Tuesday, December 16, 2008

The Next Round of Ammunition

With the Fed having cut its target interest rate today to a range of zero to 1/4 percent, many people will be asking whether the central bank has run out of ammunition. A good question. Obviously, the next step is not going to be further cuts in the federal funds rate. But there is still more the Fed can do.

Notice this passage in the Fed's press release (emphasis added):
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.
The phrase "for some time" is aimed at managing expectations in order to keep long-term interest rates down.

The next step for the Fed is to drop the "price stability" rhetoric. The Fed has never been truly committed to stable prices. After all, inflation during the Volcker-Greenspan era averaged about 2 to 3 percent. The Fed could have lowered inflation to zero if it had wanted. Now that zero, or even below zero, is a possibility, the Fed needs to convince people that we are going back to the normal inflation rate of 2 to 3 percent.

Let me suggest this wording for the Fed's next press release:
The Committee recognizes that moderate inflation would be desirable under the present circumstances. In particular, the overall level of prices a decade hence should be about 30 percent higher than the price level today. The committee anticipates keeping the stance of monetary policy sufficiently accomodative to achieve that degree of inflation over the coming decade.
That is, even if the Fed cannot reduce nominal interest rates, it can reduce real interest rates by committing to a modest amount of inflation.

Some would view this as a radical change in monetary policy. In some ways, it would be. Given how weak the economy is, however, a bit of radicalism may be called for. I am more comfortable having the Fed commit itself to modest inflation than having the federal government commit itself to a trillion dollars of new spending. The more we can rely on monetary rather than fiscal policy to return the economy to full employment and sustainable growth, the better off future generations of taxpayers will be.

The abandonment of "price stability" would be the modern equivalent of Roosevelt's abandonment of the gold standard. Of all the things that Roosevelt did to get the economy out of the Depression, jettisoning the gold standard was the most successful. Today, monetary policy is fettered not by gold but by fear of inflation. Perhaps it is time is get over that fear, at least for a while. As Jim Tobin said in an earlier era, there are worse things than inflation, and we have them.

Update: A reader points out to me that Paul Krugman seems miffed that I failed to cite his contribution to the large literature on expectations management by the central bank. Sorry, Paul. I actually do like Paul's paper on the topic quite a lot, and I cite it in my intermediate macro text when I discuss the liquidity trap (see footnote 5 on page 325 of the 6th edition).

It is funny. For academics, it is an occupational hazard to feel that your work is insufficiently cited. I had always assumed that the feeling would go away after winning a Nobel prize. I guess I was wrong.