## A Nice Piece by Jim Hamilton on the Fed--But with One Flaw: Risk Spread vs. Expected Inflation Effects of QE at the ZLB Blogging

A nicely-argued piece by Jim Hamilton. A piece I disagree with, however:

Econbrowser: Should the Fed do more?: These academic critics would like to see the Fed announce more aggressive targets in the form of either higher rates of inflation or faster growth of nominal GDP….

The primary tool available at the moment is large-scale asset purchases, in which for example the Fed buys longer term Treasury securities with newly created reserves…. [T]he Treasury could achieve pretty much the same effect if it were to do less of its borrowing with 10-year bonds and more of its borrowing with 3-month bills. So a natural question is, why aren't the above academics taking aim not at the Fed but instead at the Treasury for issuing so much long-term debt in preference to short-term debt in the first place?… [O]f all the stories you've heard why unemployment is stubbornly high, how plausible is this:

The main problem is the maturity structure of debt. If only Treasury had issued $600 billion more bills and not all these 5 year notes, unemployment wouldn't be so high. It's a good thing the Fed can undo this mistake. Maybe it would help a little if the Treasury did more of its borrowing short-term, but who could possibly expect that to be a panacea? Second… suppose… we propose to move the entire$10+ trillion in current publicly held debt… into 4-week bills. Couldn't we all agree that such a move would recklessly endanger the government's ability to manage its weekly debt financing?…large-scale asset purchases can not, by themselves, be viewed as a solution to the current disappointingly slow U.S. economic growth….

By drawing a line at keeping inflation above 2%, I think the Fed can use its limited available mechanical tools in a credible way to achieve an appropriate goal.

Perhaps there is a clear way to communicate an alternative, more ambitious goal, such as keeping nominal GDP growth above 5%, or temporarily focusing on getting unemployment down to 7%. If articulated narrowly and with some caution, these might allow the Fed to do more while still preserving confidence in what I have described as the logistics of managing potentially volatile short-term government debt.

But unlike many of my fellow academics, I worry about those logistics and am convinced that it is a mistake to ask too much from monetary policy.

I share Jim Hamilton's belief that merely taking additional duration and default risk onto the Treasury's balance sheet would not materially and significantly boost the economy. There is an effect: with less risky assets interest rates spreads will fall, and with short-term safe interest rates at the zero lower bound that means (slightly) lower spreads and (slightly) higher investment and (slightly) higher GDP. These effects are small, however. Perhaps purchasing $100 billion of ten-year Treasuries produces in the range of$10 billion of fiscal-stimulus equivalent. Perhaps not.

But purchasing bonds for cash has another effect. Cash is a perfect substitute for short-term Treasury bonds now. It won't always be the case. When interest rates normalize, the price level will be roughly proportional to the high-powered money stock. Not all of today's purchases of bonds for cash will be unwound when the economy exits the zero lower bound. If we believe that the high-powered money stock will be roughly $1 trillion after exiting the zero lower bound, and if we believe that a fraction λ of marginal bond purchases won't be unwound, then an extra$100 billion of quantitative easing boosts the expected price level ten years hence by 1%--and boosts expected inflation after the next decade by an average of 0.1%/year. That is enough to spur higher spending and a more rapid and satisfactory recovery.

In short, I think a 5% nominal GDP growth target is within the grasp of monetary policy--provided one understands that "monetary policy" means "print money and buy stuff that is not now a perfect substitute for cash, and doing so in a way that keeps you from unwinding your purchases completely in the future".[1]

Thus my basic criticism of Hamilton is that he is wrong when he writes:

the Treasury could achieve pretty much the same effect [as quantitative easing] if it were to do less of its borrowing with 10-year bonds and more of its borrowing with 3-month bills…

That seems to me to be wrong, because cash is special even at the zero lower bound precisely because we are not always going to be at the zero lower bound. As Ben Bernanke wrote back in 1999:

[I]f the [present and future] price level were truly independent of [today's] money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence…