By Steven K. Beckner
JACKSON HOLE, Wyo. (MNI) – Although the Federal Reserve has gone to
extraordinary lengths to stimulate the economy, it’s gone about it in
the wrong way, or at least has limited the effectiveness of the tools it
has used.
That is the conclusion reached by Columbia University professor
Michael Woodford in a paper prepared for presentation at the Kansas City
Federal Reserve Bank’s annual symposium here Friday.
Woodford, a respected monetary economist who has made presentations
to the prestigious gathering of central bankers in previous years,
contends that “forward guidance” about the future path of the federal
funds rate will be ineffective, non-credible and perhaps even
counterproductive if it is left conditional.
Only a firm committment to keep the funds rate near zero longer
than the Fed otherwise would will work to stimulate economic activity,
he argues. He lends support to a proposal by Chicago Federal Reserve
Bank President Charles Evans to keep the funds rate near zero so long as
unemployment is above 7% and inflation is below 3%.
Woodford also questions the effectiveness of large-scale asset
purchases — so-called “quantitative easing” — but says purchases of
mortgage-backed securities is apt to be more helpful than buying
Treasury securities. And he said QE can help reinforce the Fed’s effort
to signal that it intends to keep rates low.
Woodford also commends the Bank of England’s subsidized lending
program to the Fed’s consideration, but says it would only work if done
in coordination with the Treasury.
Since December 2008, the Fed has held the federal funds rate in a
zero to 25 basis point target range, with the effective funds rate
trading eight to 13 basis points below the rate it pays banks on excess
reserves (IOER).
After the funds rate reached the “zero lower bound” (ZLB), the Fed
bought a total of $2.35 trillion of Treasuries and MBS through the
creation of new bank reserves. It has financed additional long-term bond
purchases through the sale of short-term securities, which does not
cause a net expansion of reserves on the Fed’s balance sheet.
What’s more, the Fed’s policymaking Federal Open Market Committee
has resorted to the communication tool of stating, conditionally, that
it expects to keep the funds rate near zero for a long period. Since
January of this year, the FOMC has said it “anticipates that economic
conditions — including low rates of resource utilization and a subdued
outlook for inflation over the medium run–are likely to warrant
exceptionally low levels for the federal funds rate at least through
late 2014.”
Yet, to the Fed’s frustration, despite all its efforts, the economy
has grown too slowly to reduce the unemployment rate as rapidly as in
previous recoveries.
Woodford examines both forward guidance and quantitative easing, as
practiced by the Fed, and finds them wanting but acknowledges that Fed
policymakers may not want to go in the direction he suggests.
Woodford says the Fed is engaged in “wishful thinking” if it
believes it can provide additional monetary stimulus without committing
itself to future low rate policies and without getting involved in
targeted easing efforts that could involve it in “credit allocation.”
Forward guidance to affect expectations about future short-term
interest rates and thereby encourage near-term spending and investment
can’t work, he maintains, if market participants don’t believe the Fed
will hold rates down over an extended period, even after the economy has
begun to accelerate and/or inflation has begun to rise. To be credible,
a less conditional commitment needs to be made, he says.
“In practice, the most logical way to make such commitment
achievable and credible is by publicly stating the commitment, in a way
that is sufficiently unambiguous to make it embarrassing for
policymakers to simply ignore the existence of the commitment when
making decisions at a later time,” Woodword writes.
Mere words are not enough, he says.
“It does not make sense to suppose that merely expressing the view
of the economy’s future path make them believe it,” he writes. “If
speech were enough, without any demonstrable intention to act
differently as well, this would be magic indeed — for it would allow
the central bank to stimulate greater spending while constrained by the
interest-rate lower bound, by telling people that they should expect
expansionary policy later, and then also fully achieve its subsequent
stabilization objectives, by behaving in a way that is appropriate to
conditions at the time and paying no attention to past forecasts.”
“But there would be no reason for people believe central-bank
speech offered in that spirit,” Woodford continues. “Hence it is
important, under such an approach to policy, that the central bank not
merely give thought to the future course of conduct that it would like
for people to anticipate, and offer this is as a forecast that it would
like them to believe. It must also think about how it intends to
approach policy decisions in the future, so that the policy that it
wants people to anticipate will actually be put into effect.”
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