Archive for the 'Bernanke' Category

Larry Summers v. John Taylor: No Contest

It seems that an announcement about who will be appointed as Fed Chairman after Janet Yellen’s terms expires early next year is imminent. Although there are sources in the Administration, e.g., the President, indicating that Janet Yellen may be reappointed, the betting odds strongly favor Jerome Powell, a Republican currently serving as a member of the Board of Governors, over the better-known contender, John Taylor, who has earned a considerable reputation as an academic economist, largely as author of the so-called Taylor Rule, and has also served as a member of the Council of Economic Advisers and the Treasury in previous Republican administrations.

Taylor’s support seems to be drawn from the more militant ideological factions within the Republican Party owing to his past criticism of Fed’s quantitative-easing policy after the financial crisis and little depression, having famously predicted that quantitative easing would revive dormant inflationary pressures, presaging a return to the stagflation of the 1970s, while Powell, who has supported the Fed’s policies under Bernanke and Yellen, is widely suspect in the eyes of the Republican base as a just another elitist establishmentarian inhabiting the swamp that the new administration was elected to drain. Nevertheless, Taylor’s academic background, his prior government service, and his long-standing ties to the US and international banking and financial institutions make him a less than ideal torch bearer for the true-blue (or true-red) swamp drainers whose ostensible goal is less to take control of the Fed than to abolish it. To accommodate both the base and the establishment, it is possible that, as reported by Breitbart, both Powell and Taylor will be appointed, one replacing Yellen as chairman, the other replacing Stanley Fischer as vice-chairman.

Seeing no evidence that Taylor has a sufficient following for his appointment to provide any political benefit, I have little doubt that it will be Powell who replaces Yellen, possibly along with Taylor as Vice-Chairman, if Taylor, at the age of 71, is willing to accept a big pay cut, just to take the vice-chairmanship with little prospect of eventually gaining the top spot he has long coveted.

Although I think it unlikely that Taylor will be the next Fed Chairman, the recent flurry of speculation about his possible appointment prompted me to look at a recent talk that he gave at the Federal Reserve Bank of Boston Conference on the subject: Are Rules Made to be Broken? Discretion and Monetary Policy. The title of his talk “Rules versus Discretion: Assessing the Debate over Monetary Policy” is typical of Taylor’s very low-key style, a style that, to his credit, is certainly not calculated to curry favor with the Fed-bashers who make up a large share of a Republican base that demands constant attention and large and frequently dispensed servings of red meat.

I found several things in Taylor’s talk notable. First, and again to his credit, Taylor does, on occasion, acknowledge the possibility that other interpretations of events from his own are possible. Thus, in arguing that the good macroeconomic performance (“the Great Moderation”) from about 1985 to 2003, was the result of the widespread adoption of “rules-based” monetary policy, and that the subsequent financial crisis and deep recession were the results of the FOMC’s having shifted, after the 2001 recession, from that rules-based policy to a discretionary policy, by keeping interest rates too low for too long, Taylor did at least recognize the possibility that the reason that the path of interest rates after 2003 departed from the path that, he claims, had been followed during the Great Moderation was that the economy was entering a period of inherently greater instability in the early 2000s than in the previous two decades because of external conditions unrelated to actions taken by the Fed.

The other view is that the onset of poor economic performance was not caused by a deviation from policy rules that were working, but rather to other factors. For example, Carney (2013) argues that the deterioration of performance in recent years occurred because “… the disruptive potential of financial instability—absent effective macroprudential policies—leads to a less favourable Taylor frontier.” Carney (2013) illustrated his argument with a shift in the tradeoff frontier as did King (2012). The view I offer here is that the deterioration was due more to a move off the efficient policy frontier due to a change in policy. That would suggest moving back toward the type of policy rule that described policy decisions during the Great Moderation period. (p. 9)

But despite acknowledging the possibility of another view, Taylor offers not a single argument against it. He merely reiterates his own unsupported opinion that the policy post-2003 became less rule-based than it had been from 1985 to 2003. However, later in his talk in a different context, Taylor does return to the argument that the Fed’s policy after 2003 was not fundamentally different from its policy before 2003. Here Taylor is assuming that Bernanke is acknowledging that there was a shift in from the rules-based monetary policy of 1985 to 2003, but that the post-2003 monetary policy, though not rule-based as in the way that it had been in 1985 to 2003, was rule-based in a different sense. I don’t believe that Bernanke would accept that there was a fundamental change in the nature of monetary policy after 2003, but that is not really my concern here.

At a recent Brookings conference, Ben Bernanke argued that the Fed had been following a policy rule—including in the “too low for too long” period. But the rule that Bernanke had in mind is not a rule in the sense that I have used it in this discussion, or that many others have used it.

Rather it is a concept that all you really need for effective policy making is a goal, such as an inflation target and an employment target. In medicine, it would be the goal of a healthy patient. The rest of policymaking is doing whatever you as an expert, or you as an expert with models, thinks needs to be done with the instruments. You do not need to articulate or describe a strategy, a decision rule, or a contingency plan for the instruments. If you want to hold the interest rate well below the rule-based strategy that worked well during the Great Moderation, as the Fed did in 2003-2005, then it’s ok, if you can justify it in terms of the goal.

