There’s an aspect of Tuesday’s statement from the FOMC that’s not being emphasised by many analysts.
The Fed’s primary ability to influence the economy comes from its control of the interest rate on funds lent overnight between banks. But with that interest rate essentially at zero, nothing happens when the Fed tries to push that gas pedal down any further.
One option for the Fed in this situation is to signal what it intends to do a few years down the road, when interest rates rise off the zero lower bound and the Fed resumes its usual powers. If the public is persuaded today that the future Fed will be more expansionary once we return to that regime, such a perception potentially could help stimulate spending today. Indeed, in a theoretical framework such as that developed by Gauti Eggertson and Mike Woodford, this kind of signaling is the only power that the Fed has in a situation like the present.
Suppose you took that view, and assumed that the Fed sees things the same way. How would you interpret the following passage from Tuesday’s FOMC release?
Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.
The most natural interpretation of those words is that the Fed is aiming at a long-run inflation target that’s higher than what we’ve been seeing lately. By its nature, that is a statement about what the Fed will be doing several years down the road, not a signal of something it’s going to do in November. In other words, it sounds a lot like the Fed is trying to follow the Eggertson-Woodford policy prescription.
But the dominant reaction I see from other analysts (, ) is that the Fed is instead communicating the action it plans to take within the next few months, specifically signaling the likelihood of resumed large-scale asset purchases.
Despite the implications of Eggertson and Woodford’s theoretical analysis, the empirical evidence persuades me that the Fed could reduce long-term interest rates further in the current environment with such operations; see for example the research by Joseph Gagnon and colleagues, Greenwood and Vayanos, and my paper with Cynthia Wu. And I believe that the FOMC is also persuaded that it has this power. But these kind of nonstandard open market operations are a blunt and potentially risky policy instrument, and are certainly not the only way the Fed is thinking about responding to the current difficulties.
I am not saying that other analysts are wrong in interpreting the FOMC statement as signaling the likelihood of some near-term resumption of quantitative easing. But I don’t think that’s the only message that the Fed delivered on Tuesday.