Now is the time to reform the Fed (don’t blow it)
In today’s political environment it is very difficult to get reform measures through Congress. The Democrats control the House, while the GOP controls the Senate and the Presidency. And yet, today is a perfect time for Congress to reform monetary policy.
During the Great Recession, we learned that the current monetary regime is highly flawed and that reforms are desperately needed. Unfortunately, there was no political consensus in favor of reform at that time, as the GOP and Democrats were deeply split on monetary policy. The GOP thought the Fed was doing too much, whereas the Democrats opposed any attempt to restrain the Fed from further stimulus.
Today is very different, as there is no longer a large gap between the views of the two parties. Both parties seem to favor reforms that would make a recession less likely. The GOP has changed the most, becoming much more dovish after the election of Trump. You might argue that this change is not sincere, and that the GOP will revert back if the next President is a Democrat. But politics is the art of making a silk purse from a sow’s ear.
So today is one of those rare times when a Fed reform measure would be politically feasible. Even better, the Fed is doing a major rethink of policy at its June conference in Chicago, and one could imagine them asking Congress for legislative changes after the meeting. I’ve already offered many proposals for policy reforms (such as NGDP level targeting). Today I’ll suggest a few more useful reforms.
One of the reasons for the policy failure of 2009-13 was that Fed officials were reluctant to do enough stimulus to achieve the desired rate of growth in aggregate demand. This reluctance may have been linked to fear of future losses on its portfolio of Treasury securities. And one can also imagine a scenario where the Fed would run out of risk-free Treasuries and MBSs to purchase.
The Fed needs to make sure it has enough “ammunition” to hit its policy target. Therefore the Fed might go to Congress with the following memo:
We believe that current policy tools would be inadequate in the next recession, given the likelihood that rates will fall to the zero bound.
Here are two options for Congress to consider, to assure that monetary policy remains appropriately stimulative during the next recession:
Option A: Raise the inflation target to 3%
Option B: Allow the Fed to save enough of its profits to build up a “war chest” of $250 billion dollars; to be used to cover possible loses from future QE programs. In fact, future QE programs are likely to be highly profitable (as during the Great Recession), but there is always a slight risk of losses. By having a war chest, the Fed would have confidence to do the amount of QE required to hit its Congressional mandate of stable prices and high employment.
In addition, the Fed should be authorized to buy a much wider range of securities when the economy is at the zero bound, with the provision that the non-Treasury portion of their portfolio be sold off within a year of exiting the zero bound.
You might notice that I’ve used a “framing” trick of the sort often employed when you want political leaders to make a certain choice. I’ve given two options, where the second is clearly superior and also less politically controversial. Not many politicians would wish to vote for higher inflation, whereas most voters don’t even know that the Fed earns vast profits that are turned over to the Treasury.
Having the Fed hold on to those profits until they reach a certain threshold is likely to be relatively uncontroversial, as it’s just an accounting issue. Note that the Fed’s balance sheet is already effectively a part of the Federal government consolidated balance sheet, so this reform does not in any way deny money to the Treasury in such a way as to necessitate higher taxes. So I believe Congress would choose option B, which is also my preference.
Of course there are many other options; in a previous post I suggested that the Fed balance sheet could be merged with the Treasury balance sheet, which would remove what Bernanke called the “costs and risks” of a more aggressive approach to QE. Today’s proposals are perhaps a bit more politically feasible, as the Fed keeps its separate balance sheet and merely holds onto a certain sum to cover possible losses from QE. Once the war chest is established, profits continue to be turned over to the Treasury.
It is very unusual to have the stars line up in a way where one could conceive of Congress passing useful reforms to monetary policy, reforms that would make another recession less likely and the recovery much swifter if it did occur. It would be a tragedy if we let this once in a generation opportunity slip by. If the next recession occurs under a Democratic President, I very much doubt whether the GOP would accept a reform package to make monetary policy more effective. They certainly would not have supported such a package when Obama was President. But the Dems would support this package, knowing they might need it in 2021.
PS. Over at Econlog, I provide an overview of what the Fed should be thinking about as they try to reform monetary policy this summer.
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18. April 2019 at 08:56
Very good post. Make it happen.
As a taxpayer, I see no reason to hold the Treasury balance sheet separate from the Fed balance sheet.
18. April 2019 at 14:49
I suspect Option B would inevitably lead Congress to end up stealing that reserve fund at the most innoportune time.
Option C: Have the Fed purchase assets until national income returns to its pre-recession level.
It’s easy to find opponents of raising the inflation in Congress, but no Congressman/Congresswoman would oppose a plan to increase the nation’s income.
18. April 2019 at 15:32
David Beckworth has a comment on Twitter today that mirrors my own thinking on monetary policy, if I understand him correctly.
Here’s a link to David’s comments:
https://twitter.com/DavidBeckworth/status/966322591458832384
And I comment on his thread:
“Inflation rate = extent of expected money supply growth over expected RGDP growth, given perceptions of Fed reaction function. Since the Fed targets inflation(even undershoots), market expectations to reach RGDP* never materialize, so RDGP remains below potential.”
