Good Progress on Describing and Comparing Monetary Strategies

Janet Yellen visited San Francisco and Stanford last week. She gave two interesting talks about monetary policy, which together, in my view, break new ground, and are worthy of more discussion.

At the Commonwealth Club in San Francisco she briefly described the Fed’s monetary strategy for the policy instruments.  At the Stanford Institute for Economic Policy Research she compared the Fed’s recent monetary policy with the Taylor rule and closely related monetary policy rules.

If you view these two talks together, I think they resemble what would be required under the Requirements for Policy Rules of the Federal Open Market Committee, Section 2 of the Fed Oversight Reform and Modernization (FORM) Act which has passed the House of Representatives. That legislation requires that the Fed (1) “describe the strategy or rule of the Federal Open Market Committee for the systematic quantitative adjustment” of its policy instruments and (2) compare its strategy or rule with a reference rule. More detail here.

Let me explain why the two talks represent progress in both directions. In the San Francisco talk, Janet Yellen summarized the Fed’s strategy for the policy instruments, saying that

“When the economy is weak and unemployment is on the rise, we encourage spending and investing by pushing short-term interest rates lower. As you may know, the interest rate that we target is the federal funds rate, the rate banks charge each other for overnight loans…. Similarly, when the economy is threatening to push inflation too high down the road, we increase interest rates to keep the economy on a sustainable path and lean against its tendency to boom and then bust.” She then described “price stability” as a level of inflation of “2 percent a year,” the maximum level of employment that can be sustained in the longer run as an unemployment rate of around 4-3/4 percent, and a “longer-run neutral rate” of the federal funds as a rate of “3 percent.”

One could certainly add more detail, but the statement includes the signs of the responses by the policy instruments, though not the magnitudes; it mentions key factors driving the responses; and it gives numerical values for three key parameters.  It could be usefully added, as is, to the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy, which, despite its name, now has no strategy for the instruments, only goals.

Next consider the Stanford talk which was loaded with charts and references to the Taylor rule and other policy rules. The purpose was to compare actual Fed policy with the Taylor rule, which she states, “embodies key principles of good monetary policy,” and then explain any differences. People found that useful, and it was good to see clarification of how the FOMC uses such policy rules in a constructive manner. That’s the kind of comparison that is required in the legislation that passed the House.  My question to her at the talk (see here) was meant to explore the possibility that such a presentation could satisfy the legislation, but in her answer she still expressed opposition to the legislation. Nevertheless, I think further discussion of the issue would be useful. There are more similarities than differences between the type of presentation given by Janet Yellen in California last week and the type of presentation required by the FORM Act, suggesting that a compromise might be feasible.

To be sure, the description of the policy strategy and the comparison of policy with the reference rule took place in two different talks.  If presented in the same talk the analogy with the requirement under the legislation would be easier to make. Janet Yellen frequently uses footnotes for algebraic descriptions in her talks. If she added another footnote, an algebraic way to summarize the words used in San Francisco might be:

r = p + ay + b(p – 2) + 1

with a > 0 and b > 0, where r is the federal funds rate, p is the rate of inflation, and y = 2.3(4.75-u) where u is the unemployment rate. (The 2.3 comes from Janet Yellen, Remarks, April 11, 2012)

In contrast the reference rule (Taylor rule) is:

r = p + .5y + .5(p – 2) + 2

So the comparison is pretty obvious.

In listening to Janet Yellen’s talk I was reminded that I invited Alan Greenspan to give a talk to the same research group at Stanford 20 years ago in 1997 when I was the director. He came, and he chose as the topic, Rules vs. Discretionary Monetary Policy. He discussed the Taylor rule, about which he listed “a number of attractive features” and commented on the usefulness of monetary policy rules in general. The experience with monetary policy, both when it is rules-based and when it is not rules-based, in the United States and other countries during the past 20 years provides much useful information about how to improve monetary policy going forward. Talks such as Janet Yellen’s and further discussion about them will further this important goal.

Posted in Monetary Policy

The Room Where It Happens

I enjoy the nexus between the world of ideas and the world of action, probably because I have gone back and forth between those two worlds several times as described here. There is nothing more rewarding then developing ideas and then having the opportunity to bring them into action. The song “The Room Where It Happens” in the musical Hamilton is a wonderful rendition of this nexus where Alexander Hamilton gets his debt ideas into action.

