I was on vacation last week (far from Jackson Hole) when Ben Bernanke gave his widely anticipated speech. The media (see the Times, for example) seemed to focus mainly on his criticisms of the political branches and economic policymaking, which were accurate enough. But in my opinion, Bernanke drew the wrong lessons from those observations.

He was very clear that the problem today is unemployment, not inflation:

“Recent data have indicated that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting, and that temporary factors can account for only a portion of the economic weakness that we have observed. Consequently, although we expect a moderate recovery to continue and indeed to strengthen over time, the Committee has marked down its outlook for the likely pace of growth over coming quarters. With commodity prices and other import prices moderating and with longer-term inflation expectations remaining stable, we expect inflation to settle, over coming quarters, at levels at or below the rate of 2 percent, or a bit less, that most Committee participants view as being consistent with our dual mandate.”

He even said that we are in a situation where economic would improve the economy’s long-term performance:

“Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view–the exception to which I alluded earlier. Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow. In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.”

But what is Bernanke going to do about it? He declined to offer any new efforts to reduce unemployment, saying only that the Fed “is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.” And mainly he relied on the political branches to solve the country’s problems, calling not only for “good, proactive housing policies” but also for policies that would improve K–12 education for underprivileged households and lower health care costs.

I don’t think it makes sense to criticize the political system for being dysfunctional and then rely on the political system to rescue the economy. I understand that traditional monetary policy tools don’t work that well in this environment: short-term rates can’t go any lower, and lowering long-term rates won’t make companies invest if they don’t think there is demand for their stuff. But there’s always, you know, dropping cash out of helicopters.

It’s true that, in the speech that gave Bernanke the nickname “helicopter Ben,” he was talking about a tax cut—in other words, fiscal policy. But there’s always the option of increasing the inflation target from 2 percent to 4 percent while simultaneously buying long-term bonds to keep nominal rates from rising too much (so real rates come down). If the Fed can actually generate more inflation, that would function like a transfers from creditors to debtors, which would help solve the household balance sheet problems that are weighing down the economy. And there’s nothing magical about the number two: both Ken Rogoff and Olivier Blanchard have argued for higher inflation, given current economic circumstances. As Blanchard says, “There was no very good reason to use 2% rather than 4%. Two percent doesn’t mean price stability. Between 2% and 4%, there isn’t much cost from inflation.”

I’m not sure it would work; maybe even raising the inflation target wouldn’t actually increase inflation. But doing nothing is be the wrong policy conclusion to draw from Bernanke’s observations, which seem spot-on.

Yesterday I wrote an Atlantic column about the bizarre situation that the Federal Reserve is in. Ordinarily, we think central bank independence is important because it permits the bank to take unpopular, anti-growth steps when the political branches of government want popular, pro-growth steps. But today we’re in Bizarro world: the political branches are intent on strangling the economy, so the Fed should be ignoring the political winds and stimulating the economy—especially since it’s clear that fiscal policy is off the table. Rick Perry just provided a last-minute dose of color.

Obviously Perry and the Republicans don’t want the Fed to stimulate the economy because they don’t want the economy to recover before the 2012 elections. But I think there’s something deeper here, which Mike Konczal gets at in this great post. Konczal summarizes the nineteenth-century gold-standard ideology this way: “Paper money decreases the power of the husband over his wife and the father over his family, loosens the natural leadership that serves as the best protection against ‘effeminate’ manners, and gives us a democracy without nobility.”

For policy wonks like me, inflation (short of hyperinflation) is just a transfer of wealth from creditors to debtors and hence a way to help bring overleveraged balance sheets under control and get people spending again.* But don’t take it from me; take it from Ken Rogoff, who is nobody’s idea of a socialist. I think Olivier Blanchard, chief economist of the IMF, has also said that in today’s world inflation should be 4 percent instead of 2 percent.

