Archive for the Category Monetary Policy


Like an ox

Six years ago, I wrote a post that reflected my view of the proper relationship between the Fed and the markets:

That’s not Bullard’s job.  He hasn’t been hired to outguess the markets.  If he wants to do that he should go run a hedge fund.  His job is to be led around by the markets like a stupid ox with a steel nose ring being dragged along by a farmer.

Here’s a Bloomberg headline, reacting to today’s Fed decision:

Congratulations, Market. The Fed Is Officially at Your Mercy.

So am I ready to declare victory for market monetarism?  Not quite.  We still need a NGDP market.  TIPS spreads and stock market indices are better than nothing, but there’s no substitute for a NGDP futures market.

But we are making real progress.  The Fed is not using macro “models” to set interest rates.

Explaining Fed accountability

I frequently get questions about my recent proposal to increase Fed accountability and transparency.  Thus I thought it might be useful to make another attempt to explain the idea, based on some of the misconceptions that I have come across in conversation.  Here are 9 important points to keep in mind:

Point #1:  The Fed already does what I am asking them to do, but not in a systematic way.

All sound organizations will evaluate past decisions, in order to learn from mistakes.  Because the Fed is clearly a sound organization, Fed officials do evaluate and critique past policy decisions, but only on an ad hoc basis.  Thus when Ben Bernanke was at the Fed, he occasionally criticized Fed policy decisions made during the Great Depression (too contractionary) and the Great Inflation (too expansionary).  Bernanke was able to determine that policy mistakes had occurred by looking at outcomes—demand was too low in the 1930s and too high in the late 1960s and 1970s.  Most famously, at Milton Friedman’s 90th birthday Bernanke famously said, “You’re right, we did it.  We’re very sorry.  But thanks to you, we won’t do it again.”  Here Bernanke is also alluding to the purpose of evaluating past policy errors, to avoid similar mistakes in the future.

You might say, “Ah, but it’s easy to criticize the errors of your predecessors, not so easy to admit to your own failings.”  Yes, but Bernanke is a better man than you or I, and in his memoir (p. 280) he did exactly what you are saying is not so easy (discussing the Sept. 15, 2008 meeting):

At the end of the discussion we modified our planned statement to note market developments but also agreed, unanimously, to leave the federal funds rate unchanged at 2 percent.

In retrospect, that decision was certainly a mistake.  Part of the reason for our choice was lack of time—lack of time in the meeting itself, and insufficient time to judge the effects of Lehman’s collapse.

Bernanke doesn’t say why he now believes the decision was certainly a mistake, but I am 99.99% sure that I know why, even though I’m not a mind reader.  Bernanke believes that, in retrospect, a more expansionary monetary policy stance in September 2008 would have pushed the economy at least a tiny bit closer to the Feds inflation/employment objectives in 2009.  Maybe not a lot closer, but at least a tiny bit.

Point #2:  Monetary policy evaluation is implicitly an evaluation of whether previous policy was too easy or too tight.

One can imagine a universe where monetary policy evaluation is extremely complicated.  Where the Fed uses QE to try to control inflation and IOR to try to control employment.  But that’s not the universe we live in, or at least both the Fed and I believe things are much simpler than that.  The Fed basically works from a simple AS/AD framework, where their key policy tools all impact demand, which then impacts the various goal variables of Fed policy (PCE inflation and employment.)  That’s why in any evaluation of previous policy, one can simplify things by boiling it all down to one question:  Were previous policy settings too easy, too tight, or about right?  That’s the framework Bernanke used when discussing previous policy errors.

Point #3:  Policy self-evaluation does not constrain the Fed, or limit their ability to conduct appropriate monetary policy.

There is no good reason why the Fed would want to oppose my proposal for self-evaluation of previous policy decisions.  This is something they already do; I am merely asking for a more systematic process.  Thus under my plan the Fed might report to Congress every 6 months.  The only other requirement is that they be as specific as possible in explaining why they evaluated previous policy as being too easy or too tight.  They don’t even need to use that language; they could talk in terms of too expansionary or too contractionary.  But they should provide as much relevant data about the recent performance of the economy as possible, to make it easier for Congress to see how they reached their conclusion.  Presumably they would talk about inflation, and also various labor market indicators.

Point #4:  The evaluation process will actually be more rigorous if the Fed is given more flexibility.

This is counterintuitive, and requires some explanation.  Let’s take the example of how far back they should look, when evaluating previous decisions.  If Congress were to mandate a one-year look back, it would actually give the Fed more wiggle room.  The Fed could say, “We haven’t yet hit our targets, but that’s because it takes about 18 months for monetary policy to fully impact inflation and employment.”  Instead, Congress should let the Fed decide these technical questions.  Let them decide how long it takes, and then have the Fed look back at decisions that the Fed itself believes have most strongly impacted the current condition of the economy.  Thus the Fed might say, “Inflation is a bit too high, and we believe this reflects excessively expansionary decisions made between 12 and 24 months previously.”  They get to choose the impact lag, which prevents them from dodging blame by saying there’s not yet enough time to evaluate the decisions.

