Where the Fed Stands on Monetary Policy

The decision to embark on QE3 was right, in my view, if overdue. But perhaps I'm not the only one who's uncertain which way the Fed's strategy is evolving. Is it guided by a coherent account of how monetary policy should be conducted, and if so what exactly is that account?

Scott Sumner, the indispensable scholar-blogger who's been campaigning for nominal GDP targeting, sees the Fed's move as a step in that direction. My Atlantic colleague Derek Thompson, getting a little carried away, anoints Sumner "the blogger who saved the economy"--meaning (a) the Fed has just adopted his way of thinking and (b) it will work like a charm. The NGDP approach got another boost at the Jackson Hole central bankers' conference, when Michael Woodford, an eminent (many would say today's pre-eminent) monetary theorist, endorsed it.

So is Bernanke now targeting NGDP--and would that be a good thing? My short answers are "no" and "it depends". I'll get to my longer answers in a second, but first a word of warning. I'm still digesting Woodford's Jackson Hole paper, but some important questions are getting muddled in the way his paper has been discussed. The NGDP or not-NGDP frame isn't helping to clarify the situation. These are my notes on thinking this through. If you're aren't much interested in monetary policy, I'd definitely stop reading here.

I come to this issue as a money-GDP man myself (that's what Brits called NGDP when they were debating the subject in the 1980s, following the work of James Meade, reintroduced to policy circles mainly by Samuel Brittan of the Financial Times). But the standard case for money-GDP targeting back then was not the case being pressed today.

Back then, a target for growth in money-GDP was seen as an improvement over the prevailing targets for growth in the money supply. Why? Because the hitherto-stable relationship between money supply and demand (nominal income, money-GDP) had broken down. Since demand was the variable the central bank was really trying to guide, forget the money-multiplier and just set the policy target directly. Essentially, that was the idea. Money-GDP had other advantages. What mattered most, in my view, was that it would make policy easier to explain. Also, as compared to the alternative of setting an inflation target--which is the route central banking subsequently took--a target for growth in money-GDP has the advantage of accommodating certain kinds of economic shock more comfortably.

This short piece by Bennett McCallum, a leading advocate of nominal income targeting (as he called it) in the 1980s and after, gives a good concise summary.

This earlier discussion mostly revolved around setting a target for growth in money-GDP. The new NGDP advocates tend to argue for targeting a level. It's an important difference. On Woodford's view, the choice of level (that is, multi-year path) over year-by-year rate of change matters more than whether you choose NGDP or any of several plausible alternative measures of demand. There'd be less confusion if the main issue in contention in today's debate were understood not as NGDP vs not-NGDP, but as nominal-path-targeting vs nominal-growth-targeting.

This emerges clearly in Woodford's paper. In his model, the ideal target is the "output-gap-adjusted price level"--ie, a price index adjusted by a weighted measure of the gap between current output and full-employment output. He notes that there are some practical problems with this target, and sees a target path for NGDP as a good alternative. In explaining this, he makes points familiar to those engaged in the earlier debate.

Essentially, the nominal GDP target path represents a compromise between the aspiration to choose a target that would achieve an ideal equilibrium if correctly understood and the need to pick a target that can be widely understood and can be implemented in a way that allows for verification... Indeed, it can be viewed as a modern version of Friedman's "k-percent rule" proposal, in which the variable that Friedman actually cared about stabilizing (the growth rate of nominal income) replaces the monetary aggregate... Under [today's] circumstances, a case can be made that a nominal GDP target path would remain true to Friedman's fundamental concerns.

However, aiming to stabilize growth in nominal income isn't the same as getting nominal income back to a path it has deviated from--perhaps (as now) by a long way. Whether the central bank should promise to do that is a question to which Woodford's model gives a clear answer.

In Woodford's model, under the exceptional circumstance of interest rates at the zero bound, the central bank should commit itself to get gap-adjusted prices back to the target path. This path, by the way, can't be fixed in advance: In principle, it continually shifts up, so long as the shortfalls induced by the zero bound persist. But that's a refinement. The critical thing in Woodford's view is to rule out "letting the target path shift down in response to persistent target shortfalls during the period of the binding lower bound" [original emphasis]. There's to be no downward base drift--no forbearance of undershooting. All that lost ground in lower-than-desired demand is going to be made up later, the central bank promises, even if it means a period of faster-than-desired inflation.

