Stop Talking About Liquidity

Some ridiculous logic from Richard Fisher at the Dallas Fed:

“Nobody really knows what will work to get the economy back on course. And nobody—in fact, no central bank anywhere on the planet—has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank—not, at least, the Federal Reserve—has ever been on this cruise before.

This much we do know: Our engine room is already flush with $1.6 trillion in excess private bank reserves owned by the banking sector and held by the 12 Federal Reserve Banks. Trillions more are sitting on the sidelines in corporate coffers. On top of all that, a significant amount of underemployed cash—or fuel for investment—is burning a hole in the pockets of money market funds and other nondepository financial operators. This begs the question: Why would the Fed provision to shovel billions in additional liquidity into the economy’s boiler when so much is presently lying fallow?”

Actually, we do know what will work to get the economy back on course: It’s called spending money. The economy went through an $8 trillion housing bubble, the collapse of which still accounts for roughly $850 billion in missing annual demand. In the short term, the only way to fill that demand gap is through more government spending; the private household and business sectors are still running very high net saving rates, as the recently released flow-of-funds data showed. Over the longer term, we should hope to fill the demand gap through a reduction in the trade deficit. This means that the value of the dollar will need to fall to make U.S. goods more internationally competitive.

Of course, monetary policy can help. Arguably, the whole point of QE3 is to bring the trillions sitting on the sidelines into the game by raising inflation expectations. And for the moment, QE3 seems to be doing just that: Breakeven inflation rates have risen across the curve since the new QE program was announced. I’m still skeptical as to whether the higher inflation expectations will last – primarily because the Fed’s move was more or less a baby step in the realm of communication policy – but so far so good.

What Fisher seems to miss is that policy at the lower bound is not about the amount of “liquidity in the economy’s boiler”; it’s about how those holding the liquidity perceive the future. A future in which the Fed does nothing, which seems to be Fisher’s recommendation, would further incent market participants to sit on cash. But a future in which the Fed is bold, making an explicit commitment to bring the economy back to its potential, would free up spending. The best way for the Fed to be bold would involve adopting a nominal GDP (or price-level) target.

So I wish hawks like Fisher would stop talking about “liquidity.” It’s an irrelevant term in the current environment.


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