I wish to provoke a discussion in the blogosphere of what economists expect the exit path to look like. John Taylor recently wrote,
assuming the central tendency forecast of the FOMC, the announced buying spree will bring reserve balances to about $4 trillion in
mid-2005mid-2015. The risk is two-sided. If the Fed does not draw down reserves fast enough during a future exit, then it will cause inflation. If it draws them down too fast, then it will cause another recession.
Taylor used to be rather highly regarded in the field of monetary economics, but he has fallen out of favor with KruLong, Scott Sumner, and others. Still, I think his concerns deserve a response.
I am not sure what Richard Fisher means by“Hotel California” monetary policy, but it sounds as though he, too, is worried about the exit path.
My response would be that I am not concerned about the inflation-or-recession dilemma. I do not see a knife-edge there. I can picture a gradual transition from high unemployment to moderate unemployment, with inflation rising but staying under control–say, 3 percent. I am not predicting that this will happen, but I can picture it.
But suppose we do reach a point where the Fed has hit its unemployment target and inflation is around 3 percent? And at that point the Fed is sitting on a balance sheet of close to $4 trillion (even if this $4 trillion estimate is off by a trillion or two, we are still talking about real money, if I may allude to Senator Dirksen). And assume that fiscal policy still consists of running huge deficits as far as the eye can see.
When the Fed starts selling securities to limit the rise in inflation, what happens in the government bond market? There I do see the possibility for a knife-edge, or two very different equilibria. There is a good equilibrium in which bond investors remain confident, and rates remain low. There is a bad equilibrium in which bond investors get nervous, and rates jump. A transition to the bad equilibrium is always a possibility–that is what makes sovereign debt crises arise suddenly with no near-term warning. My worry is that a transition by the Fed from buyer to seller in the bond market could be the trigger that sends the markets to the bad equilibrium.
What is the scenario for avoiding the bad equilibrium? Some possibilities
1. No matter how many bonds the Fed sells, markets can absorb it, no problem. Why would this be?
a. Liquidity trap. For those of you who believe in liquidity traps (not my religion, but to each his own), do you think they still obtain when inflation is 3 percent?
b. Rational expectations. Not my religion, either. But you might say that by the time the Fed starts to sell, markets will have already forecast and discounted the Fed’s actions.
2. The Fed can achieve its inflation-stabilization goals by merely selling off teeny-tiny amounts of its bond holdings each year, for, say, twenty or thirty years.
I assume that many (most?) advocates/defenders of the Fed’s strategy believe something like (2). But what is the basis for that belief? We’ve never done this before.
By the way, I will not blame the Fed if this ends badly. To me, the original sin is the non-stop, out-of-control deficit spending. It is really hard to avoid having that end badly, no matter what the Fed does.