The Limits of the Fed

April 26th, 2012 at 9:44 am

Many of this AM’s Fed stories present the argument as to whether the Fed should do more or less to help the still fragile economy.  That’s fine as far as it goes, but one important point seems absent to me: there’s not that much more they can do.

They control interest rates.  In fact, they only directly control short term rates.  Indirectly, through the “twist” and QE, they can target longer term rates.  But that’s almost all she wrote when it comes to what’s under their direct control.

Don’t get me wrong—that ain’t nothin,’ especially in normal times.  But the price of capital isn’t so much the issue right now.  Borrowing’s cheap, it has been for a while, and corporate cash reserves are flush.  The missing ingredient is demand.  Without that, the Fed is pushing on a string.

Push, they should, and I think Ben and Co. are doing yeomen’s work (and I’m all for them going further).  I especially appreciate his clear-eyed look at the real economy, which he continues to see as slogging towards recovery with clear and present downside risks.

One further point.  Note that I said “almost” above re the limits of what the Fed can control right now.  The other variable I was thinking about there was inflation.  If the Fed could generate more inflation, it is said, that would help by hastening deleveraging (since inflation erodes real debt levels) and perhaps move idle capital off the sidelines.

But two problems here.  First, I think the Fed’s ability to increase the rate of inflation exists in general and right now, but it is limited.  There are economic contraints—inflation today is more a factor of global commodity markets and (very) tight labor markets—and political constraints.  Bernanke doesn’t act alone and while he’s been able to stave off the hawks thus far, that could change if he got too aggressive on pushing past their targeted inflation comfort zone (not to mention that he explicitly rejected this option in his news conference yesterday).

Second, the vast majority of workers are already suffering real wage declines.  Faster inflation would erode their paychecks further, and that’s another downside to this idea that’s been given too short shrift by folks espousing this strategy.


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8 comments in reply to "The Limits of the Fed"

  1. Guest says:

    Right but look at the countries that have done the best in the recession. Nations like Sweden, Israel and Australia, countries that have pushed their own currencies’ inflation to about 4%. Just announce that the Fed will increase money supply until we get 4 % inflation, and that will set market expectation at that. Should the promise be held as credible, it would move the market almost immediately. The same thing happened in Switzerland, they said they would print money until the current devalued to X level, and almost overnight it went to that level. Then, their exports became more competitive.

    • Chris G says:

      “Just announce that the Fed will increase money supply until we get 4 % inflation…”

      A comment which may reveal me as ignorant and which will definitely show that I’m not an economist: The Fed has increased the money supply N-fold over the last several years, yes? Under normal circumstances one would’ve expected significant inflation as a result. But there hasn’t been any to speak of. Let me clarify that statement: Commodity prices, e.g., oil and cotton, have increased but my sense is that they have been driven up by demand from developing countries, i.e., increase in US money supply has not been a driver for the commodity price inflation that we’ve observed. Again just my sense of things which I don’t have hard data on-hand to justify but, given the recent increase in the money supply and lack of inflation, I don’t see how increasing the money supply further would drive up the inflation rate. Banks and corporations are sitting on tons of money as it is. They’re just not spending/lending it. Get the $$$ circulating – force the $$$ to circulate – and I’d imagine inflation bumping up but if they just increase the money supply and why should we expect an increase in the inflation rate rather than just bigger piles of idle cash?

      There’s the question: Why should we expect an increase in the money supply to result in increased inflation rather than just larger piles of idle cash? (Obviously not purely an ‘either-or’ scenario but why believe the former will be a big effect than the latter?)

  2. foosion says:

    Presumably, you’ve read Bernanke’s paper on Japan, as well as Krugman’s recent commentary. What in those works do you disagree with?

    “the vast majority of workers are already suffering real wage declines.” You’re right as a first order effect, but are missing second order effects.

    The goal of those pushing for the Fed to increase its inflation target is to increase real GDP, leading to more hiring, more competition for workers and higher wages.

    In addition, inflation could well decrease the value of the dollar in exchange rates, leading to more exports, which means more hiring and ultimately higher wages.

    If workers can manage to keep pace with inflation, then they should be even on purchasing power, but have an easier time paying off debt, such as mortgage debt.

  3. Tom in MN says:

    It seems to me that 2% inflation is basically the background level associated with population growth, etc. What we need is wage inflation to help people get out from under debt and to shrink the inequality gap, thus let’s call 2% the new zero and move up to a 4% target. We’ve seen from the past that keeping to 2% leads to jobless recoveries and rising inequality, so this level is too low and we need to shoot for 2% wage inflation instead and accept the price inflation that goes with it.

  4. TheArmoTrader says:

    Hey Jared, one thing you left out of what the Fed can do is raise inflation expectations. While I think this is a fairly weak “tool”, those who argue for the Fed to do more (like Scott Sumner) will argue this is a major tool which can be used to help NGDP targeting which would get the economy going again.

    Personally, I think this is an OK tool to use in a normal environment. But since we are NOT in a normal environment (we are in a balance-sheet recession -BSR-, still), any Fed tools will cause very limited changes in the real economy.

    What we need is some fiscal stimulus, via tax cuts and infrastructure spending. I know your definitely more on the fiscal spending side, however you know any solid stimulus spending plan will be met with political challenges. I think infrastructure spending would be a good way in getting some stimulus spending done and have it be politcally feasible.

    As for the tax cuts, I favor a full payroll holiday for 2 years. This tax is highly regressive and in a BSR where people are paying down debt and not borrowing/spending, any income boost we can give those people (the “99%”), will be real beneficial to the economy and speed us out of the BSR.
    I would also favor a decent 1 year reduction in income taxes.

    You might ask where all this $ will come from, and as a MMTer, I’m sure you know my position. We’ll just issue the $.

  5. Mitchell Freedman says:

    I have to say I am very sympathetic to the Ron Paul folks who say “End the Fed.” Not because I think we should go back to local currency or gold standards or even silver standards. I am just frustrated that we will never have any leadership at the Fed that is not banker-centric. Notice I’m saying banker and not bank. It’s not even institutional, but geared toward helping bankers at the expense of everyone else.

    We who call ourselves New Deal Democrats should only support those who want the leadership of the Fed to be expressly for regular folks. Otherwise, saying “Bernanke and Co.” are doing even “yeoman’s jobs” is simply misguided and gives in to the bankers far more than they deserve.

  6. Michael says:

    The Fed can print as much money as it wants to start a WPA, if it so chooses.