Is A Shift In Fed Policy Coming?

From The Daily Capitalist

The Wall Street Journal is running a piece tonight (Monday) on a possible shift in Fed policy (Fed Mulls Symbolic Shift) which I don't believe they would run unless they have some insider tipping them off. The article is authored by Jon Hilsenrath who has been writing about deflation and the efficacy of Keynesian stimulus. As I pointed out, he is a good reporter, but his articles mirror the conventional wisdom which, unfortunately, has been mostly wrong.

However I will assume Mr. Hilsenrath has pretty good connections as a Journal reporter so I will take his piece seriously. Here is the gist of the article:

Federal Reserve officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum.


The issue: Whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead. Any change—only four months after the Fed ended its massive bond-buying program—would signal deepening concern about the economic outlook. If the Fed's forecast deteriorates significantly, it could also be a precursor to bigger efforts to pump money into the economy.

The article notes the disagreements among the Fed presidents about inflation, deflation, and the direction of the economy. The inflation hawks, chief among them being Thomas Hoenig of the Kansas City Fed, would probably like to increase the Fed Funds rate soon. Charles Plosser (Philadelphia), James Bullard (St. Louis), and my favorite, Richard Fisher (Dallas) have been favorable to quantitative easing by allowing the Fed to continue to buy toxic debt ("quantitative easing"). None of these Fed presidents seem to understand the causes of deflation or inflation as being something that they create through money supply manipulations.

But James Bullard has come up with another twist.

Dr. Bullard released a paper last week about the dangers of deflation ("Seven Faces of 'The Peril'"). I should tell you that he rose from the research department to president of the St. Louis Fed, which makes him a bit of a policy wonk.

Dr. Bullard says we can stop deflation by buying U.S. Treasurys (this form of "quantitative easing" is also called "monetizing debt"). He says ZIRP (zero interest rate policy) encourages deflation and violates the Taylor Rule (the Fed must keep short-term interest rates at a fixed bandwidth above or below "equilibrium" which is some theoretical balance between the rate of interest and inflation expectations). He says ZIRP loses its effectiveness, creates expectations of lower prices, and increases the likelihood of deflation.

Bullard's solution is to monetize federal debt, but to only do it  'just right':

The experience in the U.K. seems to suggest that appropriately state contingent purchases of Treasury securities are a good tool to use when infl?ation and infl?ation expectations are ?too low.? Not that one would want to overdo it, mind you, as such measures should only be undertaken in an effort to move infl?ation closer to target. One very important consideration is the extent to which such purchases are seen by the private sector to be temporary or permanent. We can double the monetary base one day, and return to the previous level the next day, and we should not expect such movements to have important implications for the price level in the economy. Base money can be removed from the banking system as easily as it can be added, so private sector expectations may remain unmoved by even large additions of base money to the banking system. In the Japanese quantitative easing program, beginning in 2001, the BOJ was unable to gain credibility for the idea that they were prepared to leave the balance sheet expansion in place until policy objectives were met. And in the end, the BOJ in fact did withdraw the program without having successfully pushed infl?ation and infl?ation expectations higher, validating the private sector expectation. The U.S. and the U.K. have enjoyed more success, perhaps because private sector actors are more enamored with the idea that the FOMC and the U.K.?s Monetary Policy Committee will do ?whatever it takes? to avoid particularly unpleasant outcomes for the economy.

Let me translate this for you:

  1. He and other Fed presidents are worried about a Japan-style deflation where they had declining prices and asset values and almost zero growth for "a decade" (actually almost 20 years at 0.6% average GDP).
  2. Nothing they (the Fed) have done so far works. Chairman Bernanke and others assumed that all they had to do was ZIRP and inflation would appear, the economy would rebound, and things would be just fine. It hasn't worked.
  3. Chairman Bernanke has no clue why deflation is occurring and neither do the other Fed presidents. He still assumes, through some neo-Classical, Monetarist econometric formula, they can manipulate the economy to their will. If they could do this they would already have done so.
  4. Japan, Bullard says, did everything wrong: ZIRP didn't work and fiscal stimulus left them with huge national debt. He is absolutely right about this. However he believes they went into deflation because (i) no one expected inflation to occur because of ZIRP and that (ii) they didn't try hard enough with quantitative easing.
  5. He believes, with absolutely no evidence, that quantitative easing helped in the UK and in the U.S. in that it prevented inflation expectations from being "too low."
  6. Monetizing federal debt, he says, will convince us that the Fed 'really means it this time' and that we can expect inflation for sure.

Bullard released this paper for a reason and that is to frame the debate about what they are all really concerned about: a sinking economy that will keep unemployment high. Continued high unemployment is not politically acceptable to Congress and the Administration, and the Fed will face tremendous pressure in the next several months as negative data continues to come in.

Most Fed presidents fear unemployment more than they do deflation. I believe they will keep ZIRP for the foreseeable future and that they will also engage in more "quantitative easing."

Monetizing debt has been a taboo among central bankers because it is a one-way ticket to high inflation. But, Dr. Bullard thinks that is what the Fed should do. That is why I believe we are eventually headed for stagflation.