Similarly, let the Fed decide what constitutes success.  They would probably include 2% PCE inflation as one component, but also include data on employment in their report.  If you specify what metrics the Fed is to use, then they can always play a shell game.  Overall PCE inflation is too high?  “We focus on core PCE inflation”.  Etc.  Better to let the Fed tell us what metrics they use to decide if policy had been too stimulative.  Then they have no place to hide.  Sure, they could suddenly claim that the inflation target is 5% or 0% (to match reality), but would that be credible?  What if they suddenly said (in a recession) that the natural rate of unemployment is 8%?  Would Congress go along with the view that more jobs would be a bad thing if the actual unemployment rate were also 8%?  It’s not as easy for the Fed to dodge responsibility as you might imagine.

Of course it’s also vastly easier to get a bill through Congress if you give the Fed more flexibility, as the Fed would then have less ability to characterize the proposal as an unwise constraint on Fed independence. (Recall the opposition to the previous monetary policy rule proposal.)

Point #5:  This is not NGDP targeting.

I am often associated with NGDP targeting, because that’s what I advocate.  And NGDP is a natural way to think about things like “demand” or “spending”.  And Fed policy certainly affects its goal variables by impacting the level of demand, or spending, or NGDP, or whatever you want to call it.  But I now generally try to avoid mentioning NGDP while discussing accountability, as I don’t want the proposal to be wrongly viewed as a sort of NGDP targeting program.  The Fed decides what targets will best achieve the Congressional mandate.

Point #6:  Reports should work backward, from the goals to the tools. 

Thus the Fed might start its report with some metrics on inflation and employment.  This data would help Congress to understand the variables the Fed used to decide whether it had achieved its mandate.  Then the Fed would make an overall judgment (taking all these variables into account) as to whether they had undershot or overshot their target.  They would presumably talk about their inflation target (currently 2%) and their estimate of the natural rate of unemployment (currently about 4.3%) At this point, the Fed would say something like, “Spending was too high (or low)”.  Or, “Demand was too high (or low)”.  Or, “Policy was too expansionary (or contractionary)”.  I’d let the Fed choose the language it preferred.

Point #7:  The Fed may have good reasons for missing its target, but that would still be very useful to know.

Thus the Fed might say that demand ended up being too low to hit their targets, and attribute that policy error to an unforeseen shock such as a banking crisis or trade war.  Alternatively, they might cite real or imagined constraints on Fed policy.  They might say, “We are not authorized to do negative IOR.”  Or they might say, “The zero bound limits our ability, and we believe that Congress does not favor us raising the inflation target to solve the zero bound problem.”  Or, “If we had done enough QE we could have hit the target, but Congress seemed very apprehensive about our QE program, and we were reluctant to push it too far.”  Put aside your personal view of these “excuses”, the point is that it would be useful to have a better understanding of exactly why the Fed fails to achieve its mandate, in cases where even at the time they set their policy instruments the Fed already expected to fall short, but were reluctant to do more.  Let’s have that conversation.

Point #8:  Accountability actually helps the Fed.

The Fed wants to achieve its policy goals.  You can debate whether they treat 2% inflation as a ceiling or a symmetrical target, but whatever it is the Fed wants to hit the target.  Their life is much, much easier when the economy is doing well, and the Fed chair is widely lauded as a “maestro”.  Accountability makes it easier for the Fed to achieve its goals, in several ways.  First, it will give the markets a more precise sense of exactly what the Fed is trying to achieve, which will help to stabilize expectations.  More importantly, it will give the Fed “cover” for controversial decisions that it believes are necessary to achieve the mandate.  Thus in the next recession the Fed may decide to adopt both substantial QE and the level targeting of prices.  That’s pretty aggressive.  Even so, it’s likely that for at least 2 or 3 semiannual reports (during the recession and early recovery) the Fed will be admitting that, in retrospect, its previous policy stance was a bit too contractionary to hit the dual mandate.  Those reports will help to deflect criticism from politicians and pundits who say they are doing too much.

Point #9:  Accountability could usefully educate the public, making good policy more popular.

Right now it is probably the case that lots of people, including many politicians, view Fed policy goals as sort of vague aspirations.  Stable prices and high employment sound wonderful, sort of like “Scott Sumner winning the Nobel Prize in Economics” sounds wonderful.  But that’s not the right way of thinking about monetary policy.  We need people to view policy as like steering a large ship.  If you are headed for New York, you better have an awfully good excuse if the ship ends up in Boston. Because of wind and waves you’ll go off course for brief periods, but you have the tools to get back on course reasonably quickly.  And the destination of a ship is crystal clear.

