What does successful monetary policy require?

Mark Thoma writes:

As for Tyler's (and others') call for monetary policy instead of fiscal policy, here's the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it's unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you'll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it's hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.

This makes perfect sense in terms of a model, but I don't see inflationary expectations as the relevant factors for the real world.  Let's say the government/central bank prints up rebate checks and mails them around.  People either spend those checks or they don't.  If the checks are spent, AD goes up and the policy more or less succeeds.

If people don't spend the checks, they are engaging in "balance sheet repair."  In absolute terms, things are going less well than in the previous scenario, but still they're going as well as possible, given the dour expectations.  Balance sheet repair probably is needed and it is preparation for a later expansion, once the repairs are finished.  The policy still is "as successful as a policy can be."  (The alternative of fiscal policy won't have much of a multiplier and the higher debt may cause some more balance sheet worry.)

Which scenario will come to pass?  I doubt if it has much to do with the expected rate of inflation, or changes in real interest rates, at least not within normal U.S. ranges for those variables.  It probably has more to do with overall sentiment, indebtedness, joblessness, and so on.  A non-credible Fed, when it comes to the rate of future price inflation, need not crush the possibility that the funds will be spent.  I don't trust the Fed, or the ECB for that matter, and last night we went out for dinner.

Keep also in mind that balance sheet repair does not require currency holdings.  (Keynes is clear on currency vs. savings, but I'm not sure the current debates always are.)  Saved funds go to the bank.  The bank may or may not make more loans, and spur more investment and durables purchases, but we're no longer in a position where financial intermediaries are "broken."  The additional lending, while it's hardly guaranteed, could indeed happen and that would occur at the same time as balance sheet repair.  What a nice outcome.  Again, it is not obvious to me that the expected rate of price inflation, or expected real intereest rates, are major factors in determining how well this goes; I would again look to the overall state of expectations, including how much uncertainty there is.  I'll blog a bit more soon on why real interest rates don't always matter so much.

Even if it does come down to credible expectations, perhaps people only need to believe that the Fed will continue expansionary policy if unemployment remains high.  If a recovery is booming, expectations can allow for the Fed to contract a bit, because the first-order influence of all those positive income effects is so high.  Let's say you thought the Fed would contract as we approached macro-near-Nirvana and that was coming in three years' time.  I still think you'd be willing to spend your rebate check today.

I'm all for credible central banks, I just don't think that is currently the missing ingredient.


Comments for this post are closed