Bernanke and others have argued that this approach is a form of “constrained discretion.” It is an appealing term, and it may be constraining discretion in some sense, but it is not inducing or encouraging a rule as the language would have you believe. Simply having a specific numerical goal or objective function is not a rule for the instruments of policy; it is not a strategy; in my view, it ends up being all tactics. I think there is evidence that relying solely on constrained discretion has not worked for monetary policy. (pp. 16-17)

Taylor has made this argument against constrained discretion before in an op-ed in the Wall Street Journal (May 2, 2015). Responding to that argument I wrote a post (“Cluelessness about Strategy, Tactics and Discretion”) which I think exposed how thoroughly confused Taylor is about what a monetary rule can accomplish and what the difference is between a monetary rule that specifies targets for an instrument and a monetary rule that specifies targets for policy goals. At an even deeper level, I believe I also showed that Taylor doesn’t understand the difference between strategy and tactics or the meaning of discretion. Here is an excerpt from my post of almost two and a half years ago.

Taylor denies that his steady refrain calling for a “rules-based policy” (i.e., the implementation of some version of his beloved Taylor Rule) is intended “to chain the Fed to an algebraic formula;” he just thinks that the Fed needs “an explicit strategy for setting the instruments” of monetary policy. Now I agree that one ought not to set a policy goal without a strategy for achieving the goal, but Taylor is saying that he wants to go far beyond a strategy for achieving a policy goal; he wants a strategy for setting instruments of monetary policy, which seems like an obvious confusion between strategy and tactics, ends and means.

Instruments are the means by which a policy is implemented. Setting a policy goal can be considered a strategic decision; setting a policy instrument a tactical decision. But Taylor is saying that the Fed should have a strategy for setting the instruments with which it implements its strategic policy.  (OED, “instrument – 1. A thing used in or for performing an action: a means. . . . 5. A tool, an implement, esp. one used for delicate or scientific work.”) This is very confused.

Let’s be very specific. The Fed, for better or for worse – I think for worse — has made a strategic decision to set a 2% inflation target. Taylor does not say whether he supports the 2% target; his criticism is that the Fed is not setting the instrument – the Fed Funds rate – that it uses to hit the 2% target in accordance with the Taylor rule. He regards the failure to set the Fed Funds rate in accordance with the Taylor rule as a departure from a rules-based policy. But the Fed has continually undershot its 2% inflation target for the past three [now almost six] years. So the question naturally arises: if the Fed had raised the Fed Funds rate to the level prescribed by the Taylor rule, would the Fed have succeeded in hitting its inflation target? If Taylor thinks that a higher Fed Funds rate than has prevailed since 2012 would have led to higher inflation than we experienced, then there is something very wrong with the Taylor rule, because, under the Taylor rule, the Fed Funds rate is positively related to the difference between the actual inflation rate and the target rate. If a Fed Funds rate higher than the rate set for the past three years would have led, as the Taylor rule implies, to lower inflation than we experienced, following the Taylor rule would have meant disregarding the Fed’s own inflation target. How is that consistent with a rules-based policy?

This is such an obvious point – and I am hardly the only one to have made it – that Taylor’s continuing failure to respond to it is simply inexcusable. In his apologetics for the Taylor rule and for legislation introduced (no doubt with his blessing and active assistance) by various Republican critics of Fed policy in the House of Representatives, Taylor repeatedly insists that the point of the legislation is just to require the Fed to state a rule that it will follow in setting its instrument with no requirement that Fed actually abide by its stated rule. The purpose of the legislation is not to obligate the Fed to follow the rule, but to merely to require the Fed, when deviating from its own stated rule, to provide Congress with a rationale for such a deviation. I don’t endorse the legislation that Taylor supports, but I do agree that it would be desirable for the Fed to be more forthcoming than it has been in explaining the reasoning about its monetary-policy decisions, which tend to be either platitudinous or obfuscatory rather than informative. But if Taylor wants the Fed to be more candid and transparent in defending its own decisions about monetary policy, it would be only fitting and proper for Taylor, as an aspiring Fed Chairman, to be more forthcoming than he has yet been about the obvious, and rather scary, implications of following the Taylor Rule during the period since 2003.

If Taylor is nominated to be Chairman or Vice-Chairman of the Fed, I hope that, during his confirmation hearings, he will be asked to explain what the implications of following the Taylor Rule would have been in the post-2003 period.

As the attached figure shows PCE inflation (excluding food and energy prices) was 1.9 percent in 2004. If inflation in 2004 was less than the 2% inflation target assumed by the Taylor Rule, why does Taylor think that raising interest rates in 2004 would have been appropriate? And if inflation in 2005 was merely 2.2%, just barely above the 2% target, what rate should the Fed Funds rate have reached in 2005, and how would that rate have affected the fairly weak recovery from the 2001 recession? And what is the basis for Taylor’s assessment that raising the Fed Funds rate in 2005 to a higher level than it was raised to would have prevented the subsequent financial crisis?

Taylor’s implicit argument is that by not raising interest rates as rapidly as the Taylor rule required, the Fed created additional uncertainty that was damaging to the economy. But what was the nature of the uncertainty created? The Federal Funds rate is merely the instrument of policy, not the goal of policy. To argue that the Fed was creating additional uncertainty by not changing its interest rate in line with the Taylor rule would only make sense if the economic agents care about how the instrument is set, but if it is an instrument the importance of the Fed Funds rate is derived entirely from its usefulness in achieving the policy goal of the Fed and the policy goal was the 2% inflation rate, which the Fed came extremely close to hitting in the 2004-06 period, during which Taylor alleges that the Fed’s monetary policy went off the rails and became random, unpredictable and chaotic.

