Is the Fed really losing its street cred?

November 4th, 2014 at 10:09 am

Ryan Avent posts an incisive and compelling critique of the US Federal Reserve, largely around their decision to end their quantitative easing (QE, or large-scale asset purchases) program even while their benchmark inflation rate remains consistently below its target rate of 2 percent.

I disagree with the vehemence of the argument—the idea that ending the asset buys is “shortsighted and dangerous” or what he calls “the most basic argument of all: the Fed is taking a serious risk in undermining the credibility of its nominal [inflation] anchor.” Also, I think he’s wrong re fiscal policy. But it’s still smart and muscular argument, well worth reading.

Avent’s argument rests of two incontrovertible points: first, the Fed, as I’ve shown in various posts, has consistently overestimated the future growth of the US economy. In this, they are not alone. These days a good economic forecaster is the one who can convincingly explain why she has consistently had to mark down her forecasts. And in fact, the Fed’s US forecasts look relatively competent compared to European counterparts. Still, Avent’s on solid ground here.

Second, and more importantly, the Fed’s benchmark inflation rate has consistently run below its 2 percent target, leading Avent to raise credibility questions:

Setting a public target, consistently missing that target, projecting that the target will be consistently missed in future, and conducting policy so as to make sure the target is in fact missed: that is lousy monetary policy making. And I cannot understand why the Fed does not see this record as detrimental to the recovery and highly corrosive of the Fed’s credibility.

What should the central bank be doing in Avent’s opinion? Keep QE going, for one. For the Fed to be moving into tightening mode now makes little sense. As long as they’re missing their inflation target so consistently, they should keep using whatever tools they have at their disposal until they reach it.

I’ve pled for Fed patience as well, though more so in terms of when they liftoff on the Fed funds rate. I don’t see tapering off asset buys as obviously problematic, especially if the stock of their purchases—the Fed’s $4 trillion balance sheet—remains fixed, i.e., no unwinding. Avent cites a small literature on this and argues, correctly in my view, that QE was helping and not hurting, i.e., it was lowering some key long term rates without ginning up an asset bubble or contributing to higher inequality (against a counterfactual of tighter monetary policy), so why not keep it up?

Fair point, but he goes too far to claim the Fed’s making a serious mistake here or that their credibility is on the line. Basically, the Fed’s not the problem. It’s the lack of complementary fiscal support.

Here’s where I thought Avent gets it wrong:

…governments are really bad at providing sufficient fiscal stimulus to boost the economy (at least when the threat of massive global conflict is not providing the necessary incentive). The rich-world record on this score over the last few years is simply abysmal. Counting on elected governments to do better in future is a recipe for deeper recessions and more volatile business cycles.

No question, that’s been the case in Europe, but at least in the US, that’s only been the case since 2010, and history did not begin then. Avent’s being far too historically chauvinistic, failing to recognize two key points.

First, it is essential to recognize the one-two punch, the inherent complementarities, of fiscal and monetary policies. The Fed can set the table but they can’t get customers to come in off the streets to order off the menu. That takes complementary fiscal policy. As we’ve seen, Fed-induced low rates absent more fiscally-driven demand will deliver growth, but it will be tepid. (BTW, while I’m onboard with the secular stagnationists, this is one problem I have with some of their rhetoric: if only we could get real interests down to their equilibrium level, they seem to argue, all would be well; I doubt it.)

Second, Avent’s wrong on the record. The US stimulus demonstrably helped a lot. It added millions of jobs, significantly raised GDP, and pulled the recovery forward. It also did not last anywhere near long enough—that’s the 2010 problem cited above. But there’s reams of analysis to support that point. I’ll post links if you insist but in the meantime just poke around yourself (I’ve always thought this comprehensive study was well done).

And not only do I count on future governments to “do better,” the record shows they almost certainly will. They could hardly do worse. One thing you quickly learn from American economic history is that one definition of a Keynesian is a Republican in a recession.

Again, I see where Ryan is coming from and I yield to no one in my profound disgust with fiscal policy as currently practiced. Even there however, it should be noted that we’re somehow doing better this year than last. In 2013, negative fiscal impulse subtracted 1.5 percentage points off of real GDP growth. This year, about zero. From the current obstructionists in Congress, I’m afraid the best you can expect is “do no harm.”

So, sure, the Fed should definitely keep monetary stimulus going full blast and as Avent says, they should overshoot their targets to help mop up the damage that all this persistent slack has caused. But a fulsome critique of their actions and credibility should include the fiscal context in which they’re working. Grading on that curve, I think they’re doing about as well as can be expected.

And there’s no way we can conclude, based on what’s passed for policy over the past few years, that smart Keynesian policies are dead forever. Even as I write this on the morning of an election day that is likely to yield results that bolster Avent’s predictions more than my own, the pendulum will swing back one day, and maybe sooner if we push it in the right direction.

True, in the long-run we’re all dead…you’ve got me there. But in meanwhile, let us not forget those immortal words of the great economist Steve Miller: “you’ve got to go through hell to get to heaven.”

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3 comments in reply to "Is the Fed really losing its street cred?"

  1. foosion says:

    If monetary policy can be effective to increase employment and growth, despite lousy fiscal policy, then the Fed can rightly be faulted for not doing enough.

    Is there any good reason to believe more aggressive monetary policy would not increase employment and real growth?

  2. Tammy says:

    Good blog. I think it’s pretty close to the reality of our economic situation and your humor, again, is appreciated. Hopefully the pendulum won’t swing too fast in the opposite direction. I think we are all ready for a little more balanced approach.

  3. Larry Signor says:

    Jared, I hesitate to disagree with you, but I think you are too willing to disagree with “the vehemence of the argument”. 90% of America has been relegated to the margin, with a preposterously inadequate response by our monetary and fiscal policy makers. The fiscal stimulus in 2010 was not an ongoing policy but a one off policy that had little history and no future. If the Fed won’t lead, it is not because of ignorance, but because they are constrained by large economic actors with their own self interest in mind. Fiscal policy has already been co-opted, and monetary policy is next on the “Koch” agenda. A better America is not in their game plan. So much for an “independent Fed”. I don’t see that Ryan is overstating the case, but very much responding in the Dean Baker mode. Sometimes, getting along is just getting by. It is past time to enjoin the battle for radical change.