Terminal Policy Rates: Hot, Cold and About Right

Last week I flew overnight from Cartagena, Colombia (90o F, very humid) to Jackson Hole, USA (37o F, plus wind chill). In both places I was asked a lot about monetary policy—by bankers at the conference in Colombia and by central bankers at the conference in the US. The most common question was “What is the real equilibrium policy interest rate?”  Is it 2% as in the original Taylor rule, or is it 0%, (Taylor rule minus 2) as the people at PIMCO (Paul McCulley and Bill Gross) have been arguing, or is it even negative as the new secular stagnationists such as Larry Summers would have it.

FOMC members have expressed their views on this for a while, with a median of around 4% nominal, which translates into 2% real if you use their 2% target inflation rate.  Recently their median is slightly lower, 3-3/4 %, and that is also what former governor Larry Meyer at Macroeconomic Advisers is saying, though this is still not much different from 4%.

Paul McCulley admits befuddlement by all this and is making the case for a change.  In a recent PIMCO newsletter he says “…for me, it is so befuddling that the Fed, and thus the markets, still clings – even if reluctantly – to one man’s estimate of an “equilibrium” real fed funds rate, made in 1993: John Taylor, who assumed it to be 2%….I’ve got to hand it to John, whom I’ve known and liked for a very long time: Twenty-one years on, and you are still hardwired into the catechism of Fed policy!”

Well there are other plenty of other catechism type “questions-and-answers” that are not hardwired, though I wish they were, such as “Q: Should the Fed adopt and state a rule or strategy for the instruments of monetary policy? A:Yes”

I have not seen convincing evidence of a new neutral for the terminal federal funds rate in a policy rule.  The 2 percent real rate was chosen back when the potential economic growth rate was estimated to be quite low (2.2% in my 1993 paper).   Most important in my view is that the poor economic performance in the developed countries in the past few years is due to economic policy in general (which can change) not to some exogenously imposed “new neutral.” Also, when you ask monetary policy analysts in emerging market central banks around the world, they do not see evidence for such low equilibrium rates. For example, I learned in Colombia the real policy rate has averaged about 2 percent since inflation targeting began. My informal poll of emerging market central bankers at Jackson Hole revealed the same: two to three percent.

Of course, this debate centers on the real policy rate in the long run.  There is more room for disagreement about the short run or the medium run, but for now the terminal rate of 4% still seems about right to me.

Posted in Monetary Policy

The American Economy: Turtle or Caged Eagle?

Last week I was on a panel with Stanford President John Hennessy and Congressman Paul Ryan at the new Hoover Institution Offices in Washington. Al Hunt moderated the discussion which focused on policies to raise economic growth. The video is here.

The discussion revealed both a sense of urgency and of optimism.  I am convinced that we sorely need a major change in US economic policy to address the problem of low economic growth, only 2 percent since the end of the recession 5 years ago compared to years of 4 or 5 percent growth following earlier deep recessions in the US. That’s huge. It means that we have far fewer resources available for both private and public use.

I argued, as I have been arguing for a long time, that the cause of weak growth is poor economic policy. But Al Hunt asked me if it was all over for a strong growth in America. After all, more and more people are talking of secular stagnation and telling stories that we have picked all the low hanging fruit. I just don’t see that, maybe because I come from Silicon Valley where you see invention and innovation all over the place. But neither does John Hennessy, who knows as much as anyone about information and technology (also from Silicon Valley), or Paul Ryan, who knows as much as anyone about policy. You get a sense of the optimism from watching them on the video.

The cover of The Economist last week portrayed the US economy as a turtle crawling along as its rider tragically tries to get it to move faster, but it is clearly incapable. This may be the way that the secular stagnationists or high-hanging fruiters see it.

Economist turtle

To me a much better picture for the US economy is a a sleeping giant ready to be awakened or better yet, a caged eagle. If you removed the cage of poor policy. then the economy would soar again.

caged eagle

Posted in Slow Recovery, Teaching Economics

The Ayes Have It, While Greenspan and Many Others Comment.

