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The US Federal Reserve’s shift to open-ended asset purchases last week caused quite a stir, not least because it seemed to be admitting the failure of its response to the crisis so far.
Faced with stubbornly high unemployment, low inflation and rates close to rock bottom, the US has very nearly become Japan. To stop the rot, Ben Bernanke’s new plan is to inject money — and keep injecting it — until economic growth returns and unemployment eases, in an acknowledgement that previous rounds of monetary easing, including Operation Twist and the zero interest-rate policy, have been insufficient to restore demand.
To some, this new strategy is just a different take on the same game: money printing. But others see the plan as a tentative step in the direction of a new brand of economics, known as market monetarism.
Unlike the Fed’s previous open-market operations, it is now making the duration of its asset purchases dependent on real progress in the economy — a move that seems to owe a debt to Michael Woodford, professor of political economy at Columbia University, who presented a paper at Jackson Hole a few weeks ago explaining why the expansion of central bank balance sheets has failed to improve overall financial conditions — and why there was no good empirical reason to expect it to.
Along with blogging economists such as Scott Sumner, a professor at the little-known Bentley University, he has put forward the argument that the Fed should instead target a level of nominal economic growth as the focus of monetary policy, and deploy aggressive QE if expectations fall below that level.
Broadly speaking, the idea of level targeting is that prices today are below trend because of the contraction in the economy. To catch up again, the Fed now needs to set the dials to maximum monetary looseness.
This is something it failed to do in its response to the subprime crisis in 2008, according to this new breed of monetarists. The common belief at the end of the housing bubble was that easy money had caused the problems, and therefore the proper response was to tighten. But Sumner has argued that nominal growth (and even inflation expectations) were showing a need for easier money in 2008, and that the Fed could have averted a recession if it had acted then with an aggressive round of quantitative easing aimed at restoring growth back to the trend.
The Fed’s new plan seems to accept some of this logic. The bank will carry on buying mortgage-backed securities at the rate of $40 billion a month, with no upper limit announced, and may continue to do so even after the economy has recovered. That suggests it will tolerate a little bit of inflation in exchange for progress on the jobs front, which led many market monetarists to claim a victory.
It was also taken as a victory for the blogosphere, where many of these ideas have been popularised and debated endlessly. Fittingly, Sumner took to his blog on Saturday to give his views on QE3, describing Bernanke’s plan as “baby steps toward level targeting”.
The problem, for Sumner and others, is that baby steps may not get the job done. Indeed, it may be “too small to decisively impact growth or the deficit, but large enough to take away support for further fiscal stimulus”.
If Obama wins, which seems likely, his hands may be tied before he starts — and that could be the biggest problem for the US during the next presidential term. The Fed has the power to exercise great control over the economy, perhaps more even than it has realised in the past, but at some point politicians will need to take responsibility for directing growth through fiscal policy.
Indeed, the market monetarists would ultimately like to see the government deciding the level that the Fed targets, creating a central bank that is more like the Bank of England — independent in its actions, but not responsible for deciding monetary policy goals.
That would be quite an achievement for a bunch of bloggers.
