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Theories of Fed Misbehavior

July 2, 2012

Right now, it looks like the Fed intends to maintain memory-less 4-5% NGDP growth. They have successfully stabilized NGDP growth, but made no attempt to “catch growth up” to the previous trend line. To me, it looks like the Fed is targeting NGDP, but is rate targeting instead of level targeting.

Level vs. Rate Targeting

Source.

Actual Policy – Looks like the dotted line to me

Out of Ammo/Ineffective
Most economists think the Fed is either “out of ammo” or at least has done pretty much all it can do. The Fed has done a fair bit already, at least if you look at the world through interest rate eyeglasses. They have added reserves and reduced the interest rates to historic lows. However, there are still government bonds out there to buy. They could do more, like stop the interest on reserves policy, or announce an explicit target.

Sumner Theory
The Sumner theory is that the Fed can control the nominal economy, and so any failure to maintain demand must be laid at their feet. In 2009-2010, this was a hard sell, but in 2012, it’s not so much anymore. We’ve seen two years of consistent NGDP growth right along the previous trend rate, except with no attempt to return to the previous level. This is perhaps the most likely reason. I think that the FOMC probably has theoretic objections to returning to the previous trend line. Perhaps they think the requisite inflation would be too damaging, or that now prices are well on their way to being fully adjusted so there is no further justification for more NGDP growth.

My Conspiracy Theory
I have a conspiracy theory that I don’t actually believe is true, but I think is fun to think about:

The FOMC is a bunch of conservatives who have an interest in thwarting policies they don’t like. Towards that end, they put the economy into a tailspin after the banking bailouts and stimulus plan to show that those policies were ineffective, knowing that only a handful of economists were smart enough to catch them (certainly not Obama, or Congress). When the Stimulus package was being discussed in Congress, they instituted the IOR policy to sterilize the increased aggregate demand. The policy had to be strong enough that anyone observing the fiscal stimulus without looking at monetary policy would conclude that fiscal stimulus hurts the economy. After all the stimulus nonsense was concluded, the Fed allowed the economy to resume growth at the previous rate, but without any return to trend lest fiscal stimulus advocates claim that “it just took some time to take effect”. Now that Obama is facing reelection, the Fed has decided to reduce AD before the election to reduce Obama’s chances. The reason why inflation expectations are dropping is because markets expect Bernanke to try to sabotage Obama in November.

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