But for Rick Perry and people like him, there’s something immoral and unmanly about inflation and about paper money. He can stand there telling people that monetary expansion is devaluing the dollars in their pockets, and those people will nod their heads, even though (a) it isn’t—check the inflation figures—and (b) many of them are net debtors and thus stand to gain from a little more inflation. The basic problem is that Rick Perry and his audience (and probably many other people) see economic questions in primarily moral terms, and in their moral universe gold is better than paper and deflation is better than inflation. (That’s the obvious inference if you say that inflation is bad.)

I’m obviously not the first person to think of this. It’s the core of George Lakoff’s book Moral Politics, which is a great description of the conservative worldview combined with an unconvincing description of a liberal worldview that he wishes existed but I think doesn’t exist.

But I think it’s particularly relevant in light of today’s op-ed by David Campbell and Robert Putnam in the Times. Campbell and Putnam use interviews going back to 2006 to see what people ended up joining the Tea Party. And it isn’t new entrants to politics, or libertarians, or people with a thing for the Constitution. Using pre-Tea Party data, the predictors of becoming a Tea Party supporter include being Republican, political activism (contacting government officials), being white, “a low regard for immigrants and blacks long before Barack Obama was president” (even compared to other white Republicans), and wanting more religion in politics. (The best predictor is being a Republican; the second best is wanting more religion in politics.)

So if the Tea Party is basically the Christian Coalition all over again, why does it fly the banners of libertarianism, strict constructionism, hard money, and low taxes? One explanation is the billionaire puppet-master story, best exemplified by Jane Mayer’s story about the role of the Koch brothers and other traditional Republican elites in the rise of the Tea Party. I’m sure there’s something there. But another explanation is that the Tea Party, like the old religious right, is a movement based on a sense of moral outrage, and the style of the Tea Party appealed to a certain segment of the population. If you think the world went all wrong in the 1960s and abortion should be illegal and there what we need is prayer in public schools, you probably also think the Constitution must be eternally pure and gold is better than paper money—even if it’s not in your own economic interests. (Just like you probably don’t like distributing condoms to teenagers, even if it is an effective way to reduce the number of abortions.)

And this is why Rick Perry can go around spouting nonsense and still be a serious contender for the presidency.

* For the record, I’m a net creditor—I have money in bond funds and TIPS and no debt to speak of—so I stand to lose from higher inflation.

In a Congressional hearing today, Representative Paul Ryan (R-WI), chair of the House Budget Committee, strongly criticized Federal Reserve Chair Ben Bernanke for failing to contain the severe inflation threat posed by the Tooth Fairy.

Ryan pointed to numerous studies showing that, despite ongoing economic sluggishness, the Tooth Fairy is paying much more for children’s baby teeth than in past years. In neighborhoods such as Winnetka, Cleveland Park, the Upper East Side, and Palo Alto, children can receive more than $20 per tooth — a dramatic increase from the 25-50 cents that the Tooth Fairy paid only a decade or two ago. In the Hamptons, summertime prices for teeth can easily exceed $100, according to a survey commissioned by the American Enterprise Institute.* Because the Tooth Fairy is able to create money magically, her purchases of unused teeth (with no apparent economic value**) increase the money supply, fueling inflation. Without explicitly accusing Bernanke of participation in the Tooth Fairy’s scheme, Ryan implied that the Tooth Fairy’s higher payouts may be part of the Federal Reserve’s quantitative easing scheme.

Ryan pointed to Tooth Fairy-driven inflation as part of “a sharp rise in a variety of key global commodity and basic material prices” that, he said, threaten to produce higher overall inflation and reduce the value of the dollar. “The inflation dynamic can be quick to materialize and painful to eradicate once it takes hold,” said Ryan, calling on Bernanke to end the quantitative easing program and raise interest rates in order to counteract the expansionary policies of the Tooth Fairy.

