Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Thursday, September 23, 2010

What is Clear, and Not So Clear, About Fed Policy

I want to comment on some of the reactions I've been reading about lately concerning the Fed's recent policy statement. The full text of the statement can be found here: FOMC September 21, 2010. Here is the last paragraph:
The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.
One reaction to this statement can be found here: Fed's Hint of Further Easing Leaves Wall Street Guessing.

Evidently, the Fed is creating some confusion for the markets. This quote from that article essentially sums it up:

Depending on whom you asked, the central bank either said too much, too little or said it poorly... 

Well, the Fed can be annoying at times, I guess. It would be nice if the next time it would say neither too much, nor too little, and--of course--to say all it is saying (and not saying) much more clearly! 

But kidding aside, is there a legitimate complaint here? Maybe. What I thought I would do is to list in my own mind the things I think are more and less clear, and then maybe talk about whether any lack of transparency (if it exists) really matters. (Note: I am writing this on the fly, so I'm not really sure where this is going to end up).
 
What is clear

First, although the Fed has no explicit long-run inflation target (something I believe should be rectified), it's implicit target is widely viewed to be around 2%.  Of course, inflation fluctuates around this target and normally, this short-run behavior is of no great concern. The Fed does appear, however, to go on alert when it detects what might be the beginning of an upward or downward trend in the inflation rate (away from the 2% target).

Second, inflation is currently running at around 1% and the short-run recent trend (if it is indeed a trend) is pointing in the downward direction. This event, in and of itself, might normally elicit only a modest concern. But combined with an economy presently weaker than expected, the concern is now heightened. And, in particular, the worry at present is the risk of a Japanese style deflation (a "deflation trap" in the minds of some, though I'm not even sure if such a thing exists).

Third, it seems clear that this risk is presently judged to be "small." But small is not the same thing as zero. Accordingly, the Fed has judged it prudent to issue a contingency plan (note the big IF in the FOMC statement quoted above). You might recall that not too long ago, the Fed was more concerned with another part of its contingency plan (the so-called exit strategy, designed to mitigate inflation fears following the massive expansion in its balance sheet).

Fourth, it seems clear that the Fed stands prepared to "do whatever it takes" to prevent inflation from trending downward any further. (It is also committed to keep inflation reigned in, should we find ourselves on the other side of the inflation target--again, this is the much talked about exit strategy).

What is less clear

The recent FOMC statement did not, however, delve into the details of what tactics the Fed would employ in the event of undesirably low inflation. On the other hand, the Fed has given us a pretty good hint at how it might proceed in its earlier statement: FOMC August 10, 2010; i.e.,

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.
In short, the Fed's going to do what it always does when it wants to loosen policy: purchase assets in exchange for newly created money. Which assets? Not short term treasuries--their yields are close to zero. No, it will almost surely include longer dated treasuries, whose yields are currently in the 2.5% range.

There remains some uncertainty in terms of how such a loosening might be implemented over time. A good bet, in my view, would be a state-contingent sequence of purchases, with the quantities purchased depending on how output and inflation evolve over time. The policy rule might take a form like this:

Asset Purchase Rule: Bt - Bt-1  =  f ( πt - π, ... )
 
where the left-hand-side denotes the size of the desired bond purchase (sale, if negative) as a decreasing function of the inflation gap (and possibly other things).

What is not so clear

What if they do all that and it turns out not to be working? In particular, suppose that inflation continues to trend downward as yields on long dated treasuries approach zero? Then what?

Well, there really aren't a lot of options. If the Fed wants to talk inflation up and back its talk with action, it will have to expand the set of securities it is willing to purchase. This much seems clear enough (to me, at least). The only question, in this event, is which securities? (Maybe this is what upsets Wall Street traders, because they would like to know which securities to long and short? If so, they should look on bright side of this opacity: they can continue to blame the Fed for their trading losses).

