Assorted Macro Musings

% of readers think this story is Fact. Add your two cents.

Some assorted macro musings:

My colleague Scott Sumner and his coauthor Ethan Roberts have a new primer on NGDPLT. It is a very accessible introduction but one that also gets into NGDPLT futures targeting. Check it out.

The Joint Economic Committee of Congress has a new report where, among other things, it lays out a monetary explanation for the slow recovery.  A key excerpt on why QE did not create a robust recovery (page 61):

Obviously, I liked this part, but the entire report is good so take a look.

Since we are on the topic, I wanted to follow up on my last post. There I piggybacked off a recent Paul Krugman paper to note that the Fed’s QE program could not generate significant nominal demand or inflation because the monetary base injections were not conditionally permanent. As a result, the Fed’s QE programs became subject to the “irrelevance results” of Krugman (1998) and Eggertson and Woodford (2003). This is a widely understood point, but one that often gets overlooked.

To be clear, this understanding does not mean the QE programs had no effect. The consensus empirical view is that the LSAPs did have some effect, lowering 10-year treasury yields somewhere around 100 basis points in total (though even this understanding is being challenged). And yes, we did not repeat the Great Depression. But again, we also did not have a robust recovery in nominal demand growth and that is a policy choice. So it seems QE was limited in what it could do.

With that said, I do want to acknowledge there is a way QE could really pack a punch. The way it would is to make the LSAPs so large that they endangered the Fed’s balance sheet via interest rate risk.  Imagine, for example, that the Fed had expanded its balance sheet 1000 times its pre-2008 size versus its almost four-fold increase that occurred in practice. 

This is extreme but makes a point. If the Fed’s balance sheet were in fact 1000 times larger it could easily be set up to take a loss on its asset holdings. That is, since QE causes the Fed to hold longer-term securities on its balance sheet, the Fed in this scenario would be more susceptible to interest rate risk. This is the risk where the price of a bond moves inversely with interest rates. The longer the bond, the more the bond’s value will swing in response to changes interest rates.  If rates were to go up, bond prices would fall and this would decimate the asset side of the Fed’s balance sheet. Meanwhile, the liability side of the Fed’s balance sheet (bank reserves and currency) would not have changed. So there would be fewer assets for the Fed to use to manage the monetary base. That means the Fed could not reign in the monetary base if inflation expectations started taking off, which they probably would in this extreme scenario. The monetary base injection would be seen as permanent. Also, with a 1000-fold increase in asset holdings, it is unlikely the Fed’s expected future seigniorage would enough to cover the hold in the balance sheet. 

Now this hole in the Fed’s balance sheet could be plugged by the Treasury Department bailing out the Fed. But since the Fed’s balance sheet is 1000x bigger in this scenario it is unlikely the Treasury could muster up enough resources to bailout the Fed without further monetizing of debt too. So we get the rapid nominal demand growth and roaring inflation. 

This is obviously undesirable and an extreme scenario to show that QE could, in theory, pack a nominal demand punch. But it would be so costly and inefficient that it should give us pause about using LSAPs. If QE requires extremes like the above scenario to generate robust nominal demand growth, maybe it is best we look elsewhere for help. NGDPLT targeting, in my view, is the answer.

Ed Nelson Podcast
This week on the show is Ed Nelson. We had a great time talking monetary economics, Milton Friedman’s legacy, and the conduct of monetary policy. Take a listen.