Tuesday, December 03, 2013

Why the Fed Should Do More - A Look at Monetary Offset

I have a new article published on Quartz titled on how recent fiscal events have shown the Fed plays still a powerful role in maintaining growth. Thus the interesting question isn't whether the Fed should do more, but rather to ask why the Fed hasn't.

An excerpt:
In its recent minutes, it appears that the US Federal Reserve has been preparing to taper. Yet given the outsize role the Fed has played in supporting the recovery, that would almost certainly be a mistake. Unemployment has been ticking down, yet long-term unemployment is still very high and labor force participation is still low. While the recovery has made progress, it is still not guaranteed, and the Fed’s accommodation will be critical if the economy is to secure the gains it has made. 
The key to understanding the argument is to understand a concept central to economic analysis: the counterfactual. Counterfactuals are alternative histories of what could have been. In military history they are the answers to questions like “What would have happened if Napoleon had won the battle of Waterloo?” In this case, the key counterfactual is “What would have happened to the economy if the Fed hadn’t done quantitative easing?” Throughout this recovery, the federal government has been tightening its belt. Indeed, as MKM Partners chief economist Michael Darda has repeatedly noted, net government outlays have fallen for two consecutive quarters during this recovery, making the recent bout of austerity the biggest since the Korean War demobilization. Had the Fed not offset such a large contraction in spending, the US almost certainly would have been sent into another recession.
This will be my last post here, and I will be continuing to blog back at my home blog, Synthenomics, once the semester is over and things become more settled.


  1. "economy has done so well despite widespread deleveraging and a drawdown in government spending is a testament to the power of the Fed"

    Surely having one of the lowest oil and natural gas price in the world cannot be an explanation.

    1. Oil and gas prices over the last four years have been relatively steady, and not much lower than they were before the crash, so they don't cannot explain the trends in US growth rates.

    2. see us oil production chart

    3. This comment has been removed by the author.

    4. Yes consumer pays the same price, but increased US oil production means less reliance on foreign oil thus reduces US current account deficit. In fact, oil price need to remain above $85 for shale oil to be economical, low oil price will cause US shale players to shut down. US need oil price to hover between $90 and $100, so it's not too expensive as to impede economic growth, but not too cheap to make shale oil uneconomical.

  2. Anonymous12:09 PM

    That creates one of those problematic questions though -- what is GDP really measuring?

    For instance, during WW II GDP rose and unemployment fell. On the other hand, there was also severe rationing, mass conscription, and industrial-scale mass murder -- hard to call that prosperity!

    Granted, the current spending certainly isn't as destructive as firebombing Dresden and Tokyo, but it's an open question how much marginal dollars do for living standards.

    And the fracking point is a good one too -- by some estimates it accounts for a large proportion of the recovery.

  3. Let me start by saying that I have no problem with a Fed that takes the short term interest rate down to zero during a recession. Also, the Fed is not dealing with a short term liquidity crisis. Different considerations would come to play in a liquidity crisis.

    QE and the asset purchase program (collectively just QE) are altogether different. If the Fed is buying assets it means the Fed is paying more for those assets than the market would offer. In addition, the Fed is taking on huge risks through QE. Risk is a hidden cost.

    Between overpaying (relative to the market), and taking on risk without attributing a cost to the risk, the Fed is engaged in direct fiscal stimulus of the economy. In my view this goes beyond the bounds of monetary policy. Further, the elected officials have made an apparently deliberate decision to run contractionary policies. It does not lie with the Fed to second guess Congress and subvert the natural consequences of democratic decisions. The Fed is trying to frustrate Congress's policies by juicing the economy through mechanisms that will hide the cost of the Fed stimulus for years.

    1. 1. Doesn't the Fed buying on the open market mean it's paying exactly what the market offers, rather than "more"?

      2. What is risk of loss to an institution that prints money? I mean that seriously. The Fed's missions are to create monetary and economic stability, not make a profit. What consequence is there for the Fed or the macroeconomy if their open market purchases result in losses?

      3. So far the Fed has greatly profited from it's purchases, in the falling interest rate environment. Some of those gains would be clawed back in a rising interest rate environment, but in that context the economy is doing well, so again ... what exactly are we supposed to be worried about?

    2. This is what separates economics from hard sciences, in hard sciences, you can never argue because B occurred after A, therefore B caused A; economists often make such arguments.

  4. There seem to be three critical questions under debate in monetary discussions right now:

    1. Has QE been modestly effective at boosting growth and employment?
    2. Is it worth the risk?
    3. Could the Fed be doing more?

    On all counts, the answer appears to me to be an overwhelming yes. QE has led to lower rates and staved off disinflation, clearly. In an economy that is below target on both inflation AND employment, the risk is doing too little. And as Michael Woodford 2012 explained at JAckson Hole, there is a lot more they could be doing with expectations-based policy.

    Mostly, these arguments look compelling to me because they make sense and the counterarguments look like grasping at straws to avoid obvious conclusions. People find twisted ways to view the economy such that Fed balance sheet expansion is not stimulatory. They imagine phantom bubbles everywhere, when it looks like we simply have moderate asset price inflation in response to the low rates (which is a feature, not a bug). And we see people insisting stubbornly that the Fed is doing all they can by pointing to the size of the balance sheet, completely ignoring the arguments about how expectations and not just balance sheets matter.

    1. The fed has simply replaced the housing bubble with a stock bubble. Déjà vu

    2. The ratio of asset price to CPI is mean-reverting, either asset price must fall or CPI must rise.