Wednesday, August 17, 2011

Does Alan Blinder Want to End the Liquidity Trap?

Some rather puzzling comments from former Fed Vice Chairman Alan Blinder. Here is what Blinder had to say about the Fed's recent statement that it anticipates keeping short-term rates near zero through mid-2013:
In doing so, the Fed violated one of the most revered canons of central banking: Always keep your options open. No one knows what might happen between now and June 2013 -- not you, not me, and not the FOMC. A booming economy by, say, Christmas 2012 doesn't look too likely right now, but it could happen. And if it does, the Fed won't want to keep the federal-funds rate near zero. So why risk the loss of credibility?  
The answer is that the FOMC was so concerned about the health of our economy that they felt they had a duty to offer some support some support to the frail economy and soothe the nearly panicked financial markets. But they had used up all their good ammunition long ago.
While it is undoubtedly true that monetary policy is more difficult at the zero bound, that does not mean the Fed is out of proverbial bullets. Indeed, the Fed could still announce an interest rate target for 10-year bonds that would amount to open-ended QE3. Or the Fed could start buying other assets. Eliminating interest on excess reserves is another possibility. There are options.

But the most perplexing aspect of Blinder's piece is his attitude towards the Fed's change in communications. The Fed didn't actually say what Blinder says it did. And that's too bad. The Fed only said that it expects short-term rates to stay parked near the zero bound till mid-2013; it did not promise to keep them there. Here is the relevant passage from the latest FOMC statement:
The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
This is certainly a more dovish statement, but it is not a commitment: it is making the Fed's own economic forecasts more transparent. If growth suddenly picked up around Christmas 2012, as Blinder imagines, nothing in this statement would preclude the Fed from hiking rates to check inflation. That's a problem.

Absent an explicit level target, a period of "responsible irresponsibility" is perhaps the Fed's best tactic for getting the economy out of a liquidity trap. After all, if markets think the Fed will react to any future above-trend inflation by raising rates, inflation expectations today will remain subdued -- and the economy will stay stuck. As Paul Krugman first suggested and Eggertsson and Woodford later expanded on, the reverse is true as well. If central banks credibly commit to maintaining expansionary policies for a prolonged period -- presumably longer than warranted -- then future inflation expectations should rise, causing real interest rates to fall and demand to pick up. Blinder's concern about the Fed boxing itself in to low rates ill-suited for future conditions is precisely the point of the policy.

Unfortunately, as long as economists remain more concerned with maintaining the Fed's future credibility as an inflation-fighter than with the devastating consequences of long-term unemployment, we will not get out of this muddle. We have enough real problems that we do not need to invent new ones.

1 comment:

  1. From what I can tell, the market, or at least major market participants, are reading the Fed as making a committment to keep rates low until 2013. They believe the apparent hedges are fedspeak, not actually hedges.