Duncan Black is skeptical that anything the Federal Reserve tries to do will be effective because “[w]hile in theory there is a lot the Fed could do, in practice it’s relying on our failed financial system to ultimately do the work.”
Maybe so, but I don’t think so. There’s an argument to be made that what’s crucial isn’t just what the Fed does, but how the Fed frames its own actions. What the Fed’s done thus far is to make “unorthodox” interventions into a variety of markets in a manner that it has described as temporary efforts to forestall emergency in the financial system. This worked at easing conditions in the financial system, but didn’t—as Black notes—do much of anything else. But what if the Fed undertook new actions that were framed differently?
Here’s a brief excerpt from Paul Krugman’s 1998 paper (PDF) “It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap.”
The central new conclusion of this analysis is that a liquidity trap fundamentally involves a credibility problem — but one that is the inverse of the usual one, in which central bankers have difficulty convincing private agents of their commitment to price stability. In a liquidity trap the problem is that the markets believe that the central bank will target price stability, given the chance — and hence that any current monetary expansion is merely transitory. The traditional view that monetary policy is ineffective in a liquidity trap, and that fiscal expansion is the only way out, must therefore be qualified: monetary policy will be effective after all if the central bank can credibly promise to be irresponsible, to seek a higher future price level.
In effect, public statements by the central bank may foster the expectation that it intends to follow what [Gauti Eggertsson and Michael Woodford] refer to as optimal monetary policy under commitment rather than prematurely remove policy accommodation in the future (as happens in EW’s no-commitment case). The expectation that the nominal short-term rate will be kept sufficiently low for long enough to ward off deflation should also prevent inflation expectations from falling, which would otherwise raise real interest rates and impose a drag on spending. Because interest rate commitments have implications for inflation expectations in equilibrium, our description of policy in terms of expected interest rate paths is closely related to the types of policies analyzed by Paul Krugman and Lars Svensson.
The Fed really hasn’t been trying to do this stuff. But Bernanke clearly understands the difference between this kind of thing and the kind of thing he has been doing. It’s not clear to me, however, why he’s not acting. It could be that he doesn’t think the situation warrants it. It could be that he doesn’t have enough support on the FOMC. It could be that he doesn’t think there’s enough political support to make such a policy tenable. But it’s possible that the confirmation of some new FOMC members combined with increased attention in the political media to this issue will spur some increased action.