Daily commentary: On monetary policy in a balance sheet recession

By Edward Harrison On May 9, 2012

There has been a lot of back and forth by academic economists on monetary policy. The reason is two-fold. First, during the so-called Great Moderation many economists increasingly looked to monetary over fiscal policy for countercyclical support. Second, even so, fiscal support is expected to wane, making some nervous about the durability of recovery.

I agree that the recovery’s durability should be questioned and the ECRI chart on real personal income is a major reason why. Meanwhile, as one would expect when income growth is weak, during this cyclical upturn, growth has waned in the second half of both 2010 and 2011. Quantitative easing and permanent zero came to the economy’s rescue each time by propping up asset prices and shifting sentiment to risk-on.

Those that want to keep the economy going via stimulus are asking for more, perhaps by raising the inflation target or targeting a higher rate of nominal GDP that comes via either inflation or real growth. Raghuram Rajan is telling these economists that the Fed has already one plenty. He says:

First, it is not at all clear that traditional savers today will go out and spend. Moreover, low interest rates could push that saver or her pension fund to buy risky long-maturity bonds. Such a move might thus set her up for a fall when interest rates eventually rise. Indeed, we may well be in the process of adding a pension crisis to the unemployment problem.
Second, household over-indebtedness in the US, as well as the fall in demand, is localized. Real interest rates are too blunt a stimulus tool, even if they work.
Third, we have little idea about how the public forms expectations about the central bank’s future actions. If the Fed announces that it will tolerate 4% inflation, could the public think that the Fed is bluffing, or that, if an implicit inflation target can be broken once, it can be broken again?
Fourth, it is not even clear that the zero lower bound is primarily responsible for high US unemployment.

His conclusion: With a savings rate of barely 4% of GDP, the average US household is unlikely to be over-saving. Sensible policy lies in improving the capabilities of the workforce across the country, so that they can get sustainable jobs with steady incomes. That takes time, but it might be the best option left.

Rajan got it right on the bubble and the crisis. Is he right now as well?

That’s it. Here are the links.