Archive for the Category Monetary Policy


My views on monetary policy: An update

It’s time to update my current preferences on monetary policy:

Monetary authority structure:

1.  As in the UK, monetary policy decisions should be made by a committee of monetary specialists.  They need not be economists, but they must be experts. Self-taught is fine. Financial regulatory decisions should be made by a separate (Treasury) committee, composed of experts on finance.

2.  The FR Board should continue to be independent.  The regional Fed banks should be abolished.

3.  The Fed balance sheet should be moved over to the Treasury so that the Fed does not incur any balance sheet risk.

4.  Anyone should be able to have a “reserve” account at the Treasury. It would pay no interest.  I.e., electronic cash.

5.  Paper currency should not be abolished (as it provides privacy.)

Policy Tool:

The Fed should use just one tool, open market operations.  Generally these operations should involve Treasury securities.  There’s no need for the Fed to recommend discount lending, reserve requirements and interest on reserves as tools of monetary policy.  Other assets should be purchased only if necessary.  If we don’t get my optimal NGDP level targeting strategy and the zero bound problem occurs frequently, then there is a much stronger argument for making the purchase of other (non-Treasury) assets a routine part of policy.  Bank bailouts should be done by the Treasury, if at all. (Hopefully not at all.)  There should be an iron curtain between the Fed and the banking system, like the separation of church and state.

Policy Target:

Nominal growth targets should be high enough to avoid the zero bound problem.  With level targeting, a 4% NGDP growth rate should be high enough.  We should target expected per capita NGDP growth, level targeting.  (Perhaps growth of one basis point a day is a nice round number, for that future time when “big data” allows us to know daily changes in NGDP.)  A nominal total labor compensation target is better for some countries.  The Fed should completely offset the impact of any fiscal policy action.

Policy Rule:

The Fed should commit to a “guardrails approach”, a willingness to sell unlimited NGDP futures contracts at a implied NGDP growth rate slightly above target and buy unlimited NGDP futures contracts at an implied NGDP growth rate slightly below target.

Policy Accountability and Transparency:

The Fed should report to Congress twice a year on the effectiveness of previous policy decisions.  They should explain whether, in retrospect, policy settings adopted 12 months earlier were too easy or too tight, even if only slightly so.  They should clearly explain the metrics they used to make this determination.  This form of accountability is especially important if NGDP targeting is not adopted, less so if it is.

What am I missing?  I may add a few items based on comments.

What if cherry pie could cure cancer?

[After reading this post, please check out my related Econlog post, an increasingly rare example (for me) of a post where I discuss a NEW IDEA for monetary policy. At least new to me.]

Imagine a world where eating lots of cherry pie was bad for healthy people.  (Not hard to do.)  Now imagine that for some strange reason the consumption of cherry pie improved the health of cancer sufferers.  And the more you eat, the quicker you get over your cancer.  A slice after every meal is good for cancer sufferers; adding an afternoon snack is even better.  Sweet!

This scenario is fanciful, but actually does describe one important aspect of monetary policy.

When LBJ became president in late 1963, the economy was in decent shape.  It was three years into an expansion and inflation was less than 2%.  But he couldn’t leave well enough alone, and a couple years later began pressuring the Fed to stimulate the economy.  The Fed responded with a massive purchase of government debt, which led to a rapid increase in the money supply.  The monetary base had risen from $33.4 billion to $44.3 billion between November 1945 and November 1963, but soared to $83 billion by November 1973—the Great Inflation was underway.  BTW, these purchases reduced the value of US government bonds, for those worried about “Cantillon effects”.

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Just as eating too much pie is bad for a healthy person, monetizing lots of debt is bad for a healthy economy.  It causes high inflation, which discourages saving and investment.

Oddly, when the economy is so unhealthy that interest rates have fallen to zero, printing money to buy back the public debt becomes a healthy policy.  The more you buy the better you feel.  And it’s also highly profitable, at least in most cases.  Of course it’s theoretically possible that you’d buy assets with a lower rate of return than cash, which earns zero.  But that’s unlikely.