If you calculate the absolute difference between the observed yearly PCE inflation rate (excluding food and energy prices) and the 2% target from 1985 to 2003 (Taylor’s golden age of monetary policy) the average yearly deviation was 0.932%. From 2004 to 2015, the period of chaotic monetary policy in Taylor’s view, the average yearly deviation between PCE inflation and the 2% target was just 0.375%. So when was monetary policy more predictable? Even if you just look at the last 12 years of the golden age (1992 to 2003), the average annual deviation was 0.425%.

The name Larry Summers is in the title of this post, but I haven’t mentioned him yet, so let me explain where Larry Summers comes into the picture. In his talk, Taylor mentions a debate about rules versus discretion that he and Summers had at the 2013 American Economic Association meetings and proceeds to give the following account of the key interchange in that debate.

Summers started off by saying: “John Taylor and I have, it will not surprise you . . . a fundamental philosophical difference, and I would put it in this way. I think about my doctor. Which would I prefer: for my doctor’s advice, to be consistently predictable, or for my doctor’s advice to be responsive to the medical condition with which I present? Me, I’d rather have a doctor who most of the time didn’t tell me to take some stuff, and every once in a while said I needed to ingest some stuff into my body in response to the particular problem that I had. That would be a doctor who’s [sic] [advice], believe me, would be less predictable.” Thus, Summers argues in favor of relying on an all-knowing expert, a doctor who does not perceive the need for, and does not use, a set of guidelines, but who once in a while in an unpredictable way says to ingest some stuff. But as in economics, there has been progress in medicine over the years. And much progress has been due to doctors using checklists, as described by Atul Gawande.

Of course, doctors need to exercise judgement in implementing checklists, but if they start winging it or skipping steps the patients usually suffer. Experience and empirical studies show that checklist-free medicine is wrought with dangers just as rules-free, strategy-free monetary policy is. (pp. 15-16)

Taylor’s citation of Atul Gawande, author of The Checklist Manifesto, is pure obfuscation. To see how off-point it is, have a look at this review published in the Seattle Times.

“The Checklist Manifesto” is about how to prevent highly trained, specialized workers from making dumb mistakes. Gawande — who appears in Seattle several times early next week — is a surgeon, and much of his book is about surgery. But he also talks to a construction manager, a master chef, a venture capitalist and the man at The Boeing Co. who writes checklists for airline pilots.

Commercial pilots have been using checklists for decades. Gawande traces this back to a fly-off at Wright Field, Ohio, in 1935, when the Army Air Force was choosing its new bomber. Boeing’s entry, the B-17, would later be built by the thousands, but on that first flight it took off, stalled, crashed and burned. The new airplane was complicated, and the pilot, who was highly experienced, had forgotten a routine step.

For pilots, checklists are part of the culture. For surgical teams they have not been. That began to change when a colleague of Gawande’s tried using a checklist to reduce infections when using a central venous catheter, a tube to deliver drugs to the bloodstream.

The original checklist: wash hands; clean patient’s skin with antiseptic; use sterile drapes; wear sterile mask, hat, gown and gloves; use a sterile dressing after inserting the line. These are all things every surgical team knows. After putting them in a checklist, the number of central-line infections in that hospital fell dramatically.

Then came the big study, the use of a surgical checklist in eight hospitals around the world. One was in rural Tanzania, in Africa. One was in the Kingdom of Jordan. One was the University of Washington Medical Center in Seattle. They were hugely different hospitals with much different rates of infection.

Use of the checklist lowered infection rates significantly in all of them.

Gawande describes the key things about a checklist, much of it learned from Boeing. It has to be short, limited to critical steps only. Generally the checking is not done by the top person. In the cockpit, the checklist is read by the copilot; in an operating room, Gawande discovered, it is done best by a nurse.

Gawande wondered whether surgeons would accept control by a subordinate. Which was stronger, the culture of hierarchy or the culture of precision? He found reason for optimism in the following dialogue he heard in the hospital in Amman, Jordan, after a nurse saw a surgeon touch a nonsterile surface:

Nurse: “You have to change your glove.”

Surgeon: “It’s fine.”

Nurse: “No, it’s not. Don’t be stupid.”

In other words, the basic rule underlying the checklist is simply: don’t be stupid. It has nothing to do with whether doctors should exercise judgment, or “winging it,” or “skipping steps.” What was Taylor even thinking? For a monetary authority not to follow a Taylor rule is not analogous to a doctor practicing checklist-free medicine.

As it happens, I have a story of my own about whether following numerical rules without exercising independent judgment makes sense in practicing medicine. Fourteen years ago, on the Friday before Labor Day, I was exercising at home and began to feeling chest pains. After ignoring the pain for a few minutes, I stopped and took a shower and then told my wife that I thought I needed to go to the hospital, because I was feeling chest pains – I was still in semi-denial about what I was feeling – my wife asked me if she should call 911, and I said that that might be a good idea. So she called 911, and told the operator that I was feeling chest pains. Within a couple of minutes, two ambulances arrived, and I was given an aspirin to chew and a nitroglycerine tablet to put under my tongue. I was taken to the emergency room at the hospital nearest to my home. After calling 911, my wife also called our family doctor to let him know what was happening and which hospital I was being taken to. He then placed a call to a cardiologist who had privileges at that hospital who happened to be making rounds there that morning.