The whole point of this rule, as Woodward emphasizes, is that it's backward-looking and time-inconsistent. In other words, because of where the economy's been, the policy will be maintained beyond the point at which it stops making sense on a purely forward-looking basis. This is a vital point that many people have failed to grasp.

[O]ne wants people to understand that the central bank's policy will be history-dependent in a particular way -- it will behave differently than it usually would, under the conditions prevailing later, simply because of the binding constraint [the zero bound] in the past. [original emphasis]

I take it for granted that Woodford's approach has all the theoretical virtues he claims for it. If an economy with interest rates at the zero bound expects stimulus to be maintained until money-GDP is back on the pre-recession path--maintained, that is, even if inflation has risen to its desired rate and the output gap has gone--then it's going to be better off overall. Again:

This means that even once financial conditions have normalized, so that it would be possible for the central bank to achieve both its inflation target and a zero output gap from then onward (at a normal level of the policy rate), it might be necessary to keep interest rates low for somewhat longer, in order to raise the gap-adjusted price level to the target path.

It's a trade-off: The promised tolerance of excess inflation in future delivers stimulus now, when it's needed. The overshoot in inflation is the price you pay for that superior outcome. But think about the challenge this poses to the central bank. It has to keep the pedal to the floor with inflation at or above its normal rate, even if this is no longer necessary to get the economy to full employment. This commitment to subsequently inappropriate policy is a tall order. According to Woodford, this is where an NGDP-path target comes in. It's a way to explain what the Fed intends and why.

For Woodford, this is also where QE comes in, by the way. Woodford doubts the utility of QE in its own right. If it's useful, he thinks it's because it serves a signaling function in support of "forward guidance". Joseph Gagnon and James Hamilton disagree with him about this: They think QE also works through more familiar channels. (I'm persuaded by their arguments, but this is another subject.)

Let's measure the Fed's announcements this week against Woodford's line of analysis. The FOMC statement did have Woodfordian aspects--not mainly because of the QE that attracted all the headlines (since, as I just mentioned, Woodford is basically a QE skeptic). Two points were notable. First: the words about keeping interest rates at their floor into 2015. That's something an NGDP-path advocate might favor, because it seems to allow for a period of catch-up inflation. Second: "To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens."

Interesting. But the trouble is, what the FOMC expects isn't a promise. Bernanke didn't actually commit the Fed to anything. You'd think otherwise from many of the accounts of his statement. Here's the Wall Street Journal, for instance:

The Fed said it will keep interest rates at near-zero "at least through mid-2015," which is six months longer than its previous vow.

Here's the Fed's wording:

[The FOMC] currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Currently anticipates. Likely to be warranted. The Fed expects. These aren't vows. They're forecasts. And look at what Bernanke said in his press conference:

In terms of the mid-2015 date, we think by that point that the economy will be recovering, will be providing the support it needs. But if you look at our projections, you'll see it doesn't involve any inflation that we still believe that inflation is going to be close to our two percent target.

Is this distinction between forecasts and commitments just pedantry? Not according to Woodford. At Jackson Hole he stressed the point.

Unfortunately, such an approach [a forecast for future short-term rates] has a serious flaw, which is precisely that a given statement about the change in the anticipated forward path of the policy rate may be subject to multiple interpretations. If an announcement that the date T at which the policy rate will first rise above its lower bound has moved farther into the future is interpreted as meaning that the first date at which a standard (purely forward-looking) Taylor Rule would require a policy rate above the floor has moved farther into the future (because of a weakening of the economic outlook) -- without in any way challenging the expectation that the bank will, as always, follow such a rule -- then the announcement (if also believed) should have a contractionary effect on aggregate demand, rather than an expansionary one... "Forward guidance" of this kind would have a perverse effect, and be worse than not commenting on the outlook for future interest rates at all.

