A decade of macroeconomic research is finally making a difference.
As everyone knows by now, the Fed’s August 9 statement marked a major change in the communication of policy:
To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. (bold added)
This is straight out of Eggertsson and Woodford’s 2003 BPEA piece, the key article for understanding how to conduct monetary policy in a liquidity trap. As Eggertsson and Woodford observe, once you’ve hit the zero lower bound, it’s not clear why massive money-financed asset purchases (like QE2) should have any direct effect. In fact, taking the path of the Fed Funds rate as given, their model shows that there is no effect. For various reasons, this probably isn’t quite true, but it’s not a bad approximation to reality either, and it provides a strong counterpoint to claims that the zero lower bound is somehow not a barrier.
So what then? If it can’t push rates below zero, and asset purchases are useless, is the Fed “out of ammunition”? Not at all: rates can’t go any lower today, but they can go lower in the future. After all, no one expects the liquidity trap to last forever—at some point, the Fed will raise rates above zero in line with improved macroeconomic conditions, in order to maintain its implicit targets for inflation and the output gap. If, when the time comes, it decides to delay these increases, the Fed will induce a boom—a period of above-target inflation and output. And if everyone today expects a boom in the future, conditions today will be better: higher expected inflation will push down real interest rates, and the expectation of future prosperity will increase demand. Eggertsson and Woodford show that these effects can be very powerful indeed—that the optimal policy can nearly eliminate the negative effects of a liquidity trap.
But there’s a catch: the Fed has to commit to a policy that, in the future, will no longer be optimal. When the time comes, the Fed will prefer not to create an inflationary boom—after all, that’s a violation of its mandate, and the Fed takes its inflation-fighting credibility seriously. They can say “we’re briefly violating our mandate now to keep a promise that prevented a far more serious violation of our mandate two years ago”, but unless everyone understands the importance of commitment (and knows what the Fed’s commitment actually was), this won’t be too convincing. And if the market today anticipates that the Fed will eventually buckle under pressure, the Fed really is impotent.
It’s imperative, therefore, that the Fed’s commitment is explicit and concrete. By moving from a wishy-washy pseudo-promise to hold interest rates low for “an extended period” (which can mean anything) to a pseudo-promise to hold interest rates “through mid-2013”, the Fed has taken a tremendous step in the right direction. It’s still not the ideal commitment: it’s a little evasive, saying that “economic conditions are likely to warrant” near-zero rates rather than articulating any actual policy. Many commentators want a more systematic commitment, like a price level or nominal GDP target. But this is still much better than what we’ve seen from the Fed in the past, and the announcement has done a decent job of anchoring expectations: futures markets show a federal funds rate below 0.1% through mid-2013, exactly as the Fed’s statement suggests.
Much has been made of the following dissent:
Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period. (bold added)
Of course, the “extended period” language is absolutely useless for making a commitment: it’s deliberately ambiguous, designed to give the Fed as much flexibility as possible going forward.
We can only conclude that Fisher, Kocherlakota, and Plosser are not interested in even a mild expansionary commitment of the kind in the August 9 statement. This would be understandable if they had some alternative proposal—say, an aggressive price level target—for escaping the current morass. In reality, however, their votes seem to be determined (at least for Fisher and Plosser) mainly by a wildly distorted view of macroeconomic conditions.
Fortunately, the rest of the FOMC is a little more worried about the worst recession the United States has endured in over a half-century, and less sanguine about the prospects for recovery. We can only hope that they continue their turn toward more aggressive policy commitment.
Edit: I should mention the intellectual history behind the Eggertsson and Woodford piece, in particular Paul Krugman’s classic 1998 BPEA article on the liquidity trap and Japan, which was the first to give us the deliciously counterintuitive idea of “credibly promising to be irresponsible”, and reintroduced macroeconomics to the long-forgotten yet deeply important paradoxes of the zero lower bound.