When I got to the hospital, I was given an electrocardiogram, and my blood was taken. I was also asked to rate my pain level on a scale of zero to ten. The aspirin and nitroglycerine had reduced the pain level slightly, but I probably said it was at eight or nine. However, the ER doc looked at the electrocardiogram results and the enzyme levels in my blood, and told me that there was no indication that I was having a heart attack, but that they would keep me in the ER for observation. Luckily, the cardiologist who had been called by my internist came to the ER, and after talking to the ER doc, looking at the test results, came over to me and started asking me questions about what had happened and how I was feeling. Although the test results did not indicate that I was having heart attack, the cardiologist quickly concluded that what I was experiencing likely was a heart attack. He, therefore, hinted to me that I should request to be transferred to another nearby hospital, which not only had a cath lab, as the one I was then at did, but also had an operating room in which open heart surgery could be performed, if that would be necessary. It took a couple of tries on his part before I caught on to what he was hinting at, but as soon as I requested to be transferred to the other hospital, he got me onto an ambulance ASAP so that he could meet me at the hospital and perform an angiogram in the cath lab, cancelling an already scheduled angiogram.

The angiogram showed that my left anterior descending artery was completely blocked, so open-heart surgery was not necessary; angioplasty would be sufficient to clear the artery, which the cardiologist performed, also implanting two stents to prevent future blockage.  I remained in the cardiac ICU for two days, and was back home on Monday, when my rehab started. I was back at work two weeks later.

The willingness of my cardiologist to use his judgment, experience and intuition to ignore the test results indicating that I was not having a heart attack saved my life. If the ER doctor, following the test results, had kept me in the ER for observation, I would have been dead within a few hours. Following the test results and ignoring what the patient was feeling would have been stupid. Luckily, I was saved by a really good cardiologist. He was not stupid; he could tell that the numbers were not telling the real story about what was happening to me.

We now know that, in the summer of 2008, the FOMC, being in the thrall of headline inflation numbers allowed a recession that had already started at the end of 2007 to deteriorate rapidly, pr0viding little or no monetary stimulus, to an economy when nominal income was falling so fast that debts coming due could no longer be serviced. The financial crisis and subsequent Little Depression were caused by the failure of the FOMC to provide stimulus to a failing economy, not by interest rates having been kept too low for too long after 2003. If John Taylor still hasn’t figured that out – and he obviously hasn’t — he should not be allowed anywhere near the Federal Reserve Board.

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The Prodigal Son Returns: The Wall Street Journal Editorial Page Rediscovers Root Canal Economics

Perhaps the most interesting and influential financial journalist of the 1970s was a guy by the name of Jude Wanniski, who was an editorial writer for Wall Street Journal, from 1972 to 1978. In the wake of the Watergate scandal, and the devastating losses suffered by the Republicans in the 1974 Congressional elections, many people thought that the Republican party might not survive. The GOP certainly did not seem to offer much hope for free-market conservatives and libertarians, Richard Nixon having imposed wage-and-price controls in 1971, with the help of John Connally and Arthur Burns and enthusiastic backing from almost all Republicans. After Nixon resigned, leadership of the party was transferred to his successor, Gerald Ford, a very nice and decent fellow, whose lack of ideological conviction was symbolized by his choice of Nelson Rockefeller, an interventionist, big-government Republican if there ever was one, to serve as his Vice-President.

In this very dispirited environment for conservatives, Jude Wanniski’s editorial pieces in the Wall Street Journal and his remarkable 1978 book The Way the World Works, in which he advocated cuts in income tax rates as a cure for economic stagnation, proved to be an elixir of life for demoralized Republicans and conservatives. Wanniski was especially hard on old-fashioned Republicans and conservatives for whom balancing the federal budget had become the be all and end of all of economic policy, a doctrine that the Wall Street Journal itself had once espoused. A gifted phrase maker, Wanniski dubbed traditional Republican balanced-budget policy, root-canal economics. Instead, Wanniski adopted the across-the-board income tax cuts proposed by John Kennedy in 1963, a proposal that conservative icon Barry Goldwater had steadfastly opposed, as his model for economic policy.

Wanniski quickly won over a rising star in the Republican party, former NFL quarterback Jack Kemp, to his way of thinking.  Another acolyte was an ambitious young Georgian by the name of Newt Gingrich. In 1978, Kemp and Senator Bill Roth form Delaware (after whom the Roth IRA is named), co-authored a bill, without support from the Republican Congressional leadership, to cut income taxes across the board by 25%. Many Republicans running for Congress and the Senate in 1978 pledged to support what became known as the Kemp-Roth bill. An unexpectedly strong showing by Republicans supporting the Kemp-Roth bill in the 1978 elections encouraged Jack Kemp to consider running for President in 1980 on a platform of across-the-board tax cuts. However, when Ronald Reagan, nearly 70 years old, and widely thought, after unsuccessfully challenging Gerald Ford for the GOP nomination in 1976, to be past his prime, signed on as a supporter of the Kemp-Roth bill, Kemp bowed out of contention, endorsing Reagan for the nomination, and uniting conservatives behind the Gipper.

After his landslide victory in the 1980 election, Reagan, riding a crest of popularity, enhanced by an unsuccessful assassination attempt in the first few months of his term, was able to push the Kemp-Roth bill through Congress, despite warnings from the Democrats that steep tax cuts would cause large budget deficits. To such warnings, Jack Kemp famously responded that Republicans no longer worshiped at the altar of a balanced budget. No one cheered louder for that heretical statement by Kemp than, you guessed it, the Wall Street Journal editorial page.

Fast forward to 2012, the Wall Street Journal, which never fails to invoke the memory of Ronald Reagan whenever an opportunity arises, nevertheless seems to have rediscovered the charms of root-canal economics. How else can one explain this piece of sophistry from Robert L. Pollock, a member of the group of sages otherwise known as the Editorial Board of the Wall Street Journal? Consider what Mr. Pollock had to say in an opinion piece on the Journal‘s website.

