It brings me great angst to observe professional critics – many of them acquaintances and friends of mine – rhetorically beating Fed Chairman Ben Bernanke about the head and shoulders for launching QE2. At the same time, the fact that Sarah Palin has joined the chorus brings me great joy. If what Ben is doing offends both the learned and the unlearned, then he is clearly acting unconventionally relative to orthodoxy. And this is good, very good.

As I wrote on these pages over a year ago¹, acting irresponsibly relative to conventional wisdom is precisely the right approach for reversing an economy facing, or worst yet, mired in a liquidity trap. Indeed, in that essay, I wasn’t so much preaching my own analytical sermon but reciting Mr. Bernanke’s own sermons of 2002–2003, grounded in a sermon he preached (in Boston) in 1999 to the Bank of Japan. In these sermons, Mr. Bernanke was echoing and enhancing the work of Paul Krugman in 1998 and Gauti Eggertsson and Michael Woodford in 2003.

And the bottom line of all these epistles was simple. To reverse the debt-deflation pathologies of a liquidity trap, when private sector deleveraging renders private sector demand for credit inelastic to lower interest rates, especially when the central bank’s short-term policy rate is pinned against the zero nominal lower bound, the central bank should:

• Openly coordinate itself with the fiscal authority, accommodating increased fiscal expansion, for example printing money to finance an economy-wide tax cut.
  
  
• Openly encourage higher short- to intermediate-term inflation expectations, via an interregnum of price level targeting, rather than year-by-year inflation targeting, implying that below-target inflation sins are not forgiven, but recovered with above-target inflation rates, until the constantly-growing long-term price level path is restored.

Yes, those were the pillars of Mr. Bernanke’s academic thinking about liquidity trap macroeconomics, grounded in his own life-time study of the Great Depression, as well as the analytical work of his rock-star academic peers.

Mr. Bernanke is no longer an academic, of course, but the chairman of the most powerful central bank in the world, the custodian of the global reserve currency, operating independently within, but not of, the democratically-elected United States government.

From the Academy to the Arena

While Mr. Bernanke’s academic scribblings – that’s a compliment in the economist profession! – hugely inform his current policy-making framework and maneuvers, the fact is that he is working in the real world, where out-of-the-box thinking is welcomed only when in-the-box thinking is proven manifestly wrong or ineffective. His job is not easy. He is living and working in an arena where, in the words of Keynes, “worldly wisdom teaches it is better for reputation to fail conventionally, rather than to succeed unconventionally.”²

The fact that Mr. Bernanke is willing to take the heat – domestically and internationally, from friend and foe alike – to launch QE2 is testimony to the strength of his convictions as to the purpose of his office. The Federal Reserve was created in 1913 by Congress, which constitutionally has the power "to coin money, regulate the value thereof.”³

Since that time, and especially since 1951, when the Fed negotiated its operational independence from the Treasury, the Federal Reserve’s relationship with the rest of the United States government has evolved, with the Full Employment Act of 1978, commonly known as the Humphrey Hawkins Act, providing Congress’ present mandate to the Federal Reserve:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”⁴

Thus, while the Federal Reserve has independence in its day-to-day monetary tactics, known as operational independence, the Fed does not have independence in the setting of the goals toward which its tactics are directed. And this is the way it should be in a democracy. Congress is responsible to the American people, and the Federal Reserve is a creation of Congress.

To its credit, Congress recognizes that democracy is inherently given to wanting the fiscal authority to spend more than it taxes, running deficits: ice cream sells much better than castor oil in getting elected. And this is particularly the case when the entire House of Representatives must stand for election every two years.

Congress – and the Executive Branch, too – would, left to their own devices, inherently, and rationally, favor a monetary authority amendable to printing up money to cover the difference between its commitment to spend and its willingness to impose taxes to pay for that spending. Recognizing this inherent and structurally inflationary impulse, Congress wisely delegated operational independence to the Federal Reserve, effectively saying “stop ourselves from ourselves.” 

