False Claims about Monetary Reforms

In a recent blog post Adam Posen complains about “new legislative efforts” which he claims are “trying to force the Fed to follow strictly a narrow policy rule when setting monetary policy even in normal times—and report to Congress in a very literal-minded short-term way about any deviations from that rule.”  The new legislative efforts which Adam refers to are embodied in Section 2 of the Fed Oversight Reform and Modernization Act which passed the House last week.  But what he says about the legislation is not in the legislation, and his claims are wrong.

The Act would require that the Fed “describe the strategy or rule of the Federal Open Market Committee for the systematic quantitative adjustment” of its policy instruments. There is nothing in the Act about strictly following a narrow policy rule: It would be the Fed’s job to choose the strategy and how to describe it, and the Fed could change its strategy or deviate from it if circumstances called for a change. The Fed would have to explain why, but there is nothing in the Act about the explanation having to be literal-minded or short-term.

Adam Posen says that “any imposition of a simplistic rigid policy rule with mechanistic monitoring will only serve to politicize monetary policy to an unprecedented extent.”  But the Act does not impose anything simplistic, rigid or mechanistic on the Fed, which would describe its own strategy.  Moreover, having a clearly stated economic strategy reduces, rather than increases, politicization.

He says “The US economy cannot be safely run on auto-pilot.” But the legislation says or implies nothing about an auto-pilot. He says that “there is no room for debate about the sheer economic irrationality of subjugating independent monetary policy to any simple-minded, rigid rule.” But the legislation does not say that the Fed should be subjugated to a simple-minded or rigid rule. Again the Fed decides, describes and reports its rule.

He says that the Act “raises the probability of higher unemployment, greater economic volatility, and recurring financial crises.”  But economic research and experience shows that when monetary policy is rule-like and predictable, the probability of all those bad things goes down, not up.

He says that “the current format of disclosures, hearings, and testimony has worked well, producing the most transparent Fed in its history.”  But more talk does not equate with more transparency, and the on-and-off bouts of quantitative easing, the frequently-changing forward guidance, and the cacophony about when and if normalization will occur are not clear or transparent.  And given that the Fed uses policy rules internally it is not transparent to conceal them.

He says that Fed policy has produced “the lowest multiyear average inflation rate since the 1950s, and the creation of 13.5 million private-sector jobs since February 2010.” But the employment-to-population ratio is still below what it was at the bottom of the recession, so that job growth has not even kept up with population growth. The disappointing growth during this so-called recovery is well below what the Fed forecast that its unconventional policies would achieve.

He says that “the Fed has delivered on its mandate to pursue price stability and full employment in the face of unprecedented financial shocks.” But there is no mention of the widely-held view that by deviating from sound regulatory policy and by setting rates excessively low and in the years leading up to the crisis, the Fed helped create those unprecedented financial shocks and thereby helped bring on tragically high unemployment rates. I am sorry to say it, but the empirical record clearly shows that the Fed has not delivered full employment during the past decade.

Accusatory language, such as “political scapegoat” or “abdicating” economic responsibilities to the American people, used in Adam Posen’s blog post tends to reinforce partisan sentiments. If so, that’s too bad, especially if it misleads people about what is actually in the legislation and thwarts discussion and constructive suggestions about the legislation itself.

Posted in Monetary Policy

Staggering Neo-Fisherian Ideas and Staggered Contracts

In a recent paper Do Higher Interest Rates Raise or Lower Inflation? and a follow-up post, John Cochrane delves into the “neo-Fisherian” idea that “maybe raising interest rates raises inflation” and lowering interest rates lowers inflation. He starts with a two-equation “new Keynesian” model (three if you include a policy rule). He then inputted a lower interest rate path and found that the inflation rate falls; similarly, with a higher interest rate path, inflation rises.   St. Louis Fed President Jim Bullard replicated and discussed the findings in his recent Permazero speech at the Annual Cato Monetary Conference.  And the results bear on the famous issue of the stability or instability of an interest peg.