[T]o the extent that the United States finds itself in a precarious fiscal situation, Federal Reserve Chairman Ben Bernanke shares much of the blame. Simply put, there is no way that Washington could have run the deficits it has in recent years without the active assistance of a near-zero interest rate policy. . . .

European governments finally decided to take cost-cutting steps when their borrowing costs went up. But Democrats and liberal economists use Mr. Bernanke’s low rates and willingness to buy government bonds as evidence that there’s no pressing problem here to be addressed.

This is a strange argument for high interest rates, especially coming from a self-avowed conservative. Conservatives got all bent out of shape when Obama’s Energy Secretary, Stephen Chu, opined that rising gasoline prices might actually serve a useful function by inducing consumers and businesses to be more economical in their their use of gasoline. That comment was seized on by Republicans as proof that the Obama administration was seeking to increase gasoline prices as a way of reducing gasoline consumption. Now, Mr. Pollock provides us with a new argument for high interest rates: by raising the cost of borrowing, high interest rates will force the government to be more economical in its spending decisions.  Evidently, it’s wrong to suggest that an increased price will reduce gasoline consumption, but it’s fine to say that an increased interest rate will cut government spending. Go figure.

Well, here’s what Wanniski had to say about the Republican obsession with reducing government spending for its own sake:

It isn’t that Republicans don’t enjoy cutting taxes. They love it. But there is something in the Republican chemistry that causes the GOP to become hypnotized by the prospect of an imbalanced budget. Static analysis tells them taxes can’t be cut or inflation will result. They either argue for a tax hike to dampen inflation when the economy is in a boom or demand spending cuts to balance the budget when the economy is in recession.

Either way, of course, they embrace the role of Scrooge, playing into the hands of the Democrats, who know the first rule of successful politics is Never Shoot Santa Claus. The political tension in the market place of ideas must be between tax reduction and spending increases, and as long as Republicans have insisted on balanced budgets, their influence as a party has shriveled, and budgets have been imbalanced.

How’s that old root-canal economics working out for ya?

Now back to Pollock. Here’s how he explains why low interest rates may not really be helping the economy.

It would be one thing if there were widespread agreement that low rates are the right medicine for the economy. But easy money on the Bernanke scale is a heretofore untested policy, one for which the past few years of meager growth haven’t provided convincing evidence.

Fair enough. Low rates haven’t been helping the economy all that much. But the question arises: why are rates so low? Is it really all the Fed’s doing, or could it possibly have something to do with pessimism on the part of businesses and consumers about whether they will be able to sell their products or their services in the future? If it is the latter, then low interest rates may not be a symptom of easy money, but of tight money.

Pollock, of course, has a different explanation for why low interest rates are not promoting a recovery.

Economists such as David Malpass argue that low rates are actually contractionary because they cause capital to be diverted from more productive uses to less productive ones.

Oh my. What can one say about an argument like that? I have encountered Mr. Malpass before and was less than impressed by his powers of economic reasoning; I remain unimpressed. How can a low interest rate divert capital from more productive uses to less productive ones unless capital rationing is taking place? If some potential borrowers were unable to secure funding for their productive projects while other borrowers with less productive projects were able to get funding for theirs, the disappointed borrowers could have offered to borrow at increased interest rates, thereby outbidding borrowers with unproductive projects, and driving up interest rates in the process.   That is just elementary.  That interest rates are now at such low levels is more reflective of the pessimism of most potential borrowers about the projects for which they seeking funding, than of the supposed power of the Fed to determine interest rates.

So there you have it. The Wall Street Journal editorial page, transformed in the 1970s by the daring and unorthodox ideas of a single, charismatic economic journalist, Jude Wanniski, has now, almost four decades later, finally come back to its roots.  Welcome home where you belong.

Too Little, Too Late?

The FOMC, after over four years of overly tight monetary policy, seems to be feeling its way toward an easier policy stance. But will it do any good? Unfortunately, there is reason to doubt that it will. The FOMC statement pledges to continue purchasing $85 billion a month of Treasuries and mortgage-backed securities and to keep interest rates at current low levels until the unemployment rate falls below 6.5% or the inflation rate rises above 2.5%. In other words, the Fed is saying that it will tolerate an inflation rate only marginally higher than the current target for inflation before it begins applying the brakes to the expansion. Here is how the New York Times reported on the Fed announcement.

The Federal Reserve said Wednesday it planned to hold short-term interest rates near zero so long as the unemployment rate remains above 6.5 percent, reinforcing its commitment to improve labor market conditions.

The Fed also said that it would continue in the new year its monthly purchases of $85 billion in Treasury bonds and mortgage-backed securities, the second prong of its effort to accelerate economic growth by reducing borrowing costs.

But Fed officials still do not expect the unemployment rate to fall below the new target for at least three more years, according to forecasts also published Wednesday, and they chose not to expand the Fed’s stimulus campaign.

In fairness to the FOMC, the Fed, although technically independent, must operate within an implicit consensus on what kind of decisions it can take, its freedom of action thereby being circumscribed in the absence of a clear signal of support from the administration for a substantial departure from the terms of the implicit consensus. For the Fed to substantially raise its inflation target would risk a political backlash against it, and perhaps precipitate a deep internal split within the Fed’s leadership. At the depth of the financial crisis and in its immediate aftermath, perhaps Chairman Bernanke, if he had been so inclined, might have been able to effect a drastic change in monetary policy, but that window of opportunity closed quickly once the economy stopped contracting and began its painfully slow pseudo recovery.

