How the Fed Destroyed its Credibility
The Fed’s credibility is obviously important. If people believe that they can and will do what they say they’re going to do — and that it will have the desired effect — they can affect the the real economy (at least short-term) by just making promises — Open Mouth Operations. (Though they must actually do things to their balance sheet, sometimes — rather than just promising to make future promises — to avoid the Turtles All The Way Down problem.)
Also obvious: the Fed has great inflation-fighting cred. They’ve fetishized inflation and that credibility for thirty years. People feel damned confident that they can and will successfully stomp on price spikes — especially wages. That’s what they do. That fixation has continued even through four years in which runaway inflation has manifestly not been a credible threat.
Meanwhile, their unemployment-fighting cred is in the tank. If they announced today that they’re going to do whatever is necessary to bring unemployment down to X%, people would seriously question their ability to do so, even their future commitment to doing so.
Tyler Cowen agrees:
The Fed, at least right now, is not able to make a credible commitment toward a significantly more expansionary policy for very long. … The market expectation has become “the Fed can/will only do so much.”
Why? Because in their frantic obsession with inflation (explanation here), they missed their chance to demonstrate their unemployment-fighting moxie. The time to do that was 2008 and 2009, when 1. unemployment was spiking and 2. monetary policy had a lot more traction on unemployment. They could have not sabotaged the fiscal efforts.
Again, Tyler agrees:
The Fed already has failed to act, for whatever reasons. That makes it all the harder to achieve the credible commitment now.
Now people may be confused, thinking that because the Fed didn’t do what was needed to fight unemployment, it couldn’t have. This could result in them believing that it can’t, now. This is obviously faulty reasoning, but the conclusion could still be correct.
I don’t know for sure. Two questions, using a fairly extreme scenario to make the conundrum clear:
1. If the Fed had bought a trillion dollars of S&P 500 stocks in 2008, would it have prevented (or greatly reduced) the unemployment carnage?
2. If the Fed bought a trillion dollars of S&P 500 stocks today, would it bring unemployment down significantly?
But one thing seems clear: that inaction (or sabotage, if you prefer) seriously damaged the Fed’s growth-enhancing, unemployment-fighting credibility. By sabotaging fiscal, it has sabotaged its own ability to reduce unemployment (or increase NGDP) by simply making promises.
Cross-posted at Asymptosis.
On both 1 and 2, I think not.
For the S&P purchases to help, you have to believe specifically, a la Roger Farmer, that wealth, and not income, effects spending.
However, the reality is that the relationship between disposable income and consumption is robust across time and most extraordinary financial events, while the realtionship of wealth to consumption is not.
http://www.angrybearblog.com/2012/04/another-look-at-wealth-and-consumption.html
An enormous Fed stock purchase would have fed another bubble – crash scenario. This does next to nothing for real people, and has a huge downside risk.
Cheers!
JzB
I’m not sure we should take it for granted that the Fed has credibility in any effective way. Fed officials and textbooks carry on about the improtance of credibility in maintaining low inflation expectations and so allowing the Fed increased flexibility. Now, show evidence. ‘Cause inflation expectations have been pretty volatile for an environment in which the central bank has credibility. I’m also not sure that we know the Fed is universally trusted to hate inflation. There are an awful lot of folks out there howling about inflation being higher than measured, that the Fed’s policies will result in inflation.
That is to say, I’m not sure you’ve earned your premise.
Jazz has a point regarding the stock purchase plan. I have a somewhat different one. Though nearly half of US households own stock, most own very little. About 2/3 of US households own (partly own) residential real estate. If the Fed is going to by equity rather than debt, why not buy equity in real assets? It won’t help the poorest all that much, but it could help those in the middle. Structured properly, real asset purchases could target the middle and leave the well-off to fend for themselves.
Taking Sumner’s wild-ass notion about the Fed sabotaging fiscal policy does you no credit. Sumner offers no evidence and flies in the face of standard assumptions about the interaction between fiscal and monetary policy. Incidentally, his claim about the Fed sabotaging fiscal policy ends up sounding very much like an assertion that fiscal policy doesn’t work.
Right now is not the right time for the US CB’s QE equivalent.
September October 2012 … that will be the politically agreed upon time for dramatic actions. Even Mr. Romney will concur that etwas muss geschehen or Es muß etwas geschehen. … something must be done…. Action must be taken.
It was done in 3 days by the polarized politicians in 2008 …. But this is a political year …. great drama and theater … for the little people.. This or that… That or this….
Enter left or right of center stage … the Federal Reserve… doing the equivalent of what a national citizen’s sovereign bank should do … create money that is work-based rather than trans generationally interest based.
It will be the worst of times and the best of times….
Remember 3 days of action yielded 7-8oo billion dollars of chump change in 2008.