That’s been my thought for a while now. I think there’s a roughly 1.5% output gap in the US. r* had risen over the past decade, but only very slowly.
I don’t think comparisons with the late 60s or early 70s are apt at all.
If I’m not mistaken Scott, you think wages must have adjusted by now, so we must be close to potential real GDP and the NAIRU. But, many people thought that two years ago, and so I don’t see how they could have been anything, but wrong. Surely, no one thinks our currently unemployment rate is unsustainably low.
18. April 2019 at 16:26
Call me irresponsible, but dang it, the US fiscal monetary policy tool-kit should include money-financed fiscal programs.
Ben Bernanke advised money-financed fiscal programs, AKA helicopter drops, for Japan. What does that tell you?
It may be that a federal deficit in combination with a QE program that is understood to be permanent is the same thing as a helicopter drop. Michael Woodford seems to think so.
By all means, go to a higher inflation target, or inflation band, or even a higher NGDPLT than is now considered nice. To suffocate the real economy in order to obtain a 1% decrease in an inflation index is monetary sadism.
The provocative thought of the day: as it stands now the developed economies appear to generate higher and higher relative levels of debt in order to promote growth. This also happens in China. Is the right role of a central bank the extinguishment of debt?
The People’s Bank of China does this, and it seems to work.
18. April 2019 at 16:56
Can’t just depend on wages to adjust to get back to full employment, even over a decade. Difference between GDP growth rate and labor compensation growth rate determines speed with which unemployment falls.
19. April 2019 at 03:23
Scott claims that if the Fed stores up some of its profits instead of remitting it to the Treasury, that would not “necessitate higher taxes”. Well it all depends on the reaction of politicians. Politicians might well say “income to fund the public spending we want has declined, so let’s raise taxes”. Or they might say “income has declined, so we’ll cut public spending”.
Either way, demand declines, and I totally fail to see the point of imposing unnecessary unemployment this year so that employment can be raised in a few years’ time. How about trying to keep unemployment as low as possible both now and in a few years’ time?
19. April 2019 at 05:34
Think bigger! Organize a push for your NGDPLT securities and guardrails.
19. April 2019 at 05:55
How can it be the time to reform the Fed when there’s no consensus among economists on the underlying problem. Just in the past two days I’ve read as many explanations for the inability to hit the inflation (growth) target as there are stars in the sky – aggregate demand has everything to do with it, aggregate demand has nothing to do with it. Never the twain shall meet. Have economists ever been this divided over fundamental questions as to how the economy works? I admire Sumner for sticking to his pony, but I fear the expectations won’t be matched by the results.
19. April 2019 at 09:11
Alex, You said:
“I suspect Option B would inevitably lead Congress to end up stealing that reserve fund at the most innoportune time.”
There’s nothing to steal, it’s just an accounting gimmick. It’s like talking about “stealing” money from the Social Security Trust Fund. The Treasury owns the Fed’s profits.
Michael, You said:
“Surely, no one thinks our currently unemployment rate is unsustainably low.”
The Fed thinks that. There has been no reduction in unemployment over the past 10 months, despite decent growth in RGDP. Meanwhile, wage growth has accelerated.
19. April 2019 at 10:24
Ideally, the 12 Fed banks would be nationalized like the Bank of England was. Maybe nationalization would not actually change much. But geez, the de jure structure of the Fed is utterly stupid and archaic.
The Fed (especially New York Fed) could also simplify and open up its operations somewhat to get more political buy-in. For example, have a public Treasury auction instead of using primary dealers. Any FedWire Securities Service bank or TreasuryDirect holder could participate. When rates hit 0%, the shortest maturities get bought at 0% rates first. STRIPS can also function like equivalent T-bills.
I don’t like the war chest idea because it cements the idea of a separate Fed balance sheet. Due to the liquidity premium, reserves will on average cost the combined Fed/Treasury less than equivalent Treasuries.
19. April 2019 at 11:42
Scott,
Random question and I suspect I’m wrong here but can’t pinpoint our disagreement.
There’s a large twitter thread in link below (scroll to top) regarding Canada’s monetary policy and the correlation between the monetary base and NGDP over the long run.
Thoughts on where I’m wrong (“Split Rock” account)? I’m basically claiming MB and NGDP correlate over the long run and since CB controls MB they effectively control NGDP almost completely.
Thanks!
https://twitter.com/SplitRockMgmt/status/1119319023332806656
19. April 2019 at 16:23
Scott,
Good post at Econlog. Agree with pretty much everything…..but,
1. As you say, the current target is not that bad
2. Power is not a problem. The Fed has nukes in their back pocket and they’re using a pea shooter.
3. Precision is high class problem. No need to worry about it until they fix the bigger problem.
4. Sufficiency as you say IS the problem. Can you imagine what would happen if a private banker caused trillions of dollars in losses and put millions of people out of work. FOMC members need to know they will be fired and incarcerated if they fail to perform their legally mandated responsibilities.
Loved the rhino pic. Would have been better if there had been an impaled central banker hoisted on the rhino’s horn.
