The Fed is using an impressive range of firepower to counter the greatest deflationary threat since the Great Depression. With such massive injections of liquidity, however, it is not surprising that leading figures are already debating exit strategies and the extent of the longer-term inflationary threat. It is a fascinating debate to watch.
John Taylor worried in the FT last month that “extraordinary measures have the potential to change permanently the role of the Fed in harmful ways.” He said, “The success of monetary policy during the great moderation period of long expansions and mild recessions was not due to discretionary interventions, but to following predictable policies and guidelines that worked.”
Writing this week in the FT, Martin Feldstein is also anxiously looking ahead: “[W]hen the economy begins to recover, the Fed will have to reduce the excessive stock of money and, more critically, prevent the large volume of excess reserves in the banks from causing an inflationary explosion of money and credit. This will not be an easy task since the commercial banks may not want to exchange their reserves for the mountain of private debt that the Fed is holding and the Fed lacks enough Treasury bonds with which to conduct ordinary open market operations. It is surprising that the long-term interest rates do not yet reflect the resulting risk of future inflation.”
Robert Hall and Susan Woodward strike a more optimistic note in a piece on the VOX site: “[T]he Fed can control inflation by varying the interest rate it pays (or charges) banks on their reserve holding. Consequently, the Fed’s exit strategy need not be constrained by concerns about inflation – reserve interest-rate policy can take care of inflation, but the Fed should publically announce this policy.”
10 replies on “The Fed’s Exit Strategy”
I find Taylor’s position the least coherent. The so-called “great moderation” was precisely the period when central banks were perceived as doing such a good job that risk aversion fell to what we now understand were unreasonably low levels — everything seemed liquid. Maybe it’s part of the central bank’s job to keep people guessing.
Intuitively, that piece on Vox appears suspect to say the least.
The Vox piece appears to have been recycled from 4 years ago or so! Obviously the price of cocaine is falling.
All that can be done is to reiterate that the Fed can do this or can do that. This can then be quoted elsewhere along with similar puffs and help to delude some of the people the rest of the time….. Pathetic, but it shows why this blog is needed as it can actually inform. Can. Still it is early days. This is one of the best of the Irish blogs on economics, given that there seem to be no blogs on the Austrian school in Eire!
The administration in the US and many elsewhere seem only to be prepared to foist inflation upon us. All else is evil. Very banker supportive of course.
Mankiw in the New York Times explicitly advocating inflation
Pat you might want to check out the Irish Liberty Forum – possibly the biggest Austrian following in Eire.
John, what do you think of Bob Murphy’s analysis that the Hall/Woodward exit strategy will simply put off the inevitable to a later date?
Thanks for the link to the Murphy piece.
If I recall correctly from before you are somewhat of a hawk on the inflation front. I am inclined to think deflation is a much bigger threat for now, but it is certaintly wise to think through the strategy for the eventually scaling down of the Fed’s balance sheet.
For those who worry about the massive increase in bank reserves on the Fed’s balance sheet, I would point out that this is the flip side of the reluctance to extend credit, which most agree is is a huge drag on the economy.
As to the paricular criticism of the Hall/Woodward proposal: I don’t see why it is storing up trouble. It is just a useful instrument to delay the drawing down of reserves in the case of rapid turnaround. Although I hate to disagree with my former teacher Martin Feldstein, I think he is also being too pessimistic about the ability to use open market operations using private debt. If there really is the economic turnaround that leads to the “feared” expansion of bank credit (and consequent drawing down of reserves), then there should be demand for this debt at non-firesale prices.
I would support Greg Mankiw’s call for an inflation target (thanks to Ciaran for the link) to focus the anti-deflation policy effort. But I think such a target would also reduce the risk of inflation getting out of control on the upside.
In sum, I think that the Fed will have enough tools to manage the scaling down of its balance sheet when necessary. But for now . . .
yes, I’m the loyal Austrian that Karl speaks so fondly of. I really don’t think deflation is the problem – or indeed a problem at all. Far from it. Falling prices will speed up recovery by pushing down prices that were bid up in the boom (think land, capital, houses). Ditto for the restriction of credit.
As to the Woodward/Hall thesis. Is there a chance that the Fed will be paying interest on reserves with newly created reserves? I think that’s what Murphy might be getting at, and it sounds crazy to me.
In other news, Mankiw assures us he is not the devil incarnate….
Selling the private debt won’t soak up the excess money. The Fed has overpaid for the assets in the first place, and even in the good times, the assets won’t be worth enough to recover the money created. Unless of course, there has been massive inflation in the meantime which increases the price of the crud assets 🙂
[…] bloggers have raised the issue of whether the additional money supply can be withdrawn in time here. John Taylor’s article, in particular, is worth a look. Referring to the increase in the […]