Since the Fed started its new policy of "QE infinity" (which it stepped up on Wednesday), acclaim has been heaped upon the economists who have promoted a policy of NGDP targeting (or "NGDP level path targeting"), which bears some resemblance to "QE infinity". Chief among these economists is Scott Sumner, who promotes his ideas mainly through his blog; Sumner was recently named one of Foreign Policy Magazine's top 100 global thinkers, and economics pundits from Tyler Cowen to Matt Yglesias have credited Sumner as being the intellectual force behind the Fed's new policy. However, Scott is far from a solitary crusader; he has been assisted by David Beckworth, Ryan Avent, Andy Harless, Steve Randy Waldman, Joe Weisenthal, Evan Soltas, and a number of other bloggers and pundits. Additionally, my own graduate advisor, Miles Kimball, has promoted similar ideas on his blog and in his academic work.
I generally support the idea of an activist Fed, unconventional monetary policy, etc. However, I do have a misgiving about a key element of the case made by the aforementioned crop of monetarists. This is the notion of an "Omnipotent Fed"...by which I mean not that the Fed can create stars and galaxies, but that the Fed can set NGDP to be whatever it wants. If this assumption is wrong, NGDP targeting (or similar policies) may simply not work.
To some, the proposition that the Fed can hit any NGDP target seems self-evident. NGDP is just real GDP multiplied by the price level; if the Fed perfectly controls the price level, and either A) knows the relationship between the price level and output, or B) can change the price level faster than real output changes, then it immediately follows that the Fed sets NGDP. You often hear this stated as the idea that "the Fed can always choose to inflate".
But what if the Fed can't set the price level? There are several ways this could be the case. For example, the price level might be discontinuous in certain regions. For example, suppose the Fed attempts to set inflation at exactly 176.73%. But it might be the case that any monetary policy that pushes inflation above 175% will automatically cause inflation to jump to 190% (and vice versa). In other words, suppose that in some region, NGDP is a step function with respect to monetary policy. That's just one example, though; in general, any time NGDP is an unstable, stochastic, or undetermined function of monetary policy, the "omnipotent Fed" proposition fails. One special case of this is Milton Friedman's idea that monetary policy acts with "long and variable lags", a notion that has been pooh-poohed by the new monetarists.
Anyway, OK, so is the Fed "omnipotent" or not? Well, how on Earth could we know? My big problem with the "Omnipotent Fed" idea is that it seems non-falsifiable. By which I mean, it doesn't seem like the evidence will ever be able to tell us whether the Fed is omnipotent or not.
Why not? Two reasons: A) Because the Fed's thought process is unobservable, and B) Because the Fed's policy toolkit is unobservable. To know what the Fed can do, we have to know what the Fed tries to do. For example, suppose we see the Fed do $1 trillion of quantitative easing, and NGDP doesn't seem to budge much.
Interpretation 1: The Fed knew that its actions would lead to a non-budging NGDP level, which is why it did what it did. In other words, the Fed chose to keep NGDP where it was, and if it had wanted to, it could have raised NGDP instead of just keeping it static.
Interpretation 2: The Fed tried to raise NGDP and failed. It failed because the people at the Fed made a mistake. They did the wrong kind of easing, or didn't manage expectations correctly, or in some other way used the wrong tools. If the Fed had used the right tools, it could have raised NGDP.
Interpretation 3: The Fed tried to raise NGDP and failed. It failed because the only way to raise NGDP would have been to cause a hyperinflation, which would raise NGDP by much, much more than it wanted.
There are more interpretations. I just highlighted these three to demonstrate a point.
How can you know what the Fed wants? You can make some guesses, but not scientific ones. The Fed keeps its decision-making process secret. And suppose you somehow could figure out what the Fed wants (say, by applying a mind-reading device to the Fed chairman during a policy announcement). That would tell you precious little about what the Fed is actually capable of. For example, suppose that expectations are very important in the determination of NGDP. Do we know what determines expectations? Not really, no. Or suppose money demand is unstable, or contains hysteresis, in certain regions. How would we know that?
Some people have claimed that an "NGDP futures market" would allow us to test the proposition of Fed omnipotence. If NGDP futures were stable, they say, that would show that the Fed can hit any NGDP target it likes. But this is just flat-out false. Low NGDP futures volatility could mean that the Fed is utterly powerless, and that investors simply expect few shocks to NGDP.
So it seems to me that the proposition of Fed omnipotence is something that we can only believe by making a leap of faith. It is functionally equivalent to the notion that an invisible God controls everything we see in the world. Thus, believers in the Omnipotent Fed will always be able to claim, without scientific or logical refutation, that every jump and juggle of NGDP was the deliberate choice of the Fed.
Does this mean that every question about monetary policy is fundamentally unanswerable? No, it doesn't. We can't observe the Fed's desires, and we definitely can't observe the Fed's total choice set. But we can observe the Fed's actual choices. If you tell me "Inflation always rises 1 for 1 with the monetary base," well, that is an easy proposition to falsify.
So what is the implication for monetary policy? I am not claiming that NGDP targeting is a bad idea, or that it definitely will not work, or even that it is unlikely to work. What I'm claiming is that, in the presence of true Knightian uncertainty about the power of the Fed, it is certain that at some point, if NGDP targeting doesn't seem to work, we will inevitably abandon the policy. And the point where we decide it has failed will depend not on scientific fact, but on intuition and heuristics. In other words, if the Fed keeps printing money and NGDP doesn't return to its pre-crisis path, at some point we will simply start to entertain the notion that the Fed is incapable of doing what we want it to do. And then we will try to think of something else. And of course the true believers will say: "No, the Fed could have done it, they just didn't really want to." And we won't be able to prove them wrong.
Update: On Twitter I asked Miles Kimball what he thought of this post, to which he responded:
It is certainly a logical possibility that the Fed can't get inflation up without overshooting...The difference is that I don't think the US is actually in that situation of having to overshoot. Japan may be.