This is obviously an important issue, but in my view the simplified new-Keynesian model used by John Cochrane and Jim Bullard is too abstract and artificial for the purposes at hand. The model is based on a Calvo version of staggered pricing with exponential weighting, resulting in a so-called new Keynesian Phillips curve.  What would happen in a staggered price or wage setting model with a rich enough micro-structure to be estimated or calibrated with detailed micro data?  And what more could you learn from that?

Some of the answers to these questions can be found by looking at existing simulations of more general and realistic staggered contract models.   For example, I presented the results from a model calibrated to BLS micro data on multi-period collective bargaining contracts at a Jackson Hole Monetary conference in 1982 (with critical monetarist and Keynesian comments from Phil Cagan and Bob Gordon.)  In those days, the task was to find a money growth path for the Fed to transition from high inflation to low inflation with the least disturbance to real output. The results showed–surprisingly to the commentators–that it was possible to change inflation without any effect on real output or the real interest rate.

These results can be applied easily to the neo-Fisherian debate by setting the policy interest rate equal to the unchanged real interest rate plus the (rationally) expected inflation rate. pi1 82The two charts show the interest rate path and the inflation rate path in the case of a policy change announced at the date shown in the charts. The first chart assumes that all wages are set in multiyear contracts and the second assumes a more realistic mixture of wage contract lengths. The real interest rate is assumed to be 2 percent, and that number is added to the expected inflation rate to get the nominal short term interest rate as shown.

As you can see, lowering the interest rate lowers the inflation rate just as in the neo-Fisherian view of the world; of course, the simulations work in reverse in the case of an increase in the interest rate. True, the path of the interest rate is much more gradual than in John Cochrane’s calculations; it was chosen that way to take account of the structure of the wage contracts and thereby prevent real output from changing.pi2 82

Nevertheless, the simulation results basically support John
Cochrane’s calculations. However, the results also point to complicating policy issues.  For example, somehow money growth has to be reduced when the interest rate is cut, even if very gradually at the start; effectively the expectational effect of the change in policy then offsets any liquidity effect. The simulations also point to the need for very strong credibility and the dependence of the results on the rational expectations assumption, or at least some forward looking behavior.

The results do not resolve the interest rate peg and stability issue. In the simulations, the money supply provides an anchor and the interest rate is determined in the markets.  The Fed is effectively saying that it will set the money supply path and the market will then set the interest rate according to the path. (That is how Paul Volcker usually put it during the transition, by the way). To examine the stability issue you need to look at interest rate rules to deal with shocks, whether along the transition path or in the new steady state.  I continue to be of the opinion that for stability the interest rate response to inflation shocks should be greater than one.

Posted in Monetary Policy

The Fed’s Letter to Congress and the FORM Debate

In advance of a House vote on the Fed Oversight Reform and Modernization (FORM) Act, Fed Chair Janet Yellen sent an open letter to Speaker Paul Ryan and Minority Leader Nancy Pelosi objecting to the legislation and generating a lot of media interest.  The letter repeats views expressed by Janet Yellen in Congressional testimony, which I have commented on before, but misunderstandings and misleading statements about the legislation persist. Let me  illustrate by focussing on Section 2 of the Act as does Yellen in the letter.

Section 2 of the Act would require that the Fed “describe the strategy or rule of the Federal Open Market Committee for the systematic quantitative adjustment” of its policy instruments. The Act does not require that the Fed use a particular rule or strategy.  It would be the Fed’s job to choose the strategy and how to describe it. The Fed could change its strategy or deviate from it if circumstances called for a change, but the Fed would have to explain why. The reform reflects economic evidence and practical experience that policy works best when it adheres closely to a clear rule or strategy.

Thus, under the legislation the Fed would set forth its strategy, but it would not be required to choose a mathematical formula or any other particular rule or strategy. Yet the Yellen letter says that the FORM act “would require the Federal Reserve to establish a mathematical formula” for adjusting the stance of monetary policy. That’s not true.

