The Fed: Twist and Fail

by CC September 23, 2011 3:05 am • Commentary

Here’s a roundup of some macroeconomic bloggers discussing their disappointment in Operation Twist and Fed policy in general as not being nearly aggressive enough for the situation at hand:


The Money Illusion

Memo to the Fed: We need a light at the end of the tunnel

The tunnel is low NGDP growth as far as the eye can see.  The evidence is low interest rates as far as the eye can see.  That looks like Japan.  The BOJ has failed to provide a light, and the results are clear.

Bill Woolsey

The decline in equity markets, the drop in treasury yields, and fall in expected inflation all indicate the public has revised down its growth expectations and the most likely reason is Fed policy.  Over the past three years the FOMC has effectively kept monetary policy too tight by failing to respond to shocks that have kept current dollar spending (i.e. aggregate demand) depressed.  This passive tightening of monetary policy started in mid-2008 and continues to this day.  Based on this experience,  markets understand that when the Fed downgrades its economic forecast it means the Fed is going to allow things to get worse.

Thus, when the FOMC announced last month that it anticipated keeping its target federal funds rate at exceptionally low levels through mid-2013, it was most likely interpreted as the Fed revising down its economic forecast over the next two years and adjusting accordingly the forecast of its target interest rate over this time to maintain the current (not very stimulative) stance of monetary policy.  In other words, the Fed was expecting the natural interest rate to remain depressed longer than previously expected and thus needed to keep its federal funds rate target lower longer than previously expected.  The Fed wasn’t adding stimulus, but maintaining the status quo as the economic outlook worsened.  Such an interpretation was entirely reasonable given the FOMC’s failure to fully restore aggregate demand over the past three years.
The question, then, is what can the Fed actually do to change the economic outlook.  As I have argued numerous times, the Fed needs to commit to an explicit nominal GDP level target.  To do this, the Fed would (1) announce its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it.  Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting.  That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause current dollar spending to adjust largely on its own.   I go into more detail here how this would work, but the key point is the Fed would be better managing nominal spending expectations.  No more spooking the markets.  Something like it worked for FDR in far more dire circumstances and would most likely work for the Fed today.  And, as Scott Sumner argues, had a nominal GDP level target been in place in 2008 it is likely the economic crisis would have been far milder all along.

This is not to say that Operation Twist 2.0 can’t or won’t have any effect. However, for it to be successful, it would have to relieve the excess demand for safe assets. The Fed has committed to a specific value of purchases. Is there any reason to believe that the magnitude of purchases announced by the Fed is enough to relieve that excess demand? Who knows? Therein lies the problem.

The biggest problem with current Federal Reserve policy is that it lacks any coherent direction or policy goal. Expectations matter. (Read Woodford, for heaven’s sake! This is supposed to be mainstream monetary theory.) For Fed policy to be successful, they need to outline an explicit goal for policy in the form of a target for nominal income and the price level and commit to using the tools at their disposal to achieve that goal. Random announcements of specific quantities of asset purchases provide no guidance and will not be effective. Temporary monetary injections are not successful for much the same reason that temporary tax cuts are not successful (see Weil, “Is Money Net Wealth?”, 1991). Without a coherent goal or strategy, monetary policy with all its fits and starts will continue to fail.

David Beckworth

Still, I am not sure this new operation twist will pack much of a punch.  The reason being is that the Fed is once again adding monetary stimulus without setting an explicit target. Without an explicit target to permanently shape expectations about future spending and inflation, it is hard to see how this new stimulus program will have any more lasting power than QE2.  The Fed needs to quit throwing  large dollar programs at the economy and instead commit to buying up as many assets as needed until some nominal GDP (or price) level target is hit.  This would signal to the public that the Fed is willing to spend whatever is necessary to restore robust aggregate demand.  QE2 and the new the operation twist, on the other hand, only commit to spending a limited amount of dollars and after that point, well, the economy is on its own.  Nominal expectations are allowed to drift and become unanchored. This is why I find this the Fed’s announcement today underwhelming.  Wake me up when the Fed really gets serious about doing monetary policy.

Brad Delong

The problem is that such policies work, to the extent that they work, by taking duration and other forms of risk onto the government’s balance sheet, leaving the private sector with extra risk-bearing capacity that it can then use to extend loans to risky private borrowers.

But buying a 10 or even a 30-year Treasury bond and selling Treasury bills does not remove all that much risk from the government’s balance sheet. Much better–if you have $400 billion to spend–to buy something much riskier…