Tuesday , October 17 2017

Complacency

Summary:
I recently listened to David Beckworth’s interview with Tim Duy.  Tim is one of most talented Fed watchers, and had a number of astute observations about the way the Fed communicates.  At one point David was asking why the Fed seemed to be behind the curve in 2008.  Duy said something to the effect that the Fed hadn’t expected to encounter a situation like that, and wasn’t quite ready to deal with the need for policy alternatives at the zero bound.  (Not his exact words.) I think that’s probably right, but it’s interesting to think about why the Fed was not better prepared for 2008. According to Lawrence Ball, Bernanke came to the Fed with pretty well formed ideas of how to deal with a liquidity trap.  Indeed that’s why I was so pleased when Bernanke was picked. But at an early meeting (in 2003), his views on policy options at the zero bound were dismissed or ignored by the Fed policy establishment.  According to Ball, after that meeting Bernanke mostly adopted the policy options of that establishment, not the options that Bernanke had previously recommended to the Japanese. So why was the Fed so complacent?  I’m not sure the answer, but I do believe that this is a key question for the Fed going forward.  I’m convinced that there were alternative monetary policy options (such as NGDPLT) that would have led to a much milder recession.

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I recently listened to David Beckworth’s interview with Tim Duy.  Tim is one of most talented Fed watchers, and had a number of astute observations about the way the Fed communicates.  At one point David was asking why the Fed seemed to be behind the curve in 2008.  Duy said something to the effect that the Fed hadn’t expected to encounter a situation like that, and wasn’t quite ready to deal with the need for policy alternatives at the zero bound.  (Not his exact words.)

I think that’s probably right, but it’s interesting to think about why the Fed was not better prepared for 2008.

According to Lawrence Ball, Bernanke came to the Fed with pretty well formed ideas of how to deal with a liquidity trap.  Indeed that’s why I was so pleased when Bernanke was picked. But at an early meeting (in 2003), his views on policy options at the zero bound were dismissed or ignored by the Fed policy establishment.  According to Ball, after that meeting Bernanke mostly adopted the policy options of that establishment, not the options that Bernanke had previously recommended to the Japanese.

So why was the Fed so complacent?  I’m not sure the answer, but I do believe that this is a key question for the Fed going forward.  I’m convinced that there were alternative monetary policy options (such as NGDPLT) that would have led to a much milder recession.  But what does the Fed think?  Here are 4 options:

1.  By 2008, nothing could have prevented a severe recession, even with 20/20 hindsight.

2.  By 2008, a severe recession could only have been prevented by switching to a different regime, such as price level targeting or NGDP level targeting.  And the Fed is not willing to make that switch.

3.  By 2008, a severe recession could have been prevented by being much more aggressive with existing tools such as cutting rates sooner, doing QE sooner and more aggressively, and doing more aggressive forward guidance.  No regime change was needed.  But the Fed had no way of knowing (in 2008) that this sort of aggressive policy response was appropriate.

4.  By 2008, a severe recession could have been prevented being much more aggressive with existing tools such as cutting rates sooner, doing QE sooner and more aggressively, and doing more aggressive forward guidance.  No regime change was needed.  And the Fed could have seen the need for this if they had focused on NGDP forecasts rather than inflation, or perhaps if they had focused on TIPS spreads rather than past inflation rates.

I believe that #1 and #3 are false, and #2 and #4 are true.  But what does the Fed believe?  It would be nice if the Fed put together a report on what sort of policy would have been appropriate, in retrospect, during 2008.  The report should also discuss whether enough has been learned so that the same mistakes would not be made, should we ever face a similar situation.

PS.  While the Fed has been too complacent about the risks posed by the zero bound, the voters of LA have been exactly the opposite—rejecting complacency by an overwhelming margin:

Angelenos on Tuesday resoundingly voted down a ballot measure aimed at limiting the construction of big, tall buildings in the city of Los Angeles.

Measure S—an initiative supported by residents frustrated with large-scale development—took a beating at the polls, winning just 31.15 percent of votes, when it needed a majority to pass.

Launched and funded primarily by the nonprofit AIDS Healthcare Foundation, the measure would have placed a two-year moratorium on buildings that did not conform with the city’s outdated General Plan, which is like the bible for zoning and land-use.

So it seems the public actually opposes NIMBYism, it’s the special interest groups that support it.

Or more specifically one special interest group:

With city elections rapidly approaching, the AIDS Healthcare Foundation continues to pour money into Measure S, contributing nearly $3 million since the start of the year.

In the first three weeks of the year, the foundation poured $300,000 into the campaign, then it funneled $1.95 million to the campaign in the three weeks from January 22 to February 18. The latest filings show it has since given another $600,000.

The AIDS Healthcare Foundation has been the main backer of the March 7 ballot measure since its inception in November 2015. If passed by voters, Measure S would put a two-year moratorium on all development projects requiring zoning or height changes or adjustments to the city’s General Plan.

Numerous individual donors have also kicked in small contributions to the Measure S campaign—but more than 99 percent of the money raised during that three-week period came from the foundation.

99 percent?  Who knew?

After my Trump posts, I feel I’ve completely run out of sarcasm.  Let’s see what commenters can come up with here.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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