Now, let's see. Additional MBS purchases are a distinct possibility. Another possibility might be purchases of state and municipal bonds.  Of course, moving along this branch of action raises additional questions. High grade or low grade assets, or both? Should the Fed discount a junk municipal bond and, if so, at what rate? But perhaps I am getting ahead of myself. The Fed (Ben Bernanke, in particular)--and indeed, even the Treasury--have both expressed reluctance at the idea of purchasing low-level government debt; e.g., see here: Fed Limited in Ability to Buy Muni Bonds. (Note: "ability" should be properly be replaced with "willingness," I think. And I'm not sure whether this alleged limited ability to buy necessarily rules out an ability to accept these objects as collateral. I will have to look into this).

What is downright blurry

In the event that the economy finds itself in an undesirable deflation dynamic, will any of what I described above actually work? Is this a question that should even be raised in public? (I ask, in part, because there are some people who believe that the Fed should not even have raised the possibility of deflation in the first place, for fear that it would create a self-fulfilling prophesy.)

If we ever arrive in such a world, it will indeed be a strange one. After all, what sort of central bank, with its power to create money "out of thin air," is powerless to affect nominal variables? The Reserve Bank of Zimbabwe  appears to have had little difficulty in creating inflation (Note: the hyperinflation in Zimbabwe ended on April 12, 2009. Note too that the Zimbabwean currency no longer exists; see here).

I'm not entirely sure what happened in Zimbabwe, but let me guess: Their fiscal authority used the central bank to create money that was then spent on goods and services that were largely consumed (someone correct me if I am wrong). Money created and used in this manner is never retired and generates no income (income that could, for example, be used to finance future purchases of goods, or retire the money stock). Yes, I think we can all be fairly confident that fiscal authorities have the power to create inflation (and expectations of inflation).
 
In the U.S., however, the Fed is independent of the fiscal authority (at least, it likes to think it is). When the Fed creates new money,  it is restricted to inject it into the economy  via asset purchases only (normally U.S. treasury debt, or other high-grade securities). How might this restriction matter?

Here is one possibility. Imagine that, for some reason, everyone expects a persistent deflation of, say, 2%. Moreover, imagine that the "natural" (real) rate of interest on high-grade securities is also 2%. Then, if the Fed targets the nominal interest rate anywhere above zero, the real rate of interest will be "too high" (depressing aggregate demand). The Fed is compelled to cut its interest rate to zero. A no-arbitrage-condition implies that the nominal yields on similar assets will also fall close to zero. In this event, swaps of zero interest money for zero interest securities is not likely to have any effect at all.

The Fed could, however, try to purchase higher-risk asset classes.  The yields on these assets are far above zero, reflecting the probability of default, one would guess. Now, these assets will either pay off or not. If they pay off, the Fed is obliged to remit this profit to the Treasury (hence, the Fed has no control over how this profit is ultimately spent). If they don't pay off, the Fed will take a loss. Well, not a loss exactly. The Fed might (in principle, at least) simply keep the nonperforming loan on its books as an asset that expected to pay off sometime in the infinite future. In short, it becomes a perpetual zero interest loan--in effect, a lump-sum transfer of cash into the economy.

I haven't thought through the logic entirely yet, but it appears that out of these two scenarios, the expectation of outright defaults would resemble a series of lump-sum cash injections into the economy; something that we are fairly confident would generate inflationary pressure (it works well in our models, at least). On the other hand, if the assets are largely expected pay off, with the profits remitted to the Treasury, the inflationary consequences will depend on the subsequent actions of the fiscal authority.

So, at the end of the day, the Fed acting on its own, and under the current institutional framework, may not even have the capacity to influence nominal variables in some (low probability) states of the world. A commitment to an inflation target would, in this case appear to require explicit language explaining the joint monetary/fiscal behavior deemed necessary to achieve the stated goal.

I'm not holding my breath waiting for this language to appear anytime soon, primarily because I think that the risk of this scenario is still judged to be relatively small.  But, we shall see.

25 comments:

  1. Fiscal policy is key, no doubt. Debt-financing creates the incentives to monetize the debt.

    David, please elaborate upon your statement that the inflationary consequences of the Fed buying government bonds with printed money will depend on the actions of the fiscal authority.

