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Jackson Hole paper calls for more potent tool than QE3

August 31, 2012: 2:30 PM ET

Just hours after Federal Reserve Chairman Ben Bernanke seemed to make the case in favor of more large bond purchases, a Columbia University professor argued that the Fed has an even more potent tool in its arsenal.

Michael Woodford, an economics professor at Columbia University in New York, believes the central bank would get more bang for its buck if it made a more explicit promise to keep interest rates "exceptionally low" into the future. He presented his paper on Friday to a room full of the world's top economists, including Bernanke, in Jackson Hole, Wyo.

Currently, the Fed is saying its rates will remain near zero until late 2014. But as Bernanke said earlier Friday: "This guidance is not an unconditional promise."

Woodford advocates that instead of tying the promise to a calendar date like 2014, the Fed should bind it to a certain economic target. His favorite measure is called nominal gross domestic product, or NGDP – a measure of broad economic activity that doesn't strip out inflation.

By that measure, the U.S. economy is currently far from its full potential. As this chart from Woodford's paper shows, the economy veered far off its historical trend in 2007 and has yet to make up for lost ground.

NGDP

The solid line on this chart shows that nominal GDP veered away from its trend in 2007. (Click the chart to read Michael Woodford's full paper)

If the Fed were to express an outright promise to keep its policies accommodative until NGDP is back on track, it would give markets and the public a better understanding of when interest rates are likely to rise in the future, Woodford says.

That in itself is considered a powerful tool because mere expectations about the future, are an important factor influencing the way interest rates move in financial markets.

"The reason why it can be powerful is because expectations about how the Fed can conduct policy in the future have very big effects on financial markets, and that has effects on how people are going to spend in the economy," Woodford said.

In contrast to Bernanke's speech earlier in the day, Woodford's paper says buying assets -- like in QE3 -- remains "an awkward and possibly costly form of signal."

Because NGDP includes inflation, this proposal is likely to appease hawkish members of the Fed who fear inflation will someday pick up rapidly as a result of the Fed's stimulative policies. It's also likely to win over Fed doves, because it allows the central bank to boost the economy now.

"I would think it addresses the important concerns of both wings," Woodford said.

The two sides just have to hash out how exactly they should define their target, and that's not necessarily an easy task.

Minutes released from the Fed's last meeting a month ago show policymakers discussed tying their interest rate guidance to explicit targets for the economy – although it's unclear whether they discussed using NGDP as the main measure.

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About This Author
Annalyn Censky
Annalyn Kurtz
Writer, CNNMoney

Annalyn Kurtz is a senior writer at CNNMoney, where she covers America's jobs crisis, Federal Reserve policy and other economic news. Before joining the site in 2010, she served as a Rotary Ambassadorial Scholar in Prague and interned at Fortune Small Business magazine. @annalynkurtz

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