The Fed Should Write Debt Off
A bold workaround for discretionary monetary policyDiscretion is human -- and while a case can be made for discretion in some limited circumstances, such as in responding to tremors in financial markets before they appear in inflation or real output numbers, discretion unambiguously weakens monetary policy during deep recessions.
This failure comes from the fact that discretionary monetary policies have less credibility than policy rules. They create, in other words, weaker market expectations, because the policy can change, or the "goalposts" can shift or be fudged, and the central bank is not as clearly accountable for not doing what it said it would.
The problem this poses for discretionary monetary policies in recession is that ad-hoc commitments to continued future accommodation are less credible than they could be -- markets know that such a commitment would require the central bank to tolerate more inflation than it normally likes, and so they doubt. The central bank's "inflation hawk" credibility in good times now works against it, as it cannot “credibly commit to being irresponsible” due to what economist Gauti Eggertson's "deflation bias."
The credible-commitment problem manifests itself in the graph above. The Federal Reserve has dramatically expanded the U.S. monetary base since 2007. And yet measures of the money supply have not increased by anywhere close to as much. Nor have prices. Why? To put aside the roles of the velocity of money and the supply curve for this exercise -- they aren't relevant right now -- it's because nobody in their right mind expects the Fed to accept a three-fold increase in prices when the economy improves. Nobody expects the monetary base to remain at this swelled state forever. As a result, the Fed loses control over the money supply and prices -- in the sense that they cannot increase reserves in a way that makes either increase -- in what economists call a "liquidity trap," and discretionary monetary policy falls flat on its face, totally ineffective.
While I have made calls since I started this blog for a shift to NGDP targeting of some form, one of the concerns I have lingering in the back of my mind relates to the strength of expectations under economic trauma like supply shocks and deep recessions. Scott Sumner has long encouraged the Fed to "target the forecast," and manage market expectations directly, but I still see the possibility that under extreme circumstances, expectations could go unhinged in the short run. In other words, it could be immensely practical for the central bank to have a "shock-and-awe" monetary policy tool with which it convinces markets that "it's really serious" and reaffirms its long-term commitment to a monetary policy rule when short-term tools are inadequate protection for the rule's credibility.
At this point I wander off the reservation.
I think that expansions of the balance sheet give the Fed a new tool it hasn't considered yet: writing off a portion of its Treasury debt holdings permanently. (After I came up with it, I found a Dean Baker piece discussing it here, but that's it.)
It's accumulated so much of this debt -- 11 percent of all outstanding Treasury debt -- as it expanded bank reserves during the financial crisis and quantitative easing programs -- and these have been promptly not lent out, have remained as excess reserves, and have done nothing. At the same time, the value of these Treasury debt has been increasing. (Remember: bond prices have an inverse relationship with their interest rates, which have been falling towards zero.) As a result, the Fed has been returning profits hand over fist to the Treasury -- $77 billion in 2011, $79.3 billion in 2010.
I would propose that instead of returning these funds, it simply cancel out its profits by writing down the value of its Treasury holdings by that much, that it write off some fraction of that amount, or that it threaten to do such a thing. It would accomplish a number of objectives:
(1) It would resolve the credibility problem of a central bank which uses discretionary monetary policy. Why? Because this would be a permanent expansion of the monetary base, and I think it would then translate into a more immediate increase in the money supply. I think this would work well to approximate a Woodford-like price-level target, since we could reasonably estimate the increase in money supply and prices from the change in the monetary base if there were no excess reserves.
(2) It would depress interest rates, perhaps far more than we've seen so far. By making a fraction of all Treasury debt outstanding vanish, the supply of such debt falls, and so its price rises, and the interest rate falls. I wonder to what extent interest rates remain higher than they otherwise might, in fact, because the market is expecting the Fed to "return" by selling a substantial amount of their Treasury holdings. If they didn't, might there be panic-buying of debt, and shifting into longer-term debt, corporate debt, or equities, which is exactly the sort of thing we need to see to stimulate investment?
(3) Of course, it eliminates some of the national debt. This is not a bad idea, for the long run.
(4) If things really get out of hand -- I'd recommend using the write-offs in small doses, with threats for much larger amounts, to avoid the uncertainty of this new approach -- I think the Fed has a few last-resort options. In other words, this is "almost permanent." A few options: reverse repos, term deposit agreements, reserve requirement hikes. But I think this raises the bar to action, and therefore it makes the Fed's decision more credible.
Update (4/29/12): The blog "Bond Vigilantes" suggests a similar program for the Bank of England.