Credible commitments and the Federal Reserve

Political scientists, so far as I know, aren’t typically on the guest list for the Kansas City Fed’s economic symposium in Jackson Hole.   (But honestly, who in their right mind would give up a trip to New Orleans in a hurricane for a weekend in the Grand Tetons?)   Coverage of this year’s conference though reminds me that more attention could be paid to the political and institutional constraints under which the Fed makes monetary policy.   I was struck in particular by coverage of a paper delivered in Jackson Hole by economist Michael Woodford.  The paper assessed the effectiveness of alternative monetary policy choices for stimulating the economy, concluding that the Fed’s asset purchases and commitments to keeping inflation low through 2014 are largely ineffective (if not counter-productive in jump-starting and sustaining economic growth).

What struck me about Woodford’s paper was his call for the Fed to change the way it communicates about its future policies.  The most recent statement from the Federal Open Market Committee (FOMC) states that the FOMC expects that economic conditions are “likely to warrant exceptionally low levels of the federal funds rate at least through late 2014.”  Woodford and others criticize the Fed’s reliance on so-called “lift-off” dates for raising rates, arguing instead that when interest rates are already effectively zero, the Fed should commit to a particular policy path until after the economy has recovered.  Many economists in this vein recommend that the Fed target nominal gross domestic product (NGDP), meaning that the Fed would keep rates low even after markets might otherwise expect the Fed to begin to tighten on the grounds of preventing inflation.  Let the economy gather steam before raising rates, Woodford and many others argue, even if that entails allowing inflation to rise above the Fed’s self-imposed 2 percent target.  A credible commitment to act differently in the future is said to be essential for jump-starting economic growth today.

Economists (and political scientists) have certainly written a great deal about the difficulty policy makers face in making credible commitments.  In short, if policy makers have discretion to reneg on their commitments, no one will take their policy commitments seriously in the first place—undermining policy makers’ ability to create incentives for behaviors that they favor.  But I’m struck that in all the recent discussion of the macroeconomic value of NGDP targeting (or other “results-based” monetary policy options) that the political and institutional feasibility of such action has been given short-shrift.

What constraints would the Fed face in credibly committing to something akin to NGDP targeting?  Here is a partial list:

1. Bernanke might not still be chairman of the Fed’s Board of Governors come February 2014.  Would a different Obama-appointed or a Romney-appointed Fed chair feel pre-committed to continuing the previous chair’s policy?  Woodford argues that  the FOMC publicly stating a commitment would make it “embarrassing for policymakers to simply ignore the existence of the commitment when making decisions at a later time.”   I’m somewhat skeptical that central bankers would feel constrained by a previous Fed’s policy commitment if (for example) they believed it was ineffective or otherwise undesirable going forward.

2.  Even if Obama is re-elected and Bernanke agrees to serve a third term, there is no guarantee that a Bernanke committed to NGDP targeting could secure confirmation again.  Certainly a GOP-led Senate would have second thoughts about confirming a nominee committed to allow a little inflation to generate growth, and a Democratic-Senate might be unable to secure sixty votes on confirmation.  At 70 votes for confirmation in 2010, Bernanke would not have a lot of votes to spare.

3. The federal structure of the Fed all but guarantees a diversity of hawks and doves on its monetary policy committee.   And given turnover in the presidencies of the Fed’s regional banks and the rotating scheme by which the bank presidents alternate as voting members of the FOMC, the continuity in membership necessary for sustaining a credible commitment to a certain policy course might well unravel—assuming it could be cobbled in the first place.

4.  More problematic, as many economists have noted, the Fed’s reputation today has been built on its success fighting inflation over the past thirty years.   That same reputation makes it harder to credibly commit to allow inflation to rise above a level at which alarm bells would normally ring for the Fed to begin tightening.  We might think of this as the Fed’s path-dependence problem: Past policies raise the cost of changing course in the future—making some policy alternatives far more costly and thus less likely than others.  NGDP targeting- or other results- based targeting—seems likely to entail such reputational costs that the Fed might be unwilling to bear.

5.  Finally, the Fed is ultimately a creature of Congress.  As such, the Fed would be unlikely to adopt a policy if it threatened to raise the wrath of one party’s congressional overseers.  Even if many Democrats might welcome more aggressive stimulus from the Fed, a policy commitment to target economic growth would surely raise GOP hackles on the Hill—where Republicans have already voted for more invasive monetary policy audits and called for abolishing the Fed’s dual mandate.  To be sure, partisan polarization might preclude legislative agreement to limit the Fed’s discretion.  But polarized parties also make the Fed’s job harder, since critics outside the Fed help to amplify dissent within the FOMC.

Maybe NGDP targeting is going nowhere, and thus consideration of the Fed’s political or institutional capacity to embark down such a path is besides the point.  But some Fed watchers detect movement in the FOMC towards tying monetary policy more closely to improvements in the economy, while others note that such policy prescriptions are now “very close to the center of the profession of monetary policy.”  Whether the Fed will have the institutional and political capacity to embark convincingly down and stay on such a path remains an open question.


9 Responses to Credible commitments and the Federal Reserve

  1. PBR September 4, 2012 at 12:00 pm #

    Great insight. Thanks for posting.

