Many economists regard asset purchases as the most powerful tool the Federal Reserve could use to stimulate the economy. But Michael Woodford, an economics professor at Columbia University, argued Friday that a second option would actually be much more effective – both because it would have significant economic benefits, and because the benefits of asset purchases are significantly overstated.
The option favored by Professor Woodford is a modified version of the Fed’s statement that it intends to keep interest rates near zero until late 2014. In a paper presented at the annual monetary policy conference in Jackson Hole, Wyo., he said that the Fed should instead declare its intention to hold down interest rates until the economy meets certain benchmarks, like a specified increase in economic output. In other words, to increase growth now, the Fed must promise to tolerate higher inflation later.
The Fed’s chairman, Ben S. Bernanke, has repeatedly resisted similar ideas, but in a separate speech at the conference earlier on Friday, he appeared to suggest a greater receptivity.
The core of Professor Woodford’s argument is that changes in Fed policy can happen for two reasons: either its economic outlook changes, or the Fed decides to change the way that it responds to a given economic outlook – in other words, a change in strategy, or in circumstances.
The Fed has described its forecasts as reflecting a change in circumstances, not strategy. It has said that it is simply describing the way that it is most likely to act if the economy slogs along at the pace it presently predicts.
Professor Woodford writes that this is at best ineffective and potentially even damaging. It can be described as an effort to push down interest rates by convincing investors that the economy will remain weaker for longer than they had previously believed. But investors may not regard the Fed as having better information about the economic future. And if they do take it seriously, the implications are negative: The situation is worse than they thought, while the planned response is unchanged.
“Forward guidance of this kind would have a perverse effect, and be worse that not commenting on the outlook for future interest rates at all,” he said.
What can work, he writes, is promising to behave differently. In the current situation, where the Fed would push rates below zero if it could, he argues that the proper response is to promise that it will refrain from raising interest rates above zero as quickly as circumstances would otherwise warrant.
“One wants people to understand,” Professor Woodford writes, “that the central bank’s policy will be history-dependent in a particular way — it will behave differently than it usually would, under the conditions prevailing later, simply because of the binding constraint in the past.”
Charles Evans, president of the Federal Reserve Bank of Chicago, has embraced a version of this approach, arguing that the Fed should maintain interest rates near zero until the unemployment rate falls below 7 percent or the rate of inflation rises above 3 percent. Professor Woodford says this would be an “important improvement,” but he prefers a different approach, tying Fed policy instead to a minimum rate of growth in the nominal gross domestic product (N.G.D.P.), meaning economic growth plus inflation.
Christina D. Romer, former chairwoman of President Obama’s Council of Economic Advisers, has explained the virtues of N.G.D.P. targeting.
Mr. Bernanke has generally resisted proposals for the Fed to shift its policy framework – and he has specifically branded as “reckless” ideas that would raise the Fed’s inflation target, like N.G.D.P. targeting.
But he has also said that in periods of high unemployment the Fed sometimes should move more slowly to restrain rising inflation, and in his speech Friday he appeared to underscore that the Fed, at least in part, is trying to tell markets it plans to move more slowly.
He began with his usual description of the Fed’s policy forecast as consistent with its standard decision-making framework. But he added that “a number of considerations also argue for planning to keep rates low for a longer time than implied by policy rules developed during more normal periods.”
Mr. Bernanke then made the further claim that the Fed was already sending this signal to markets, and that it was being received.
He noted in particular that a regular survey of economic forecasters has documented a steady drop in their estimate of how low unemployment must fall before the Fed’s policy-making group, the Federal Open Market Committee, begins to withdraw its stimulus.
The evidence, he said, “appears to reflect a growing appreciation of how forceful the F.O.M.C. intends to be in supporting a sustainable recovery.”
Article source: http://economix.blogs.nytimes.com/2012/08/31/a-critique-of-fed-policy/?partner=rss&emc=rss
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