Because eating lots of cherry pie has a bad reputation, lots of doctors would discourage their cancer patients from eating too much for fear they might get diabetes. Even if consuming cherry pie worked miracles for cancer patients, some doctors would keep recommending chemo and radiation.  As an analogy, certain mushrooms dramatically reduce depression in patients with terminal cancer, but many doctors refuse to recommend this enjoyable drug because . . . well . . . I’m not sure why.  Perhaps it’s our puritan instincts.

Even though QE is a miracle drug that helps a zero bound economy get better and usually leads to big profits for the government, our economic doctors warn against taking too much of this delicious medicine.  After all, QE is bad for healthy economies.  In their view it’s better to rely on fiscal stimulus, which not only is not profitable, it imposes trillion dollar losses on the Treasury.  We live in a world where the Very Serious People tell us we need economic equivalent of chemo, not cherry pie.  Even though cherry pie is far tastier, and more effective.


PS.  Kevin Erdmann has a new piece in the Wall Street Journal.  Also, please order his excellent new book on housing, it will lead you to completely rethink many of your views of what happened during the boom and bust.



What should we expect from Fed officials?

I occasionally see comments from people who have an unrealistic set of expectations for Fed officials.

An institution like the Fed will tend to reflect the consensus view of economists. Back in late 2008, I was among perhaps a few dozen people in the entire world who blamed the Great Recession on a tight money policy of the Fed. Even today, that view is only slightly more popular, mostly due to the effort of market monetarist bloggers. It’s entirely unrealistic to expect Fed officials to reflect the views of market monetarists—that’s now how our system works. Nor will they reflect the views of other obscure groups, like MMTers or fans of the fiscal theory of the price level. That’s why I favor NGDP level targeting, it’s a regime that will lead to pretty good results under almost any competent leadership.

I’m not saying the people appointed to the Fed don’t matter at all. Bernanke did better than Volcker or Greenspan would have done (based on their public comments during the Great Recession), and better than the average economist would have done. Mario Draghi did better than Trichet. But for the most part, Fed policy merely reflects the consensus view of economists and financial market pundits. Don’t expect anything more than that.

David Beckworth recently interviewed Neil Irwin, who pointed out that Bernanke was under a lot of pressure to adopt a more contractionary policy.  He also noted that while Trump has criticized the Fed for raising rates, he has also appointed Marvin Goodfriend to the Fed, a relatively hawkish economist.  Obama also appointed several people who were more hawkish than Bernanke.  If Trump wants dovish policies then he might try appointing doves.

Over at Econlog, I have a “Ted talk” on the future of money.

What’s the problem?

The problem isn’t the recent decline in equity prices; the stock market tends to be more volatile than the underlying economy.  Nor is it the recent increase in the fed funds rates (2.4% isn’t very high in an economy growing at 5.5% in nominal terms.)  Rather, the problem is two-fold:

1. Unrealistic forward guidance, which ignores market forecasts.

2. Too much inertia in adjustments in the fed funds rate.

Elsewhere I’ve argued that the second factor may explain the strange absence of mini-recessions in postwar US history.  And this absence is really, really strange.  Just imagine how perplexed geologists would be if the Earth had no small earthquakes, only large ones.  What model could possible explain that? I’ve argued that the sluggishness in the response of interest rates might explain why it is that when we start to slide into a recession we never seem to stop halfway, with the unemployment rate rising by only 0.9 to 2.0 percentage points.

The fed funds rate is currently around 2.4%, and the market forecasts a rate of 2.3% out in July 2020.  That forecast is down sharply in recent months, although still not in recession territory.  Unfortunately, the Fed is forecasting two rate increases next year, and the markets seemed to react poorly to Powell’s attempt to explain this forward guidance.  Even worse, the Fed is often reluctant to change course, because of a perception that it reduces credibility.  Just the opposite is true.  The credibility that matters is the Fed hitting its macro targets, not its interest rate forecasts.

Earlier I suggested the following reform:  Each day, have every FOMC member email their preferred IOR rate, calculated to the nearest basis point.  Set the IOR at the median vote.  Tell the market that the rate will likely follow something close to a random walk, with an increase on one day often followed by a decrease the next.

