AS THE headline promises, here are a few quick thoughts about monetary policy.
1) I mentioned yesterday that given the intensity of the political uproar over monetary policy of late, the Fed would likely be even more reluctant than normal to take action in the months leading up to the 2012 election. That means the Fed is quickly running out of opportunities to make big, near-term course corrections to policy. And that means thatthis, via Tim Duy, is disconcerting:
Nathan Sheets, who retired as director of the Federal Reserve‘s international affairs group this summer, said he believes the central bank will pause for a while after taking unconventional steps in August and September to bring down long-term interest rates as it assesses the impact of its actions.
“I wouldn’t expect at its November meeting the Fed is going to roll out some additional package,” he said in an interview.
The Fed isn't leaving itself much time to act.
2) The Fed isn't the only institution that can conduct "monetary policy". The Treasury can, too. Douglas Irwin recently published a paper showing that the Treasury's decision to sterilise gold inflows from 1936 to 1938 had a sharply contractionary effect on monetary policy, pulling the American economy into the "recession within a depression". James Hamilton notes that during QE2 the Treasury ramped up its issuance of long-term Treasuries, essentially cancelling out the impact of the Fed's purchases of same. Mr Hamilton goes on to note that during the original "Operation Twist", the Fed and the Treasury were cooperating. If Fed and Treasury policy continue to be at odds with each other, then new Fed purchases may be even less effective than the 1960s version.
3) Monetary policy works through a number of mechanisms. As the Fed has responded to the crisis, it has become clear that Ben Bernanke places a big emphasis on the impact of the Fed's market operations on interest rates and, through them, on the economy. Some monetary economists argue that this policy channel is less important and less powerful than the Fed's influence on expectation. When Fed purchases have a strong impact on the economy, for instance, that seems largely to be due to the signaling power those purchases have and the resulting shift in market expectations.
There is ample support for this line of thinking in the literature (consider thesetwo very recent papers, for instance). Just last month, monetary economist Michael Woodford argued forcefully in the Financial Times that the Fed was falling short of its policy goals by declining to communicate clearly where it wants the economy to go and what actions are likely to be taken when to get it there.
There are signs of an ongoing debate within the Federal Open Market Committee concerning how to deploy these tools. The change in the Fed's language in August hinting that it would likely not raise rates for the next two years represented a—short, halting—step toward greater deployment of the expectations channel. Two things seem clear to me, however. First, it makes little sense to argue that monetary policy is impotent when the Fed has scarcely touched its strongest weapon. And second, to the extent that the Fed's move this weak emphasised its focus on a portfolio-balance model of monetary policy rather than an expectations-based outlook, there's plenty there to account for market disappointment.
The Fed can and should do more, but it's far from clear that it will.