    Other than raising taxes, what can the fiscal authority do? Not spend bond-financed revenue? Are you hinting at negotiated wage settlements with public sector unions?

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  2. I think this is on the right track.

    Suppose the Fed bought assets, the value of which was positively correlated with inflation and recovery. Essentially, Bernanke takes a $trillion bet on recovery. If the economy does not recover, and deflation continues, the Fed loses the bet, and the monetary injection is permanent. Which is a contradiction. If the economy recovers too quickly, and inflation is too high, the Fed wins the bet, and it's balance sheet is restored, and it withdraws the money. Which is a contradiction. So the only equilibrium is somewhere in between.

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  3. Westslope:

    Not sure which statement you are referring to exactly. I think it is the one where the Fed monetizes high-risk debt (e.g., low-grade munis)? If so, then what I meant was that the profit from this investment must be returned to the treasury. The inflationary consequences are now determined by the fiscal authority, not the monetary authority. What will the FA do with this money? There are several options. It could use it to buy goods or assets, retire its own debt, lower taxes, distribute it in the form of transfers, etc. Not all of these actions are going to have the same inflationary consequences. (Hope I answered your question)

    Nick:

    Is your comment here related in any way to your own blog post on why the Fed should buy procyclical assets? I suspect so (unfortunately, I never had time to read that one carefully). Anyway, I think I know what you're trying to say, though I'd be more comfortable with the idea if it survives in an explicit model. (Is it possible to model in an OLG framework?). I will give it some thought.

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  4. This question is likely to reveal embarassing ignorance on my part: why can't the Fed buy government debt to finance consumption, despite the restriction on its activities you mention?

    Here's why I'm confused: In 1st year Macro, I learnt that the CB grows the quantity of money in line with the growth of the real economy, all else being equal. How does it do this? It can't be achieved, in the long-run, by buying the outstanding stock of gilts, because eventually that stock would be depleted. It has to work by the government issuing new debt, the Fed buying it, and it staying in the Fed's vaults effectively with a sign over it saying "we're never going to want paying back" (i.e. it will be rolled over in perpetuity and the yield on it returned to the govt via Treasury 'profit'). This is seignorage as I understand it - the govt gets to finance a slice of its spending by printing money.

    So, why can't the Fed just buy govt debt and hang that sign over it? You write: "swaps of zero interest money for zero interest securities is not likely to have any effect at all" but monetising the government debt in this way ought to relieve pressure on the need to finance govt spending out of taxation (stop everybody fretting about future tax rises) and free up money to pay for government salaries (so all those teachers don't have to be fired etc. and every stimulon's dream job-creating infrastructure project could be paid for) and it would be very inflationary (the money is never retired).

    I must be missing something - either I have misunderstood you, or my understanding of central banking is wrong, because it looks to me like you're saying it's diffficult for the Fed to create inflation, but by my reckoning it's as easy as pie.

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  5. David: Yes, it just seemed to me that our thoughts were converging. That the conclusion you were coming to at the end of your post was related to an old post of mine: http://worthwhile.typepad.com/worthwhile_canadian_initi/2008/12/central-banks-should-bet-on-recovery-literally.html

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  6. Luis

    I think you are spot on.

    I dont think they really want to create inflation, whatever that is. Main problem is no three people can really agree what inflation is. Some who go by the quantity theory of money talk about the Fed just increasing the money supply exogenously, problem is the fed doesnt have control over the money supply, credit worthy borrowers do.
    The money supply is controlled endogenously.

    Some say its when prices rise............. except the prices of houses, stocks,
    and some other things owned by a precious few of our citizens.

    Others say its the dollar devaluation, reflected in soaring gold prices that is the harbinger of doom for inflationaphobes.

    So we're stuck without a true goal, except that we know that those who are sitting on high potential bond haircuts and stock losses dont want to take those and our CB is trying its darndest to appease these folks.

