Expectations and the Fed

Apparently, Obama's jobs bill is dead.  At least Eric Cantor says so.  Honestly, I'm pretty apathetic at this point.  It certainly would have helped, but not nearly enough to make a huge debt in unemployment ($500 billion into a $14 trillion+ economy isn't much).  So the last place we can realistically do something about jobs is through monetary policy.  And this is where it's worth going into a semi-technical discussion about what the Fed can do to support employment in a liquidity trap.

So right now, the economy is in a textbook liquidity trap-- we're nowhere near full employment, the federal funds rate is as low as it can get, and there's an excess of desired savings over desired investment.  As a result, everyone's rushing to hold Treasuries (10-years ended today at 1.79%), businesses are sitting on cash, and investment is depressed along with GDP.  Theoretically, this means more monetary policy is just a dead end, right? Well, no, not quite.  See, the Fed has a dual mandate-- stable prices and full employment.  And while inflation continues to run steady and low (though there was a blip as a commodity blip made its way through the economy), unemployment is unacceptably high.  So what can the Fed do about that unemployment problem? Well, step one is to signal its intent.  The federal funds rate is already at zero, and we've had two rounds of quantitative easing (buying longer-dated securities), and now we've got Operation Twist (driving down long-term rates to encourage investment).  And the impact has been positive, but very muted (on the QE; economists seem to agree that Operation Twist is unlikely to do much).

But Brad DeLong points out an interesting thought experiment by Larry Summers.  Summers asks: if the Swiss National Bank wanted to lower the value of the Swiss franc, which step would require it to print more money: announcing that it would print whatever it takes to get the value to where it needs to be, or announcing that it would print X number of francs, then reassess the situation.  The answer is, obviously, the latter.  It signals an action, while the prior scenario signals a goal.  Scott Sumner applies the lesson to the US.  He argues that the Fed has plenty of credibility... but it's using that credibility to convince consumers and businesses that inflation will remain low.  But why low inflation and a strong dollar are always a good thing is baffling to me.  The inevitable response will be, "WEIMAR GERMANY OH NO!".  Which would be compelling if it weren't intensely wrong-- yelling about hyperinflation in today's US is like yelling about the risk of hypothermia in Abu Dhabi.  But there's no research indicating that, say, 4 or even 5 percent inflation is any worse for the economy than 2 percent inflation.  And the Fed committing itself to an explicit inflation target of 4 percent would be a very good thing.  Why? Well, it's pretty simple.

Imagine the Fed announced its new inflation target tomorrow and immediately started printing money.  Assuming investors and businesses consider the Fed to be credible, they will react rationally.  And those investors and businesses are sitting on huge stacks of cash right now.  If they expect the real value of that cash to decline by 4 percent in the next year, you'd better bet they're not going to sit on that cash-- they'll deploy it somewhere where they'll get returns.  That might mean moving up investment (if you need to replace your factory within the next 5 years, but you expect doing so to be 25% more expensive in 5 years, you're going to do it as soon as possible), or it might mean reinvesting the cash in higher-yielding assets, but either way it discourages holding cash.  The same incentives apply to consumers.  The important thing to note about consumers is that they are, by and large, still very indebted.  But if they expect their wages to rise 4% in the next year, that debt will stop looking as daunting (wages can rise, but debts stay the same size), and their cash will be less encumbered.  More importantly, they'll look to spend or invest their savings, which will drive up demand further and get money circulating through the economy.

Of course, avoiding a wage-price spiral is important, but if the Fed has credibility, it can target, say, a 3 year program of 4% annualized inflation, after which it will cut back.  With any luck, in that stretch, the economy will grow substantially and we will be in much better shape than we are today.  Of course, this is all speculation.  My argument really isn't anything unique-- Ben Bernanke made it persuasively in his analysis of the Great Depression and Japan's Lost Decade, and I think if he were the only person in charge at the Fed, it's something he would consider.  Unfortunately, there are others at the Fed who fear doing anything, so it's not likely to happen.  But the point is that there ARE tools available that the Fed could use to get unemployment down... if only the will to use them existed.