  2. andrew long September 4, 2012 at 12:31 pm #

    I’ve mentioned this elsewhere, on Yglesias and DeLong posts, but never got a real answer.
    If the Fed is forever committed to 2-%/year inflation, does that mean that we will never again be able to bounce back quickly from a bad recession? A quick recovery requires robust GDP growth over at least a few quarters, doesn’t it? And robust GDP growth is very often associated with increased inflation, no?
    Is this pathological commitment to low inflation one of the factors in the sharp change in recovery trajectories starting with the 1990 recession? Jobless recoveries have become our norm, and I wonder if it’s more than a coincidence that the first jobless recovery occurred just three years into the tenure of Alan Greenspan.

    • Sarah September 4, 2012 at 2:34 pm #

      Andrew– Alas, I’m a political scientist, not an economist. And so can’t give you a satisfying answer to your questions. There’s a large literature on the potential causes of recent jobless recoveries– including increased productivity, structural changes in labor markets, policy uncertainty, deleveraging by households (forestalling demand), and other explanations. (See for example Bernanke’s 2003 speech on the causes of jobless recoveries, for starters.) Certainly macroeconomists have noted that jobless recoveries coincided with the onset of Greenspan’s Great Moderation, but my layman’s [so to say] skim of the literature suggests that there’s relatively little work that explores a direct causal link between the two. That is, did the post 1970s decline in economic volatility directly shape the nature of recoveries that followed? And if so, through what mechanism? Sorry to leave you with more questions than answers!

      • andrew long September 4, 2012 at 3:49 pm #

        yes, of course. thanks for the detailed reply!

  3. Peter Palms September 4, 2012 at 5:31 pm #

    The Exclusive legal right to counterfeiting money (fiat currency with nothing behind it) was given to a private Cartel of banks in 1913. I The Federal reserve is neither an arm of the government nor is it private. It is a hybrid. It is an association of the large commercial banks which has been granted special privileges by Congress A more accurate description would be simply that it is a Cartel protected by federal law It originally was a hundred year charter but in 1930 during the great depression caused by them, they had the law amended to “in perpetuity” Because all fiat currency in history has always collapsed. . The money supply will continue to expand, inflation will continue to roar, and the nation would continue to die. Issuing money without gold or silver backing violates the constitution. They are not subject to the law. It should be abolished. They are not independent of the government. they have taken over the government.
    • It is incapable of accomplishing its stated objectives.
    • It is a cartel operating against the public interest.
    • It is the supreme instrument of usury.
    • It generates our most unfair tax.
    • It encourages war.
    • It destabilizes the economy.
    • It is an instrument of totalitarianism.
    It is is not abolished the fifth collapse of the four previous Central banks of the United is imminent and inevitable. A book of facts has been published of 600 pages

    Long term price stability is possible only when the money supply is based upon the gold (or silver) supply without government interference.

    For a nation to enjoy economic prosperity and political tranquility, the monetary power of its politicians must be limited solely to maintenance of honest weight and measures of precious metals.

    A nation that resorts to use of fiat money has doomed itself to economic hardship and political disunity.

    Fraction money will always degenerate into fiat money. It is but fiat money in transition

    When men are entrusted with the power to control the money supply, they will eventually use that power to confiscate the wealth of their neighbors

  4. Lorenzo from Oz September 6, 2012 at 6:02 am #

    Australia has not had a recession for 21 years. The Reserve Bank of Australia has an explicit target agreed between the RBA Governor (the equivalent of Fed Chair) and the Treasurer (equivalent of Treasury Secretary) of 2-3% inflation on average over the course of the business cycle. This allows spending to get up some steam before the RBA puts on the breaks and it also means that RBA interest rate shifts send signals on both prices and output.

    The longer the framework works, the more credible it becomes. Shifting to an NGDP target is no different that shifting to an inflation target, which was managed by many central banks, including the Fed.

    • Sarah September 6, 2012 at 3:32 pm #

      Point well taken. Keep in mind though that the Fed’s inflation target (2%) falls below the Australians’ target. And, although Chairman Bernanke has called the target a “symmetric objective,” many argue that the Fed has been treating 2% as a ceiling. In other words, many argue that the Fed seems unwilling to allow inflation to rise sufficiently to get NGDP back on track.

      Not surprisingly, this was essentially the concern of congressional Democrats some years back when the Fed started to discuss adoption of an inflation target. Democrats asked: “Would targeting inflation undermine the Fed’s dual mandate to maximize employment?” That question again seems relevant today.

      • Lorenzo from Oz September 7, 2012 at 3:06 am #

        The answer to the Democrats’ question is clearly “yes” precisely because, as you intimate, the Fed treats 2% as a ceiling.

        But thinking about the performance of the Fed, the ECB, the BoE and the BoJ is just so depressing. Particularly when there is a working model available in what the RBA does.

  5. Bobby (3rd Century Prophet) September 13, 2012 at 10:28 am #

    Money (ie “gold” .. “BOOTY”) is what women wear when they ovulate.

    Women started the business of prostitution to curb violence. Sadly, the Federal Reserve has raided Women’s Rights to be Self-Employed (Prostitute, Mom, HomeWorker).

    Bureacracy has added paper-work, chain-of-command, and compartmentalisation to a woman’s right to be self-employed. And the prostitute on gets a 10% of the profits. The remaining 90% go to the Federal Reserve, War Raqueteering, and Poice State Propaganda.

    End the Fed. Start Human Evolution
    Women and Men have gotten along -BEFORE!- the Banks killed Freedom.

    Judas is the keeper of Jesus’ Treasury and Judas stole from it constantly (history repeats itself)

    “Everything is good and neat -whenever bobby speaks” -Namste