    Using all these topdown measures wont work (if your goal is job creation, which is NOT the goal of any of our policy makers and business leaders imo). Picking certain stock and bond winners is completely against a market based economy. What makes you think that just because you guarantee someones bond and put cash in their hand they are going to go hire someone or undertake a productive venture? This is subscribing to the notion that the reason a business hires is because they have all the money they need so they decide to hire someone. Is that how hiring decisions take place? I think not

    WHAT IS OBVIOUS

    If the fed supported a bottom up policy of putting money into peoples hands via a JG and a payroll tax holiday, people would pay their loans down, buy cars........participate in the markets we've created. They could do it for less than they have spent and are considering spending on buying stocks or bonds to keep the interest income going to those who have had to cut back to 2 trips to the Hamptons a month.

    You brought up Zimbabwe David. Zimbabwe was a "real" loss of economic production of their primary source of wealth. When that supply gets cut in half there is no where else for the price to go. Its easy to say that the govt should have stopped paying the people but there would have been no less of human toll. If real prices of food double and income stays the same, there is going to be starvation. Especially in an economy so close to the edge already.

    You are right about the Fed being unable to act on its own. This is a point that Mosler, Mitchell and Wray make constantly.

    Another thought provoking post David

    Cheers

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  7. Luis Enrique:

    I think you are asking an excellent question. Let me try to clear it up for you.

    What is a Fed note? One can think of it as a risk-free claim to a future Fed note. The nominal interest rate on this note is zero.

    What is a Treasury note? It is a risk-free claim to a future Fed note. The nominal interest rate on the Treasury note is typically positive (we say, the Treasury note is "discounted").

    What happens if the Treasury note is not discounted? It then becomes indistinguishable from a Fed note. Both assets represent risk-free claims to future cash and these claims earn zero interest.

    We may as well relabel these notes, "green notes" and "blue notes." These different colored notes now trade at par.

    The part you have to explain to me now is how the composition of green and blue notes now matters (this is what monetary policy does--it swaps different notes).

    There is no point in "monetizing the debt" to help lower future taxes. When the debt earns zero interest, it is effectively money already.

    Does this help?

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  8. Greg:

    Thanks! A couple of points...

    The Fed has a very clear definition of inflation. Everyone knows what this defintion is. Now, one can legitimately argue whether this is the best measure, but that's a different matter.

    I'm not sure I understand this comment of yours: If the fed supported a bottom up policy of putting money into peoples hands via a JG and a payroll tax holiday, people would pay their loans down, buy cars...

    A policy of "putting money into peoples' hands" is a political decision. The Fed has no jurisdiction over such matters. Even commenting on such desires in public is likely to draw the wrath of Congress and threaten Fed independence.

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  9. Re: Zimbabwe.

    Your instincts are right about Zimbabwe; "quasi-fiscal operations" conducted by the central bank stoked the hyperinflation. These included subsidies to favored cronies and various voting blocks.

    For a good account, read Sonia Munoz's "Central Bank Quasi-fiscal Losses and High Inflation in Zimbabwe" at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=984614

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  10. Re: Fed and municipal securities.

    This is an embarrassingly specific topic I've researched in the past. Small and Clouse provide the definitive interpretation of what the Fed can buy, and on what collateral it can lend.

    Municipal debt with no more than 6 months before maturity can be bought, according to section 14 of the FR Act. But this debt must have been issued "in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues". I interpret this as meaning the debt must be well collateralized, or collateralized by specific properties.

    As for collateral, I'm sure muni bonds pose no legal problem. The Fed can accept almost anything as collateral.

    In sum, the Fed can, but it doesn't want to.

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  11. JP Koning:

    Thanks for the link to that paper; looking forward to reading it.

    I too interpret FRA section 14 as meaning high-grade debt. In fact, in its capacity as a bank, the Fed always insists on monetizing only high-grade securities (e.g., the new MBS it purchased). The Fed's function in this capacity is as an asset transformer (transforming illiquid assets into liquid assets). The point is whether this asset transformation activity is inflationary. Not clear. What would be inflationary is to transform pure junk into money--this is like a permanent lump-sum transfer of cash. But the Fed (and Congress) does not view this as falling under the Fed's mandate. The Fed could try to do this, but if it does, it would risk the wrath of Congress (and rightfully so, I think -- we do not want unelected Fed officials to dictate whom among us should receive transfers of cash. Collateralized lending against good collateral is one thing. But outright cash transfers fall in the realm of fiscal policy).