I’d like to see politicians spending less time asking Fed officials about income inequality or the budget deficit and 100 other issues that are beyond their control, and spend a lot more time discussing exactly how they are doing in terms of achieving the Congressional mandate of stable prices and high employment.  I don’t recall many occasions where Congressmen or women asked Fed officials to explain whether policy decisions taken a year or two ago were, in retrospect, too expansionary or too contractionary to hit the target.  But that’s exactly what they should be asking.

PS.  Question:  Did anyone in Congress ask Bernanke during 2009 or 2010 why the Fed had decided not to cut interest rates right after Lehman failed in Sept. 2008?

The actual problem

The global media seems endlessly fascinated by the question of whether monetary policy in the US is too easy or too tight, even as the Fed comes amazingly close to hitting its targets.  I suppose this interest can be partly justified by the size and influence of the US, which David Beckworth calls a “monetary superpower”.  Nonetheless, there should be more discussion of the fact that monetary policy in the Eurozone and Japan is way off course, and that these policy mistakes are a danger to the global economy.

Core inflation in the Eurozone is 1.0%, far below the ECB’s roughly 1.9% target:

Screen Shot 2019-01-23 at 12.20.01 PMAnd growth in the Eurozone is slowing as we go into 2019.

Core inflation in Japan is even further below the BOJ’s 2% target:

Screen Shot 2019-01-23 at 12.20.32 PMAnd growth in Japan is also slowing.

My suggestion is that both central banks consider switching to level targeting and adopt a “whatever it takes” approach to hit their targets.  These changes might require legislation, and I’m not expert on the political barriers to getting this done, which I presume are formidable.  Fortunately, these two changes might well be enough; I doubt they’d need to take any additional “concrete steps”.

PS.  Commenter LK Beland constructed a monthly series of wage income for the US, by multiplying average hourly earnings, average hours per week and payroll employment.  In some respects, this data is superior to NGDP as an indicator of the appropriateness of monetary policy. Interestingly, the graph shows even greater stability than NGDP growth, mostly hovering around 4% to 5%:

Screen Shot 2019-01-23 at 12.24.28 PMThis is what I’ve been advocating as a long run policy ever since I started blogging in early 2009.  However I would have liked to have seen faster “catch-up” growth in the early years of the recovery.  Even so, this is a good sign.  If they can keep roughly 4% growth going forward then . . . . we win.

When should we be worried about monetary policy?

During late December, there was a lot of chatter in the press and the blogosphere about monetary policy.  Many pundits expressed concern that policy was off course.

Back in September 2010, there was relatively little chatter about monetary policy.  Why is there a great deal of discussion at some points in time, but not others?  One answer is that people talk about monetary policy when it is not hitting its targets.

Let’s look at the most recent unemployment and (PCE) inflation data that was available as of late September 2010 and late December 2018:

August 2010:  12-month PCE inflation = 1.38%, unemployment = 9.5%

November 2018:  12-month PCE inflation 1.84%, unemployment = 3.7%

Hmmm, which set of data points is closer to hitting the Fed’s dual mandate?

Which set of data points suggest that policy is clearly off course?

It might be argued that the Fed was out of ammunition in September 2010.  Actually, that is not the case:

1.  Bernanke insisted the Fed had more ammunition.

2.  The Fed was paying interest on reserves.

3.  The Fed was not doing quantitative easing.

4.  The Fed was not doing significant forward guidance.

So why was there a lot of discussion of the Fed being off course in late December of last year, but very little discussion in September 2010?

1.  A lack of understanding that if AD is too high or too low it’s always 100% the Fed’s fault.

2.  An inability to understand what it means for money to be easy or tight.

Thus most pundits wrongly assumed the Fed was tightening policy in 2018, even as NGDP growth picked up.  This so-called tightening was seen as a “concrete step” that threatened the recovery.  In 2010, policy was wrongly seen as being “expansionary”, and the Fed was wrongly seen as being not responsible for the fact that AD was currently far too low to achieve the Fed’s dual mandate.

Bottom line:  When discussion of monetary policy is at its highest pitch, there is often less cause for concern than when almost no one it talking about it.  Consider late 2008, when monetary policy was disastrously off course, and yet there was almost no discussion of that fact in the media.

That’s not to say that policy is not currently off course—it may well be.  Rather my point is that any errors in the current policy setting are trivial compared to 2008 or 2010, when people were mostly ignoring the Fed.

Kocherlakota wins 2013 (and Powell loses)

The minutes for 2013 were just released, and I’ve only had time to consider the January transcript. It’s clear that Narayana Kocherlakota is the clear winner.