Bernanke responded, “On the inflation front, we have recently seen increases in some highly visible prices, notably for children’s teeth. . . . Nonetheless, overall inflation is still quite low and longer-term inflation expectations have remained stable.” He pointed out that all measures of domestic inflation — the prices that real Americans pay for the real stuff that they actually buy — are at historic lows: core inflation of 0.7 percent in 2010, the price index for personal consumption expenditures at 1.2 percent, and average hourly earnings at 1.7 percent. He also pointed out that inflation in emerging markets is higher because those economies are growing faster and that commodity prices are always volatile. But Ryan insisted that the Fed take aggressive action against the Tooth Fairy because an unemployment level of 9 percent would fail to contain the inflationary spiral that would inevitably result from this particularly sinister form of monetary expansion, taking place quietly, in the dark, in our children’s own bedrooms.

“There is nothing more insidious that a country can do to its citizens than debase its currency,” he said, apparently forgetting for a moment that he has proposed replacing Medicare with a voucher system whose benefits are explicitly designed to grow slower than the rate of health care cost inflation.*** Ryan also apparently believes that a more valuable currency is always better than a less valuable currency, which is crazier than a kid believing in the Tooth Fairy. After all, if you’re six years old and the tooth under your pillow gets replaced by money and a note from the Tooth Fairy, then that’s physical evidence in favor of her existence. Paul Ryan seems to believe that China (like Korea, Taiwan, Germany, and France before it) is hurting its economy by keeping the value of its currency low in order to promote exports and create jobs. This fetishization of the dollar’s exchange rate is even crazier than the typical fetish, which at least attaches to some object. Paul Ryan’s fetish attaches to an abstract ratio and elevates it to moralistic terms.

* In inner-city Detroit, however, survey respondents gave answers such as, “No Tooth Fairy comes around here. Haven’t you seen nobody has a job anymore?” The AEI report concluded that the Tooth Fairy must value teeth from the Upper East Side more than teeth from Detroit.

** See the introduction to a This American Life episode for some children’s theories about what the Tooth Fairy does with all those teeth.

*** The growth rate of benefits is capped at GDP plus one percentage point. Historically health care costs have grown significantly faster. More to the point, the whole point of the Ryan-Rivlin plan is to force Medicare to grow more slowly than health care costs overall; if health care cost growth is GDP plus one percentage point or less, then converting Medicare to a voucher system provides no fiscal benefits.

Paul Krugman’s speaking notes are here. Ben Bernanke’s are here.

Bernanke’s speech is largely a defense of the Federal Reserve’s monetary policy in the past decade, and therefore of the old Greenspan Doctrine dating back to the 1996 “irrational exuberance” speech–the idea that monetary policy is not the right tool for fighting bubbles. The Fed has gotten a lot of criticism saying that cheap money earlier this decade created the housing bubble, and I think it certainly played a role.

But I actually agree with Bernanke here:

“[T]he most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.”

(Note that the purpose of stronger regulation, according to Bernanke, is to constrain the housing bubble that he denied existed at the time–not to protect consumers.)

The problem, for the Greenspan-Bernanke legacy at least, is that the Fed is also the chief regulator of the financial system, with jurisdiction over all bank holding companies and primary responsibility for consumer protection statutes applying to all financial institutions. Here Bernanke makes a partial attempt at an apology:

“The Federal Reserve and other agencies did make efforts to address poor mortgage underwriting practices. In 2005, we worked with other banking regulators to develop guidance for banks on nontraditional mortgages, notably interest-only and option-ARM products. In March 2007, we issued interagency guidance on subprime lending, which was finalized in June. After a series of hearings that began in June 2006, we used authority granted us under the Truth in Lending Act to issue rules that apply to all high-cost mortgage lenders, not just banks. However, these efforts came too late or were insufficient to stop the decline in underwriting standards and effectively constrain the housing bubble.”

In other words, we did nothing until 2005, and then we didn’t do much. [Also see Update 2 below.]

I don’t really care about apologies. The more important question is what Bernanke and the Fed will do in the future. On that front, he has this to say:

“The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country’s overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms.”

There are basically only two things in this paragraph, one of which is disingenuous at best. Bernanke claims that he is getting serious about consumer protection, yet he has lobbied against the Consumer Financial Protection Agency, which everyone who is serious about consumer protection wants. I’m disappointed that Bernanke would stoop to this kind of misleading rhetoric.