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  12. What are some potential market responses to Fed risk asset purchases?

    Let's say the Fed targets the spread of high yield over corporates at a record-low level. Companies would have an incentive to lever their balance sheet to the point of ratings downgrades to non-investment grade. This, of course, would increase leverage and systemic risk. Now, Tinkerbell might appear, and actors might invest in real projects with debt issuance as a result of these improved "price signals". Or they might see it purely as an artifact of Fed intervention and just buy in their own stock. The latter would create less equity cushion, more leverage, and future financial system fragility that (again) leaves the economy vulnerable to even the mildest of shocks.

    Meanwhile, high yield bonds would offer low returns to new pension investors. The result of those low returns (here comes Tinkerbell) might be to force them into even higher-risk investments. Or it might lead to lower return targets for pension holders, which would cause them to save more to meet future consumption needs, thus depressing AD. The experience of Japan would tend to support the latter conclusion.

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  13. "A policy of "putting money into peoples' hands" is a political decision. The Fed has no jurisdiction over such matters. Even commenting on such desires in public is likely to draw the wrath of Congress and threaten Fed independence"


    As is the policy of buying up distressed assets. The entire charter of the CB is political. There is no more sound economic reasoning to buying bad debt and possibly other assets (stocks) then there is to "funding" a job guarantee. You are correct about the howling form Congress (and the people) but there was howling about the buyer of last resort activity of the fed in 2008 (which I BTW support) but somehow the howling was ignored when it was about protecting the assets of our financial masters.

    Contrary to what Reagan professed, we do pick winners and in the "who to save" lottery the winner was..... those who administer the lottery, To quote Church Lady..... "How conveeeeeeenient!"

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  14. "In fact, in its capacity as a bank, the Fed always insists on monetizing only high-grade securities... What would be inflationary is to transform pure junk into money--this is like a permanent lump-sum transfer of cash. But the Fed (and Congress) does not view this as falling under the Fed's mandate."

    David, I'd mostly agree with all that. I depart with your "always insists". The Maiden Lane entity set up to buy the Bear Stearns assets that JPM didn't want holds some pretty grisly looking assets.

    This reminds me of one of Nick's posts:
    http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/06/why-its-a-really-good-thing-that-the-ecb-has-overpaid-for-greek-junk-bonds.html

    While I wouldn't advocate destroying Fed assets, overpaying for them, or having the Fed buy worthless paper (your pure junk to money), it would definitely start prices moving upward.

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  15. Greg:

    I don't know how old you are, but you're probably too young to be so cynical! ;)

    In fact, I think there is a sound economic rationale (Re: Bagehot) for the Fed discounting what it perceives to be good quality but temporarily distressed assets during a financial market meltdown.

    I am less certain of the economic rationale for the Fed discounting "job guarantees" when we are not in a financial crisis, but I stand willing to be persuaded. But even if you persuade me, it will never happen unless Congress first grants Fed the explicit authority (you might argue that such authority already exists in the FRA, but I really think that political legitimacy for such an action would really require Congressional approval first).

    JP Koning:

    Yeah, the "always insists" was too strong. Keep in mind, however, that Bear Stearns is a tiny component of the Fed's portfolio. (I think the same is true of ML).

    Moreover, to the best of my knowledge, the Fed has not (yet) lost a penny on any of its crisis interventions. Indeed, in 2009, the Fed remitted a record $50B to the Treasury (twice as much as in 2008). I am still trying to get my head around how the Fed's interventions constituted a "bailout" when they made so much money for the U.S. taxpayer!

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  16. Yup, the Fed made a lot for the Treasury. Mind you it doubled its balance sheet and its portfolio got riskier, so a higher return should be expected.

    And yes, Bear Stearns is minuscule. My understanding is that the Fed has written off several billion on the investment. Even then, that's not much. Looking past the dollar figures, I'd say the damage with the Fed's Bear Stearns purchase is the precedent that's been set.