When asked by the Wall Street Journal and Bloomberg News about by favorite books for 2016, I chose books that fell into this nexus.  For the Wall Street Journal list, I chose The Man Who Knew, Sebastian Mallaby’s excellent biography of Alan Greenspan, and War by Other Means by Robert Blackwill and Jennifer Harris. Here are the reasons that I gave and that the Journal published:


For Bloomberg News I chose The Euro and the Battle of Ideas by Markus Brunnermeier, Harold James and Jean-Pierre Landau (I also wrote a longer review here) and The Curse of Cash by Ken Rogoff.  Again here are the reasons as published by Bloomberg News:



Posted in Teaching Economics

Show Us Your Model and Your Method

In a Wall Street Journal op-ed today I addressed claims made by Neel Kashkari in an earlier op-ed about rules-based monetary reforms, showing that his claims that the reforms were mechanical or computer-run were simply false and misleading.

Kashkari mentioned the Taylor rule a lot in his op-ed. For example, he reported that “my staff at the Minneapolis Fed,” found that unemployment after the 2008 financial crisis would have been higher with a Taylor rule. However, he gave no reference to the study, its methodology, or even its authors, unlike many other Fed officials who write or speak on policy. In my response I cited research that got opposite results to those reported by Kashkari. That research is published and publicly available.

So many people have asked me:  What model did Kashkari use, and how did he use it?  I hope that someday the Minneapolis Fed study will see the light of day, but in the meantime we do not know the answers. From the op-ed it sounds like the staff did an old fashioned “alternative path” simulation with some model rather than a more realistic “alternative rule” simulation. (For an historical review of the old and new models and methods, see my recent paper for the Bank of Canada.) Thus the calculation did not take account of expectations or other systems effects normally considered essential when evaluating policy. Rather than evaluating a monetary rule over time they looked as a one-time change in the policy instrument.

If so, this is pretty bad economics. Nearly all of the hundreds of studies of monetary policy rules over the past 30 years have taken this systematic approach. Kashkari is welcome to weigh in on this debate, but to do so he needs to report the model and the methodology that form the basis of the results.

Posted in Monetary Policy

Unconventional Monetary Policy, Normalization, and Reform

This week the Monetary Policy Subcommittee of the House Financial Services Committee held a hearing on “Unconventional Monetary Policy.”  Charles Plosser, Mickey Levy, Simon Johnson and I testified. It was a good hearing with pertinent questions by Members of Congress, led by Chairman Bill Huizenga, and candid answers from the witnesses.chair-huizenga In my view the hearing was good because it focused on monetary reform in a practical context where reform is now seen as a real possibility. Here’s a link to a video and written testimonies.

I led off by reviewing how the Fed’s move toward unconventional monetary policy can be traced back to the “too low for too long” period of 2003-2005, and much research shows that the results were not good. (References to research are in my testimony.) Along with a breakdown in the regulatory process, these policies were a cause of the financial crisis and the Great Recession. While the Fed did a good job during the panic in 2008 as lender of last resort, it then moved sharply in an unconventional direction starting in 2009 with large scale asset purchases, erratic forward guidance, and near zero interest rates long after the recession was over. Again the results were not good.  My research and that of others shows that these policies were not effective, and may have been counterproductive.

The policy implication of this experience is clear. Monetary policy should be normalized. The Fed should transition to a rules-based monetary policy like the one that worked in the past while recognizing that the economy and markets have evolved. This appears to be the intent of the Fed, but normalization, or transition, is difficult in practice, and the pace has been slow and uncertain.taylor-dec-7-mpt-hfsc

Normalization is easier if there is an understanding of the basic monetary strategy. This points to monetary reform where the Fed would describe the strategy or rule for the systematic adjustment of its policy instruments.  Recent empirical research by Alex Nikolsko-Rzhevskyy, David Papell, Ruxandra Prodan shows that if this reform had been in place in recent years, the Fed would have had to explain the deviations, and this would have likely reduced their size. Additional research by Carl Walsh shows that economic performance would improve if the Fed were accountable about the rule for achieving goals as well as about the goals.

Monetary normalization and reform have important implications for the international monetary system. Unconventional monetary policies with near zero policy rates have spread internationally, as the Bank of Japan, the European Central Bank, and other central banks adopted similar policies. Thus the international monetary system has deviated from a sound rules-based system. This has increased the volatility of the dollar and other exchange rates. Because a key foundation of a rules-based international monetary system is rules-based policy in each country, normalization and reform by the Fed would contribute to international monetary stability, which will in turn benefit the United States economy.