The other thing is a lot of talk about systemic risk. Yes, systemic risk is important. But all the words I hear about it, and the fact that the importance of systemic risk is one of the few things that everyone can agree on, are making me start to worry. Specifically, I wonder if a lot of regulatory apparatus aimed at systemic risk will serve as a distraction from old-fashioned regulation of individual institutions. Yes, it’s true that the thing that hit us in 2008 was systemic risk. But it’s also true that regulators already had the power to supervise Citigroup, Bank of America, Wachovia, Washington Mutual, Lehman Brothers, Bear Stearns, and Countrywide and force them to pare back their risky activities–and didn’t. Talking about systemic risk is a way of passing the buck–of excusing regulatory failure by saying that regulators didn’t have the authority to look at systemic risk. But the fact remains that someone looked at Citigroup’s range of businesses and its asset portfolio and decided it was a healthy bank.That was at least as big a problem.

I’ve been on the fence about Bernanke’s confirmation, mainly because I’m not so optimistic we’ll get anyone better from a policy standpoint, and we could certainly get someone worse from the standpoint of intelligence, knowledge, thoughtfulness, and work ethic. But now that I’ve read this speech, I’m against confirmation.

Update: I should clarify one thing. I am sure there are better people out there. I’m less confident about whomever Obama and his advisers would pick. This is a deeply centrist administration, at least on economic issues, and one that is absolutely not going to make a major policy shift anytime soon; whether or not we agree with them, their current message is that they have done a good job fixing the financial system and running the economy. So I think that if Bernanke by some miracle were not confirmed, Obama would take pains to appoint someone with the same policy positions.

Update 2: Mike Konczal at Rortybomb points out what Bernanke left out of Bernanke’s defense of the Fed: the fact that the Fed actively ignored warnings going back to 1998. Funny how a factually correct statement can be deeply misleading.

By James Kwak

Duy takes as his starting point a series of statements by Fed governors and bank presidents indicating “hawkishness,” which in central banker jargon means caring primarily about inflation, not economic growth. (“Doves” are those who care more about economic growth and jobs, although, just like in the national security context, no one likes to be known as a dove. This itself is a disturbing use of language, since it implicitly justifies beating up on poor people, but let’s leave that for another day.)

Hawks also like to talk a lot about “credibility,” which means a reputation for being willing to fight inflation. People use the word credibility in this context because the conventional wisdom used to be that national governments would not be willing to take tough steps (raising interest rates) against inflation because that would cost jobs, and hence votes in the next election. So central banks had to prove that they were willing to raise interest rates and put people out of work, even though that might be politically unpopular. Now that our Fed governors and bank presidents are accountable to just about no one, beating on their chests and proclaiming how willing they are to be tough in the face of the political winds rings a little hollow to me — especially in a “middle-class” country that considers inflation to be a greater evil than unemployment. Arguably, the situation has reversed; it has become so accepted that the primary job of a central bank is to fight inflation, despite the Fed’s dual mandate (to both fight inflation and promote stable economic growth), that fighting inflation has become the politically safe thing to do. But I digress again.

This is what Duy sees:

• Kevin Warsh of the board of governors: “If ‘whatever it takes’ was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed’s institutional credibility.”
• Richmond Fed president Jeffrey Lacker, from Bloomberg: “The Federal Reserve will need to raise interest rates when the economic recovery is ‘firmly’ in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.”
• Philadelphia Fed president Charles Plosser: “[J]ust as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. …  The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.”

Can you feel the testosterone?

Duy argues that all this manliness is misplaced. The Fed hawks’ basic argument seems to be that, because it acted so aggressively to stimulate the economy last year, it will have to act equally aggressively to dampen growth at some point — just to send a message. And to send that message, they need to be willing to raise interest rates while unemployment is still 10% (Lacker) or “well before unemployment rates and other measures of resource utilization have returned to acceptable levels” (Plosser).