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  17. Never too young to be a cynic ;-) I've certainly been called worse.

    I wonder why you and others arent more cynical?. All these monetary efforts to reverse the slide and promote more investment/employment have been going on for two plus years, with very little success.

    Yes the financial system was(seemingly) stabilized, an excellent outcome if true (there are those arguing we've simply kicked can down road and FIXED nothing.........we'll see), but that was the EASY part. Just change some numbers in different accounts and voila everything looks good and people feel better. Now....... about those people who were fired/laid off in the panic, when we THOUGHT we didnt have any more money to pay them......... well, what to do now?

    We KNOW we have the money, all we do is change numbers in accounts and trillions show up to stabilize balance sheets and ease fears. The gig is up on that one. We ALWAYS have whatever "money" to do whatever we WANT. Why dont we really want to address the employment problem?


    What exactly do you think the lever is by which these monetary operations will produce the desired result? Will rising asset prices make people feel wealthier, eventually getting them to buy something with that wealth? If so why would they feel wealthier when they KNOW that the govt simply bought their stock/bond from them? That it wasnt a market operation but a transfer from the govt? Isn't the govt simply "printing money" supposed to be faux wealth?

    So yeah, I get cynical when it looks like all this CB operation fetishizing is only an exercise in justifying "transfers" to those who hold assets and demonizing "transfers" to those who cant find work. It seems a transfer is bad only when it goes to someone in a T shirt rather than a cardigan.

    Help me understand this

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  18. Greg:

    I assure you that I'm about as cynical as they come. But I also like to temper my assessment of situations by placing them in the broader context of human history (where the little guy frequently paid for a crisis with his life, instead of his job, for example).

    Implicit in your laments are a couple of assumptions that may be more or less true. (My own view is that they are less true).

    The first is that our "employment problem" can be fixed by simply printing money and using it to finance job creation. The resource allocation problem in a growing and dynamic economy is probably a little more complicated than this.

    The second is that the Cardigans are the recipients of transfers while the T-shirts go wanting. In fact, in the U.S., the bottom 40% of earners pay negative net federal taxes, and the top 10% of earners pay 3/4 of federal taxes. See: http://andolfatto.blogspot.com/2010/04/some-interesting-tax-facts-us-style.html

    So, like I said, I don't want to make any excuses for bad behavior. But I think some context is needed. It will help keep you sane!

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  19. David,

    A propos of recessions, but not this post specifically, I believe you might have some interest in this article from George Selgin:

    http://www.ajc.com/opinion/recession-fed-policy-and-622763.html

    Best, Prof J

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  20. David


    Actually our "employment problem" could be fixed with money printing to finance jobs. Would this solve all our other problems? Of course not, and I dont think anyone argues that it would BUT it would give everyone a job.

    You are right to question the level of production they'd generate but what level of production are they (the unemployed) generating NOW? I'd argue that our people are our most valuable resource and they are being wasted.

    Taxation levels are not really germane here because I'm talking about the Fed transfers via TARP and all the other asset buybacks which are essentially printing money to guarantee the price of a security. Certainly you agree that this amounted to "money printing" to buy the assets that had no market price that was acceptable to the seller? And as I said, this is a completely legitimate use of our Central Banks ( I know there are those who disagree). Being buyer of last resort and lender of last resort can help get complex modern economies through crisis'.

    I'm a little bewildered though that so few acknowledge the utility of getting spending power in the hands of consumers and letting growth occur form the bottom up as well. We have such imbalanced policy views, looking only with one eye. THIS is the context I"M talkin' 'bout!!


    Cheers

    My only comment about your taxation ratio/ quintile is that the upper 10% also controls well over 75% of the wealth, so they should pay over 75% of taxes in an equitable system, but I do not support our tax system as it is currently arranged right now, so dont take this as an endorsement of the US tax system.

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  21. David,

    Thanks for the reply. I think we may still be talking at cross purposes.

    Was your response above intended as an answer to my question about why the Fed being restricted to only buying assets means it cannot "do a Zimbabwe" by printing money to finance consumption?

