Tuesday, September 25, 2012

Credibility of the Fed

Monetary economist today, Bond super villian tomorrow

The world's preeminent monetary economist, Michael Woodford, does not believe that the Federal Reserve went far enough. A step in the right direction, sure, but still far from the goal that monetary policy needs to address: reducing uncertainty. 

If people believe the economy will get better, then they will start spending and investing again instead of hording their dollars under a mattress; waiting for sunnier days to be upon us. There is some disagreement about the importance of confidence to economists. For instance, Paul Krugman often calls this idea: "the confidence fairy"; but others attach more weight to it as it makes an intuitive sense on the individual level.

Going into the last Federal Open Market Committee (FOMC) meeting, the goal was to guess what - if any - action the Federal Reserve was going to pursue. The question coming out of the meeting was what "on-going", "substantially", and "sustained" means. A general strategy was laid out, but it was filled with vague adjectives that the market is unsure what to make of.

Mr. Woodford is glad that the Federal Reserve is taking action, but he would prefer something different. His latest work is about how setting specific goals with specific policy actions to achieve those goals would boost the economy significantly more than one-off programs. Mr. Woodford is looking for established benchmarks along the lines of an NGDP target, or an established inflation/unemployment target.

The reason for this is simple: Once a goal has been established, then it is difficult to dislodge.  It becomes an institutional force. Everyone and everything moving with the same guiding principles. A new idea is introduced here that is beyond confidence: Credibility.

Bernanke is like Santa Claus. He can bring you anything, but you better be happy with what you get.

The makers and movers of markets are now confident that the Federal Reserve is going to take action to boost the economy. But for how long and to what end? When the Federal Reserve says they are going to keep interest rates low until 2015, is it believable? They have the power to turn quantitative easing on and off at will, so how do we know if they have a sudden change in heart? But most importantly, what happens when the members of the board changes in 2014? 

Consensus built around established goals answers these questions. It lends credibility to the institution and the decisions in which are made. It depoliticizes any specific action in favor of a larger strategy. Whoever occupies the Oval Office will have confidence that the Central Bank is doing whatever it deems most appropriate to achieve the same targets that did for their its predecessors and their successors. Perhaps we will see Ben Bernanke move to established goals before the end of his term.

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