Thursday, December 29, 2011

How do you know when the Fed is being successful?

The first question you should ask is: successful at what?

Sumner on the 1936 Fed:
This is one of the most chilling statements I have ever read.  The opening sentence is the sort of thing juvenile delinquents say to each other when their prank has gone horribly awry, and they are nervously working on a joint alibi.  An incredible effort at denial runs all through the piece.  First he admits that they raised reserve requirements because “some recession was desirable.”  Then he claims it was just a “coincidence in time” that the downturn followed the reserve requirement increase, even though the express purpose of the increase was to cause a “recession.”  Then he claims that if they reverse their decision it will look like the previous decision had caused the recession.  Then he said that a depression can’t be happening, because there is no good reason for a depression.  Well it was happening, unemployment rose to almost 20% in 1938.  In the end, they decided to stick with the high reserve requirements throughout the rest of 1937.
Sumner on the 1960's-70s Fed:
The Fed can always raise short term rates.  It’s true that this doesn’t always result in higher long term rates.  But that’s not a sign that monetary policy is ineffective, rather exactly the reverse.  The Fed raises short term rates to keep inflation down close to 2%.  If long term rates don’t budge very much, that’s a sign that monetary policy is credible.  In the 1960s and 1970s both long and short rates tended to rise together, hence increases in short rates weren’t enough to get ahead of the curve.  Real rates didn’t rise, as the Fed wasn’t following the Taylor Principle.  Because the “tight money” policies weren’t credible, inflation expectations rose.
Glasner on the September 2011 Fed:
In this environment small changes in expected inflation cause substantial movements into and out of assets, which is why movements in the S&P 500 have been dominated by changes in expected inflation.  And this unhealthy dependence will not be broken until either expected inflation or the expected yield on real assets increases substantially. ...
Operation Twist has almost certainly not been responsible for the rise in stock prices since it was implemented.
Why has the stock market been rising? I’m not sure, but most likely market pessimism about the sway of the inflation hawks on the FOMC was a bit overdone during the summer when the inflation expectations and the S&P 500 both were dropping rapidly. The mere fact that Chairman Bernanke was able to implement Operation Twist may have convinced the market that the three horseman of the apocalypse on the FOMC (Plosser, Kocherlakota, and Fisher) had not gained an absolute veto over monetary policy, so that the doomsday scenario the market may have been anticipating was less likely to be realized than had been feared.
Sumner on the August 2011 and January 2012 Fed:
My hunch is that I misjudged the Fed move back in August, when they promised low interest rates for the next two years.  That seemed pointless without making the promise condition on some sort of nominal growth target (GDP or inflation. Now there are indications that the Fed may do just that at the January meeting. ... It’s interesting that it took me so many months to have second thoughts about my negative verdict on the policy last August.  Equity investors seemed to need only about 30 minutes to figure this out (after the 2:15 announcement.)
And what should the Fed be doing? Here is Glasner arguing in favor of targeting nominal GDP over nominal wages - though both are highly correlated, targeting nominal GDP will avoid mistaking good supply shocks for contractions.

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