    (I think) I see your point about blue and green notes trading at par, but aren't there still some salient differences between the two assets (they are not "indistinguishable"), namely that only one color of note (green) is used as a medium of exchange, collected in taxes and used by the government to pay salaries and other purchases. Right now (some) people are worried that the government is spending more green notes than it collects in taxes, and a worried about the government's future need to collect green notes via taxation, whilst others would like to see the government spend more green notes on the basis that doing so will have a direct effect on the real economy (i.e. the level of employment). Having the Fed print up a bunch of green notes handed them to the government relaxes a pragmatic constraint and allows the government to spend those green notes and raise the level of employment without increasing the quantity of green note denominated, tax financed, future liability. I don't see how the observation that both color notes are "risk-free claims to future cash and ... earn zero interest" changes any of the foregoing.

    You might say that in some fundamental sense green and blue notes are indistinguishable, but printing blues notes or printing green notes has different implications for government finances, current spending and future taxes and hence real economic activity. By printing a blue note, swapping it for a green note and using it to pay a teacher's salary (i.e. finance consumption), the government promises to pay the bearer of the blue note a green note in the future, whereas in the scenario I am suggesting (crudely, just printing green notes) the government does not have to find a future green note (i.e. the future green note liability a.k.a. the national debt is not increased).

    Of course in what I am describing is usually regarded as madness and a ticket to hyperinflation, but here we seem to be disputing the Fed's ability to go down that road even if it wanted to.

    But I must be missing something fundamental, because nothing I have yet written is going to be news to you. I have flu: blame that.

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  22. Luis:

    Yes, it was meant as a reply to your question.

    You say: Having the Fed print up a bunch of green notes handed them to the government relaxes a pragmatic constraint and allows the government to spend those green notes and raise the level of employment without increasing the quantity of green note denominated, tax financed, future liability.

    To begin, you are confusing fiscal and monetary policy. I am saying that if you take the outstanding nominal debt (money plus bonds) as given, then altering the composition of this debt (which is monetary policy) will not matter if bonds earn zero interest.

    If the fiscal authority wants to issue new bonds and have the Fed monetize them, that's another issue (one that is beyond the full control of the Fed, since it requires action on the part of the Treasury).

    But in any case, if bonds pay zero interest, then the Treasury would be indifferent between raising the purchasing power it needs by issuing new bonds on the open market, or having the Fed swap these bonds for money.

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  23. David,

    thanks v much. I prefer to think I am not so much confusing monetary and fiscal policy, as thinking about what "the government" in broad sense (Fed + Treasury) can do to generate inflation using all means available, despite notional restrictions on the Fed. On your last point, even a bond paying zero interest needs the principal repaying, whereas I'm talking about having the Fed swap bonds for money and not requiring repayment. I can't see that the Treasury would be indifferent between those two choices.

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  24. Luis:

    Yes, you are thinking about a consolidated Fed+Treasury (or, at least, a coordinated action between Fed+Treasury). But I was asking what the Fed might be able to accomplish on its own.

    On your last sentence. What does it mean to repay the principal of a nominal debt that pays zero interest? A $100 bill is a claim to $100 bill. A maturing $100 bond is a claim to $100 bill. Whether the Fed prints up $100 and gives it to the Treasury to repay its debt, or whether the Treasury just prints its own $100 bond to raise the requisite cash...what does it matter?

    I'll let you have the last word.

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  25. David,

    Since you asked me a question I'd better try to answer it ... but really I'd prefer just to use my last word to say thanks for taking the time to respond.

    I guess what I have in mind is the eventual (likely) requirement of having to repay bonds out of tax revenues in one case but not in the other. If the Fed promised to always supply the Treasury with the $100 bills it needs to repay $100 bonds, so there would be no demand on tax revenues in either case, then I guess the Treasury would be indifferent and it wouldn't matter, as you say. But I didn't think that was the situation. I was thinking of a Caballero helicopter drop free lunch in which the Fed slips the Treasury some cash and then effectively writes off the debt, in contrast to the Treasury issuing a bond that leaves it with a future obligation (that it may or may not be able to finance by calling on the Fed again).

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