The Impotence of Monetary Policy

Bernanke's Jackson Hole speech was meant to give some insight into what the Fed might do in coming months. I think it reveals how powerless the Fed is in general, and how little it understands the economy it is meant to oversee.

The prospects for household spending depend to a significant extent on how the jobs situation evolves. But the pace of spending will also depend on the progress that households make in repairing their financial positions... But on the other hand, the upward revision to the saving rate also implies greater progress in the repair of household balance sheets. Stronger balance sheets should in turn allow households to increase their spending more rapidly as credit conditions ease and the overall economy improves.

Agreed. But then here are the policy options he puts forth.

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities

How does changing the term structure of Fed assets help households repair their balance sheet?

A second policy option for the FOMC would be to ease financial conditions through its communication, for example, by modifying its post-meeting statement.

How does the Fed saying different words help households repair their balance sheet?

A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System

How does lower IOER (already just 0.25%) help households repair their balance sheet? Actually, this seems to make things worse, whereas the others have simply been irrelevant.

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability.

And what mechanisms does the Fed have in place to help it achieve its "medium-term inflation goal" regardless of where that goal is set?

What's happening is that, in a time of over-indebted households and weak aggregate demand, workers are simply losing their jobs and remaining unemployed. While unemployed, they draw Government benefits, and thus maintain some baseline level of consumption, avoiding 1930s style debt deflation. At the same time, this large pool of unemployed workers mean businesses can keep wages down, sell into what Government supported aggregate demand is there, and pocket the rest as profits.

The big lever here is fiscal policy -- announce a payroll tax holiday, and let households actually repair their balance sheets.

UPDATE: In the meantime, low interest rates take income out of the economy. Their net effect is very unclear.

Do Bush's tax cuts help restaurants?

Recently, I wondered where the marginal unit of aggregate demand comes from to guess at what impact raising taxes on the rich might have. In comments, JKH wondered how much marginal AD came from luxury items such as yachts etc.

The top 3% by income in the US make approximately $200,000 to $249,999. Not bad, but not investment banker money either. Two college educated professionals with technical degrees in mid-career, or a single lawyer fairly senior in his firm, or specialist MD, could make that by themselves. The question them becomes, how much does this group eat out at mid-end restaurants?

Bush's tax cuts

One general question about tax cuts is, where does the marginal unit of aggregate demand come from? One argument says that you give it to the poor, as they spend most of their income. Another argument says that you give it to the rich, as they have more discretionary spending, and so control marginal aggregate demand.

Here's some thinking on that topic from Mark Zandi.

In most times, raising taxes on the wealthy by such a modest amount has had little impact on the economy. But these aren’t most times. The well-to-do appear unusually sensitive to changes in their finances, probably because their nest eggs are significantly smaller with the drop in stock and housing prices. Only the top 3 percent of households would have to pay higher taxes if the president got his way, but this rarefied group currently accounts for a fourth of consumer spending. If they pull back, even a bit, the recovery could be derailed.

Consumer spending makes up about 70% of the economy, so that 3% of households generate about 20% of total AD.

The impotence of monetary policy

This post by Krugman sums it up. It's a pity things are even worse than he suspects:

A problem with the current BOJ policy, however, is its vagueness. What precisely is meant by the phrase “until deflationary concerns
subside”? Krugman (1999) and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation.

…

BOJ officials have strongly resisted the suggestion of installing an explicit inflation target. Their often-stated concern is that announcing a target that they are not sure they know how to achieve will endanger the Bank’s credibility; and they have expressed
skepticism that simple announcements can have any effects on expectations.

OK, so say the BOJ or Fed announce a higher inflation target. Now what? Inflation means higher price levels, and for a price, you need a transaction. Announcing a target does not create a transaction, and therefore, does not influence a price. The BOJ's concerns that their credibility is on the line are right on -- the standard monetary mechanism (overnight interbank interest rates) has no impact on prices.

Unconventional monetary mechanisms, like changing other rates, have no impacts for the same reason. The only thing that has impact are transactions, a transfer of nominal assets from the Govt to the non-Govt sector. And this is fiscal policy, not monetary policy.

RIP: Google Wave

Last year, I remarked that Google Wave reminded me of Lotus Notes. Ouch.

This year, thankfully, it's been killed.

The article lists the usual excuses engineers give to a product they built that fails: "lack of a decent marketing campaign", "ahead of its time", etc. etc. I think the main issue was that it didn't solve a real human problem.

Capital Constraints at the Margin

Macroeconomic Resiliance thinks that new firm entry means that banking, at the sector level, is not capital constrained.

A popular line of argument blames the lack of bank lending despite the Fed’s extended ZIRP policy on the impaired capital position of the banking sector. For example, one of the central tenets of MMT is the thesis that “banks are capital constrained, not reserve constrained”. Understandably, commentators extrapolate from the importance of bank capital to argue that banks must be somehow recapitalised if the lending channel is to function properly as Michael Pettis does here.

The capital constraint that is an obvious empirical reality for individual banks’ does not imply that bank bailouts are the only way to prevent a collapse of the monetary transmission channel. Although individual banks are capital constrained, the argument that an impairment in capital will induce the bank to turn away profitable lending opportunities assumes that the bank is unable to attract a fresh injection of capital. Again, this is not far from the truth: As I have explained many times on this blog, banks are motivated to minimise capital and given the “liquidity” support extended to them by the central bank during the crisis, they are incentivised to turn away offers for recapitalisation and instead slowly recapitalise by borrowing from the central bank and lending out to low-risk ventures such as T-Bonds or AAA Bonds.

So the bank capital “limitation” that faces individual banks is real, in no small part due to the incestuous nature of their relationship with the central bank. But does this imply that the banking sector as a whole is capital constrained? The financial intermediation channel as a whole is capital constrained only if there is no entry of new firms into the banking sector despite the presence of profitable lending opportunities. Again this is empirically true but I would argue that changing this empirical reality is critical if we want to achieve a resilient financial system.

I would disagree. A bank knows what its cost of capital is. A bank should be able to estimate what the profitability of a new loan should be. Therefore, practically speaking, the constraint is whether the marginal profitability of the loan more than compensates for the marginal cost of capital that needs to be set aside in order to make that loan. So a bank many have plenty of capital but still not make loans if it feels they will not be profitable.