Wednesday, April 27, 2011

Can the Fed do more?

Bernanke unprecedentedly goes public today with a post FOMC meeting news conference!

The progressive pack wants to hold him accountable for not "doing more" to fight unemployment (here's David Leonhardt for example).

But, can Chairman Ben do more?

Well in one sense, yes, he could always announce another policy initiative. QE III anyone?

But the important question is can the Fed do anything right now to reduce unemployment faster?

I don't think so.

All the policies Leonhardt mentions require the Fed to make a credible current commitment to an unusual set of future actions (set interest rates at near zero for several more years, create higher than "normal" future inflation).

In other words, for these types of polices to work, the Fed has to change expectations about future Fed behavior.

People, there is a huge literature exactly about the fact that the Fed cannot credibly commit to some future optimal policy (the so called "time-inconsistency" literature).

Fed promises to do strange things in the future simply are not believable and are thus extremely unlikely to produce the desired private sector reaction.

To my knowledge, none of the proposals being floated for the Fed to do more avoids this basic issue, and thus, I do not believe the Fed can do anything at this point to make unemployment fall appreciably faster.

1 comment:

Charlie Deist said...

I generally agree with your tag "macro is harder than that," but I think you are mischaracterizing the literature. Svennson (2003), for example, offers a foolproof escape from the liquidity trap. Bernanke didn't seem to think it was all that hard until he was at the helm and had to deal with hawkish members of the FOMC plus a skeptical public.

I see the Fed's inability to commit to a long-run optimal policy as an institutional/political problem, not a mechanical one. There are plenty of simple ways to signal a commitment to higher future inflation, and I think the Fed overestimates the risks to its independence and credibility that these policies would entail.