To improve communication the Act requires that the Fed compare its rule or strategy with a reference rule, which happens to be the so-called Taylor rule. However, describing the difference between a particular rule or strategy and this reference rule is a common and routine task for the Fed. Many at the Fed already make such comparisons including Chair Yellen. In fact, the Fed staff paper cited by Yellen in her letter makes extensive use of the rule to measure the impact of the Fed’s unconventional policies. As Janet Yellen stated in 1996 “the framework of a Taylor-type rule could help the Federal Reserve communicate to the public the rationale behind policy moves, and how those moves are consistent with its objectives”

To be clear nothing in the bill would require the Fed to follow a Taylor rule. Nevertheless, much of the letter is devoted to the therefore irrelevant claim that if the Fed had adhered to that rule after the recession then the results would have been worse. But the Yellen letter ignores the much more important view that if the Fed had adhered to that rule, or more generally to the rule-like policy of the 1980s and 1990s,  in the years leading up to the 2007-2009 recession, then we would likely have avoided the search for yield and risk taking that led to the deepness of the recession and the tragic rise of unemployment in the first place. In other words, the letter ignores the harm that came from deviating from rules-based policy in the period leading up to the crisis

The letter also says that “no simple policy rule has yet been devised that would adequately address the effective lower bound on the policy rate.” But the zero lower bound was not a reason to have deviated from rules-based policy in 2003-2005 and it is not a reason now, with the zero bound no longer binding. The zero bound appears to have been binding in 2009, but the zero bound was taken into account in policy rule design research long ago, as in my 1993 book Macroeconomic Policy in a World Economy; this research led to the view that interest rate rules are best thought of as part of a more encompassing rule in which the instrument becomes money growth in deflationary or hyper inflationary situations as in my 1996 paper Policy Rules as a Means to a More Effective Monetary Policy. Moreover the rule proposed by David Reifschneider and John Williams in the late 1990s was designed to deal with the lower bound

The letter says the legislation would “cast aside the bipartisan approach” of the late 1970s.  But it was in 1977 that very similar reporting and accountability legislation was put into the Federal Reserve Act by congress and signed by the president; though originally strongly objected to by the Fed, the legislation required the Fed to report on its policy in terms of ranges for money growth. So there is bipartisan precedent for this type of legislation. The previous legislation did not specify exactly what the numerical settings of these ranges should be (that is similar to the proposed legislation), but the greater focus on the money and credit ranges were helpful in the disinflation efforts of the 1980s.  When the requirement for reporting ranges for the monetary aggregates were removed from the law in 2000, nothing was put in its place. The reform in Section 2 of FORM would fill that void.

The Yellen letter discusses the Government Accountability Office quite a lot.  The Fed has objected to an expanded auditing role for the GAO many times before, but the issues here are different. There would be no GAO audit under Section 2 assuming that the Fed complied with the law, and concerns about compliance are likely the reason why the GAO appears in Section 2. I am sure that there are alternative compliance methods that the Fed could propose, and more generally, constructive suggestions and comments from the Fed that could improve the legislation.

Posted in Monetary Policy

It’s Still Not About Monetary Conspiracy Theories

I see that Paul Krugman is complaining again about an op-ed that Paul Ryan and I wrote in Decmber 2010.  I responded to Krugman back in February of this year when his complaints first appeared on his blog and in his New York Times column. But rather than deal with the economics of the response, he now again resorts to the same old claim that the article was promoting “monetary conspiracy theories.”   This is absurd.  Our op-ed said nothing about a conspiracy, it had no discussion of individuals, and it made no mention of people conspiring or even talking with each other. Our op-ed raised concerns about the ineffectiveness of quantitative easing and about the departure from rules-based policy—concerns expressed by many people then and now. Our op-ed also said that an upcoming round of “QE2 will create more economic uncertainty” and that quantitative easing operations “involved the Fed in areas of fiscal policy, such as credit allocation,” which were the proper role of Congress. Of course, we now know that QE2 was followed by QE3 about which even more questions about ineffectiveness have been raised.

In his blog post earlier this year Krugman also claimed that the only evidence of ineffectiveness we had in 2010 (when we wrote the op-ed) was that the economy did not strengthen. But there was and is evidence, including econometric research by Johannes Stroebel and me, later published in the International Journal of Central Banking, not to mention basic finance theory as explained here by John Cochrane.

