Wednesday, January 8, 2014

It's Time For The Fed To End QE

Remarks by Bill Dudley of the NY Fed and the most recent Fed minutes reveal what I have been saying for almost a year: No one has any idea what the purpose of QE really is or how it works.

Here is what Dudley said:
“We don’t understand fully how large-scale asset-purchase programs work to ease financial market conditions—is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?”

Here is what last month’s FOMC minutes say about QE:
“Most participants viewed the program as continuing to support accommodative financial conditions, with a number of them pointing to the importance of purchases in serving to enhance the credibility of the Committee's forward guidance about the target federal funds rate.”

Is that clear? The Fed doesn’t know why it is buying bonds, but figures that QE signals an accommodative “stance” and enhances the “credibility of its forward guidance”. No one mentions the fact that the Fed’s credibility has been badly wounded by the failure to achieve either of its mandates over the past few years.

Did the committee have a thought-provoking discussion concerning the steady decline in money growth over the past two years, and what to do about it? No, it was not discussed. It was noted without remark that "M2 contracted in November." But this rather inconvenient fact did not dampen the committee’s self-congratulation, noting that “The projected improvement in economic activity was expected to be supported by highly accommodative monetary policy.” Negative money growth is highly accommodative, if you turn the chart upside down, or stand on your head.

So we have a situation in which money growth is low, unemployment remains high, inflation is far below target, and QE is being withdrawn--although no one is quite sure what QE does.

The Fed should cease this farce and end QE now, immediately. Since QE has no measurable effect on anything, and no logical rationale, let’s get it out of the way. It is an excuse that allows the committee to advertise that it is providing a “highly accommodative monetary policy” while doing nothing of the kind. It's a place-holder for real policy.

I would recommend that the Fed unearth the old Bernanke textbook, and implement price-level targeting (PLT), such that the more the Fed undershoots on the inflation rate, the more it will need to correct. The committee should target the price level that would have been achieved had the Fed been fulfilling its 2% target. Yes, nominal output targeting would be even better, but price-level targeting is radical enough: sufficient unto the day is the unconventional policy thereof.

If the Fed were to implement PLT, it would have quite a bit of catching up to do, requiring a few years of above-target inflation. The announcement of PLT would raise inflation expectations, lower the real funds rate, and stimulate demand. The measure of success would be widening TIPS spreads and rising bond yields (which should be at least 4% at this stage of the recovery).

All of this is old hat for the committee. Inflation and/or price-level targeting has been on the table for at least 15 years. As Bernanke told the Japanese in 1999:
“A target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the price-level gap created by eight years of zero or negative inflation.”

It may be that Bernanke was wrong, and that there is some fatal flaw in a PLT policy. Fine--let the FOMC debate it. It’s frustrating that the Fed minutes read like those of the Titanic’s health and safety committee: much discussion of the irrelevant, and no discussion of what matters. What matters right now is inflation.

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