Farmer Bernanke, dry fields, and other monetary policy metaphors
By Neil Irwin
In a segment on the Rachel Maddow Show Monday night, guest host Christopher Hayes attacked the Federal Reserve for not taking more aggressive steps to support the economy--and developed an elegant metaphor for monetary policy in the process.
If the nation were a farm, Hayes argued, the Fed would be the agency in charge of water and irrigation. Its job is to keep water (money) flowing enough to maximize crops (strong job creation), but not pump in so much water as to cause flooding (inflation). We're currently in an extreme drought (a deep recession), but the Fed is refusing to pump in more water because it's afraid that doing so will cause flooding down the road.
I think it's a useful and apt way of thinking about things up to that point, but I do think that in the segment Hayes could have expanded the metaphor further to more fairly reflect the predicament the Fed is currently in. So here's my effort to do that.
This drought is so bad that the Fed has already drained its main reservoir completely (cut the federal funds rate to zero). So if it's going to take new efforts to water the fields, it has to find more water through some unconventional means, such as by airlifting water in by helicopter, or piping it in from a nearby lake. (These are the equivalents of quantitative easing, or buying Treasury bonds and other securities to increase the money supply and drive down long-term interest rates).
The problem is, while the Fed has lots of experience and knowledge about how the controls on its normal reservoir work, and how much to open the valves to get the right amount of water onto the fields, these other tools are untested. If they pipe water in, they're not sure how much will get to the fields--it might be too little to do much good, and it might be so much as to cause flooding.
They're not sure about the impact of helicopter airlifts either; they might be effective at getting more water onto the fields, but there's a small chance they'll crash and burn and thereby set the fields on fire. (That's what would happen if quantitative easing by the Fed caused global investors to believe they would continue printing money to fund budget deficits indefinitely, which could cause a big rise in inflation expectations and a long-term loss of confidence in the U.S. economy).
Meanwhile, while the fields are still awfully dry, there has been a little bit of rain in the last few months (the economic recovery is underway, though it is sluggish). And Fed leaders' weather forecasting suggests that rain levels will continue to gradually return toward normal (their economic forecast is for continued expansion), which would render airlifts of water unnecessary.
Hayes and others who advocate for more aggressive Fed action rarely acknowledge some of these complications, but they're very real. Still, plenty of smart economists of varying ideological predispositions (liberal Paul Krugman, technocratic Joe Gagnon, and conservative John Makin are a few) argue that the dismal employment situation, slowing recovery, and risk of a deflationary spiral justify taking acting despite the uncertainty and risks involved in unconventional policy action.
If they're right, and the economic outlook continues to deteriorate, it will be a long, dry year.
August 17, 2010; 4:14 PM ET
Categories: Federal Reserve
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