Time For The Fed To Act?

Andrew Sullivan —  Sep 12 2012 @ 10:14am

As we wait to hear whether Bernanke and the Fed will undetake another round of quantitative easing (known as QE3) in the next couple of days, it's worth reviewing economist Michael Woodford's recent paper (pdf) on nominal GDP (NGDP). Dylan Matthews provides background on the paper:

Woodford’s paper is an extended argument for the Federal Reserve to stop targeting a certain level of inflation (about 2 percent annually) and to start targeting a certain level of nominal (that is, not adjusted for inflation) gross domestic product. Woodford is hardly the first person to endorse this idea, commonly known by the not-particularly catchy name of“NGDP level targeting”. Bentley University’s Scott Sumner popularized the idea first on his blog, The Money Illusion, and then in a long essay in National Affairs. It has since been endorsed by Christina Romer, who was President Obama’s head economist earlier in his term, Paul Krugman and the economic team at Goldman Sachs.

The idea is that NGDP encompasses both the rate of inflation and the rate of real economic growth. So, if either inflation grows too large or economic growth is too slow, NGDP targeting would recommend action to correct that. By contrast, inflation targeting such as that engaged in by the Federal Reserve in recent years does not react as aggressively to recessions.

Joe Weisenthal uses an analogy to explain NGDP targeting:

Bernanke is driving a race car across the country from New York to Los Angeles. He already has the accelerator all on the floor, so he can't pump faster. To convince everyone that he'll get to his end goal even faster, he disables the brake pedal, so that he can't slow down in the future, even if he wants to.

Wonkblog rounds up a range of views on whether the Fed will pull the trigger on QE3. Wiesenthal thinks the Fed won't. Bill McBride not only differs, but explores why this round of asset purchases "might be more effective than most people expect":

[O]n effectiveness, one of the key transmission channels for monetary policy is through residential investment and mortgages. The previous rounds of QE (and "twist") have lowered mortgage rates and allowed homeowners with excellent credit and income to refinance. However this channel has been limited as Bernanke noted in his Jackson Hole speech. … As residential investment recovers, and house prices increase (or at least stabilize), this channel will probably become more effective. Last month I summarized some of The economic impact of a slight increase in house prices. This includes mortgage lenders and appraisers becoming more confident in the mortgage and housing markets. I think that is starting to happen, and I think QE might have more traction now through the housing channel.

Meanwhile, Yglesias argues Bernanke won't act because of vanity:

If he says "hey, Michael Woodford and Christina Romer and Charles Evans and Jan Hatzius are right, let's start pairing these asset purchases with an explicit nominal GDP level target" and the economy starts rapidly improving, that will show what a disaster his tenure in office has been. So it won't happen.