The Long, Victorious Campaign

For the twenty-five years following the 1978 passage of the Humphrey Hawkins Act, the division of labor between Congress (and the Executive Branch) and the Federal Reserve worked well, providing political cover for Chairman Volcker to turn the monetary screws tightly to reverse double digit inflation, and for Chairman Greenspan to continue Mr. Volcker’s fight against too-high inflation until that war was won decisively. And won it was, with the Federal Open Market Committee (FOMC) embracing de facto official victory on May 6, 2003, declaring (my emphasis, not the FOMC’s):

“Although the timing and extent of that (economic) improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.”⁵

To counter that probability of unwelcome disinflation, the FOMC took the Fed funds rate to 1% – not at, but very close, to the zero lower nominal bound – and in August of that year, broke with conventional monetary tactics and pre-committed to holding that 1% rate for a “considerable period.”⁶

That considerable period lasted until June 2004, at which point the FOMC, armed with evidence that self-sustaining, job-creating economic recovery was underway, in the context of inflation reversing marginally to the upside, embarked on what it pledged to be a “measured pace” of hiking its policy rate.⁷ And indeed it was measured, the beginning of a series of 25 basis-point hikes in the Fed funds rate at 17 consecutive FOMC meetings, ending at 5 ¼% for the Fed funds rate in June 2006.

A key reason – I would argue the key reason – that the FOMC was successful in aborting the risk of unwelcome disinflation in 2003–2004, while fostering a robust economic and job recovery in following years, was that the U.S. economy was not in a liquidity trap. Quite to the contrary, household sector demand for credit, notably credit collateralized by housing, was very elastic to friendly interest rates and even more elastic to the markets’ systemic degradation of underwriting standards for such credit. Nothing like low rates combined with the expansion of the availability of credit to those hitherto denied to foster a credit-fueled housing sector boom! It was the Forward Minsky Journey.⁸

And it was followed by the Minsky Moment and the Reverse Minsky Journey.⁹

The grand, multi-decade campaign against too-high inflation had been won, but in a major way, it was a pyrrhic victory.¹⁰ Price stability (mandate-consistent inflation) that promotes bubbles in asset prices and debt creation is a prescription for a debt-deflation bust and a subsequent liquidity trap, as Minsky had so presciently warned.

Living in a Liquidity Trap

And that’s where we are right now, as bluntly explained by (among others) Chicago Fed President Charles Evans just a few weeks ago:

“So we have all the ingredients for a liquidity trap: Businesses are cautious about new investment and households are too worried to meaningfully increase consumption. And interest rates can’t fall in the way needed to increase investment and consumption because short-term rates are already at zero: They’ve fallen as far as they can go. If this state of affairs continues, it could very well stifle any reasonably robust recovery. Unemployment would remain unacceptably high, and disinflationary pressures would be reinforced – clearly an undesirable outcome.

These rare occasions of liquidity traps are very different from typical economic recessions. Consequently, they require a unique monetary policy response. Economic theory tells us that in such circumstances monetary policy should aim to lower the real, or inflation-adjusted, rate of interest by temporarily allowing inflation to rise above its long-run path.

My preferred way of doing so is to implement an approach called price-level targeting. Simply stated, under this approach, the central bank strives to hit a particular price-level path within a reasonable period of time. For example, if the rate of change of the price-path is 2 percent and inflation has been under-running the path for some time, monetary policy would strive to 'catch-up' so that inflation would be higher than the inflation target for a time until the path was regained.

This higher inflation rate would decrease the real interest rate, raising the opportunity cost of holding money. This would provide an incentive for banks and corporations to release funds for investment, and in the process spur job creation.

In my opinion, such a strategy is entirely appropriate. The Fed has a mandate from Congress to encourage conditions that foster both price stability and maximum employment. Recently the Fed has missed on both dimensions of this dual mandate, with inflation running below the 2 percent level I associate with price stability, and with unemployment staying well above any reasonable estimate of the natural rate.

Practically speaking, price-level targeting in the current environment would call for a series of large-scale asset purchases to recover the shortfall in inflation. At the same time, we would continue to carry a large balance sheet in order to maintain low interest rates for an extended period. Most important, we would clearly communicate the path for prices that we expect to attain, in order to enhance the public’s understanding of the Fed’s intentions.”¹¹

Last week, the FOMC did not, of course, embrace President Evan’s advocacy of price-level targeting. Nonetheless, QE2 was launched, with planned purchases of some $75 billion per month of longer-term Treasuries through the middle of next year, subject to review along the way and presumably, continuation and expansion beyond, if needed.

It was a courageous decision, no doubt also contentious, which we will learn more about in two weeks time, when the minutes of last week’s FOMC meeting are released. It was a decision made in the context of a benefits-costs calculus, as foretold by Chairman Bernanke at Jackson Hole in late August.¹² By a 10–1 majority, the FOMC decided that the likely benefits outweighed the likely costs.

