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Josh Marshall: A Lot of I Told You Sos

This Is Indeed a Gloomy Day: Department of Macroeconomic Policy

In a liquidity trap conventional monetary policy--the swapping of highly-liquid bank reserve cash for short-term government securities--is ineffective because the macroeconomic financial market imbalance is not a shortage of cash relative to demand but rather a shortage of high-quality (and perhaps long-duration) assets relative to demand. The private sector's finances are sufficiently shaky that it cannot create high-quality assets--if it could, we wouldn't have a problem. (And a private sector that cannot create high-quality assets cannot create any long-duration assets either--except for highly speculative ones.)

The government thus ought to take action--just as the government takes action in a normal monetary-policy episode by swapping cash for short-term Treasuries and thus alleviating the shortage of cash relative to demand that is causing unemployment.

What actions can the government take?

  1. Diminish demand for high-quality financial assets and increase demand for real goods by credibly announcing that the inflation tax on high-quality financial assets will be a hair higher in the future--i.e., through quantitative easing and inflation targeting.

  2. Manufacturing more high-quality assets through fiscal policy, by issuing more Treasury bonds and using the proceeds to pull government spending projects forward in time and push taxes back into the future--i.e., through expansionary fiscal policy.

  3. Have the Treasury create additional high-quality assets by becoming the tail risk-bearing partner of the private sector, or possibly by expanding its own balance sheet--i.e., through financial markets policy.

  4. Have the Federal Reserve alter the supply of high-quality assets by taking some low-quality private-sector assets onto its own balance sheet and financing it by expanding its own short-term safe nominal liabilities--through what it calls non-standard monetary policy and I call financial market policy.

Note in this context what the Federal Reserve said that it might do yesterday: as its private-sector assets mature, it will buy long-term Treasury bonds--thus taking duration and some systemic but not default or other tail risk or other systemic risk onto its own balance sheet. This is very weak tea as far as a policy to remedy financial-market imbalances is concerned.

So I am disappointed.

I am also disappointed with senators 51-60 in the U.S. Congress, who in spite of a mammoth educational lobbying effort by Christie Romer, Larry Summers, and company persist in their refusal to allow the Obama administration to create more jobs by (2).

And I am also disappointed by the Treasury--which could, I think, be using its existing TARP authority to do an awful lot more of (3) than it is.

Others are disappointed as well.

Felix Salmon:

The Fed gives up on tightening: The big market reaction following today’s FOMC statement took place in the 10-year Treasury bond, where yields sank to 2.77% right after the statement came out, from 2.82% beforehand. That’s a big move by Treasury-bond standards, and constitutes the continuation of a longer trend: the yield was above 3% as recently as July 29, and we’re now well into yields not seen except during the very worst part of the financial crisis, when the flight-to-quality trade was in full force.

Today’s Treasury yields aren’t a function of flight to quality, necessarily, and the immediate impetus for this move was the fact that the Fed has committed to buying up more Treasury bonds itself:

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.

In other words, the Fed’s balance sheet had been shrinking, up until now, but that shrinking has now come to an end, and it’s going to remain at its current bloated level for the time being. This is tantamount to a very modest rate cut — not a full quarter-point, perhaps, but maybe half of that. Of course, when rates are at zero, basis points loom larger than they normally do, so these moves on the side of quantitative easing become very important. And more important still is the signal that the Fed is sending: we thought we were OK to tighten things up a little bit, but now we’ve changed our mind, and we’re getting a little bit looser instead. The recovery, in other words, still needs Fed support in order to maintain any semblance of sustainability or momentum.

The bigger picture, however, is one of the Fed largely having run out of ammunition. Most of what it’s doing now is symbolic: the real national response, as Mohamed El-Erian says, needs to come from the government rather than the central bank, and needs to be structural rather than monetary in nature. Given today’s decision, though, we can at least assume that any moves from the White House to try to bolster the national economy will be met with the strong support of Ben Bernanke...

Alex Frangos:

Is the Fed making the same mistakes Japan did when it comes to quantitative easing?

Macquarie Asia economist Richard Jerram says the Fed’s move Tuesday to reinvest maturing bonds rather than absorbing the cash reminds him of the “incremental policy shifts” the Bank of Japan made over the last decade that failed to convince markets of the bank’s intentions. “There are echoes of BOJ policy from 2001-04 in the Fed’s move. The BOJ made repeated incremental policy shifts, but struggled to explain why they were necessary or how they would affect financial markets or the real economy. There is a worryingly similar lack of clarity from the Fed,” Jerram writes in a note Wednesday morning Tokyo time.

