Saturday, September 29, 2012

Beating the Same old Drum on Portfolio Balance

Kevin Drum explains nonstandard monetary policy very well.

I make my usual comment.

What the Fed does in normal times is target the Federal Funds extremely short term interest rate.  Your explanation of how nominal GDP targeting works doesn't have anything to do with nominal GDP targeting.  I think the problem is that you understand the issue better than most advocates of nominal GDP targeting (I guess Woodford probably understands it as well as you do but not better (non irony alert: I really think this -- the issue isn't so complicated that you are missing anything -- at all)

If the Fed credibly promises to keep the interest rate low even if inflation rises the Fed has used all the tools at its disposal (plus credible pre-commitment which is not a tool at its disposal).

It is easy to set an upper bound on the room for better Fed policy along the lines of what is called nominal GDP targeting (and which is really, as you note, a commitment to low interest rates even if inflation rises) because long term interest rates are equal to the expected geometric average of short term rate plus a clearly positive risk premium. So the room for improvement can be calculated for different values of "a good long time."   I personally think it is very safe to assume that that good long time can't reach past the end of the terms of most FOMC members (january 2015).  The 5 year Treasury interest rate is 0.625% (way way down from around 0.69% before QEIII was announced).  

This means that bond traders are quite confident that the Fed will keep interest rates extraordinarily low for a good long time.  My view (as you know) is that there was little more to be done along these line *before* QEIII.

My view is not that there was little the Fed can do.  I think QEIII was a very useful shift and that the Fed can do much more along the same lines.

But that is because QEIII was not just the same as declaring a nominal GDP target or making promises about short term interest rates years from now.  The Fed also committed to taking a lot of mortgage default risk out of investors' portfolios in the near future.  That, I think is what had an effect (also on expected inflation).

So, as usual, I say that right now the key issue is portfolio balance not forward guidance (so I disagree with Woodford and Krugman and lots of people who would be to put it mildly economic giants if I were an economic microbe).

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