The opportunity for monetary reform is now better than it has been in years. Remember that tax reform, regulatory reform, budget reform and monetary reform go together. They reinforce each other. All are crucial to a prosperous economy.

Posted in Monetary Policy

A New Opportunity for Monetary Reform

The opportunity for pro-growth tax reform (lower rates with a broader base) and pro-growth regulatory reform (with rigorous cost-benefit tests) is now better than it has been in years, because of similarities between reform ideas put forth by Congress—many in bills that have passed the House—and those put forth by president-elect Trump.

Although less commented on, the opportunity for monetary reform also seems better than it has been in years. And the reason is the same. Goals such as insulating the Fed from political pressures and creating a more predictable-transparent-accountable policy appear to be common to the Congress and the incoming Administration.  To see this, take a look at the often-overlooked monetary passages on pages 44 and 45 of the House economic reform document A Better Way: The Economy. Here’s an excerpt:

“… our economy would be healthier if the Federal Reserve was more predictable in its conduct of monetary policy and more transparent about its decision-making…. Legislation sponsored by Rep. Bill Huizenga and approved by the House – the Fed Oversight Reform and Modernization Act (the FORM Act) does the following:

  • Protects the Fed’s independence to chart whatever monetary policy course it deems appropriate, but requires the Fed to give the American people a greater accounting of its actions.
  •  Requires the Fed to generate a monetary policy strategy of its own choosing in order to provide added transparency about the factors leading to its monetary policy decisions.
  •  Helps consumers and investors make better decisions in the present and form better expectations about the future.

These improvements are important for Americans to enjoy greater economic opportunity. By pursuing this expansion through increased transparency instead of policy mandates, the FORM Act further insulates the Fed from political pressures.”

Here is a detailed statement of support of this monetary reform from economists and practitioners. Of course, there is much to be worked out, including incorporating constructive comments from the Fed, which has not yet been forthcoming. Monetary reform is at least as controversial as tax and regulatory reform, but no less crucial to a prosperous economy. The economics behind pursuing monetary, tax and regulatory reforms together can be found in First Principles: Five Keys to Restoring America’s Prosperity.


Posted in Monetary Policy

Central Bank Models: A Key to Future Monetary Policy

In thinking about the future of monetary policy, it’s important to consider legislative reforms and appointments, but it’s also important to consider the economic models that have come to be a key part of policy making in central banks. The Bank of Canada showed a great deal of vision last week when it invited economists and practitioners to discuss “Central Bank Models: The Next Generation.”

We can learn from history here. In my keynote address for the conference I reviewed the 80-year history of macro policy models from Jan Tinbergen’s model of 1936 to the present. I showed how policy making with models began in “path-space” (simulating paths for the policy instruments and seeing the impact on the paths for target variables), but, with a major paradigm shift 40 years ago, moved to “rule-space” (simulating rules for the instruments and seeing the impact of economic stability over time).  Central bank models followed these developments, though with a lag, to the benefit of monetary policy and economic performance.

However, there was a retrogression in parts of the central banking world in the past dozen years, and economic performance has deteriorated with a great recession and a very slow recovery. This history suggests that a pressing problem for central bank research is to get back to a “rule-space” framework. The framework was good while it lasted, and still benefits countries that continue to implement it. The departure from this approach should be fundamentally reconsidered, which means finding out how to get back to the framework, understanding why the departure occurred, and figuring out how to prevent future departures.

But what can researchers do? What kind of research can help?

I offered some some ideas for research direction and workflow, giving examples from Chapter 15 by Volker Wieland, Elena Afanasyeva, Meguy Kuete, Jinhyuk Yoo and Chapter 28 by Jesper Linde, Frank Smets, Raf Wouters  in the new Handbook of Macroeconomics.  As explained here, research should focus on

— how changes in the economy and models of the economy affect monetary policy rules.  Examples include changes in the technology of financial inter-mediation, increased integration of the financial and real sides of the economy, behavioral economics factors, new distribution channels of monetary policy, agent-based models, heterogeneous price and wage setting, and the impact of an effective lower bound on the interest rate.

— designing models for the purpose of evaluating policy rules. Having a purpose in mind helps determine the size, scope and type of model.

— robustness through transparent and replicable macro model comparisons such as in the new Macroeconomic Model Comparison Initiative using the Macro Model Data Base.

— the interface between policy models and policy decisions. Here more transparent reporting on policy rules used in practice as in recent legislation that has passed the House would be useful.