As I have observed a number of times (here, here, and here), the paradigm for the kind of aggressive monetary easing that is now necessary is FDR’s unilateral decision to take the US off the gold standard in 1933. But FDR was a newly elected President with a massive electoral mandate, and he was making decisions in the midst of the worst economic crisis in modern times. Could an unelected technocrat (or a collection of unelected technocrats) take such actions on his (or their) own? From the get-go, the Obama administration showed no inclination to provide any significant input to the formulation of monetary policy, either out of an excess of scruples about Fed independence or out of a misguided belief that monetary policy was powerless to affect the economy when interest rates were close to zero.

Stephen Williamson, on his blog, consistently gives articulate expression to the doctrine of Fed powerlessness. In a post yesterday, correctly anticipating that the Fed would continue its program of buying mortgage backed securities and Treasuries, and would tie its policy to numerical triggers relating to unemployment, Williamson disdainfully voiced his skepticism that the Fed’s actions would have any positive effect on the real performance of the economy, while registering his doubts that the Fed would be any more successful in preventing inflation from getting out of hand while attempting to reduce unemployment than it was in the 1970s.

It seems to me that Williamson reaches this conclusion based on the following premises. The Fed has little or no control over interest rates or inflation, and the US economy is not far removed from its equilibrium growth path. But Williamson also believes that the Fed might be able to increase inflation, and that that would be a bad thing if the Fed were actually to do so.  The Fed can’t do any good, but it could do harm.

Williamson is fairly explicit in saying that he doubts the ability of positive QE to stimulate, and negative QE (which, I guess, might be called QT) to dampen real or nominal economic activity.

Short of a theory of QE – or more generally a serious theory of the term structure of interest rates – no one has a clue what the effects are, if any. Until someone suggests something better, the best guess is that QE is irrelevant. Any effects you think you are seeing are either coming from somewhere else, or have to do with what QE signals for the future policy rate. The good news is that, if it’s irrelevant, it doesn’t do any harm. But if the FOMC thinks it works when it doesn’t, that could be a problem, in that negative QE does not tighten, just as positive QE does not ease.

But Williamson seems a bit uncertain about the effects of “forward guidance” i.e., the Fed’s commitment to keep interest rates low for an extended period of time, or until a trigger is pulled e.g., unemployment falls below a specified level. This is where Williamson sees a real potential for mischief.

(1)To be well-understood, the triggers need to be specified in a very simple form. As such it seems as likely that the Fed will make a policy error if it commits to a trigger as if it commits to a calendar date. The unemployment rate seems as good a variable as any to capture what is going on in the real economy, but as such it’s pretty bad. It’s hardly a sufficient statistic for everything the Fed should be concerned with.

(2)This is a bad precedent to set, for two reasons. First, the Fed should not be setting numerical targets for anything related to the real side of the dual mandate. As is well-known, the effect of monetary policy on real economic activity is transient, and the transmission process poorly understood. It would be foolish to pretend that we know what the level of aggregate economic activity should be, or that the Fed knows how to get there. Second, once you convince people that triggers are a good idea in this “unusual” circumstance, those same people will wonder what makes other circumstances “normal.” Why not just write down a Taylor rule for the Fed, and send the FOMC home? Again, our knowledge of how the economy works, and what future contingencies await us, is so bad that it seems optimal, at least to me, that the Fed make it up as it goes along.

I agree that a fixed trigger is a very blunt instrument, and it is hard to know what level to set it at. In principle, it would be preferable if the trigger were not pulled automatically, but only as a result of some exercise of discretionary judgment by the part of the monetary authority; except that the exercise of discretion may undermine the expectational effect of setting a trigger. Williamson’s second objection strikes me as less persuasive than the first. It is at least misleading, and perhaps flatly wrong, to say that the effect of monetary policy on real economic activity is transient. The standard argument for the ineffectiveness of monetary policy involves an exercise in which the economy starts off at equilibrium. If you take such an economy and apply a monetary stimulus to it, there is a plausible (but not necessarily unexceptionable) argument that the long-run effect of the stimulus will be nil, and any transitory gain in output and employment may be offset (or outweighed) by a subsequent transitory loss. But if the initial position is out of equilibrium, I am unaware of any plausible, let alone compelling, argument that monetary stimulus would not be effective in hastening the adjustment toward equilibrium. In a trivial sense, the effect of monetary policy is transient inasmuch as the economy would eventually reach an equilibrium even without monetary stimulus. However, unlike the case in which monetary stimulus is applied to an economy in equilibrium, applying monetary policy to an economy out of equilibrium can produce short-run gains that aren’t wiped out by subsequent losses. I am not sure how to interpret the rest of Williamson’s criticism. One might almost interpret him as saying that he would favor a policy of targeting nominal GDP (which bears a certain family resemblance to the Taylor rule), a policy that would also address some of the other concerns Williamson has about the Fed’s choice of triggers, except that Williamson is already on record in opposition to NGDP targeting.

In reply to a comment on this post, Williamson made the following illuminating observation:

Read James Tobin’s paper, “How Dead is Keynes?” referenced in my previous post. He was writing in June 1977. The unemployment rate is 7.2%, the cpi inflation rate is 6.7%, and he’s complaining because he thinks the unemployment rate is disastrously high. He wants more accommodation. Today, I think we understand the reasons that the unemployment rate was high at the time, and we certainly don’t think that monetary policy was too tight in mid-1977, particularly as inflation was about to take off into the double-digit range. Today, I don’t think the labor market conditions we are looking at are the result of sticky price/wage inefficiencies, or any other problem that monetary policy can correct.

