The Monkey Cage

Credible Commitments and the Federal Reserve

Political scientists, so far as I know, aren’t typically on the guest list for the Kansas City Fed’s economic symposium in Jackson Hole. (But honestly, who in their right mind would give up a trip to New Orleans in a hurricane for a weekend in the Grand Tetons?) Coverage of this year’s conference though reminds me that more attention could be paid to the political and institutional constraints under which the Fed makes monetary policy. I was struck in particular by coverage of a paper delivered in Jackson Hole by economist Michael Woodford. The paper assessed the effectiveness of alternative monetary policy choices for stimulating the economy, concluding that the Fed’s asset purchases and commitments to keeping inflation low through 2014 are largely ineffective (if not counter-productive in jump-starting and sustaining economic growth).

What struck me about Woodford’s paper was his call for the Fed to change the way it communicates about its future policies. The most recent statement from the Federal Open Market Committee (FOMC) states that the FOMC expects that economic conditions are “likely to warrant exceptionally low levels of the federal funds rate at least through late 2014.” Woodford and others criticize the Fed’s reliance on so-called “lift-off” dates for raising rates, arguing instead that when interest rates are already effectively zero, the Fed should commit to a particular policy path until after the economy has recovered. Many economists in this vein recommend that the Fed target nominal gross domestic product (NGDP), meaning that the Fed would keep rates low even after markets might otherwise expect the Fed to begin to tighten on the grounds of preventing inflation. Let the economy gather steam before raising rates, Woodford and many others argue, even if that entails allowing inflation to rise above the Fed’s self-imposed 2 percent target. A credible commitment to act differently in the future is said to be essential for jump-starting economic growth today.

Economists (and political scientists) have certainly written a great deal about the difficulty policy makers face in making credible commitments. In short, if policy makers have discretion to reneg on their commitments, no one will take their policy commitments seriously in the first place—undermining policy makers’ ability to create incentives for behaviors that they favor. But I’m struck that in all the recent discussion of the macroeconomic value of NGDP targeting (or other “results-based” monetary policy options) that the political and institutional feasibility of such action has been given short-shrift.

What constraints would the Fed face in credibly committing to something akin to NGDP targeting? Here is a partial list:

  1. Bernanke might not still be chairman of the Fed’s Board of Governors come February 2014. Would a different Obama-appointed or a Romney-appointed Fed chair feel pre-committed to continuing the previous chair’s policy? Woodford argues that the FOMC publicly stating a commitment would make it “embarrassing for policymakers to simply ignore the existence of the commitment when making decisions at a later time.” I’m somewhat skeptical that central bankers would feel constrained by a previous Fed’s policy commitment if (for example) they believed it was ineffective or otherwise undesirable going forward.
  2. Even if Obama is re-elected and Bernanke agrees to serve a third term, there is no guarantee that a Bernanke committed to NGDP targeting could secure confirmation again. Certainly a GOP-led Senate would have second thoughts about confirming a nominee committed to allow a little inflation to generate growth, and a Democratic-Senate might be unable to secure sixty votes on confirmation. At 70 votes for confirmation in 2010, Bernanke would not have a lot of votes to spare.
  3. The federal structure of the Fed all but guarantees a diversity of hawks and doves on its monetary policy committee. And given turnover in the presidencies of the Fed’s regional banks and the rotating scheme by which the bank presidents alternate as voting members of the FOMC, the continuity in membership necessary for sustaining a credible commitment to a certain policy course might well unravel—assuming it could be cobbled in the first place.
  4. More problematic, as many economists have noted, the Fed’s reputation today has been built on its success fighting inflation over the past thirty years. That same reputation makes it harder to credibly commit to allow inflation to rise above a level at which alarm bells would normally ring for the Fed to begin tightening. We might think of this as the Fed’s path-dependence problem: Past policies raise the cost of changing course in the future—making some policy alternatives far more costly and thus less likely than others. NGDP targeting- or other results- based targeting—seems likely to entail such reputational costs that the Fed might be unwilling to bear.
  5. Finally, the Fed is ultimately a creature of Congress. As such, the Fed would be unlikely to adopt a policy if it threatened to raise the wrath of one party’s congressional overseers. Even if many Democrats might welcome more aggressive stimulus from the Fed, a policy commitment to target economic growth would surely raise GOP hackles on the Hill—where Republicans have already voted for more invasive monetary policy audits and called for abolishing the Fed’s dual mandate. To be sure, partisan polarization might preclude legislative agreement to limit the Fed’s discretion. But polarized parties also make the Fed’s job harder, since critics outside the Fed help to amplify dissent within the FOMC.

Maybe NGDP targeting is going nowhere, and thus consideration of the Fed’s political or institutional capacity to embark down such a path is besides the point. But some Fed watchers detect movement in the FOMC towards tying monetary policy more closely to improvements in the economy, while others note that such policy prescriptions are now “very close to the center of the profession of monetary policy.” Whether the Fed will have the institutional and political capacity to embark convincingly down and stay on such a path remains an open question.