— the connection between monetary policy rules and an international rules-based monetary system. Perhaps there is no more important, and no more difficult, application of “rule-space” analysis.  One research idea would study an international agreement in which each central bank would report and commit to its monetary rule or strategy, and thereby help build the foundation of the international monetary system.

— distinguishing between instrument rules, “forecast targeting,” and “constrained discretion,” which means delving deeper into the classic rules versus discretion debate.

In my view, these ideas are worth pursuing at central banks and by monetary researchers outside of central banks, even if one has different views of the reasons for poor economic performance during the past decade.

Posted in Monetary Policy, Teaching Economics

A World Cup in the Battle of Ideas

Markus Brunnermeier, Harold James and Jean-Pierre Landau have just published a fascinating book, The Euro and the Battle of Ideas, in which they bring together their respective skills in economic theory, economic history and economic policy to bear on one of the most important macroeconomic problems of our times—the rules versus discretion debate. Anyone who has studied this debate—and that’s just about anyone who has taken a course in economics—would benefit from reading this book.

The book focuses on the role of government in the economy and how conflicting ideas about this role affect economic policy in Europe and beyond, including at the International Monetary Fund. But most of the economic policy ideas revolve around the rules versus discretion debate, and include policy credibility, accountability, time inconsistency, policy flexibility, moral hazard, and fiscal consolidation versus stimulus.  All of these issues have been extensively researched, and views differ. Many economists (including me) are of the view that rules-based policies are more effective, while others (including Larry Summers) argue against rules.

The fascinating hypothesis—and the organizing principle—of the book is the authors’ view that ideas differ by country. In particular, they argue that in Europe the battle of ideas is largely between Germany, on the side of rules, and France, on the side of discretion. They note related differences in other parts of the world: in Italy they see a regional split in which “great liberals…come from the North, whereas the pioneers of practical Keynesianism…are Southerners.”  And I can think of other examples where opinions appear to differ by group. In the United States, for example, there have been schools of thought—Cambridge versus Chicago, Samuelson versus Friedman—distinguished by positions in the rules versus discretion debate. Ulrike Malmendier and her colleagues show that the degree to which Fed policy makers are rules-based appears to be related to whether they personally experienced the great inflation or not.france-map

But this book is mainly about France versus Germany, and in portraying the battle of ideas this way the book provides novel explanations of why certain policies are chosen. Rather than a question of good policy versus bad policy, it is a question of who is up or down politically, and the relative power of France versus Germany.

The authors consider key debates within the rules versus discretion framework: quantitative easing, bailouts, fiscal stimulus. Within Europe they argue, for example, that “Starting from the negotiations for the Maastricht Treaty and the SGP, fiscal policy rules following the traditional German rigorist approach clashed with the deeply ingrained Keynesian instincts in France.”

I particularly liked the book’s discussion of the IMF’s decision to break the rules of its exceptional access framework when it lent to Greece. This framework was put in place in 2002, and it led to a stop in financial crises emanating from emerging market countries which had been raging before then.  Unfortunately, these rules were broken in 2010 when the IMF made a large loan to Greece which eventually led to a bailout of private creditors. Many realized it was a mistake, but the U.S. Treasury objected to restoring the rules arguing the case that discretion was needed. With the IMF management, staff and other countries in favor of restoration, a shift in the U.S position was all that was needed to make the needed changes. When the U.S. Treasury finally agreed to remove its objection, the Congress supported the reform, which then passed. I was involved in the restoration effort and saw how the battle of ideas had both a country basis and an intellectual basis, much as the book tells the story.

While many of the chapters conclude with a sensible set of policy recommendations, the book provides more of a “positive approach” rather than “normative approach” to policy. This perspective is useful in helping to identify barriers to better policy, and possible compromises. It is not, of course, a replacement for traditional analytical research which has the power to change views based on ideas rather than national differences.

In this regard, it is promising that the authors show that national views change over time. Indeed, France and Germany switched sides:  Early in the book the authors show that the current French-German dichotomy is relatively new.  Before World War II, they argue that Germany was more statist and discretionary (they give the example of Friedrich List criticizing free trade), while France was more laissez faire and rules-based (they give the examples of the classical liberal economists Jean-Baptiste Say and Frederic Bastiat).  But the experiences of the World War II, they argue, caused a counter reaction and a switch with Germany now more rules-based and France more discretionary. Maurice Allais, who they classify as a classical liberal and who was writing in France during and after World War II, is an exception.

Posted in Financial Crisis, International Economics, Monetary Policy, Regulatory Policy