How can the Fed precommit to a permanent expansion of the money supply ?
A challenge for monetary authorities in a liquidity trap is that it is hard convince people that they won’t reverse expansionary policies as soon as the economy leaves the liquidity trap. The other problem is that they can’t do much other than affect expectations while the economy is in a liquidity trap. This suggests that they can’t do much at all. This argument assumes model consistent expectations (aka rational expectations) but that doesn’t mean it is totally wrong.
My view has been that the key word is “Much” and that the monetary authority can also bear risk. In particular, I think that the Fed can and should bear mortgage default risk by buying mortgage backed securities.
The disadvantage of this approach is that, if house prices and/or GDP tank, then the Fed’s balance sheet won’t balance. It would not be possible for the Fed to retire as much of its obligations as it might choose, because they are worth more than its assets.
This disadvantage is an advantage. It means if things turn out to be worse than expected, then the Fed will not be able to reverse the expansion of the money supply. This means that, if the Fed loses on its investments, then, when the economy recovers, there will be higher than target inflation — the Fed would like to reduce the money supply but won’t be able to do so.
I think this is exactly what the economy needs. The disadvantage of Fed purchases of risky assets is, in fact, a huge advantage.
If the Fed wins its bet, we win (it would transfer the profits to the Treasury). If the Fed loses its bet, we win (it would automatically commit to high inflation even if when the inflation comes the Fed wants lower inflation).
OK Ken, the ball’s in your court.
In a liquidity trap, it seems that anything the FED does is somehing in the second decimal place.
AKA whistling in the wind.
This is exactly why we need expansionary fiscal policy.
And that us why –
WASF,
JzB
Fed losses belong to the Treasury: the Fed could operate indefinitely without equity capital, but it would not remit profits until its capital was restored. Thus, there is no difference between Treasury buying mortgages and the Fed buying mortgages: in each case, the risk of losses is bourne by the taxpayer. The suggestion that the Fed purchase mortgages is merely fiscal policy that circumvents Congress’s legislative authority. A utilitarian might argue its better to subvert our democratic process when the need requires it; others might say the long-term effects of doing so are negative for our democracy.
In the case where demand for bank reserves is positive, Fed asset purchases are “monetary policy”. In that case, the Fed need not purchase mortgages. It can lower the FFR (a positive marginal demand for bank reserves implies a positive FFR). Or it can engage in OMO of Treasuries.
The Fed always transfers the risk of balance sheet losses to the Treasury. Therefore, risk asset purchases are always fiscal policy. The one exception if the liquidity risk component of risk assets, which the Fed extinguishes rather than passing on. It does so because the Fed’s balance sheet can never have liquidity risk.
Yes indeed, my aim is to circumvent Congress. The only point is that the Fed can’t transfer losses to the Treasury. A capital loss for the Fed can’t be made good by the Treasury. The effect of the loss would be lower profits in the future, hence lower transfers to the Treasury. The present value of the loss of that income to the Treasury would be equal to the capital loss.
Actually, my latest crazy idea is to have the Fed deliberately lose money by participating in Treasury auctions and bidding absurdly high. Then it could sell those Treasury securities in the real auction (which would be called an open market operation). Basically this would be just like the Fed giving the Treasury money (in addition to indirectly loaning the Treasury money as it does when it buys Treasuries). The point is that I want the Fed to lose a Trillion (to commit to high powered money of at least a trillion) but I don’t want the bankers and financiers to profit.
The totally bogus anti-democratic purely accounting transfer from the Fed to the Treasury would do the trick.
I am not 100% joking. I think this would be good policy. Of course it is no more likely than constitutional fiscal policy (the FOMC is no more willing to follow my advice than is Congress).
Robert,
The Fed and Treasury balance sheets are one and the same for purposes of loss accounting, and so is a drop in profit remittances (vs. a Treasury injection).
I think you fail to econpass the negative long term effects of the Fed circumventing Congress. Look at the Fed’s public status today after the 2008 bail outs: it is rock-bottom. Arguably, part of the force behind both the Tea Party and OWS is the Fed’s actions during that time frame. Finagling with our democracy will further fuel the backlash and possibly lead to a reduction in Fed independence. Especially since asset purchases benefit banks and the top 1% much more than households and small businesses.
Questions of macro policy cannot help but revolve around politics. Pretending the Fed is (or even should be!) permanently shielded from political influence/transformation is risky.