The Fed's New Twist

The Fed's latest unorthodox intervention-- "Operation Twist", which involves selling $400 billion in short-dated debt and using the proceeds to buy longer-dated debt--did not go over too well in the markets. I'm guessing the problem was the mismatch in the announcement between (a) the strong signal of increasing Fed anxiety about the state of the economy and (b) the relative timidity of the response.

The Twist is certainly better than nothing. The amount was bigger than some analysts had expected, and the operation will encourage a bit more mortgage refinancing and other borrowing. But it is a milder initiative than I would have recommended: an open-ended commitment to renewed QE, linked to a target for growth in nominal GDP. Bet on more outright QE before this is over--adoption of a nominal GDP target, alas, is much less likely--but in any event the Fed is falling further behind the curve. The prospects for a useful short-term fiscal stimulus have just worsened sharply. This increases the need for bolder monetary stimulus right away.

As I say, I wouldn't bet on an entirely new monetary-target regime: the politics is too daunting. A tweak in the right direction (as suggested by Greg Mankiw) might be the best that can be done, and even that is challenging now that so many Republicans are attacking the Fed not for timidity but for recklessness. Lack of a good framework to shape expectations of future policy is going to limit what the Fed can achieve. It also makes judging the effectiveness of its measures more difficult. For instance, asking how much, if at all, Twist or QE will cut long-term nominal interest rates is not right. What one wants is lower real interest rates. A rise in long-term nominal rates would be fine if it were caused by (controlled) expectations of higher inflation. To guide those expectations, you need a clearer account of the Fed's future actions.

The existing dual mandate is not up to that job, as I argued here. Dissent within the Fed only worsens the problem, because it further obscures the Fed's medium-term intentions. That's the downside of openness.

Monetary policy is not impotent right now, any more than fiscal policy is impotent. For reasons of their own, policy-makers are choosing not to deploy them to the fullest extent.