The startling recovery in risk assets in October – global equities rose by 11 per cent during the month - was triggered mainly by reduced pessimism on the eurozone’s debt crisis, but was probably also helped by easier monetary policy from several of the major central banks. As usual, the Federal Reserve has been in the vanguard of this action, and further measures are expected from the FOMC when it meets on Tuesday and Wednesday.
There have been calls for major innovations, such as the introduction of a target for the level of nominal GDP, but the Fed has given little indication that it is ready for anything quite so drastic. Much more likely are some further modest steps to improve the communication of the Fed’s thinking on the future path of short rates, with the aim of keeping long rates as low as possible. And there might also be some more purchases of mortgage backed securities.
The case for introducing a target path for nominal GDP was well argued by Christina Romer in the New York Times yesterday. She compares the current crisis of high unemployment with the crisis of high inflation which faced the Fed in 1980. Then Paul Volcker broke the mould by introducing targets for the money supply, which made it easier for him to win a consensus on the FOMC for a continuous tightening in monetary policy over several years.
Now, Professor Romer says it is Ben Bernanke’s moment to change the rules of the game by adopting a target for the level of nominal GDP, with the intention of restoring it to the path which it would have followed from 2007 onwards in the absence of a recession. Because this target would focus on the level of money GDP, and not its annual rate of change, it would mean that any shortfall relative to target would have to be restored in future years. That would entail raising the current level of national income by around 10 per cent, a herculean task which would completely change the terms of the debate on the FOMC. It would also radically change the outlook for financial assets.
Although the idea has merit, and may well be discussed by the FOMC in future, it is not likely to emerge from this week’s meetings. Ben Bernanke has discussed many radical actions for monetary policy in the past, notably relating to Japan a decade ago, but I do not recall him ever giving much attention to a nominal GDP target. He has consistently focused on the advantages of adopting a clear and consistent target for the rate of inflation (note, not the level of prices, but their rate of change, so past shortfalls would not need to be restored), and in a recent speech on 18 October he said the following:
As a practical matter, the Federal Reserve’s policy framework has many of the elements of flexible inflation targeting…The FOMC is committed to stabilising inflation over the medium term while retaining the flexibility to help offset cyclical fluctuations in economic activity and employment.
He went on to argue that inflation targeting had proven its worth in stabilising inflation expectations in both directions in recent years, and he concluded as follows:
My guess is that the current framework for monetary policy – with innovations, no doubt, to further improve the ability of central banks to communicate with the public – will remain the standard approach, as its benefits in terms of macroeconomic stabilisation have been demonstrated.
That does not sound like a Fed Chairman who is contemplating a major shift in the whole apparatus of monetary policy right now. Furthermore, recent speeches by Janet Yellen and Bill Dudley, the Chairman’s key lieutenants, have been gradualist in their approach. Certainly, they have spoken of an economy which is growing too slowly for their liking, with downside risks. Bill Dudley, in particular, has stressed the importance of breaking the downward spiral in housing, which implies that there might be increased purchases of mortgage backed securities. But, other than that, their main focus seems to be on making further changes to the FOMC’s communication strategy.
Janet Yellen is particularly important here, since she is in charge of a Fed committee examining the matter. In her speech, she said:
We have been discussing potential approaches for providing more information — perhaps through the SEP — regarding our longer-run objectives, the factors that influence our policy decisions, and our views on the likely evolution of monetary policy.
The SEP is the Summary of Economic Projections, in which FOMC members give their outlooks for the main economic variables in the years ahead. It seems from Janet Yellen’s guidance that the Fed might decide to beef up this document so that it becomes more explicit about the nature of its long run inflation and unemployment objectives, and about the conditions underpinning its commitment to hold interest rates close to zero until mid 2013.
It is even possible that FOMC members might start to publish their entire expected path for short rates over future years, conditional on their economic forecasts. (Read my lips: no new rate hikes!”) The Chairman has explicitly pointed out that other central banks publish such projections of policy rates, which help influence market expectations of central bank policy.
The idea here would be to increase the confidence of the markets that short rates are intended to remain at zero for a very long time to come, which might in turn reduce long bond yields even further. That would be useful in easing monetary policy slightly, but it cannot be expected to have very much effect when short rate expectations are already so low. More drastic options, like a target for the level of nominal GDP, will have to wait a while.