This week the House Financial Service Committee voted to approve legislation requiring the Fed to report a policy rule or strategy for setting the instruments of monetary policy.  The legislation now goes to the full House, with a vote likely sometime in September. Technically the Committee vote was on a “Motion to Report Favorably H.R. 5018, The Federal Reserve Accountability and Transparency Act of 2014, as amended.” The requirement for policy rules is Section 2, the first main section of that bill. (For a civics lesson, you can watch the clerk of the Committee count the Ayes and Nays on this video starting at 45:55 and ending with “Mr. Chairman the ayes were 32 and the nays were 26”)

Since this bill was first introduced on July 7 there have been hearings and a lot of interesting commentary in op-eds, TV interviews, blogs and social media as I summarized in previous posts here and here.

More commentary came this past week including importantly from former Fed Chair Alan Greenspan who said this on Bloomberg TV at 13:00

“What I found very interesting is that this new legislation, which of course is to match the Taylor rule, came out recently. When the Taylor rule was originally [proposed] in his econometric analysis of what the Fed was doing from 1987 to 1993. So I think that if we could replicate that in some form or another that’s the way we should be functioning.  The problem however is going from where we are now, which is a very bloated set of balances sheets, which require an unprecedented procedure.  We are not yet back to the point where we have a normalized monetary policy. And I think that‘s a critical question that’s going to be an experiment issue. It’s going to be very tough.”

Of course the legislation does not require the Fed to follow the Taylor rule—that rule simply serves as a reference rule. But Greenspan reminds us that during periods when the economy was doing well, policy was close to the recommendations of such a rule, and as a matter of logic monetary policy should try to replicate that.

Other commentary worth studying includes Martin Feldstein’s Fighting the Fed on Project Syndicate,  Peter Ireland’s A Useful Rule for Monetary Policy on Ec21, David Papell’s How Janet Yellen Might Have Responded to the Policy Rules Legislation on Econbrowser, and Simon Johnson’s The Fed in Denial on Project Syndicate.

Feldstein says that the legislation “still leaves the Fed substantial discretion” while Ireland and Papell show, in different and complementary ways, how the Fed could conduct policy if the new legislation was in place. Simon Johnson is more skeptical and criticizes the Fed on other grounds.

Feldstein also delves into the history of thought when he writes that the Taylor rule was “based on his statistical estimate of what the Fed appeared to have been doing under Paul Volcker and Alan Greenspan during a period of both low inflation and low unemployment.” But my paper had no statistical estimates. The design of that rule, including the choice of right-hand-side variables and the left-hand-side interest rate instrument, was based on research with new monetary models that I was developing at the time, especially simulations of alternative rules in such models.  I compared the proposal with decisions during the early Greenspan period (but not the Volcker period) to show that the proposal was practical, as I wrote in a blog several years ago.

Posted in Monetary Policy

Discussion of Policy Rule Legislation Continues

Discussion and debate about new policy rule legislation continued during the past week.  I replied to Alan Blinder’s  article, “An Unnecessary Fix for the Fed,” published in the Wall Street Journal last Friday (July 18).  I show that Alan’s article was actually criticizing a straw man of his own making, not the proposed law itself. His main argument is that the legislation “seeks to intrude on the Fed’s ability to conduct an independent monetary policy, free of political interference.”  I anticipated and refuted this argument in an article, “How to Spark Another ‘Great Moderation,’” published in Wall Street Journal on July 16. As I stated there, the legislation is very clear that “the Fed, not Congress, would choose the rule and how to describe it” and “since the Fed chooses its own rule, its independence is maintained.” My response goes into more detail.

Another example where the commentary does not address the actual bill is a blog at The Economist which states that “The legislation would require the Federal Reserve to set interest rates according to a Taylor rule.”  That’s incorrect. There is nothing in the bill that says that.  Again the Fed would choose its own rule or strategy and also choose how to describe it to the Congress and the American people.  I also note that back in 2007 The Economist was one of the first publications to use the Taylor rule to point out the problems with deviating from rules-based policy leading up to the financial crisis. The new writers have now adopted a different view.

