I’m Quantitatively Eased

No. Sorry. I’m not about to lambaste Ben Bernanke. A quite informative article in the April 2012 Atlantic, titled “The Villain,” persuades me that Bernanke is all right. But he is merely another mortal in a world of subprime collective intelligence. Collective intelligence, of course, is always subprime. The Fed Chair has been trying his damndest to try to help the economy with what little in the way of tooling is available to the monetary ruler of the land.

Quantitative easing? Apparently it’s an innovation we have from Japan. They coined the phrase in 2001 using the words “quantitative monetary easing.” Functionally it consists of central bank purchases of financial assets—such as bonds. The money for this purpose is in fact “printed,” thus created (in our case) by the Federal Reserve Bank. It is intended to bring down long term interest rates.

To understand why the traded value of bonds changes the value of the bond’s yield, we must understand that bonds have a face or par value (e.g. $1,000) but, when traded in the market, they may be bought for less or for more: their market value. Bonds, however, have a coupon rate, set on the face value, say 4 percent of par, thus $40 a year. But when a bond’s traded value rises, say to $1,500, the yield remains $40/year, but the interest rate has now dropped to 2.7 percent.

The motivation behind quantitative easing is to stimulate the market by lowering the cost of money—the presumption evidently being that people aren’t borrowing because interest rates are too high. If only interest rates were lower! But what if people aren’t borrowing for some other set of reasons? Suppose that they do not borrow because they have no confidence? Suppose they do not borrow to build new factories because they don’t believe they can sell the goods they would be making? What if interest rate is, uh, irrelevant for the moment.

That being the case, let’s just suppose, the Federal Reserve is, in fact, facing a hopeless situation. Its tools are inadequate to influence collective behavior. Interest rates have been creeping at rock bottom levels for a long time. Our bank now offers an interest rate on savings of—are you ready?—0.1 percent. Why? They don’t need money. Nobody is borrowing. But the Fed wishes to do good. The other part of government, meanwhile, which could stimulate the economy by actually buying things and services, is entirely mesmerized by trillion dollar deficits.

I look at that headline of mine up there. Am I really quantitatively eased? Maybe not.

Suddenly NGDP?

Economists who want to kick-start the economy want the Federal Reserve to do it. Why the Fed? Because our government, which controls the fiscal purse-strings, is hopelessly deadlocked. That only leaves monetary policy, the Fed’s area of action.

Pots are all a-boil, a-bubble on economics blogs. People want a relatively new idea implemented. It’s called NGDP targeting. The N here stands for nominal. Nominal Gross Domestic Product. That really means GDP as measured in ordinary, current dollars, dollars valued as we use them right here, right now. The conventional way to measure GDP is in real, meaning constant dollars—dollars with inflation removed. GDP data are collected in nominal dollars (of course), but expressed in constant dollars—so that any two periods may be compared. We want to know what really changed: how much has production of goods and services increased or decreased. Get rid pure price increases. The Consumer Price Index lets us do that.

Now why do the economists want NGDP targeting? Why not RGDP targeting? The answer is very simple. The Fed has absolutely no way of influencing real GDP. But it could influence NGDP. Let’s start with the reasons for that.

When we measure nominal GDP in two successive periods, the change we see is caused by two components hidden, as it were, inside that nominal dollar. Part of the change is actual growth in products and services delivered. The other part is due to increase in prices, inflation. Thus—

NGDP = Growth + Inflation.
RGDP = Growth - Inflation.

Suppose that nominal GDP grew by 5.5 percent, but the inflation was 1.12 percent. Then growth was responsible for 4.38 and inflation for 1.12 percent. Real GDP growth would therefore be 4.38 percent in the period.

Let’s look next at how the Fed comes into this. Their role emerges when we note that Inflation itself has two parts—although CPI only measures both together, indistinguishably mixed. One part is due to increase in prices, the other is due to increase in the money supply. And the Federal Reserve controls this second part. Let’s see that equation again:

NGDP = Growth + (price inflation + increase in money supply)

When we see it this way, we start to understand the NGDP targeting advocacy. The Fed can cause the money supply to grow or to shrink. And when it does this, it can influence the NGDP. The Fed’s long standing policy is to control the aggregate, inflation. It does so by causing the part that it controls to change. The Fed targets inflation as a whole. It tries to keep that measure within bounds—without causing a recession.

The Fed has three ways of influencing the money supply. One of these, and the most important, is (1) the Federal Funds Rate, thus interest charged on banks’ borrowing of federal funds; low rates cause more borrowing—therefore money supply grows. The others are (2) lowering or increasing bank reserve requirements; lowering these increases, raising these decreases money supply; with low reserve requirements, banks have more cash on hand; and (3) buying or selling Treasury bills from banks or securities dealers; buying these puts cash into the economy; selling these draws cash away.

How would NDP targeting work? Instead of targeting the inflation rate, the Fed would announce an NGDP growth rate as its target. To hit that target, it would take (or forgo) monetary actions. With the growth rate target widely known, bankers, investors, indeed the whole economy, would know in advance what the Fed would do. This is known as “expectations,” and the more accurate these are, the more rational is economic behavior (thus our economists).

To use the example above, suppose the Fed had set a goal of a 6 percent NGDP growth but the actual NGDP grew 5.5 percent (as above). With targeting in place, and publicly known, the Fed would now attempt to increase inflation by 0.5 percent, from 1.12 to 1.62 percent by one or a combination of the above-described monetary activities. The real growth (4.38 percent) plus the new inflation rate (1.62 percent), would soon deliver the targeted 6 percent NGDP growth.

Similarly, if inflation suddenly increased, say because oil prices spiked up, the Fed would not immediately take steps to counter this increase—the tendency when inflation is the target. The Fed would know that these high prices will also dampen physical growth. It might therefore leave the inflation take its course—or only mildly counter it.

Advocates of NGDP targeting foresee major benefits from this more sophisticated approach. My feeling is that they want inflation increased now somehow. NGDP targeting is one way to do it. And this because they don’t see the Administration succeeding in passing fiscal stimulus bills.