery process". But if that is Mohammed El-Erian’s model, why have a Federal Reserve that engages in open-market operations at all? If open-market operations distort the functioning of the price-discovery process and lead to misallocation of capital, why not simply have the Federal Reserve put its hands in the air and slowly back away from the economy?

Paul Krugman writes that it’s just bizarre to angst about how the Fed might “distort” markets that are already hugely distorted. More importantly, the Fed’s duty is to try to correct the distortions that the liquidity trap situation creates, above all the distortion of mass unemployment.


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