Jerram figures maintaining the size of the Fed’s expanded balance sheet in this way might not have much of an impact on the economy anyway. “The idea that moderate and temporary debt purchases by the central bank affect bond yields is controversial. A survey of the BOJ’s experience found that most of the impact came from the commitment not to raise rates until inflation was positive (similar to the Fed’s “extended period”). They struggle to find a direct impact on bond yields from the balance sheet expansion.”

Ryan Avent:

Monetary policy: Small stuff: ONE of the most hotly anticipated Federal Open Market Committee statements has just come out, and it doesn't fail to disappoint. After acknowledging that recovery has slowed and, "is likely to be more modest in the near term than had been anticipated", the Fed opts to:

[M]aintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature. The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability....

The Fed is keeping the "extended rate" language to which Kansas City Fed president and inflation hawk Tom Hoenig objects... the Fed has opted to take a "symbolic" step in reinvesting the proceeds from maturing mortgage-backed securities... it is adjusting the composition of its balance sheet away from MBS and toward long-term Treasuries. It's not quite clear what's behind that; perhaps the Fed simply wants to reduce its intervention in mortgage markets. The long and short of it is that the Fed has taken the minimum possible non-contractionary action. I am struggling to understand it. Perhaps the Fed is wary of doing too much at once. Perhaps it is interested in demonstrating that it is aware of the economic risks but not yet convinced that further action is warranted. For now, though, it seems as though the Fed has acknowledged risks but refused to do anything substantive about them.


Monetary policy: The day after: READERS won't be surprised to hear me express disappointment with the Fed's decision. I'm not alone in my dismay. Markets continue to swoon in the wake of the decision; American indexes opened off around 2%. Commodity prices are sinking as well, in response to signs from around the globe that economic activity is likely to slow through the end of 2010. This morning, Census reported a significant increase in America's trade deficit, up from $42 billion in May to $50 billion in June, as exports declined slightly while imports increased. Fed activity won't help; the news that a new round of quantitative easing isn't immediately forthcoming boosted the dollar.

Macroeconomic Advisers try to find the silver lining:

We read today's statement as signaling that the Committee may have rapidly moved from a tightening bias to an easing bias, in which case a restart of long-term asset purchases is on the table. This could partly reflect a move to a "risk management" approach, in addition to the apparently significant downgrade in the FOMC's forecast....

I see the Fed as failing in two key ways. Policy... is too tight. (And it's somewhat bizarre; as Paul Krugman says, what are the odds that the current size of the Fed's balance sheet, which the Fed has opted to preserve, was right for last year's scariest moments, this spring's optimism, and the current period of nervousness?) But perhaps more distressing, the Fed's communication has been simply miserable. It hasn't explained why its outlook has changed enough to alter policy but not enough to alter policy meaningfully. It continues to emphasise price stability while inflation expectations decline. It's all very unhelpful. But perhaps the members of the Federal Open Market Committee are watching today as traders bid down stocks and commodities and bid up the dollar and understanding that they have reinforced the economy's disinflationary, pessimistic mood. The question is: come September, what are they going to do about it?


Trade: A perfect storm: Leaders in America and China are very nearly without options; America's Congress is too paralysed to pass stimulus or deficit reduction plans, and China is squeezed between international pressure to rebalance and domestic pressure to maintain growth. Against this backdrop, America's recovery looks ever weaker, joblessness is rampant, and elections loom. The ground could hardly be more fertile for protectionist populism, and politicians are beginning to rise to the occasion.

Matthew Yglesias:

Matthew Yglesias » Overselling vs Doing Nothing: Right now the inflation rate is below-target and the price level is below trend. There’s some greater-than-zero quantity of currently idle resources that could be mobilized before a higher level of aggregate demand pushed the price level above trend. Does that mean 6 percent unemployment or only 8.5 percent unemployment? I have no idea, but there’s only one way to find out and that’s to go see.

In terms of structural issues, I think that all countries at all times feature some of these and could and should be working on improving the fundamentals. Recessions tend to turn minds out of cheerleading mode and draw attention to these issues, but they’re not necessarily propitious moments for dealing with them. The tendency is for all incumbents and all policies they promote to become unpopular during recessions, which makes it hard to build support for anything aimed at reaping long-term benefits.

The Fed should do its job, and then everyone will get off their cases and go back to ignoring monetary policy. If it doesn’t, people like me are going to have to start publishing tedious articles complaining about the absurd governance structure of the FOMC.