The Economist blog post also refers to an opinion poll of a group of economists who disagree with provisions in the new bill.  I would note that this is the same opinion poll of economists who argued that the stimulus package worked, a issue about which other economists disagree. As with the effectiveness of the stimulus  there are plenty of economists who disagree with the economists in that poll on the new bill.

There is a clear precedent for the type of congressional oversight in the new bill. During another period of poor economic performance in the late 1970s the Federal Reserve Act was amended to require that the Fed report the ranges for the future growth of the money supply, but these requirements were removed from the law in 2000. The requirements did not reduce the Fed’s independence, though initially the Fed vigorously protested the proposed legislation.  In fact many judge that the 1980s and 1990s were a time when the Fed regained its de facto independence. That could well happen again if the new bill were passed into law.

Posted in Monetary Policy

What a Rollout!

Last week (July 7) I wrote on this blog about a newly-introduced bill  that would require policy rules for the Fed. Since then a Congressional hearing was held on the bill on July 10, Fed Chair Janet Yellen was cross-examined about it in two more Congressional hearings on July 15 and 16, and the proposal has been widely-covered in the press, social media, blogs, and opeds. And all this occurred just 6 weeks following the Centennial conference we had out here on policy rules for the Fed. What a rollout!

Here is the first main section (Section 2) of the legislation, HR 5018, which has attracted so much coverage.  Section 2 is only 10 pages, and much of that is a list of definitions.  So you do not have to wait until it is passed to read it.

Here is some of the reporting on the July 10 hearing: House Republicans Restart Their War on the Fed,   Republicans  Want Fed  to Report to Congress on Monetary Policy,   House GOP Bill Turns to Bush Economist to Rein in Fed,   Congress Eyes Rules for the Fed. Here is my written testimony at that hearing and the complete video of the hearing.

Here is the New York Times and Wall Street Journal news reports on yesterday’s hearing.

Here is an informative blog post submitted by David Papell and his colleagues on Econbrowser explaining why the bill’s authors chose the Taylor Rule to be the Reference Rule

Here is my Wall Street Journal article from yesterday.

There is much more that you can uncover with search engines, but overall I think the debate has been informative, including that during the semi-annual hearings with Janet Yellen and subsequent press reporting . As I read the legislation, I have to say that I completely disagree with Janet Yellen that it would be “grave mistake” for Congress to pass it or that it “would essentially undermine central bank independence.”  I have to agree with the Members of Congress who characterized this as an alarmist response as reported in the New York Times by Binyamin Applebaum.

Posted in Monetary Policy

New Legislation Requires Fed to Adopt Policy Rule

A lot of research and experience shows that more predictable rules-based monetary policy leads to better economic performance—both in terms of price stability and steadier-stronger employment and output growth.  But in practice there have been big swings in Fed policy between rules and discretion, with damaging results as in the 1970s and the past decade of a financial crisis, great recession and slow recovery.  This experience—especially the swing from rules to discretion in the past decade—demonstrates the need for legislation requiring the Fed to adopt rules for setting its policy instruments.

So it is good news that today the ‘‘Federal Reserve Accountability and Transparency Act of 2014” was introduced into Congress. It requires that the Fed adopt a rules-based policy.

In particular, Section 2, the first main section of the Act, titled “Requirements for Policy Rules for the Federal Open Market Committee,” would require that the Fed “submit to the appropriate congressional committees a Directive Policy Rule… which shall describe the strategy or rule of the Federal Open Market Committee for the systematic quantitative adjustment of the Policy Instrument Target to respond to a change in the Intermediate Policy Inputs.”  Thus the rule would describe how the Fed’s policy instrument, such as the federal funds rate, would change in a systematic way in response to changes in the intermediate policy inputs, such as inflation or real GDP. The rule would also have to be consistent with the setting of the actual federal funds rate at the time of the submission.

The Fed, not Congress, would choose its Directive Policy Rule and how to describe it.  But if the Fed deviated from its rule, then the Chair of the Fed would have to “testify before the appropriate congressional committees as to why the [rule] is not in compliance.”  The Comptroller General of the United States would determine whether or not the Directive Policy Rule was in compliance and report to Congress.

