The Asymmetric Nature of Monetary Policy

Steve Roth, over at Angry Bear, recently had a good post on the future of monetary policy titled, The Fed Faces the End Game -- And Blinks? Roth elaborates on a game theory perspective outlined by Ryan Avent:

After three decades of taking away the (wage- and employment-)growth punchbowl when the party starts getting (“too”) hot, and after four years of subordinating their employment mandate to their cherished inflation-control credibility, the Fed has a serious shortage of “growth credibility.”

Which means that the Fed has created a game that is asymmetrical. It has great power to quash growth through open-mouth operations; we know they’ll sell bonds if they promise and need to, and that doing so will dampen inflation (and growth).

But on the expansionist side, we can’t believe their promises. They would need to make actual bond purchases to spur growth. And even if they do both promise and live up to the promise, we (with the exception of [market] monetarists, few of whom are running large businesses or managing large amounts of money) don’t have great or certain expectations for the results.

In Search for Austerity Continues as Central Banks Undermine Stimulus, I made a similar observation:

central banks ability to affect inflation, and to a lesser extent growth, is heavily skewed in favor of slowing either measure.

Whereas Roth suggests that asymmetric credibility stems from the Fed’s actions, I believe it is actually an inherent condition in our current monetary system. The Fed sets the base price for money and credit, but with private banks free to create credit, it holds relatively little control over the total amount outstanding at any time. As growth in the US has exceeded inflation for much of the past three decades, the conditions were ripe for borrowing and credit outstanding now greatly surpasses the sum of base money.

Even if the Fed promised indefinite QE, it’s hard to see the mechanism, aside from adjusting inflation expectations (wealth effects are minimal), by which this would spur real growth. Given the Fed’s skewed abilities and determination to maintain its credibility, it seems more obvious why inflation targeting remains prominent. Further, this may help explain why the Fed downplays its employment mandate (which should be removed anyways). Facing the endgame, the Fed knows it can reduce inflation (and growth) but remains unsure how successful it could be at achieving other targets.

Therefore it seems I actually agree with Avent’s conclusion and Roth’s translation:

Ryan thinks that the Fed’s afraid that it:

…will need to roll out dramatic, unconventional actions—the fear being, of course, that such actions would leave it hopelessly politicised and powerless to fight inflation. … [They're] fighting to maintain their vulnerable independence.

Translation: They’re fighting to avoid the MMT-World end game, where the Fed becomes an irrelevant mechanical actor.

Related posts:
Political Fears May Keep ECB Easing On Hold
Fed's Treasury Purchases Now About Asset Prices, Not Interest Rates