“Stepping up is hard to do” – Lack of leadership at the Fed

Christina Romer, former CEA Chair has her monthly column at the NYT today – “It´s Time for the Fed to lead the way”:

Beyond worrying that expansionary action might cause some inflationary pain, many Fed officials argue that the benefits, in terms of reduced unemployment, are likely to be small.

On this topic, there’s a severe disconnect between central bankers and academic monetary economists. As Laurence Ball of Johns Hopkins University discussed in a recent paper, Mr. Bernanke epitomizes the two very different views. As an academic, he mocked the Bank of Japan for its claim in the 1990s that it was helpless in the face of persistent economic weakness. He detailed all the ways that a central bank could help an economy even when its benchmark interest rate was zero.

Yet, as Fed chairman, he has seemed to side with those who say the Fed’s tools are limited right now. Professor Ball suggests that Mr. Bernanke’s change of view was a result of peer pressure and groupthink among his Fed colleagues.

The academic literature shows that monetary policy can be very effective at reducing unemployment in situations like ours. In the recovery from the Great Depression, for example, aggressive expansion of the money supply played a large role in lowering the real cost of borrowing and in spurring growth.

After the Fed has pushed interest rates down to zero, its main remaining tool is communications. It can affect expectations of future growth and inflation, which can have powerful effects on consumer spending and business investment today. But to have a big impact, the monetary actions need to be bold — and pursued with gusto. In an earlier column, I discussed one of economists’ favorite examples of such a policy: setting a target for the path of nominal gross domestic product.

If the Fed doesn’t want to do something as drastic as adopting a new operating procedure, it could at least make any smaller actions it takes more effective. The previous rounds of quantitative easing may have done little to improve expectations because their size and duration were limited in advance. If the Fed does another round, it should leave the overall size and end date unspecified. Or, better yet, the ultimate scale and timing could be tied to the goals the Fed wants to achieve.

Likewise, the Fed’s statement about the federal funds rate has seemed almost intended to undermine any positive confidence effects. It says the Fed expects a low rate through late 2014, which is supposed to give people hope. But the low rate is then justified by invoking continued weakness in the economy, which is likely to make people want to hide under the covers.

It appears Christy Romer also favors a “Third Way” in economic policy, to free it from the constraints imposed by the leading explanations for the slowness of the recovery which, on the one hand, says that lack of counter-cyclical spending is mostly to blame, and on the other says that it is this very spending, and the uncertainty it brings about, which is the culprit.

Sounds very much like a “catch-22” situation! One in which, as I showed in this post, Fed leadership is essential if the impasse is to be broken.

So the evidence is clear. There are times like wars, be them of the “hot” or “cold” variety, when government steps up spending. Following those times there are periods of “demobilization”. What happens to the real economy depends very much on the behavior of the Fed. An ‘appropriate monetary policy’ is key to the outcome you get.