To provide some flexibility the legislation allows for the Fed to change the rule or deviate from it if the Fed thought it was necessary. As stated in the legislation: “Nothing in this Act shall be construed to require that the plans with respect to the systematic quantitative adjustment of the Policy Instrument Target be implemented if the Federal Open market Committee determines that such plans cannot or should not be achieved due to changing market conditions.” But “Upon determining that plans…cannot or should not be achieved, the Federal Open Market Committee shall submit an explanation for that determination and an updated version of the Directive Policy Rule.”

An interesting part of the requirement is that the “the report to the congressional committees must include a statement as to whether the Directive Policy Rule substantially conforms to the Reference Policy Rule and with an explanation or justification if it did not. What is the reference policy rule?

According to the legislation “The term ‘Reference Policy Rule’ means a calculation of the nominal Federal funds rate as equal to the sum of the following: (A) The rate of inflation over the previous four quarters. (B) One-half of the percentage deviation of the real GDP from an estimate of potential GDP. (C) One-half of the difference between the rate of inflation over the previous four quarters and two. (D) Two.

So it’s the Taylor Rule.  Of course the legislation does not require the Fed to follow the Taylor rule, but only to describe how it might differ.  Describing this difference is a task undertaken as a matter of course by most researchers working on different policy rules, so it is a straightforward task for the Fed.

This bill along with the several following sections on cost-benefit analysis and transparency was introduced as HR 5018 by Bill Huizenga and Scott Garret, members of Congress from Michigan and New Jersey, respectively. It is not clear how the Fed will react to this legislation. Some will likely object, but many at the Fed favor a more rules-based policy. In many respects the bill simply replaces reporting requirements for the policy instruments that were removed from the Federal Reserve Act in 2000 as I described here.  If the legislation were passed into law, I am sure the Fed could make it work to a good end.

I will be testifying on the legislation at a hearing at the House Financial Service Committee on Thursday at 10 am.

Posted in Monetary Policy

Stanford’s Economics 1 Now Coming Online

I have been teaching economics at Stanford for many years. Economics 1 is one of my favorite courses, and it’s been one of the most popular courses at Stanford.  I usually teach it in a large lecture hall with hundreds of students and occasionally I have guest lecturers like the famous economist Milton Friedman when he was alive.  And sometimes I goof around, as when I brought my baby granddaughter to be the guest lecturer.  One year Tiger Woods took the course and he learned the famous concept of opportunity cost so well that he left Stanford and joined the pro-golf tour.

This summer starting on June 24 we are giving an open online version of that on-campus course. People can register here for the open course. We have packaged the course in a new, different, and I think effective way as follows:  Each day just after giving a 50-minute lecture to hundreds of students, I went to a recording studio in the David Packard Building on the Stanford campus and gave the same lecture but divided into smaller segments, designed for easier online viewing. We then mixed in graphs, photos, and other illustrations, just as they would appear in the large lecture. And we captioned and indexed each video so it could be easily searched. We then put these videos on a new Stanford online platform “class.Stanford.edu” Then we added review and study material to the platform and set up discussion groups. We provided links to make a complete self-contained course.

The course covers all of economics at a basic level. It stresses the key idea that economics is about making purposeful choice with limited resources and about people interacting with other people as they make these choices. Most of those interactions occur in markets, and this course is mainly about markets, including the market for bikes on campus, or labor markets, or capital markets.  We will show why free competitive markets work well to improve people’s lives and how they have removed millions from people from poverty around the world, with many more, we hope, still to come.

People who participate in the open online course and take the short quizzes following each video will be awarded a Statement of Accomplishment. As with many open online courses, this one runs in parallel with a for-credit Stanford Economics 1 course that also includes a midterm test, a final exam, problem sets, and homework, which are all graded and count toward a final grade and credit for Stanford students. An unique feature of this for-credit course is that it is also offered online–using the same Stanford online platform–to Stanford students and incoming freshman who happen to be off campus this summer.


Posted in Teaching Economics