A Reawakening of Monetary Policy Research

Last May a group of economists, central bankers, market participants, and financial journalists convened at Stanford’s Hoover Institution “to put forth and discuss a set of policy recommendations that are consistent with and encourage a more rules-based policy for the Federal Reserve and would thus improve economic performance…”  Here’s the agenda, the published volume, and my summary.

Since then much has happened:  The House Financial Services Committee passed a policy rules bill out of committee, the Senate Banking Committee proposed a similar bill with other structural reforms (which also passed out of Committee), the Bank of England instituted significant communication reforms, a slew of economists and Fed officials weighed in (both pro and con) on proposals to make central bank policy rules more transparent, and Congress held several public hearings.

To analyze these new developments, many of the experts from last year’s conference and others convened last week to present papers and discuss key issues. All the papers are posted here. They were novel, on point, and rigorous whether using equations, regressions, history, legal analysis or political theory. The discussion was candid, with new questions raised about the effectiveness of the Fed’s deliberations. In my view it was kind of a reawakening—part of a broader reawakening—of monetary policy research. A written record of the whole conference is planned. In the meantime, here’s a quick summary:

Paul Tucker opened the conference. His paper showed that a systematic strategy for setting the instruments of policy is desirable, but that integrating that strategy with a more discretionary lender-of-last resort function is difficult and still needs to be worked out. He argued that “the central bank…should publish the Operating Principles” (the rules for the instruments), even stressing that simply doing this “is more important than that any particular set of principles or any particular instrument-rule be entrenched in a law that is justiciable via the courts.”

John Cochrane, the lead discussant of Paul’s paper, had different views about the focus on discretion in emergency lending saying that “Crisis-response and lender-of-last-resort actions need rules, or ‘regimes,’ even more than monetary policy actions need rules.” He then went on to propose that bailout problems be addressed through reforms in which “all fixed-value demandable assets had to be backed 100% by our abundant supply of short-term Treasuries,”

Next, David Papell presented a paper which used statistical methods to explore how recent policy rules bills would work in practice. Employing a counterfactual hypothesis and going back to the 1950s, he found that no single policy rule would have had the federal funds rate within a 2 percentage point band of the rule for every year, though some rules can be adjusted to fit certain periods. This suggests that attempts to use rules in seemingly arbitrary ways to justify policy in one period could backfire in later periods.  Except to say that such legislation would make policy more predictable, his paper did not draw conclusions about whether the legislation might affect the responsiveness of policy in one direction or another, such as during the early years of the Volcker disinflation period or during the 2003-2005 period when the policy deviations were quite large. Nevertheless, his is the first paper to apply formal econometric methods to these legislative questions.

In his discussion of David’s paper, Mike Dotsey of the Philadelphia Fed, argued that if one considered rules with the lagged interest rate on the right hand side then the actual funds rate comes well within a 2 percent band, though some noted that using lags this way can simply perpetuate monetary policy past errors.  There was also a discussion of the interesting new report (co-authored by Dotsey) at the Philadelphia Fed on using policy rules for benchmarking without being required by Congress.

Carl Walsh’s paper also used macroeconomic research methods in a novel way to assess the recent bills that require Fed reports on instrument rules. He employed both a simple calibrated new Keynesian model and a more complex estimated model to investigate whether such a rules-based requirement could improve on a goals-based requirement in which the central bank is simply required to achieve a goal of 2% inflation. More specifically, he asked how much weight should be placed on each of the two alternative requirements. In the case where the required rule is optimal (for the model used) his conclusion is to put all the weight on the rules-based requirement, but if the required rule is not optimal then the weight depends on whether shocks are demand-side or supply-side. In each case, the gain is the improvement in output stability and employment stability compared with the discretionary solution.

In discussing Carl’s paper, Andy Levin argued that the gains from using and reporting on the central bank’s strategy for the instruments go well beyond the calculations in Carl’s paper which he worried paid too little attention to model uncertainty. He argued that the Fed could do much more to clarify its strategy for the instruments, noting as evidence that the Fed’s recent Statement on Longer-Run Goals and Monetary Policy Strategy is all about goals and nothing about strategy.

Kevin Warsh’s paper and, even more so, his oral presentation on the lack of effective deliberations at the FOMC was one of the most surprising findings at the conference especially for people who have never attended an FOMC meeting. As Binyamin Appelbaum, attending from the New York Times, tweeted, there were “fascinating reflections from Kevin Warsh on the absence of real debate inside the FOMC.”  Binyamin also asked why publication of the transcripts years later would affect what people say inside.  Although Warsh, John Williams and Charles Plosser all indicated that it did not affect them, they all thought that it affected others.

Peter Fisher, former Fed, Treasury and Blackrock official, now at Dartmouth, began his discussion of Kevin’s presentation by noting the refreshing candor, and then read out a fascinating list of ways to judge whether a policy committee was functioning well. Among other things he listed the willingness of committee members to change priors in a Bayesian fashion when presented with new arguments or data. Another highlight of the discussion was a disagreement between Paul Tucker and Kevin Warsh about what went wrong on Lehman weekend.  Much more investigative and financial research is needed here.

The final paper of the day was by Michael Bordo whose broad historical sweep demonstrated the value of diversity of opinion coming from the district Fed banks and their presidents, and the danger of centering more power in Washington.  He argued for a more rules-based monetary policy as in the House and Senate bills, but was against having the presidents being appointed by the President of the United States.

In discussing Mike’s paper, Mary Karr, the General Counsel at the St, Louis Fed, reviewed the ways in which there are checks and balances in the current system of appointing district bank presidents, adding that the process is not a source of regulatory capture.  George Shultz, in one of his many helpful interventions at the conference, said he was reassured by Mary’s explanations but still worried, especially about the process at the NY Fed.  A common answer he got was “well, the NY Fed is different.”

The concluding policy panel featured John Williams, Charles Plosser and George Shultz. John Williams built on his recent speech on policy rules legislation, adding among other things that the Fed minutes were becoming too detailed and thereby detracted from Fed deliberations. Charles Plosser indicated the FOMC deliberations were more constructive when viewed from a multi-meeting perspective than by the conversation at a single meeting. Plosser also emphasized the importance of the Fed being a limited purpose institution, to which George Shultz responded at the start of his presentation with the word “Amen.”  George Shultz went on to argue that the Fed was in dire need of developing and communicating a strategy for the policy instruments making novel analogies with foreign policy and drawing on specific examples from his experience as Secretary of Labor, State, and Treasury. I expect more to be written about this analogy.

In sum there were many agreements about the importance of a rules-based policy or strategy at a general level, but disagreements about how a central bank should deliberate, implement and communicate about such policies, and thereby the need for more research. In this regard I noted at the conference a healthy respect for good economic research that must underlie effective policy, along with a great deal of congeniality as represented, for example, by John Williams and me exchanging T-shirts at the conference.

T-shirt exchange

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