The Fed’s credibility is obviously important. If people believe that they can and will do what they say they’re going to do — and that it will have the desired effect — they can affect the the real economy (at least short-term) by just making promises — Open Mouth Operations. (Though they must actually do things to their balance sheet, sometimes — rather than just promising to make future promises — to avoid the Turtles All The Way Down problem.)
Also obvious: the Fed has great inflation-fighting cred. They’ve fetishized inflation and that credibility for thirty years. People feel damned confident that they can and will successfully stomp on price spikes — especially wages. That’s what they do. That fixation has continued even through four years in which runaway inflation has manifestly not been a credible threat.
Meanwhile, their unemployment-fighting cred is in the tank. If they announced today that they’re going to do whatever is necessary to bring unemployment down to X%, people would seriously question their ability to do so, even their future commitment to doing so.
Tyler Cowen agrees:
The Fed, at least right now, is not able to make a credible commitment toward a significantly more expansionary policy for very long. … The market expectation has become “the Fed can/will only do so much.â€
Why? Because in their frantic obsession with inflation (explanation here), they missed their chance to demonstrate their unemployment-fighting moxie. The time to do that was 2008 and 2009, when 1. unemployment was spiking and 2. monetary policy had a lot more traction on unemployment. They could have not sabotaged the fiscal efforts.
Again, Tyler agrees:
The Fed already has failed to act, for whatever reasons. That makes it all the harder to achieve the credible commitment now.
Now people may be confused, thinking that because the Fed didn’t do what was needed to fight unemployment, it couldn’t have. This could result in them believing that it can’t, now. This is obviously faulty reasoning, but the conclusion could still be correct.
I don’t know for sure. Two questions, using a fairly extreme scenario to make the conundrum clear:
1. If the Fed had bought a trillion dollars of S&P 500 stocks in 2008, would it have prevented (or greatly reduced) the unemployment carnage?
2. If the Fed bought a trillion dollars of S&P 500 stocks today, would it bring unemployment down significantly?
On #2, Tyler thinks not — that action today would have a fifth or a tenth of the effect that ’08 action would have had — for several reasons, mainly having to do with reduced potential. (Arguably caused by the Fed’s inaction.)
But one thing seems clear: that inaction (or sabotage, if you prefer) seriously damaged the Fed’s growth-enhancing, unemployment-fighting credibility. By sabotaging fiscal, it has sabotaged its own ability to reduce unemployment (or increase NGDP) by simply making promises.
Cross-posted at Angry Bear.
Comments
6 responses to “How the Fed Destroyed its Credibility”
I just don’t see that the Fed can do anything about unemployment with conventional policy. So that brings us to proposals such as buying “a trillion dollars of S&P 500 stocks”, which I think are ill advised for a variety of fundamental reasons.
Does anyone actually advocate this?
@Detroit Dan
Comment by rsj at Nick Rowe’s:
There is this thing called the “Federal Reserve Act” that specifies what the CB is and is not allowed to buy. And to whom it may or may not lend.
Because purchasing risky assets bears a possibility of loss, which corresponds to fiscal policy, and the constitution specifies which branch of government is required to do fiscal policy. Said branch tends to be jealous about delegating its powers to other institutions when it writes laws. That is why the CB can only purchase assets backed by the government. In that case, there is no risk of loss to the government.
You may also be surprised to know that there is this thing called a “Debt Ceiling”, which Treasury is not allowed to exceed. Once again, prior to the creation of the debt ceiling, each bond sale required an act of congress. When this got too burdensome (at the time of the Panama Canal), Treasury was allowed to borrow up to a limit set by congress.
Once again, congress controls fiscal policy, it may allow another institution to tweak it on the edges a bit, but basically it is not going to give real fiscal authority to anyone other institution.
Attempts to do back-handed fiscal policy via the CB run into this problem. In the real world.
Thanks Tom. That actually makes sense.
So is anyone actually advocating that the Fed test the limits in this regard?
@Detroit Dan
The Fed has pretty broad emergency powers, Dan, but I doubt it would resort to obvious fiscal for several reasons. First, it would sending a message that things are really, really bad and it is using extreme measures that are questionably legal, and, secondly, at least some people in Congress would have a conniption over usurpation of powers. Ron and Rand Paul would go ballistic. So unless things would really go south, all this is just gassing, in my view. Bernanke is calling on Congress to do the fiscal and I doubt he would just step in if they refuse. That would be taunting them.
Good. Thanks. I really don’t have the patience to wade into a discussion at one of the Modern Monetarist sites. But the there really doesn’t seem to be anything there…
*But there really doesn’t seem to be anything there* (I had an extra “the” in the sentence)