These are issues that economists and others can research and discuss, but they are not about conspiracy theories, even if you try to tie them into current political campaigns as Krugman does in his most recent foray.

Posted in Monetary Policy

Doing Away with Evils in the International Financial System, Again

Seventy years ago President Harry Truman signed the Bretton Woods Agreements Act of 1945, officially creating the IMF and the World Bank. As Treasury Secretary Henry Morgenthau put it, the Bretton Woods agreements aimed to “do away with economic evils.”

One serious economic evil was the repeated competitive devaluations and currency wars. The British devalued the pound in 1931, and they gained a competitive advantage, but they slammed other countries’ economies in doing so. Other countries followed, including the US which devalued the dollar in 1934. These actions led to harmful government restrictions and interventions in other countries.  After trying such interventions, Italy, for example, finally devalued in 1936, matching precisely the US devaluation of 1934.

A second economic evil was the prevalence of “exchange controls,” in which importers of goods were forced to make payments to a government monopoly in foreign exchange, or confront multiple exchange rates and government licenses to export and import.

To deal with these problems the reformers developed a strategy. Each country would commit to two basic monetary rules.  First, they agreed to swear off competitive devaluations by having any exchange rate change over 10% from certain pegs be approved by a newly-created IMF. Second, countries agreed to remove their exchange controls, with a transition period because many had extensive controls in place.

With commitment to these two rules, the IMF would provide financial assistance in the form of loans.  Chicago economist Jacob Viner explained the deal: “Other countries make commitments with respect to exchange stability and freedom of exchange markets from restrictive controls while we in turn pledge financial aid to countries needing it to carry out these commitments.” He concluded that “It is largely an American blueprint for the post war economic world…. It seems to me a magnificent blueprint.”

In important respects the blueprint succeeded. Exchange controls were removed, though it took more than a decade, and the currency wars ended, though the adjustable peg system itself fell apart in the 1970s and gave way to a flexible exchange rate system.  The 1970s were difficult because monetary policy lost its rules-based footing and both inflation and unemployment rose. But in the 1980s and 1990s policy became more focused and rules-based and economic performance improved greatly.  By the late 1990s, many emerging market countries were adopting rules-based monetary policies, usually in the form of inflation targeting, and entered into a period of stability.

Unfortunately this benign situation has not held, and today the challenges facing the international monetary system resemble those at the time of the creation, including currency wars, as I explained here, and new interventions and controls.  In my view the problem traces to a departure from rules-based monetary policies at both the national and international level. These deviations not only helped bring on and worsen the global financial crisis, they have been a factor in the sub-par recovery and the recent global volatility.

So we need a new strategy, and it can build on the old strategy of the ‘40s.   We now have evidence that the key foundation of a rules-based international monetary system is simply a rules-based monetary policy in each country.  Research shows that the move toward rules-based monetary policy in the 1980s was the reason why economic performance improved in the 1980s and 1990s.  More recent research shows that the spread and amplification of deviations from rules-based monetary policy are drivers of current international instabilities.  And research shows that if each country followed a rules-based monetary policy consistent its own economic stability—and expected other countries to do the same—a rules-based internationally cooperative equilibrium would emerge.

As in the 1940s we should forge an agreement where each country commits to certain rules.  In keeping with today’s global economy, it would not be an adjustable peg system, but a flexible system in which each country—each central bank—describes and commits to a monetary policy rule or strategy for setting the policy instruments. The strategy could include a specific inflation target, some notion of the long run interest rate, and a list of key variables to react to in certain ways. Experience shows that the process should not impinge on other countries’ monetary strategies nor focus on sterilized currency intervention.  The rules-based commitments would reduce capital flow volatility and remove some of the reasons why central banks have followed each other in recent years.

Such a process would pose no threat to either the national or international independence of central banks.  It would be the job of each central bank to formulate and describe its strategy.  Participants in the process would not have a say in the strategies of other central banks, other than that the strategies be reported. And the strategies could be changed or deviated from if the world changed or if there was an emergency. A procedure for describing the change and the reasons for it would be in the agreement.

