Krugman’s legacy: Fed gets over fear of commitment

September 20, 2012

Jonathan Spicer contributed to this post

An important part of the Federal Reserve’s recent decision to embark on an open-ended quantitative easing program was a fresh indication that the central bank will leave rates low even as the recovery gains steam. According to the September policy statement:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.

Just why does the Fed believe promising to keep policy stimulus in place for a long time might help struggling economies recovery? Mike Feroli, chief U.S.economist and resident Fed watcher at JP Morgan, traces the first inklings of the idea to the work of Paul Krugman, the Nobel-prize winning economist and New York Times columnist.

The genesis of the Fed’s revolutionary actions this week date back to the late 1990s. It was at that time that Princeton professor and former Reagan administration official Paul Krugman undertook an investigation of the deflation then beginning to afflict the Japanese economy. Krugman’s prior supposition was that surely a central bank-engineered increase in the money supply would quickly lift Japan out of deflation.

Further investigation disabused him of the notion that increasing the money supply when interest rates are at zero could generate inflation. Instead, his research pointed to the conclusion that a central bank must ‘commit to act irresponsibly.’ The following decade and a half saw a flourishing in research as to how central banks could stimulate growth when interest rates had reached their lower bound of zero.

A common theme of this literature – beginning with Krugman and culminating in Michael Woodford’s now-famous Jackson Hole paper this year – is that a central bank needs to commit to stimulating growth, pledging to keep stimulus in place even after the economy regains some health. This is the intellectual heritage of the Fed’s new policy.

Perhaps unsurprisingly, Krugman and Woodford welcomed the new policy, even if both might have preferred a more emphatic, even numeric target for growth or inflation over the Fed’s qualitative approach. Woodford told Reuters in an interview:

The uncertainty about how things might be unfolding next is one of the biggest obstacles to the economy improving, so how you affect perceptions is really critical at this point to what they’re trying to do.

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