Morning Must-Read: Ryan Avent: Monetary policy: When Will They Learn?

October 14, 2014

Ryan Avent: Monetary policy: When will they learn?: “THE monetary economics of a world in which interest rates are close to zero are not especially mysterious. Stimulating the economy at that point requires central banks to raise expected inflation. Disinflation, by contrast, results in passive tightening, since the central bank can’t lower its policy rate…. In this world, the downside risks are much larger than those to the upside. There is infinite room to raise interest rates if inflation runs uncomfortably high…. But there is no room to reduce interest rates if inflation is running to low. That, in turn, forces central banks to use unconventional policy or run psychological operations to try to boost expectations. Central banks are not very good at those sorts of things. You need to overshoot, in other words, because undershooting feeds on itself….

Fatigue may be setting in at the Federal Reserve, which is expected to end its asset-purchase programme at its meeting later this month. Hawkish members of the Federal Open Market Committee are seizing on a relatively low and falling unemployment rate and on good hiring numbers as evidence that the economy can stand on its own. And if the Fed’s main policy rate were at 4% rather than just above 0%, they might have a point. But the FOMC ought to have learned by now that an economy at the ZLB does not function like an economy in which interest rates are well above zero…. American markets are once again hunkering down for a bout of disinflation. Expectations for inflation over the next five years have fallen half a percentage point since July…. The yield on long-term Treasuries is tumbling again; the 10-year is down to around 2.2%, from nearly 3% earlier this year…. My question for the Fed is: what happens when disinflation continues in November and December after the Fed has terminated its asset purchase programme? Is it prepared to start purchases up right away, or will it wait to see whether things turn around? If so, how long is it prepared to wait? What is the plan here?…

The sensible course is what it has been for the last six years: keep pushing until the economy is well clear of danger. If inflation gets up to 3% or 4% or 5%, well, there are far worse things, and the response is simple enough: tighten policy. Erring in the opposite direction may end up far more costly, however. As, I fear, we all may learn.

In retrospect, looking at the time patterns of key macro-financial indicators, it is very difficult to see Ben Bernanke’s taper-talk of 2013 and the subsequent adoption of the taper as anything other than the last of his many shying-at-the-jumps in which he failed to do what was needed to stabilize the forward growth passive nominal GDP:

Key Macro-Financial Indicators
Graph 10 Year Treasury Constant Maturity Rate FRED St Louis Fed

Graph 10 Year Treasury Constant Maturity Rate FRED St Louis Fed

October 14, 2014

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