Now, there may be something to this. Duy points out that the hawks seem to be worried about recreating the debt bubble of the last decade through too much cheap money. If cheap money is going to flow straight into overvalued houses, then that’s a problem. But Duy says that that is a failure of regulation. Low rates are supposed to stimulate capital investment by businesses, which is what long-term economic growth depends on. But earlier this decade, despite low rates, capital investment never returned to 1990s levels, because all the cheap money was flowing into housing instead — for reasons we know.

“Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade’s debt bubble? …

“With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards.”

The solution, then, is better regulation to protect against misallocation of credit to the next asset bubble. Simply raising rates will choke off an asset bubble, but it will also choke off real investment by businesses.

This goes back to what StatsGuy said in a post here:

“In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). …

“But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.”

In other words, if you’re going to throw in the towel on regulation, then there is no place for cheap money to go except the next asset bubble. You might as well try to prevent that, but then you are consigning the real economy to a long, slow decline since you have no way of getting monetary stimulus where you need it (factories, not new condo towers).

So there seem to be two possible futures. If we repeat the Greenspan policy of low rates during a boom, we’ll just create a bubble all over again, since none of the underlying factors (weak consumer protection, weak bank regulation, etc.) have changed. Or if the hawks win (both in the Fed and in Congress, which controls fiscal stimulus), we’ll have high unemployment for a long, long time, since no one will have the guts to risk higher inflation. Being a “hawk” has become the safe, comfortable choice — even in a week when monthly job losses were up and weekly new unemployment claims were up.

By James Kwak

Former Fed Chairman William McChesney Martin is most famous for his notorious quip that the job of the Fed is to “take away the punchbowl just as the party gets going.” It seems this has evolved into a full fledged theory of monetary management.

Unfortunately, structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar. (Some specific mechanisms are listed in the previous comment.)

Why does this matter? Because it means the Fed cannot use monetary policy as effectively to keep the country going at full throttle and avoid a prolonged fall in utilization rates (unemployment and idle machines).  How can it be that capacity utilization is still lower than at the bottom of the 81/82 recession and we’re ALREADY raising the bubble/inflation alarm? (Paul Krugman discusses this here, and the answer is that the output gap is itself defined against neutral inflation, not just capacity utilization.)

Here is a less semantic answer: When the Fed pumps money into the system to prevent deflation, the disincentive to holding cash/reserves is supposed to get money moving and thus restore the savings/investment equilibrium. In a sense, the goal is to decrease the incentive to use money as a store of value and therefore increase its use as a medium of exchange. Unfortunately, many conventional macroeconomists (unlike their brethren in the real-world finance schools) haven’t admitted that this monetary stimulus “leaks” out of their models (which focus on closed domestic economies without moral hazard). Where does it go?

Partly, it gets sopped up by large financial institutions with asymmetric reward functions (aka, government owns the downside) and government guarantees (Too Big To Fail) that give them cheap access to credit. Rather than forcing it into the real US economy, it flows into financial assets (some of this is good, since it’s necessary reflation, but too much creates a new bubble, and the asymmetric reward function certainly creates massive distributional inequities).

The monetary stimulus also “leaks” due to globalization of capital flows. It flows out of the country through a variety of mechanisms that traders might describe as dollar hedging (into commodities, foreign assets, and an anti-dollar carry trade). This is one of the most dominant trading features in the current market environment.

In order for the Fed to actually be able to fully use monetary policy to keep the economy humming at full throttle, we need financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up). This latter point is not entirely intuitive, and I might argue that the best way to avoid future expectations of devaluation is get the Renminbi/Yuan revaluation (which everyone expects, but over which there is massive uncertainty) over and done with. China, however, is not too keen on this idea.

So in these regards, Team Obama seems to “get it”. I concede that they have identified the right issues. How well they execute depends on many factors. As Professor Johnson notes, focusing on currency valuations (a very sensitive issue in China) on a highly public world stage like the G20 may not be productive.  By contrast, quietly moving a bill through Congress might be a better option.

