How the Fed Destroyed its Credibility

The Fed’s credibility is obviously important. If people believe that they can and will do what they say they’re going to do — and that it will have the desired effect — they can affect the the real economy (at least short-term) by just making promises — Open Mouth Operations. (Though they must actually do things to their balance sheet, sometimes — rather than just promising to make future promises — to avoid the Turtles All The Way Down problem.)

Also obvious: the Fed has great inflation-fighting cred. They’ve fetishized inflation and that credibility for thirty years. People feel damned confident that they can and will successfully stomp on price spikes — especially wages. That’s what they do. That fixation has continued even through four years in which runaway inflation has manifestly not been a credible threat.

Meanwhile, their unemployment-fighting cred is in the tank. If they announced today that they’re going to do whatever is necessary to bring unemployment down to X%, people would seriously question their ability to do so, even their future commitment to doing so.

Tyler Cowen agrees:

The Fed, at least right now, is not able to make a credible commitment toward a significantly more expansionary policy for very long. … The market expectation has become “the Fed can/will only do so much.”

Why? Because in their frantic obsession with inflation (explanation here), they missed their chance to demonstrate their unemployment-fighting moxie. The time to do that was 2008 and 2009, when 1. unemployment was spiking and 2. monetary policy had a lot more traction on unemployment. They could have not sabotaged the fiscal efforts.

Again, Tyler agrees:

The Fed already has failed to act, for whatever reasons. That makes it all the harder to achieve the credible commitment now.

Now people may be confused, thinking that because the Fed didn’t do what was needed to fight unemployment, it couldn’t have. This could result in them believing that it can’t, now. This is obviously faulty reasoning, but the conclusion could still be correct.

I don’t know for sure. Two questions, using a fairly extreme scenario to make the conundrum clear:

1. If the Fed had bought a trillion dollars of S&P 500 stocks in 2008, would it have prevented (or greatly reduced) the unemployment carnage?

2. If the Fed bought a trillion dollars of S&P 500 stocks today, would it bring unemployment down significantly?

On #2, Tyler thinks not — that action today would have a fifth or a tenth of the effect that ’08 action would have had — for several reasons, mainly having to do with reduced potential. (Arguably caused by the Fed’s inaction.)

But one thing seems clear: that inaction (or sabotage, if you prefer) seriously damaged the Fed’s growth-enhancing, unemployment-fighting credibility. By sabotaging fiscal, it has sabotaged its own ability to reduce unemployment (or increase NGDP) by simply making promises.

Cross-posted at Asymptosis.