Within that majority, I have no doubt that there was a range of views as to the non-precise ratio between those likely benefits and costs. Indeed, I have serious gut pains when thinking about it, because I fervently believe, as Chairman Bernanke voiced back in 2002–2003, that quantitative easing coupled with pro-active fiscal expansion, alongside price level targeting, is the hat-trick with the most likely probability of success in breaking an economy out of a liquidity trap. But, while far from the best outcome given the paralysis of the fiscal agency, that does not mean that one-hat QE2 will be ineffectual.

Chairman Bernanke made this case well the day after the FOMC’s decision, writing that:

“The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”¹³

Bottom Line

Ever since, as noted at the outset, Chairman Bernanke has come under attack, particularly from international quarters, as one of the transmission mechanisms from QE2 (indeed, the anticipation of it) to “easier financial conditions” is a weaker foreign exchange value for the dollar. But this is not “strange,” Mr. Bernanke said over the weekend:

“There’s a sense out there that, quote, quantitative easing, or asset purchases, is something completely foreign, new; strange kind of thing, we have no idea what the hell is going to happen, and it’s an unanticipated and unpredictable policy. Quite the contrary: this is just monetary policy. Monetary policy involves the swapping of assets – essentially, the acquisition of Treasuries and swapping those for other kinds of assets. (It) will work, or not work, in much the same way that monetary policy – ordinary, more conventional, familiar monetary policy – will work. (There is) not as much discontinuity as people think.”¹⁴

Indeed, had the Fed not been pinned against the zero lower bound for the nominal Fed funds rate, and had been able to cut that rate, rather than launch QE2, it would have been most rational to expect the same flight to risk assets, alongside a weaker dollar and firmer commodity prices that has unfolded, since Ben spoke at Jackson Hole.

This is how monetary policy ease is transmitted, be it conventional or unconventional. Indeed, as I argued in August,¹⁵ unconventional has now become conventional. Nattering nabobs of negativism should accept that. To be sure, current monetary ease is likely to be much less effective in bolstering aggregate demand growth than historically, given liquidity trap conditions. But the transmission mechanism is the same, including a lower level for the foreign exchange value of the dollar.

The Fed makes policy consistent with its legislative mandate handed down by the democratically-elected government of the United States. And that’s what the Fed is pursuing: mandate-consistent levels for inflation and the unemployment rate. This is as it should be.

The rest of the world should simply accept this outcome as reality, and adjust – or not adjust – their own domestically-oriented objectives and policies accordingly.  Is there room for multi-lateral dialogue, perhaps even some degree of coordination, as various jurisdictions grapple with heterogeneous economic and financial exigencies? Absolutely. But that does not imply that the Fed should abdicate its responsibilities to pursue the mandate given to it by the American people. Pursuing that mandate is precisely what the Bernanke-led FOMC is doing.

Bravo, Ben: Illegitimi non carborundum.

Paul McCulley
Managing Director
November 9, 2010
mcculley@pimco.com

¹ What If? (Global Central Bank Focus, July 2009)
² The General Theory, Chapter 12, page 158.
³ http://www.constitution.org/constit_.htm#con1.8.5
⁴ http://www.federalreserve.gov/aboutthefed/section2a.htm
⁵ http://www.federalreserve.gov/boarddocs/press/monetary/2003/20030506/default.htm
⁶ http://www.federalreserve.gov/boarddocs/press/monetary/2003/20030812/default.htm
⁷ http://www.federalreserve.gov/boarddocs/press/monetary/2004/20040630/default.htm
⁸ The Plankton Theory Meets Minsky, (Global Central Bank Focus, March 2007)
⁹ Comments Before the Money Marketeers Club Minsky and Neutral: Forward and in Reverse, (Global Central Bank Focus, December 2007)
¹⁰ Pyrrhic Victory, (Global Central Bank Focus, September 2005)
¹¹ http://www.chicagofed.org/webpages/publications/speeches/2010/10_19_evanston_speech.cfm
12 http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm
¹³ http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html
¹⁴ Sewell Chan, "Bernake Attempts to Sooth Doubters," New York Times November 6, 2010,
 http://www.nytimes.com/2010/11/07/business/economy/07fed.html?_r=1&ref=alan_greenspan
¹⁵  When Unconventional Becomes Conventional, (Global Central Bank Focus, August 2010)