But what happens if we fail to fix the structural issues? Well, the answer is not good. Without the right scalpels and scaffolding, the Fed will use a sledgehammer – taking away the punchbowl during booms and giving it back during busts. Except that it will almost always get the timing wrong – taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility.* If it tries to support a weak economy by keeping the punchbowl on the table (as in 2003-2005, when we had a “jobless recovery”) then we get a really bad bubble.

That is what a central bank staffer called “Second Best Punchbowlism” on Brad DeLong’s blog, and it is a very scary prospect indeed. Remember when the Fed kept rates tight in August and early September 2008 (arguably to fight the commodity bubble/dollar run)? And when, in the post-September 2008 crisis, the Fed continued its deflationary policies, even though it was abundantly clear to the entire world that aggregate demand was (to paraphrase Warren Buffett) falling off a cliff? The Fed didn’t bring out the heavy weapons until March of 2009, until things looked pretty bleak indeed. This is what we can look forward to if the Fed’s new paradigm becomes Second Best Punchbowlism.

It’s also important to recognize that we can’t just kill the Fed right now. We NEED monetary policy to be effective in order to implement new financial regulation (especially higher capital asset ratios) without killing the US (and world) economy by reducing the total supply of money. As we phase in higher capital asset ratios and other regulations, we must compensate by injecting liquidity to offset a decrease in velocity. This must be done in a highly coordinated fashion. Otherwise, financial regulation that aims at a long term equilibrium with a more stable overall money velocity (which I would argue is a good thing) could risk deflation in the near future (which will undoubtedly cause people to blame the administration currently in charge).

*“I’m acutely aware that the current FOMC has inherited the inflation policy credibility that was hard won by our predecessors. One thing that has impressed me since taking my position last year is the seriousness with which my colleagues approach the duty to protect that legacy. I am confident that the Federal Reserve’s institutional commitment to maintaining low and stable inflation will prevail.”

– Dennis Lockhart, President, Atlanta Fed, August 2008

By StatsGuy

The question seems to be whether the Fed will be able to tighten monetary policy fast enough when necessary to dampen the potential inflationary effect of its current expansive monetary policy (Fed funds rate at zero, buying long-term securities, etc.). My read on the situation is as follows:

1. Almost everyone agrees that expansive monetary policy has been appropriate during the crisis and recession to date.
2. Everyone agrees that at some point monetary policy will have to be tightened.
3. No one knows when that will happen.
4. Everyone agrees that because policy has been so expansionary recently, tightening monetary policy when necessary will be more difficult than usual.
5. Everyone agrees more or less on what tools will be available to the Fed.
6. No one is certain the Fed will or will not be successful, because there are no relevant datapoints to compare it to.
7. No matter what Bernanke actually thought, he would still have to say exactly what he is saying this week.

I don’t see much in there worth arguing about.

As Catherine Rampell says, a more interesting question is when the Fed will start tightening policy. This is the kind of thing that can set the Fed against the administration, as stereotypically one focuses on inflation and the other on unemployment. But since most people think it is too early to start now, that debate would be purely speculative at the moment.

* He does need a grammar checker, though. His first sentence – “The depth and breadth of the global recession has required a highly accommodative monetary policy” – contains an error in subject-verb agreement.

By James Kwak

These ideas are appealing under the circumstances, but this Fiscal First approach also has definite limitations, for both domestic and foreign reasons. 

Most obviously, Congress will reasonably want to impose constraints on the amount of government debt that is issued, particularly absent a longer-term solution for Social Security and Medicare. 

In addition, the Administration’s big deficit push relies critically on an “easy enough” monetary policy which, at the same time, precludes ”too much money, too soon.”  They need long interest rates to remain low, particularly for the housing scheme to make sense – rates have to come down for borrowers, at the same time as there is sufficient margin to cover credit losses, so it only works if the 10-year Treasury rate is roughly at current levels. 

