Forget Bernanke: A Paper At Jackson Hole May Have Changed The Future Of Economics

If you just knew two things about the current state of the US economy — that unemployment was unacceptably high and that inflation was subdued — you’d suggest that the proper course for the Federal Reserve would be to lower interest rates, and make money cheaper.

The problem is: interest rates are at ~0%.

This is the defining monetary puzzle of our time.

Since the crisis hit, the Federal Reserve has attempted to juice the economy through a program that’s called Quantitative Easing, which is buying long-dated government bonds and mortgage backed securities It’s the same scheme that the Bank of Japan has tried in its long battle against saggy growth and deflation.Continued below.

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The effect has been to balloon the size of the Federal Reserve Balance Sheet, as you can see in this chart, which comes The Cleveland Fed.

In his Jackson Hole speech in 2010 (.pdf), Ben Bernanke explained how the program worked.

Specifically he cited the “portfolio balance channel”, which means that QE would work by reducing the supply of super-safe Treasuries and Mortgage Backed Securities, and instead push investors into other areas (like corporate bonds), thus depressing yields and borrowing costs in the private sector. Think of it this way: During the crisis, everyone sought refuge in the safety of Treasuries. Bernanke was now seeking to deprive them of this safety valve, and force their cash into areas where it might do some good in the economy.

Here are his words:

The channels through which the Fed’s purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short- term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial as-
sets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

It’s worth noting that although this was all new territory for the Fed, this wasn’t new territory for monetary economists, who had spent a lot of time talking about what Japan could do to get itself out of its post-crisis funk. One of the economists who wrote a lot about Japan was Ben Bernanke.

Two years later, the jury is still out on QE. The fact that unemployment is high, inflation is subdued, and growth is mediocre implies it hasn’t been a raging success. Also the fact that we’re talking about doing QE3 is a little bit damning.

Nonetheless, at Jackson hole this year, Bernanke gave a vigorous defense of QE, meaning that not only does he believe it worked, he believes its appropriate for the ongoing labor crisis we’re experiencing today.

He said:

Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.

So Bernanke talked about the dismal state of the economy, and he insisted that QE works, which is why so many people believe that another round is coming, if not in September, then at the December meeting.

And now here’s where things get interesting…

Following Bernanke’s speech at Jackson Hole, a paper was delivered at the conference by Michael Woodford, a Columbia economist who is considered to be one of the world’s foremost experts on monetary policy and interest rates.

The title of the paper was Accommodation at the Zero Lower Bound and clocking in at 97 pages, it provides an exhaustive overview of which monetary stimulus techniques really work when the Fed’s official interest rates have hit ~0%.

Woodford’s paper was a rebuke to Bernanke. What it says is that asset purchases have modest, difficult-to-quantify effects, and are not even theoretically robust. Instead, what really works, are verbal commitments by central banks to target a certain economic or financial outcome. Woodford ends up coming out in support of Nominal GDP Level Targeting, one of the buzziest ideas in academic economics, which we’ll go explain below.

First, he builds the case that what central bankers say and target actually matters. Why do people obsess so much about whether the Fed says it expects to hold rates low until 2014 or 2015? This is why.

Woodford presents a clear-cut example of a central bank making a forward-looking statement, and then watching it play out in financial markets.

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