Most people will focus on the fact that Kocherlakota’s 2013 policy advice (to be more stimulative) was clearly superior, evaluated in retrospect. I pay little attention to that fact, as it might have been merely due to luck. Rather I’d focus on the fact that Kocherlakota laid out a clear and logical approach to monetary policy determination, which was superior to that of the other FOMC members:

Mr. Chairman, my comments are not about the specific changes, but rather about the statement in its entirety. I supported the statement, what I’ll be calling the “principles statement,” a year ago. Today I’d like to reaffirm my support, but even more enthusiastically. By design, the principles statement encompasses a wide number of approaches to the making of monetary policy. Nonetheless, over the past year, I have found it to January 29–30, 2013 be sufficiently specific to provide valuable guidance when thinking about the appropriate stance of policy. To explain my thinking, Mr. Chairman, I think it’s helpful for me to refer back to a speech that you gave in December 2004 called “The Logic of Monetary Policy.” In that speech, you contrasted two approaches to monetary policy. Under what you called the “simple feedback” approach, the central bank responds in a relatively automatic fashion to the evolution of current and past variables. The Taylor rule is one example of this approach. In contrast, under the second, the “forecast-based” approach, the central bank chooses the action that it forecasts will produce the best overall results, taking account of the risks to the economy. Thus, if the central bank judges its results relative to targets for inflation and unemployment, it chooses the policy that is forecast to bring the economy closest to those targets. Lars Svensson has been a particularly vocal proponent of this approach.

As I’ll describe, my reading of what will now be the penultimate paragraph of the principles statement is that it is firmly grounded in the forecast-based approach. Correspondingly, that paragraph has led me to put considerably more weight on the forecast based approach in my own thinking about policy. The opening sentence of that key operational paragraph says that we should begin by asking, will the current path of monetary policy result in deviations between inflation and the longer-run goal of 2 percent? Equally, will it result in deviations between employment and its maximum level? The current policy path does imply such deviations. Then that same first sentence prescribes that we should adopt monetary policy actions to mitigate them. Suppose, for example, that given the current policy path, inflation is expected to run below its longer-run target over the next year or two and employment is expected to run below its maximum level. Then that first sentence implies that we should seek to mitigate those deviations by adding accommodation. Of course, decisions are more difficult when only January 29–30, 2013 one of the two variables is expected to be below its desired level. For example, suppose the current policy path is expected to lead to inflation of exactly 2 percent over the next few years, but also to lead to employment being below its maximum level. Here the second part of the paragraph provides the needed guidance. It espouses a balanced approach in the situation, and this means, I think, that we should add accommodation to mitigate the employment deviation. So I posited that inflation was exactly 2 percent. Adding accommodation would end up resulting in inflation running somewhat above target. But this is, I think, what a balanced approach has to mean: that monetary policymakers are willing to follow policies that give rise to slightly positive inflation deviations in order to mitigate negative employment deviations. The Committee has, of course, explicitly evinced that kind of willingness in the December 2012 FOMC statement.

Key takeaways:

1. Kocherlakota understood that the Fed needed clear policy goals.

2. Kocherlakota understood that policy needed to be set at a position where the Fed forecast equaled the Fed target for those goal variables.

3. Kocherlakota understood that the Fed’s dual mandate implied that if both targets could not be hit at the same time then inflation should be countercyclical, that is, above 2% inflation when unemployment is high, and vice versa.

4. Kocherlakota understood that the 2013 Fed economic forecast under the (consensus) “Alternative B” policy option was expected to lead to below target inflation and employment, and hence that the consensus policy choice was too tight.  This is discussed later in the transcript:

Now, as I said in the previous go-round, given the current stance of policy, I expect inflation to average less than 2 percent over the next two years, and I expect unemployment to remain above 7 percent over the next two years. This forecast conforms closely to the outlook described in alternative B and in the outlook in the Tealbook, and I think it’s actually fairly similar to a wide range of the forecasts we’ve heard around the table, certainly on the inflation front. So we’re confronted with a small negative deviation relative to our inflation goal and a January 29–30, 2013 large negative deviation relative to our employment goal. Yesterday, Mr. Chairman, we took the step of reaffirming the principles statement, the long-run goals and strategy statement, which I think will, over time, assume a quasi-constitutional status in this Committee. I think that statement is clear in its operational, penultimate paragraph about what needs to be done in this situation. The Committee should seek to mitigate these deviations from its goals by adding accommodation.

PS.  There’s discussion in the press of how Bernanke was pressured by the “three amigos” to slow down the QE program.  This led to the famous “taper tantrum” of 2013.  Ironically, two of those “amigos” were Obama appointees to the Board.  Their pressure to curtail QE might have slowed the recovery enough to cost Hillary the election (although of course it’s hard to be sure—in a close election almost anything can swing the result.)  Even more ironically, one of those Governors was appointed by Trump to be Fed chair, despite it being well known that his views were more hawkish than those of Yellen.  Fortunately, he is doing a good job so far, if one judges by the Lars Svensson criterion.