You see the point. The Fed shouldn't say, as it did, we judge that low interest rates will be appropriate for longer. That's liable to be interpreted as bad news about the health of the economy. It needs to say, we'll keep interest rates at zero for a while even when that's no longer appropriate. The words about maintaining accommodation for a considerable time after the recovery strengthens hint at that--but only hint. It's just a very hard thing for a central banker to commit to policies that in due course will look wrong. But that's exactly what Woodford says they have to do.

Woodford surprised me a little by congratulating the Fed on its announcement, saying it had more clearly linked its policies to "the degree of improvement in the economy and not just to a calendar date". The QE is open-ended, but the interest-rate guidance mentions 2015. Isn't that a calendar date? Bernanke assured the markets that the Fed's projections don't "involve any inflation". I'd have expected Woodford to say that was the wrong message. But the main thing is that the Fed isn't binding itself.

I can imagine an argument that says Bernanke is a Woodfordian by accident: People (perhaps including Woodford) saw in his statement what they wanted to see, this argument might go--a promise that wasn't really there--and thanks to this misreading, the necessary stimulus will be delivered. I can also imagine an argument that says Bernanke is an undercover Woodfordian, obliged to cloak his tolerance of higher inflation yet secretly hoping to be "misunderstood". But these interpretations aren't very plausible, are they? If you take Bernanke at his word, the Fed's new easing is quite consistent with its previous initiatives and its long-standing approach: adjust-on-the-fly, forward-looking, flexible inflation targeting.

Thus, is Bernanke now targeting NGDP? No.

Would we be better off if he was? That depends. My feeling is, NGDP-path targeting in the hard form envisaged by Woodford wouldn't work. The commitment to subsequently inappropriate policy won't fly. The Fed has to live in the real world. Soft hybrids are thinkable: path-like targets that aren't history-dependent in the way Woodford recommends. But of course targets which lack that feature wouldn't have the full benefits that Woodford demonstrates for his approach. On this, see his discussion of the 7/3 threshold rule proposed by Charles Evans of the Chicago Fed. I found it especially revealing.

Under this proposal the FOMC would pledge to maintain the funds rate target at its current low level as long as unemployment remains above 7 percent and the expected rate of inflation "over the medium term" remains below 3 percent per year, but would begin to raise the funds rate as soon as either threshold were breached. Adoption of such a commitment by the FOMC would be an important improvement upon current communication policy, in my view. It would emphasize the conditions for exit from the current extremely accommodative policy stance, rather than a date. And the stated conditions would involve both parts of the Fed's dual legislative mandate...

Nonetheless, the Evans proposal fails to incorporate an important feature of the optimal policy commitment...: the commitment to compensate subsequently for target misses due to the binding zero lower bound on interest rate policy. Like a simple Taylor rule, the "7/3 threshold rule" is an example of a purely forward-looking criterion for policy: the appropriate policy at any time depends only on the paths for inflation and unemployment that can be achieved from that time onward, independently of the path by which the economy may have reached its current state... [S]uch a rule... would not imply any commitment to keep the policy rate low for longer than would a strict inflation target or a purely contemporaneous Taylor rule. This means that a credible commitment to such a rule would do nothing to mitigate the problems created by the zero lower bound...

I still like NGDP for all the reasons I used to. Flexible inflation targeting--the prevailing approach in most countries--means the central bank takes the real economy into account alongside its inflation goal. It wants to stabilize output and employment as well as keep inflation low. It's another way of saying "dual mandate"--which can be explicit (as in the Fed's case) or implicit (as in Britain). I still think the best and most helpful way to express this in quantitative terms is as a target for growth in NGDP. Moreover, though a purely forward-looking target like growth in NGDP rules out commitments to subsequently inappropriate policy, and the benefits that go with them, it obviously doesn't forbid adjusting the target by reference to an assessment of the output gap.

One last thing. "Three Cheers for NGDP" would be a poor headline for Woodford's article. Truer to its spirit would be, "The Necessity of Fiscal Policy at the Zero Bound". Remember Woodford is a QE skeptic and, as I've tried to explain, his theory of effective monetary policy with interest rates at their floor relies on the Fed's making a promise that would be difficult to believe. What's left? Fiscal policy. In Woodford's model, it's not much of a simplification to say that in normal times you don't need fiscal policy for stabilization; in abnormal times, at the zero bound, fiscal policy's about all you've got.