What do the Fed's policy and poker have in common?

It is no accident that, at the last FOMC meeting, one of the “outsiders” present was NY Fed economist Gauti Eggertsson, of Eggertsson and Woodford (2003) fame—the paper he co-authored with Michael Woodford discussing a central bank’s policy options when nominal interest rates are near the zero bound.

Two of the paper’s conclusions could point to the Fed’s thinking in the months ahead, in my view. First, that quantitative easing is redundant as a tool for preventing deflation, over and above central bank commitments with regard to the interest-rate path. (Although some of the assumptions they make can be challenged, especially for situations like 2008/09, where markets were dysfunctional). In the words of the authors,

“neither the extent to which quantitative easing is employed when the zero bound binds, nor the nature of the assets that the central bank may purchase through open-market operations, has any effect on whether a deflationary price-level path will represent a rational-expectations equilibrium. Hence the notion that expansions of the monetary base represent an additional tool of policy, independent of the specification of the rule for adjusting short-term nominal interest rates, is not supported by our general-equilibrium analysis of inflation and output determination.” (my emphasis)

Second, rather than quantitative easing, the optimal policy consists of a commitment to a “history-dependent” rule driven by the price level (i.e. not the rate of inflation of the consumer price index). Under that rule, the central bank commits to a given path for the level of the price index, and undertakes to make up for past inflation shortfalls (which would drive the price level below the target) by allowing future inflation to be sufficiently higher to bring prices back up towards the target path.

The motivation behind a rule like this is to bestow the central bank the ability to manage inflation expectations (and, thus, control the level of the real interest rate), even when the nominal rate is stuck at the zero bound. By raising inflation expectations, the Fed could provide stimulus by lowering real interest rates, as well as penalizing cash holders, thus forcing them to put that cash to alternative uses—consumption or investment.

While conceptually appealing, the proposed rule is vulnerable to lack of credibility. This is because, in order to conduct policy, a central bank needs not only a rule but also a tool to implement that rule. But here, the rule and the implementation tool virtually coincide: The rule is the central bank’s intention to allow higher inflation in the future in the event of past inflation shortfalls; and the tool is simply the verbal expression of that intention.

This makes monetary policy akin to bluffing in poker: If the market buys the bluff, inflation expectations rise, real rates fall, cash gets spend, aggregate demand recovers. But why would the market buy the bluff, if, for example, it suspects that the central bank will renege on its “promise” of higher inflation in the future, and that it will “cheat” by raising interest rates once aggregate demand picks up?

In short, how can a central bank demonstrate its commitment to higher inflation, besides simply stating that this is its intention?

A number of economists have sought to address this question, including Eggertsson and Woodford (E&W) in their 2003 paper. One approach, proposed by Lars Svensson involves a price-level targeting rule combined with the pegging of the domestic currency to a foreign one after it has been depreciated by a certain amount. By pegging to the currency of a trading partner that is experiencing (positive) inflation, the central bank can demonstrate that it is serious about generating inflation at home.

Clearly, while this might be a tool available to countries like Japan or Sweden (the latter being the only country to have actually experimented with price-level targeting in the 1930s, and one that involved an eventual peg to the British pound), it is not a policy available to the Fed today.

A dollar devaluation would be unacceptable to any one of the three major economic areas (the EU, the UK and Japan), given that they face a similar economic quagmire to that of the US. And of course, a peg to a basket of emerging market currencies is not credible, given that the size of foreign asset purchases the Fed would have to make would be too large compared to the size of these markets—not to mention the capital controls (see China) that prohibit the entry of foreign players into domestic markets.

So is the Fed powerless? Not entirely. But the solution rests on calling a spade a spade—or, in the current context, calling the Fed’s large-scale asset purchases of (domestic) Treasuries (or LSAPs) “debt monetization.” In this way, the LSAPs can serve as the tool with which the Fed can make its commitment to higher future inflation credible. E&W make this point:

“[T]he tax cut can be financed by money creation, because when the zero bound binds, there is no difference between expanding the monetary base and issuing additional short-term Treasury debt at zero interest. This is essentially the kind of policy imagined when people speak of a "helicopter drop" of additional money into the economy, but here it is the fiscal consequences of such an action with which we are concerned.

[I]f the central bank also cares about reducing the social costs of increased taxation—whether because of collection costs or because of other distortions—as it ought if it really takes social welfare into account, the result is different. As Eggertsson has shown elsewhere, the tax cut will then increase inflation expectations, even if the government cannot commit to future policy.”

The bottom line here is one I’ve been arguing all along: that the only real way to boost aggregate demand at this stage is through a fiscal operation—one that is targeted towards safeguarding the economy’s productive capacity and/or facilitating the deleveraging of companies and households that remain overwhelmed with debt. (Mind you, this is not necessarily something that I, as a taxpayer, would be crazy about—I am talking strictly on economic grounds.)

The Fed’s role in this operation would be to facilitate its financing and, in the process, raise inflation expectations and help the economy avoid falling in (or escaping from) a liquidity trap. In other words, the stated motivation behind any LSAPs should not be the so-called “portfolio balance” effect (whose impact is doubtful at this juncture) but the outright monetization of government debt.

How likely is that the Fed will come out and say so on November 3rd? Don’t hold your breath—especially with a pretty nasty US midterm election a day before! In which case, the Fed’s policy will continue to resemble bluffing in poker for a little while longer.