The Monster in the Mirror
By Scott Sumner
I seem to vaguely recall a horror story where the protagonist searches everywhere for the monster, and at the end sees himself in the mirror, realizing that he is the monster. If there is no such story, there should be.
I was reminded of this when reading an article about Janet Yellen’s recent speech at the Fed’s Jackson Hole conference:
For all the talk of a radical shift in central banking policy, from the permanent use of negative rates to helicopter money drops, Federal Reserve Chair Janet Yellen appears to believe she can tackle any future downturn using the tools currently at her disposal.
Speaking in Jackson Hole, Wyoming, on Friday after a Fed policymaker and other economists proposed a radical overhaul of central banking, Yellen argued that bond purchases and the ability to pay interest on excess reserves as well as forward guidance would be enough to combat any downturn.
“Our current toolkit proved effective last December (when the Fed raised rates),” Yellen said in a speech in which she firmed up expectations of a second rate rise from the Fed, possibly as soon as September. . . .
Yellen on Friday defended the models used by the Federal Reserve.
She said that barring an “unusually severe and persistent” recession, its policy tools were sufficient and rates did not need to go negative, as even at the lower bound for interest rates asset purchases and forward guidance could push long-term rates even lower on average than when nominal rates fell below zero.
There’s an element of circular reasoning in these remarks. In the past, “unusually severe and persistent recessions” tend to occur when the economy is at the zero bound. Even worse, these recessions are almost certainly caused by a failure of monetary policy. The Fed persists in viewing itself in a role similar to a fireman, rescuing the economy when it goes off course. But that’s not at all the right metaphor. They are more like a ship captain, steering NGDP or inflation, and if the ship is off course it’s because they’ve done a poor job in steering it.
Interest rates tend to fall about 500 basis points during recessions. How can we have confidence in the Fed’s current regime, which relies on conventional policy tools, if the level of interest rates is likely to be no more than 1% at the peak of the next boom? (According to fed funds futures markets.) How will the Fed prevent another sharp drop in NGDP, as occurred in 2008-09? They don’t have any good answers, and outside economists are not impressed:
“Yellen seems to have developed into the ultimate ‘status quo’-chair,” said Lars Christensen founder and owner of Markets and Money Advisory, an independent firm focused on monetary policy issues.
“It is clear that she fundamentally does not want to see any change to the Fed’s policy framework despite the fact that inflation expectations have become de-anchored and markets have lost trust in the Fed really fundamentally wanting to deliver on its 2 percent inflation target,” Christensen said.
One option is negative interest on reserves:
Yellen’s seeming reliance on more quantitative easing was challenged at Jackson Hole by Marvin Goodfriend, a professor of economics at Carnegie Mellon University and a former policy adviser at the Richmond Federal Reserve bank, who said he believed negative rates would be a far more effective policy tool.
“Interest rate policy is by far the most flexible, the least intrusive to markets, and has proven capable of targeting low inflation,” he said in a presentation after Yellen spoke.
I first suggested this idea back in early 2009, and it’s clearly a useful policy tool. But I think a much more fundamental change is needed. Switzerland has cut its interest on reserves to negative 0.75%, and still falls short of its inflation target. Even worse, 50-year government bond yields in Switzerland recently went negative.
Elsewhere I’ve criticized the NeoFisherian model, but they do make one good point. A policy regime of low interest rates forever is likely to be associated with very low inflation. Hence low nominal interest rates alone are not an adequate form of monetary stimulus. As I’ve said 100 times before:
It’s the regime, stupid.
We need level targeting, preferably NGDP level targeting.