This reform is important, but supporting reforms are also needed.  A second reform would set up rules for eventually removing capital controls. Currently, 36 countries now have open capital accounts, but 48 are classified as “gate” countries and 16 as “wall” countries with varying degrees of capital controls.  The removal should be gradual and accompanied by adequate safety and soundness regulations. Though controversial, the reform would be conceptually the same as the agreement to remove exchange controls in 1944.

A third ingredient to the rules-based system would be a rule for the IMF itself to apply when making loans to countries.  The most practical way to proceed would be to restore the Exceptional Access Framework. This sensible rule was first put in place in 2003, but was broken in the case of Greece in 2010 when loans were made in a clearly unsustainable situation, contrary to the framework.

A fourth reform would wean the IMF from making unnecessary loans as part of its advice giving and monitoring activities.  When the real need is simply for the IMF to give advice to a country in implementing or monitoring reforms, there is no need for a loan.  The most practical way to proceed would be to greatly expand the use of the Policy Support Instrument which was introduced in 2005.

And finally there should be an inclusive process for selecting the next managing director of the IMF, who could well be from an emerging market country. The impacts of departures from rules-based policies have been particularly hard on emerging markets as explained by Agustin Carstens.

More details about these reform proposals can be found in my Truman Medal talk along with reform proposals for the many other institutions created in the 1940s.

Posted in International Economics

Colliding with Bill Dudley at a Crossroads

New York Fed President Bill Dudley and I debated The Fed at a crossroads: Where to go next? at Brookings yesterday, moderated by David Wessel.  Bill argued against a more rules-based road ahead for the Fed. I disagreed, but this kind of discussion from the Fed is helpful given recent legislation requiring it to report its rule or strategy.

Surprisingly, most of Bill’s points were directed at the Taylor rule, and here we collided.

First, Bill says that the Taylor rule is not forward-looking because it includes current inflation and output rather than forecasts of those variables.  But the Taylor rule was designed to deal explicitly with forecasts, and it is in fact forward-looking in important ways. Note that when a central bank indicates that it will predictably follow a rule in which the interest rate reacts to the current inflation rate, it automatically says that next period’s interest rate will react to next period’s inflation rate. That’s forward-looking. Moreover, the current level of inflation and output are factors in the forecast of inflation, and the coefficients in the Taylor rule take that into account.

Now, one could replace current inflation with a forecast of inflation in the Taylor rule—as Bill seems to suggest, but the coefficients would most likely have to be different.  And that approach raises the question of whose forecast to use and how to evaluate the rule. Remember that forecasts—including the Fed’s forecasts—are not that good. Also rules with forecasts of inflation and output on the right hand side tend not to be robust.

Second, Bill argues that the equilibrium interest rate in the Taylor rule should not be a constant.  The original rule took the real equilibrium rate to be 2%, meaning that with the 2% target inflation rate in the rule, the equilibrium nominal rate would be 4%.  But there is no reason why a moving rate could not be incorporated into the rule, and many have suggested doing so. In my view debates about the implications of changes in the equilibrium interest rate are more productive if they are conducted within the framework of a policy rule rather than in the abstract. According to the Fed’s dots, the equilibrium rate is slightly lower than FOMC members earlier believed—3.5% rather than 4.0%. That’s no reason to steer away from rules-based policy.

The adjustment that I suggested in 2008 to add a smoothed spread between Libor and the overnight index swap to the rule is an example of how such developments can be incorporated. Bill mentions this adjustment as reason why the Taylor rule should not be used mechanically.  I agree that the Taylor rule should not be used mechanically, and I emphasized that in the original paper.  The adjustment I suggested in 2008 was meant to deal in a systematic way with a particular problem in the money market at that time. The models that were used to find the Taylor rule in the first place implied such an adjustment.

Bill also refers to the zero lower bound as a reason to deviate from the Taylor rule. Well, the zero bound was not a reason for the deviation in 2003-2005 and it is not a reason now, with the zero bound no longer binding. The zero-bound was taken into account in policy rule design research long ago.  My view has been that interest rate rules are best thought of as part of a more encompassing rule in which the instrument becomes money growth in deflationary or hyper inflationary situations.