If the Fed eases “too much,” then actual or expected inflation will jump.  This would reduce real debt burdens and could help reflate the US and global economy more broadly, but the higher interest rates would compromise the fiscal/housing strategy.  (If the Fed holds down long rates in the face of sharply rising inflation expectations, then will we will have a crazy credit boom that makes all other bubbles seem relatively sensible.)

On the foreign side, all other governments have an incentive to free-ride on the US fiscal policy.  The dollar will tend to appreciate, on top of any strengthening due to safe haven-related developments.  Both Europe and leading emerging markets can, in this scenario, hope to recover based on their exports.  Sure, they like to criticize the US for its role in placing everyone on fragile growth paths with increasingly hard-to-sustain debt paths, but almost everyone would like – in the short-term – to go right back there.

Again, if the US approach were more slanted towards expansionary monetary policy, this would tend to cause dollar depreciation and it would force the hand of other governments.  Either they would ease their own interest rates and potentially increase their supply of money, or their export sectors and growth would suffer further. 

Most countries around the world have limited capacity for fiscal expansion, but almost all could engage in a more expansionary monetary policy.  This, of course, runs counter to 20 years of orthodoxy in central banking, but nothing is without risks.  And that includes the first set of fiscal moves by the Obama Administration in their global economic chess game.

(Thanks to Mark Thoma for flagging this.)

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve’s quiver–the provision of liquidity–remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. . . .

Second, the Federal Reserve can provide backstop liquidity not only to financial institutions but also directly to certain financial markets, as we have recently done for the commercial paper market. Such programs are promising because they sidestep banks and primary dealers to provide liquidity directly to borrowers or investors in key credit markets. In this spirit, the Federal Reserve and the Treasury jointly announced last week a facility that will lend against asset-backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration. . . .

Expanding the provision of liquidity leads also to further expansion of the balance sheet of the Federal Reserve. To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed’s balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way. However, that is an issue for the future; for now, the goal of policy must be to support financial markets and the economy.

There have been a number of articles in the last week on the shift toward quantitative easing, and in particular the fact that the Fed is no longer sterilizing all of its liquidity injections (compensating for them by selling Treasuries to suck up cash). Here’s one from FT Alphaville with some nice graphs.

In their Real Time Economics post a week ago, Simon and Peter argued that this is precisely what we need. However, opinions differ – some fear that the increased long-term risk of inflation outweighs the benefits of monetary stimulus now.

The action by the Federal Reserve on buying mortgage-backed securities brings the full force of monetary policy to bear on the credit markets. Having already reduced the benchmark federal funds rate to just 1 percent, the central bank is now effectively using what economists call “quantitative easing” to reduce the costs of money.

Instead of trying to reduce overnight lending rates in the hope of influencing longer-term interest rates for things like mortgages, the Fed is directly subsidizing lower mortgage rates. It is doing so by printing unprecedented amounts of money, which would eventually create inflationary pressures if it were to continue unabated.

The Bloomberg article has a similar passage, indicating that this is a message the Fed is consciously putting out, while taking care to deny that they are trying to increase inflation (emphasis added)

The Fed won’t be removing cash from other parts of the financial system to make up for the purchases, government officials told reporters on a conference call. They rejected any comparison with Japan’s so-called quantitative easing effort to combat deflation, saying that the Fed’s objective is to buttress credit markets rather than ramp up money.

What does this mean? It looks like the Fed will be buying securities either by wiring cold, hard cash to sellers, or by increasing their account balances at the Fed itself, without simultaneously selling Treasuries (or asking the Treasury Department to issue new Treasuries) to sop up an equivalent amount of cash. This ordinarily would run the risk of increasing inflation, but with short-term prices falling, arguably a bit of inflation is just what we need, as Simon and Peter argued yesterday.

(If you found the last paragraph confusing, see my Federal Reserve for Beginners post.)

More economics bloggers trying to be funny: Free Exchange reported on today’s $800 billion worth of announcements and concluded with this sentence: “So, you know, hopefully that will work out.”

James Hamilton at Econbrowser has a plan for how to create some inflation (he suggests a target of 3%). And if that doesn’t work, he has an even more clever plan.