19. April 2019 at 17:23
As part of Fed reforms, I think when the FOMC board sits down to make decisions, they should wear robes like the Supreme Court justices.
Also, the Fed Chair (or other FOMC members) should never submit to tawdry interviews with the media or hold press conferences. The Fed needs a very able spokesman, but in civilian clothes, who speaks on their behalf. The FOMC should appear august, to have great gravitas, and perhaps needs an instantly recognizable symbol, such as Christians have the cross, or Muslims the Crescent.
Perhaps Fed staffers should have some sort of uniforms, ala certain federal employees (soldiers, post office), and like devoted public servants in other countries. And secretly, are you comforted when the captain of your airliner wears a uniform, and the stewardesses too? What would think of an airline captain shrumpily attired in in a jogging suit?
But why these symbolic reforms and changes at the Fed?
Scott Sumner has written many times on the need for Fed guidance and for the public to have faith in the Fed.
So, how to make the public believe in the Fed? It is unsettling that sober, serious-faced monetary policy should rest upon a squishy-wishy-washy behavioral economics platform, but there you have it. The public must believe. Faith! Faith is important!
One thing bugs me: If you read right-wingers for the past 30 years, at Cato say, or read the bulk of the financial media, or listened to a high-priest in his own right, Martin Feldstein, you would have thought the Fed had zero credibility. Less than zero—th Fed was routinely purported to be an instrument of pending higher and then runaway inflation.
And right-wingers in general have a better understanding of monetary policy than left-wingers!
So….what gives?
Why no inflation? In fact, lower and lower inflation the more the relevant public shrieked about inflation!
This monetary policy stuff is tricky….
19. April 2019 at 19:26
Benjamin Cole asks whether a central bank ought to extinguish debts. I suggest not. Reason is that those who incur debt do so on the basis of a claim that they can pay it back. If they can’t, that proves incompetence and it is not in the interests of the country as a whole if resources are put at the disposal of the incompetent.
20. April 2019 at 04:11
Scott,
You replied:
“The Fed thinks that. There has been no reduction in unemployment over the past 10 months, despite decent growth in RGDP.”
This was in reply to my statement that surely no one thinks unemployment is unsustainably low right now. I’m perhaps being too picky with language, but given that the Fed recently loosened policy a by indicating a strong willingness to pause rate hikes this year, I’d think they find the current unemployment rate sustainable.
The more important point you make though it’s that employment growth has been flat over the past ten months, while wages have risen. The rise in ECI has been particularly strong over the past two years or more.
It’s obviously a defensible view that we’re at or near full-employment, and hence potential RGDP, but I think that’s wrong. I think tighter money over the past ten months has hurt employment growth and that wage growth could be even higher. There was a temporary boost to RGDP last year, but clearly the Fed snuffed it out in the final quarter. Their own behavior indicates they over-tightened, hence their reversal.
I think there’s a sort of pseudo-multiple equilibrium phenomenon that is a function of this particular era in monetary policy. A result of the regime near the ZLB.
20. April 2019 at 06:17
“Benjamin Cole asks whether a central bank ought to extinguish debts. I suggest not. Reason is that those who incur debt do so on the basis of a claim that they can pay it back. If they can’t, that proves incompetence and it is not in the interests of the country as a whole if resources are put at the disposal of the incompetent.”–Ralph Musgrave
Well, maybe so.
1. But what of public debt? The Bank of Japan has basically been monetizing debt for years, primarily Japanese government bonds. Was the nation of Japan “incompetent”?
2. The collapse of commercial property values in the US in the Great Recession was actually greater than the collapse in residential values. Institutional buyers of real estate, armed with spreadsheets and backed by sophisticated financiers, were slaughtered. Were banks that financed commercial property pre-2009 “incompetent” or were they caught in the Great Recession? As an aside, do we blame unemployed people in the Great Depression for being unemployed?
3. It seems to me that “moral hazard” is a real thing, but then the worst time to preach moral hazard is during a recession. Running lots of banks and property owners out of business during a recession…well, does not that aggravate the recession?
4. As the US economy depends upon the endogenous creation of money by commercial banks, does cratering banks in a recession (in service of moral hazard) make any sense?
5. I will say this: I think rather than generate higher and higher levels of debt to promote growth (the current model, in the West and in China), monetary policy would be more effective if the Fed simply printed money and engaged in money-financed fiscal programs.
6. Do orthodox economists have any ideas on how to keep an economy growing without higher debt-to-GDP ratios? Where have these policies been tried and worked?
7. But mostly, Ralph Musgrave, I am deeply disappointed you did not comment on my proposal that the FOMC members wear robes while holding policy-meetings, and that Fed staffers wear uniforms—this will increase their perceived gravitas, and make forward guidance more effective.
20. April 2019 at 09:34
In fairness, if I step outside of myself, Scott’s conventional view is more parsimonious. Also, he’s much more likely to be correct, because he knows much more about economics than I do.
But, I just can’t get past the notion that there’s a clue in the productivity numbers that something is wrong with this understanding.
30. April 2019 at 02:36
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