Third, Bill says the Taylor rule is too simple because it omits certain variables. Well, the Taylor rule is simple, because we made it simple.  At the time people were coming up with all sorts of complex rules that included many of the types of variables that Bill thinks should be there, including asset prices. These rules were too complex to be workable in practice. So we boiled them down. It was amazing that we could. We found that removing certain variables gave just as good a performance in many models and was more robust over all. It certainly was something more practical for policy makers to work with.

In any case Bill seems to want to complicate things again by adding in many more variables.  But saying that you need to take account of everything under the sun is not a good way to make policy. A “careful elucidation,” as he describes it, of key factors sounds better, but not if you don’t have a strategy to react to those factors. That strategy is what is missing from Bill’s favored approach. That is why I disagree with it, and why I favor a rules-based policy for the Fed with the Fed choosing its strategy, which of course does not have to be the Taylor rule.

Posted in Monetary Policy

Lessons Learned on the 30th Anniversary of the Plaza Accord

The Plaza Accord, which took place 30 years ago this month, provides two important (and fascinating) economic lessons essential for anyone interested in reforming, or simply teaching, the international monetary system.  First, sterilized exchange market interventions are largely ineffective. A newly published book, Strained Relations, by Mike Bordo, Owen Humpage, and Anna Schwartz makes this crystal clear using data from the period. They studied 129 separate interventions against the yen and mark and found “no support for the view that intervention influences exchange rates in a manner that might force the dollar lower, as under the Plaza Accord, or maintain target zones as under the Louvre Accord”

That the dollar depreciated across the board—as much against the mark as against the yen—suggests that it was part of a general reversal of the dollar appreciation experienced during 1981-1985 due to the monetary policy strategy the Fed had put in place.  As Alan Greenspan put it in an FOMC meeting in 2000, “There is no evidence, nor does anyone here [in the FOMC] believe that there is any evidence to confirm that sterilized intervention does anything.”

Second, the Plaza Accord had widely different effects on the monetary policies of the 5 participants: France, Germany, Japan, the US, and the UK.  Compare the US and Japan, for example. For Japan there was a clear effect on its monetary policy strategy. The following chart, which comes directly from a chart published by the IMF, shows the actual policy interest rate in Japan (the call money rate) for the years 1984 to 1992 along with the policy rate recommended by the Taylor rule as calculated by the IMF.  The chart shows how the interest rate was too high relative to the rules-based policy in late 1985 and throughout 1986. It also shows the swing with the policy rate set well below the rule from 1987 through 1990.japan taylor rule

The dates of the Plaza and the Louvre meetings are marked in the chart. Observe how the move toward an excessively restrictive policy starts at the time of the Plaza meeting. Indeed, as chart shows, the Bank of Japan increased its policy rate by a large amount immediately following the Plaza meeting, which was in the opposite direction to what macroeconomic fundamentals of inflation and output were indicating. Then, after a year and a half, starting around the time of the Louvre Accord, Japanese monetary policy swung sharply in the other direction—toward excessive expansion.  The chart is remarkably clear about this move. The policy interest rate swung from being up to 2¼ percentage points too high between the Plaza and the Louvre Accord to being up to 3½ percentage points too low during the period of time from the Louvre Accord to1990.

The evidence of an effect of the Plaza Accord on Japanese monetary policy goes beyond this simple correlation. The Plaza and Louvre communiques included specific commitments about Japanese monetary policy actions.  In the Plaza Accord Statement, the Government of Japan committed to “flexible management of monetary policy with due attention to the yen rate.”  In the Louvre Accord Statement, “The Bank of Japan announced that it will reduce its discount rate by one half percent on February 23.”  Thus, the policy deviations were clearly due to the way that Japan implemented the Plaza Accord and later the Louvre Accord.

In contrast, for the US, the Fed’s monetary policy strategy was not affected at all, as Chairman Paul Volcker readily admits. The communique simply confirmed that the overall strategy that the Fed was pursuing would continue.

As will I explain in a paper prepared for the 30th anniversary conference next week, these two lessons have important implications for the future. What is past is prologue.  Study the past.

Posted in International Economics