Fed fail: The implosion of a policy regime
Everyone from Paul Krugman to Steve Waldman to Yichuan Wang is giving their spin on the plunging nominal interest rates.
It’s beginning to look like Keynes was wrong about liquidity traps, at least when he argued that there’s a certain minimum nominal yield that government bond investors demand, and that long term rates can be reduced no further. Wherever people draw a line, bond yields just seem to plunge right through, to one record low after another. And we know from Japan that they can go even lower. But what does this mean?
It probably means multiple things. For instance it suggests that the Keynesian/market monetarist AD pessimists and the Great Stagnation AS pessimists are both right. We are looking at BOTH low inflation and low real GDP growth for many years to come. Why don’t I think AD explanations are enough? Partly because even the 20 year T-bond now has a negative real yield. Indeed it suggests the Bernanke “global savings glut” hypothesis is also correct, a point I’ve argued previously. Japan is the future of the world.
But I’m more interested in what it means for Fed policy. Even if the Fed does something semi-bold on August 1st, it most likely won’t be enough to change the underlying dynamic. And the reason is pretty basic; the Fed simply doesn’t have a grip on what went wrong. They had a policy regime that targeted short-term interest rates as a way of targeting inflation. Both of those decisions were flawed, and now the regime has collapsed. Markets are saying that the Fed may never again be able to using its preferred interest rate targeting mechanism. Let me emphasize that I still believe interest rates are more likely than not to eventually rise above zero. But these low yields are consistent with a non-zero probability of the US essentially becoming Japan.
This reminds me a lot of the end of Bretton Woods. When Bretton Woods collapsed the central banks of the world were in a completely new policy environment, with the price level having no nominal anchor. It took them a decade to figure this out, and come up with a new policy regime that could operate in a world with no gold price peg. When they finally did it was something close to the Taylor Rule. And its was actually a pretty decent monetary policy regime, as long as short term nominal rates were not zero.
But if they were zero, then things got much trickier. Now it was only a workable policy regime if the rate was expected to rise above zero in a reasonable period of time. In that case, the Fed could do a sort of Woodfordian policy, steer the economy by making explicit or implicit promises about what circumstances would lead them to raise interest rates.
Unfortunately, it turns out the Fed was too conservative, too cautious, to adopt the Woodfordian policy. They weren’t willing to commit to a future path of the price level or NGDP. Instead they simply hoped that things would somehow get better. And although I’ve been pretty harsh in my criticism, let me express a tiny bit of sympathy. The rate of nominal GDP growth in the US over the past 3 years has been above 4%, which is considerably higher than in Japan. I would have thought that might well be enough. (The fact that it wasn’t makes me think Japan is light years away from exiting the zero bound.)...MORE