Making new bullets for policymakers

Ben Bernanke’s much awaited Jackson Hole speech implicitly showed the constraints that he operates under. In his speech, he outlined the tools available to the Federal Reserve:

I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee's communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists--namely, that the FOMC increase its inflation goals.

On the fourth “inflation strategy”, he said [emphasis added]:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

On the fourth “inflation strategy”, it seems that the Fed does not want a policy of debt monetization. Of all the analysis of the Bernanke speech, the one that I find most interesting comes from Mohamed El-Erian of Pimco:

What Bernanke did not say, or said only timidly:

• Very few linkages to other components of macro policy—particularly fiscal and structural policies
• Very few references on what is going on in the rest of the world and how this impacts the US
• Virtually nothing on whether the US is navigating through a series of national and global re-alignments

 Some open questions in my mind that I still worry about:

• Is the Fed trying to carry too much of the macro policy burden?
• Is the Fed under-estimating the risk of a liquidity trap?
• Does the Fed have sufficiently-effective tools at its disposal?
• Is the Fed under-estimating national and global structural re-alignments?

Are policymakers out of bullets?
On his latter points, the main concern among market participants is the question of whether the Fed out of bullets. Former Fed vice chair Alan Blinder recently wrote an editorial stating that the Fed was running low on ammo. Blinder believed that while the Fed is not out of bullets, the ammunition remaining left in its pouch is weak and not very effective.

Then can we rely on fiscal policy? The Dallas Fed put out a paper entitled Can the Nation stimulate its way to prosperity? The apparent answer is no [emphasis added]:

Compared with no stimulus, the stimulus plan in 2009 alone was expected to increase GDP by 1 to 3 percentage points, raise payroll employment by 500,000 to 1 million jobs and lower the unemployment rate by half a percentage point.

At first glance, it doesn’t appear the stimulus achieved these objectives. In the year after the plan’s passage, the labor market continued to hemorrhage jobs and unemployment climbed above 10 percent. Indeed, the unemployment rate is now higher than it was expected to be without the stimulus plan—and has been every month since the plan’s passage.

Already there are worries about a looming debt crisis. The stimulus question is getting highly politicized. There is a fight brewing over tax policy ahead of the November election and suggestions/accusations that the Republicans are blocking stimulus for political gain.
Notwithstanding the politics, what can fiscal or monetary policymakers do?


When you have a hammer…
I believe that the question has been improperly framed. As the saying goes, if you have a hammer, every problem looks like a nail. As we have economic problems, fiscal and monetary authorities look for macroeconomic solutions.

The Economist recently raised a couple of interesting points about the current situation. First, the Fed may be helpless over unemployment because of its current structural nature. In that case, we may be looking for solutions in the wrong places. The answer may be to look beyond stimulus, which is macroeconomic in autre, and look to microeconomic policies for solutions:

Much of what economists know about structural unemployment has been gleaned from the sorry history of continental Europe, where fat benefits and rigid firing rules dulled labour-market efficiency. That experience mostly offers pointers to what not to do, from adding to employers’ regulatory burdens to letting the long-term jobless shift to the disability rolls.

Getting the to-do list right is trickier, not least because misguided meddling could make unemployment worse. But two avenues seem worth pursuing. The first is a more determined effort to help those trapped in “negative equity” to restructure the mortgages on their homes—an area where the Obama administration has been notably timid. The dire figures for house sales during July, released this week, show how urgent this is. Legal changes, such as a revision to the bankruptcy code that allowed judges to reduce mortgage debt, could help. The second line of attack is to overhaul schemes that help workers retrain and encourage them to search for work. That need not mean more spending (though America does spend a lot less than other rich countries on such “active” labour-market policies). The bigger problem is that existing schemes are fragmented and often ineffective.

I have not fully considered the implications of these suggested microeconomic policy solutions and therefore I have no strong opinions about them, but I think that it’s time to think about a new framework of considering micro as well as macro solutions to the current slow growth environment.