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I think Ben just did it…

This is what I in a post earlier today asked the Federal Reserve to do:

Rather for example the Fed could just start at every regular FOMC meetings to state for example that “the expectations is now that without changes in our policy instrument we will undershoot our policy target and as a consequence we today have decided to use our policy instrument to increase the money base by X dollars to ensure that we will hit our policy target within the next 12 months. We will increase the money base further if contrary to our expectations policy target is not meet.”

I must admit Ben Bernanke nearly got it right! Here is from the FOMC’s statement:

“The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.  Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.  The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective….

…To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. 

…The Committee will closely monitor incoming information on economic and financial developments in coming months.  If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. “

So we nearly got what I asked for: 1) A clear target – not an NGDP level target, but a light Mankiw rule/Evans rule based on the Fed’s dual mandate. 2) A clear instrument to increase the money base: Mortgage backed securities. 3) A promise to do more if the target is not hit.

Now the markets should do a lot of the additional lifting.

I think it would be ungrateful to ask for more – yes, yes it is not NGDP level targeting and a lot of things can go wrong, but today I think we can take a little victory lap. This is excellent news for the US economy and for the global economy. Then we can hope that we in the coming months will get an even more clear defined “Bernanke rule” so we finally can back to a rule based rather than a discretionary monetary policy.

Related posts:

Scott Sumner has two comments (here and here) on the FOMC decision.

David Beckworth also has a comment and so has David Glanser.

While Scott and two times David share my general happiness about the Fed’s actions our friend Marcus Nunes is less euphoric. Marcus as always been the skeptic among the Market Monetarist bloggers, but he has also often been right so maybe we should be a little bit careful in not being carried away.

Update: Dajeeps and JPIrving are also happy.

Update 2: Our friend Mayor(!) Bill Woolsey also comments on the fed. Bill is as happy as the rest of us with the progress in the thinking of the FOMC, but he also correctly raises some points about the dangers of targeting real variables such as unemployment rather than focusing on nominal variables such as the NGDP level. Bill’s comment in many ways can be seen as the Market Monetarist reply to George Selgin’s friendly reminder to us (the Market Monetarists) that we should not become too friendly with the fed exactly because the fed is now so clearly targeting a real variable. Bill post was however (I think) written prior to George’s comment. Needless to say I agree with George and Bill. The FOMC’s actions is major step forward, BUT I am certainly also somewhat uncomfortable with the fact that the fed now so clearly targeting a real – rather than a nominal – variable.

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Time to end discretionary monetary policy!

This week has been nearly 100% about monetary policy in the financial markets and in the international financial media. In fact since 2008 monetary policy has been the main driver of prices in basically all asset classes. In the markets the main job of investors is to guess what the ECB or the Federal Reserve will do next. However, the problem is that there is tremendous uncertainty about what the central banks will do and this uncertainty is multi-dimensional. Hence, the question is not only whether XYZ central bank will ease monetary policy or not, but also about how it will do it.

Just take Mario Draghi’s press conference last week – he had to read out numerous different communiqués and he had to introduce completely new monetary concepts – just take OMT. OMT means Outright Monetary Transactions – not exactly a term you will find in the monetary theory textbook. And he also had to come up with completely new quasi-monetary institutions – just take the ESM. The ESM is the European Stability Mechanism. This is not really necessary and it just introduce completely unnecessary uncertainty about European monetary policy.

In reality monetary policy is extremely simple. Central bankers can fundamentally do two things. First, the central bank can increase or decrease the money base and second it can guide expectations. It is really simple. There is no reason for ESM, OMT, QE3 etc. The problem, however, is that central banks used to control the money base and expectations with interest rates, but with interest rates close to zero central bankers around the world seem to have lost the ability to communicate about what they want to do. As a result monetary policy has become extremely discretionary in both Europe and the US.

That need to change as this discretion is at the core the uncertainty about monetary policy. Central bankers therefore have to do two things to get back on track and to create some kind of normality. First, central banks should define very clear targets of what the want to achieve – preferably the ECB and the Fed should announce nominal GDP targets, but other target might do as well. Second, the central banks should give up communicating about monetary policy in terms of interest rates and rather communicate in terms of how much they want to change the money base.

In terms of changes in the money base the central banks should clarify how the money base is changed. The central bank can increase the money base, by buying different assets such as government bonds, foreign currencies, commodities or stocks. The important thing is that the central banks do not try to affect relative prices in the financial markets. When the Fed is conducting it “twist operations” it is trying to distort relative prices, which essentially is a form of central planning and has little to do with monetary policy. Therefore, the best the central banks could do is to define a clear basket of assets it will be buying or selling to increase or decrease the money base. This could be a fixed basket of bonds, currencies, commodities and stocks – or it could just be short-term government bonds. The important thing is that the central bank define a clear instrument.

This would remove the “instrument uncertainty” and the ECB or the Fed would not have to come up with new weird instruments every single month. Rather for example the Fed could just start at every regular FOMC meetings to state for example that “the expectations is now that without changes in our policy instrument we will undershoot our policy target and as a consequence we today have decided to use our policy instrument to increase the money base by X dollars to ensure that we will hit our policy target within the next 12 months. We will increase the money base further if contrary to our expectations policy target is not meet.” 

In this world there would be no discretion at all – the central bank would be strictly rule following. It would use its well-defined policy instrument to always hit the policy target and there would be no problems with zero bound interest rates. But most important it would allow the financial markets to do most of the lifting as such set-up would be tremendously more transparent than what they are doing today.

Today we will see whether Ben Bernanke want to continue distorting relative prices and maintaining policy uncertainty by keeping the Fed’s highly discretionary habits or whether he want to ensure a target and rules based monetary policy.

PS a possibility would of course also be to use NGDP futures to conduct monetary policy as Scott Sumner has suggested, but that nearly seems like science fiction given the extreme conservatism of the world’s major central banks.

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