Looking further ahead, my preference would be to have the Fed entirely cease its targeting of interest rates and let the market determine the appropriate rates.  Instead, the Fed would give the New York open market desk the following instructions:

1.  A range for one year NGDP growth–say 3.5% to 4.5%.

2.  Instructions for the New York Fed to take unlimited short positions on NGDP futures contracts at 4.5% and unlimited long positions at 3.5%.

3.  Instructions to do open market purchases and sales (with Treasury securities) in such a way as to avoid losses in their trading of NGDP futures contracts.

That’s all.  Let the market set interest rates; they are much better able to determine the appropriate fed funds rate.

OK Fed, you’ve got a landing. Now let’s make it “soft”.

PS.  As I contemplate the Fed’s current (flawed) policy regime, I feel sad and blue:

Screen Shot 2018-12-25 at 12.59.20 PMTyler Cowen recently linked to an article on the Chinese industry of copying famous oil paintings. This is a detail from an oil painting I purchased in China, for about $15 dollars.  It hangs in my office.  In downtown LA, people spend thousands on paintings by hip new artists.  I can get better art in China for a tiny fraction of the price. You might argue that they aren’t really buying art, they are buying a story.  And “I support hip young artists” is more appealing than “I buy Chinese knockoffs of famous paintings.”  Fortunately, I don’t care what other people think of my taste in art.

Merry Xmas and Happy New Year

PPS.  You want a Christmas theme?  Here’s an even better painting (by Titian), recently restored to its former glory:

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A very subtle distinction

It will be easier to understand this post if you first read the previous post.  The Fed delivered two monetary shocks today.  The first occurred at 2:15pm, and caused yields on 2 and 5 -year bonds to increase.  The second occurred about 30 minutes later, and caused yields on 2 and 5-year bonds to fall back, and end the day slightly lower.  And yet both shocks seemed “contractionary” in some sense.  Obviously there are some very subtle distinctions here, which require an understanding of Keynesian and Fisherian monetary shocks. More specifically, the first shock was Keynesian contractionary and the second was Fisherian contractionary

At 2:15 the Fed raised its target rate as expected, and also indicated that another two rate increases are likely next year.  This announcement was a bit more contractionary than expected, especially the path of rates going forward.  As a result, 2 and 5-year yields rose, while 10-year yields fell on worries that the action would slow the economy, eventually leading to lower rates.

Later, the markets became increasingly worried that the Fed was not sufficiently “data dependent”, that it would plunge ahead with “quantitative tightening” and that the Fed stance on rates (IOR) would be too contractionary.  Watching the press conference, I had the feeling that Powell might have wanted to be a bit stronger in emphasizing that no more rate increases are a clear possibility, but felt hemmed in by his colleagues at the Fed.  But perhaps I was reading into it more than was there.  In any case, Powell said “data dependent”, but didn’t really sell the markets that he was sincere, or as sincere as the market would wish.  This monetary shock probably reduced NGDP growth expectations, and drove 2 and 5 year yields lower.

Do you see how utterly inadequate it is to talk about monetary policy in terms of interest rates?  Even the “sophisticated’ new Keynesian view that it’s the future path of rates that matters is nowhere near adequate.  The 2 and 5-year yields can go up with tightening, or they can go down with tightening.  Today they did a bit of both, within one hour.

If you insist on using Keynesian language, you might say the 2:15 action tightened primarily by raising expected future rates relative to the natural rate, by raising the expected path of the policy rate.  In contrast, the press conference impacted the gap by depressing the natural interest rate by depressing NGDP growth expectations.

PS.  The discussion on CNBC involved lots of people dancing around the “circularity problem”, i.e. the Fed looking at markets while the markets look at the Fed.

PPS. I laughed when a CNBC person suggested Trump might use the Fed as a “scapegoat”.  Hello, who appointed all the top Fed officials?  Has scapegoating the Fed ever worked for any President, even when they weren’t his appointees?

Update:  I forgot to mention Powell’s most interesting comment.  He says the Fed reappraisal of policy techniques planned for this summer in Chicago will look at the zero bound problem in monetary policy.  I view that as really good news.