Should the Fed Promise to Do the Wrong Thing in the Future to Have the Right Effect Now?

  Scott Sumner: Professor of Economics at Bentley University and Author of the Blog TheMoneyIllusion

Scott Sumner: Professor of Economics at Bentley University and Author of the Blog TheMoneyIllusion

The question of the title is a question for Scott Sumner in particular.  A few months ago, Scott Sumner used a phrase very similar to what I used in my post “Going Negative: The Virtual Fed Funds Rate Target” in his post “What Ben Bernanke Can Learn from Humpty Dumpty.”  Scott talks about a “shadow fed funds rate target.”  I considered that phrase for my proposal, but set it aside because I thought it sounded too much like the fed funds rate target of the Shadow Open Market Committee, an organization of prominent economists of a certain viewpointwho critique the Fed’s actions.  (Once upon a time the Shadow Open Market Committee was Monetarist and relatively hawkish in its monetary policy recommendations–that is, leaning toward recommending tight monetary policy–but the current membership seems pretty mainstream to me.)  The word “virtual” not only evokes the “virtual reality” of computers that allows the impossible, but also the “virtual particles” of quantum mechanics which can arise even in empty space, stealing the energy for a ghostly existence using the opening provided by the Heisenberg uncertainty principle. 

In addition to using “shadow” instead of “virtual,” there is a crucial difference between Scott Sumner’s proposal and mine.  I am envisioning the Fed as using the virtual fed funds rate target to communicate what it intends to do in the near future with balance sheet monetary policy.  Scott wants the Fed to use a shadow fed funds rate to communicate what it will do in the more distant future.  Aside from “doing whatever it takes” to reach a nominal GDP goal, I am not clear about exactly what the Fed is communicating it will do in the future. 

One possible meaning of a shadow fed funds rate target that may or may not be what Scott has in mind is as follows.  I hope that Scott will clarify his position, either by saying that the following interpretation is consistent with what he intends, even if he thinks the emphasis is off, or by distancing himself from the following view.  Believers in Wallace neutrality as applied to the real world think that the only way the Fed can do more stimulus once the fed funds rate is at zero is to promise to overstimulate the economy in the future once the fed funds rate has lifted off from zero.  For example, even with Wallace neutrality, the Fed can stimulate the economy now by promising to keep the fed funds rate at zero so long that the economy will get overheated in the future.  This would be very different from what I recommend.  The great virtue of balance sheet monetary policy (which works by taking advantage of departures from Wallace neutrality)–and therefore with the virtual fed funds rate target that communicates the stance of balance sheet monetary policy–is that it avoids making promises to do the wrong thing in the future in order to have the right effect now.