The U.S. Federal Reserve yesterday finally took the step many of us had been urging for some time.
Let’s start with the Fed’s summary of current conditions:
Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.
In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.
The second paragraph is similar to the wording that the Fed introduced in its previous January statement. The Fed is trying to communicate that it sees the very low inflation rates (and threatened deflation) of recent months as unhealthy for the economy and something it intends to prevent. The Fed is very mindful of the role of expectations in the current setting, and wants with this statement to communicate clearly to the public that it’s not going to allow deflation.
What’s new in yesterday’s statement is what the Fed says it’s going to do about it.
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.
What’s with all these numbers appearing in the statement? Traditionally the key number that the members of the FOMC would vote on and that the Fed would communicate to the public with a statement like this would be a target interest rate that the Fed had settled on for the fed funds rate, an interest rate charged on overnight interbank loans. But that traditional policy tool has been fundamentally irrelevant for months now, as the fed funds rate scraped along the zero lower bound. The Fed has accordingly finally settled on an alternative way of framing its quantitative strategy in terms of specific quantitative expansions it intends to implement.
This is what I have been urging the Fed to do. Personally I would have focused more on purchasing long-term Treasuries (particularly TIPS) rather than the agency issues, but this should get the job done. And the job, in my mind, is to make sure that the Fed prevents deflation.
Let me be very clear that I am using the term “deflation” here in a very specific and narrow way. I am defining deflation (as do most academic economists) as an increase in the real purchasing power of each dollar bill outstanding, as measured by a decrease in the level of a broad price index such as the CPI or PCE deflator. I think that deflation is an important condition for the Fed to avoid because deflation magnifies and aggravates the real burdens of debtors (dollar sums owed become an even bigger real burden), which would drive us even deeper into our current problems.
There’s a second reason why I believe achieving a modest rate of inflation (my number is 3%) should be job 1 for the Fed. The goal of fiscal stimulus is to increase aggregate nominal demand. The notion is that there is sufficient slack in the economy that we could increase nominal GDP without causing nominal prices to increase, and thus generate an increase in real incomes. Once we get to the point where that stimulus starts to produce inflation, we know we’ve done all we can with the policy of demand stimulus.
I have favored federal fiscal stimulus as the preferred policy tool for purposes of investment in infrastructure that could be justified on the basis of the direct productivity of the projects themselves and preventing fiscal contraction at the state and local level. However, monetary policy to me makes more sense as the tool to use for the goal of increasing total nominal spending beyond the level achieved by those first two categories of fiscal stimulus. And I frankly have never understood the position of those who claim that policies such as that adopted by the Fed yesterday will have no consequences for the purchasing power of a dollar.
I emphasize that I am decidedly not suggesting that either fiscal or monetary policy stimulus are capable of solving all of our problems. Real debt imbalances, both domestic and international, frictions in moving resources out of housing and autos and into other sectors, and the profound problems with our financial system all place important physical constraints on what any stimulus package, monetary or fiscal, is capable of achieving. Once we get to 3% inflation, that to me will be a clear indication that we’ve accomplished all we can with tools to stimulate aggregate demand.
I would also like to say a word about the short-run versus the long-run outlook for inflation. I am fully in agreement with those who worry that the prospective new debt issue by the U.S. Treasury and risky asset position of the Federal Reserve put in play some powerful forces for inflation over the longer run that may prove quite difficult to contain. But while I agree that this is quite an important issue, I believe it would be dead wrong to interpret yesterday’s statement from the Fed as confirmation that we are now starting down that path. The actions by the FOMC yesterday were, in my opinion, not influenced in the slightest by those long-run pressures, but instead were motivated entirely by the short-run concerns I outlined above. I believe the Fed shares my goal that what we want to see is 3% inflation, no more, and that when we get there, they’ll stop.
What will be the indication that we’ve done all we can with this tool? I would urge the Fed to be watching the exchange rate and commodity prices quite closely for an indication that the deflation tide has turned.
The Fed has declared pretty loud and clear that it is not going to allow deflation. So here’s my personal investment advice: don’t bet against the Fed.