The unemployment rate in 1977 was 7.2%, at least one-half a percentage point less than the current rate, and the cpi inflation rate was 6.7% nearly 5% higher than the current rate. Just because Tobin was overly disposed toward monetary expansion in 1977 when unemployment was less and inflation higher than they are now, it does not follow that monetary expansion now would be as misguided as it was in 1977. Williamson is convinced that the labor market is now roughly in equilibrium, so that monetary expansion would lead us away from, not toward, equilibrium. Perhaps it would, but most informed observers simply don’t share Williamson’s intuition that the current state of the economy is not that far from equilibrium. Unless you buy that far-from-self-evident premise, the case for monetary expansion is hard to dispute.  Nevertheless, despite his current unhappiness, I am not so sure that Williamson will be as upset with what the actual policy that the Fed is going to implement as he seems to think he will be.  The Fed is moving in the right direction, but is only taking baby steps.

PS I see that Williamson has now posted his reaction to the Fed’s statement.  Evidently, he is not pleased.  Perhaps I will have something more to say about that tomorrow.

Two Cheers for Ben

I admit that I have not been kind to Ben Bernanke. And although I have never met him, he seems like a very nice man, and I think that I would probably like Mr. Bernanke if I knew him. So, aside from my pleasure at seeing a concrete step taken toward recovery, I am happy to be able to say something nice about Mr. Bernanke for a change. And it’s not just me, obviously the stock market has also been pleased by Mr. Bernanke’s performance of late, and especially today.

Almost three months ago, I wrote a post in which I complained when the FOMC in its statement described a weakening economic recovery and falling inflation, already less than the Fed’s target, with no sense of urgency about improving the economic situation and ensuring that inflation would not continually fail to reach even the stingy and inadequate target that the Fed had set for itself.  A few days later, I voiced alarm that inflation expectations were falling rapidly, suggesting the risk of another financial crisis. The crisis did not come to pass, and Bernanke’s opaque ambiguity about policy, combined with an explicit acknowledgment of a weakening economy, provided some Fed watchers with grounds for hope that the Fed might be considering a change in policy. But in his testimony to Congress in July, Bernanke declined to offer any reassurance that a change of policy was in the offing, a wasted opportunity that I strongly criticized. However, in its August meeting, the FOMC finally gave a clear signal that it was dissatisfied with the current situation, and would take steps to change the policy in September unless clear signs of a strengthening recovery emerged that would indicate that no change of policy was necessary to get a recovery started.  By late July and early August, the perception that the Fed was moving toward a change in policy led to a mini-rally even before the August FOMC meeting.

Thus, the entire summer can be viewed as a gradual build up to today’s announcement. From early July until today, inflation expectations, as approximated by the 10-year breakeven spread between 10-year Treasuries and 10-year TIPS, have been gradually rising as have stock prices. And today, the 10-year breakeven spread increased by 11 basis points, while the S&P 500 rose by almost 2%, the gains coming almost entirely after release of the FOMC statement shortly after 12PM this afternoon. Since early July, the 10-year breakeven spread has increased by 38 basis points, and the S&P 500 has risen by 9%.

The accompanying chart tracks the 10-year breakeven TIPS spread and the S&P 500 between July 12 and September 13 (both series normalized to be 100 on July 12). The correlation coefficient between the two series is 92.5%.

To provide a bit more perspective on what the increase in stock prices means, let me also note that today’s close of the S&P 500 was 1459.99. That is still about 100 points below the all-time high of the S&P 500, reached almost 5 years ago in October 2007. If the S&P 500 had increased modestly at about a 5% annual rate, the S&P 500 would now be in the neighborhood of 2000, so the S&P 500, even after more than doubling since it bottomed out in March 2009, may be less than 75% of the level it would be at if the economy were performing near capacity. To suggest that the S&P 500 is now overvalued – just another bubble — as critics of further QE have asserted, doesn’t seem even remotely reasonable.

So Mr. Bernanke had a very good day today. Let’s hope it’s the start of a trend of good decision-making, and not just a fluke.

The Good News and the (Very) Bad News about Bernanke’s Speech

UPDATE:  In response to a comment, I have revised slightly the third paragraph of this post to remove an unnecessarily harsh rhetorical attack on Mr. Bernanke.

Ben Bernanke gave his commentary about US monetary policy at the annual late summer monetary conference at Jackson Hole, Wyoming sponsored by the Federal Reserve Bank of Kansas City. At the 2010 meeting, just after the stock market had fallen by nearly in the month of August as fears of potential deflation were rapidly gathering strength, Bernanke signaled that the FOMC would undertake its second round of quantitative easing, prompting a quick turnaround in both inflation expectations and the stock market. The rally in inflation expectations and the stock market continued impressively from September through February when a series of adverse supply shocks, the loss of Libyan oil supplies after the uprising against Colonel Gaddafi’s regime, the earthquake, tsunami, and nuclear meltdowin in Japan, put a damper on the modest expansion that was getting underway. A similar downward drift of inflation expectations this spring led to a substantial drop in stock prices from their early 2012 highs, prompting Bernanke and the FOMC to emit faint signals that a third round of quantitative easing just might be in the offing at some future time if it seemed warranted. Those signals were enough to reverse a months long downward trend in inflation expectations producing a rebound in stock prices back close to their highs for 2012.

