In Krugman’s Legacy: Fed gets over fear of commitment, Pedra da Costa gives a nice summary of Paul Krugman’s view that the Fed needs to commit to overstimulate the economy in the future in order to stimulate the economy now.  In a post back in June, I asked the question “Should the Fed Promise to Do the Wrong Thing in the Future to Have the Right Effect Now?” directing my question to Scott Sumner in particular. This was really a question about whether  "Quantitative Easing" (see my post “Balance Sheet Monetary Policy: A Primer”) has an effect independent of how it changes people’s expectations about future safe short-term interest rates such as the federal funds rate. If buying long-term and risky assets has an independent effect, then with large enough purchases, the Fed can stimulate the economy now without committing to push the economy above the natural level of output in the future, as I discussed in “Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy,” where the picture of a giant fan at the top of the post symbolizes the idea that a small departure from the way things work in a frictionless model, multiplied by huge purchases of long-term and risky assets, can have a substantial effect. In my view, Krugman made an error by trusting a frictionless model too much. In other contexts, economists are suspicious of frictionless models that make extremely strong claims if applied uncritically to the real world, as I discuss in “Wallace Neutrality and Ricardian Neutrality.”

On the question of how the world works, “Wallace Neutrality and Ricardian Neutrality” links to Scott Sumner’s answer, while “Trillions and Trillions: Getting Used to Balance Sheet Monetary Policy,” links to Noah Smith’s answer. Scott, Noah and I are on record against the frictionless model behind Paul Krugman’s views. I have tried hard to convince Brad DeLong on this issues, as you can see in “Miles Kimball and Brad DeLong Discuss Wallace Neutrality and Principles of Macroeconomics Textbooks.” My sense is that Brad has come around to some degree, though that may be just wishful thinking on my part. 

There is a technical name for what I am talking about in this post–a name you can see above: “Wallace neutrality.” For some links on Wallace neutrality, see my post “‘Wallace Neutrality’ on wikipedia.”

Let me be clear that this scientific issue will become most important when the economy has recovered. At that some, I forecast that some voices will call on the Fed to “keep its commitment” to leave interest rates low even after the economy has recovered “in order to maintain credibility for stimulative promises in the more distant future.” The Fed needs to be able to point back to a clear record of statements showing that it never made such a commitment. Those most concerned about inflation (“inflation hawks”) in the FOMC  (the Federal Open Market Committee, which is the monetary policy decision-making body in the Federal Reserve System) should be particularly worried about this, and should make clear in every speech that the Fed has not made any precommitment to overstimulate the economy in the future.

If large scale asset purchases have an independent effect on the economy (not working through expectations), building up a track record of following through on promises to overstimulate the economy is unnecessary. In other words, if the real-world economy does not obey Wallace neutrality, situations in which the federal funds rate and the Treasury bill rate are close to zero can be dealt with by purchasing other assets, instead of by promises of future overstimulation.

My recommendation is that the Fed continue to insist that it is only predicting its future policy, not precommitting. Even better would be to make clear that the Fed will continue very vigorous stimulative policy until output is again fully on track to reach its natural level, but is making no commitment to push the economy above its natural level of output (unless doing so is necessary for price stability). If I understand correctly, recommendations by Market Monetarists that the Fed should announce that it is targeting nominal GDP are in this spirit.