So the good news from Bernanke’s speech is that he argued that, contrary to those who deny that monetary policy can be effective at the zero lower bound, there is empirical evidence showing that the previous rounds of quantitative easing had a modest stimulative effect. Bernanke maintains that quantitative easing has increased GDP by 3% and private payroll employment by 2 million jobs compared to a scenario with no QE. That Bernanke went to the trouble of making the case that previous rounds of QE have been effective suggests strongly that Bernanke has decided that the time has come to try one more round of QE, notwithstanding the opposition of some members of the FOMC, like Richard Fisher of the Dallas Fed, and among the other regional Federal Reserve Bank Presidents, notably Jeffrey Lacker of the Richmond Fed and Charles Plosser of the Philadelphia Fed. That’s the good news.

Now for the bad news — the very bad news – which is that the arguments he makes for the effectiveness of QE show that Bernanke is totally clueless about how QE could be effective. If Bernanke thinks that QE can only work through the channels he discusses in his speech, then that gives us a very acute insight into why the Fed, under Bernanke’s watch, has failed so completely to bring about a decent recovery from the Little Depression in which we have been stuck since 2008.  Consider how Bernanke explains the way that the composition of the Fed’s balance sheet can affect economic activity.

In using the Federal Reserve’s balance sheet as a tool for achieving its mandated objectives of maximum employment and price stability, the FOMC has focused on the acquisition of longer-term securities–specifically, Treasury and agency securities, which are the principal types of securities that the Federal Reserve is permitted to buy under the Federal Reserve Act.  One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors’ portfolios.  For example, some institutional investors face regulatory restrictions on the types of securities they can hold, retail investors may be reluctant to hold certain types of assets because of high transactions or information costs, and some assets have risk characteristics that are difficult or costly to hedge.

Imperfect substitutability of assets implies that changes in the supplies of various assets available to private investors may affect the prices and yields of those assets. Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.

Bernanke seems to think that changing the amount of MBSs available to the public can alter their prices and change the shape of the yield curve. That is absurd. The long-term assets whose supply the Fed is controlling are but a tiny sliver of the overall stock of assets whose prices adjust to maintain overall capital market equilibrium Affecting the market for a particular group of assets in which it is trading actively cannot force all the other asset markets to adjust accordingly unless the Fed is able to affect either expectations of future real rates or future inflation rates. If the Fed has succeeded in driving down the yields on long term assets, it is because the Fed has driven down expectations of future inflation or has caused expectations of future real rates to fall. The balance-sheet effect can at most affect the premium or discount of particular securities relative to other similar securities.  If I am in a position to change the price of crude oil at Cushing Oklahoma, it does not mean that I can control the price of crude throughout the entire world.  Bernanke continues:

Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. Such signaling can also increase household and business confidence by helping to diminish concerns about “tail” risks such as deflation.

Bernanke is on to something here, but he is still not making sense. What does Bernanke mean by “a more accommodative policy stance?” The policy stance of the central bank does not exist in isolation, it exists in relation to and in the context of the state of the real economy. Thus, any signal by the central bank about the future path of the federal funds rate is ambiguous insofar as it reflects both a signal about the central bank’s assessment of the public’s demand for accommodation and the central bank’s supply of accommodation conditional on that assessment. When the central bank announces that its lending rate will remain close to zero for another year, that doesn’t mean that the central bank is planning to adopt a more accommodative policy stance unless the central bank provides other signals about what its assessment of, or target for, the economy is.  The only way to provide such a signal would be to announce a higher target for inflation or for NGDP, thus providing a context within which its lending rate can be meaningfully interpreted.  And a signal that increases household and business confidence by diminishing concerns about deflation should not be associated with falling nominal interest rates and falling inflation expectations — precisely the result that Bernanke feels that earlier rounds of QE have accomplished. Actually, the initial success of QE2 was associated with rising long-term rates and rising inflation expectations. It was only when the program petered out, after adverse supply shocks caused a temporary blip in commodity prices and CPI inflation in the spring of 2011, that real interest rates and inflation expectations began to drift downwards again.

Because he completely misunderstands how QE might have provided a stimulus to economic activity, Bernanke completely misreads the evidence on the effects of QE.

[S]tudies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP [large-scale asset purchases] program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points.  Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield.  These effects are economically meaningful.

The reductions in long-term interest rates reflect not the success of QE, but its failure. Why was QE a failure? Because the only way in which QE could have provided an economic stimulus was by increasing total spending (nominal GDP) which would have meant rising prices that would have called forth an increase in output. The combination of rising prices and rising output would have caused expected real yields and expected inflation to rise, thereby driving nominal interest rates up, not down. The success of QE would have been measured by the extent to which it would have produced rising, not falling, interest rates.

Bernanke makes this fatal misunderstanding explicit later on in his speech.

A second potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability. It is noteworthy, however, that the expansion of the balance sheet to date has not materially affected inflation expectations, likely in part because of the great emphasis the Federal Reserve has placed on developing tools to ensure that we can normalize monetary policy when appropriate, even if our securities holdings remain large. In particular, the FOMC will be able to put upward pressure on short-term interest rates by raising the interest rate it pays banks for reserves they hold at the Fed. Upward pressure on rates can also be achieved by using reserve-draining tools or by selling securities from the Federal Reserve’s portfolio, thus reversing the effects achieved by LSAPs. The FOMC has spent considerable effort planning and testing our exit strategy and will act decisively to execute it at the appropriate time.

Bernanke views the risk of an unanchoring of inflation expectations as a major cost of undertaking QE. Nevertheless, he exudes self-satisfaction that the expansion of the Fed’s balance sheet over which he has presided “has not materially affected inflation expectations.” OMG!  The only possible way by which QE could have provided any stimulus to the economy was precisely what Bernanke was trying to stop from happening. Has there ever been a more blatant admission of self-inflicted failure?


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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