A Revival of Research on Monetary Policy Rules for the Instruments

Recently I had the opportunity to participate in several conferences on monetary policy: the annual Hoover monetary policy conference at Stanford in May, the 2019 Fed Review conference in Chicago in June, and the Macro Model Comparison Conference in Frankfurt also in June.  There are many takeaways, but one was very evident.  I will call it a “Revival of Research on Monetary Policy Rules for the Instruments.” Policy rules were the subject of much research in the 1970’s, 1980’s and 1990’s, but in recent years there was a lull.  Now there’s a big pickup. Here are some examples, with the many links found at the conference web pages.

At Stanford, Mertens and Williams (2019) evaluated different interest rules with a new Keynesian model and Cochrane, Taylor and Wieland (2019) evaluated rules with seven different models. In Chicago, Sims and Wu (2019) evaluated different monetary policy rules with a new structural model, and Eberly, Stock and Wright (2019) evaluated monetary policy rules using the FRB/US model. In Frankfurt, Andreas Beyer (2019), Gregor Boehl (2019) and many others evaluated interest rate rules in specific models, and Nikolsko-Rzhevskyy, Papell and Prodan (NPP) (2019) compared policy rules with discretion historically using new econometric techniques. NPP considered a specific policy rule for the interest rate and measured discretion as deviation of actual interest rate from that rule. They did calculations for 400 rules and found that the average loss in high deviation periods was greater than the average loss in low deviations periods.  They also noted that “inflation-tilting” rules result in better performance. This matrix summarizes their results.

And the evidence goes beyond these conferences. Some have looked at other instruments such as the money supply, including Belognia and Ireland (2019), but most others continue to look at interest rate instruments. Bernanke, Kiley and Roberts (2019) examined ten different monetary policy rules for the instruments using the FRB/US model. The ten interest rate rules are in this table:

And a whole new section on monetary policy rules for the instruments appeared in the Fed’s Monetary Policy Report (2019) with five different policy rules presented and compared with actual policy. This is the fourth time in a row that such explicit discussion of rules has appeared in the Report effectively in real time. Here are the rules:

What explains the revival?  One explanation is simply a revealed preference for such research on the part of monetary policy officials and others interested in monetary policy making. At the Chicago Fed conference, Cecchetti & Schoenholtz (2019) found “The most frequently mentioned topic is the desirability of having a clear understanding of policymakers’ reaction function.” And there are statements by central bank leaders: including Raghu Rajan, former governor of the Reserve Bank of India, “what we need are monetary rules,” Mario Draghi: “we would all clearly benefit from…improving communication over our reaction functions…”  and Jay Powell “I find these rule prescriptions helpful”

Another explanation is the desire to figure out how to deal with the effective or zero lower bound on the interest rate. There is genuine concern at the Fed about the lower bound in the case of a need for substantial easing. How else can one evaluate alternative proposals for “lower for longer” policy, such as the Reifschneider-Williams proposal, than with a rule?  This is a huge motivation behind the work presented by Lilley and Rogoff (2019) and Bordo and Levin (2019) at the Hoover monetary conference.

Another explanation is the disappointment with monetary policy leading to great recession and especially the deviation from rules in the 2003-2005 “too low for too long” period.

Another explanation is the recognition that we need rules to evaluate quantitative easing proposals. At the Chicago conference, Brian Sack (2019) said “‘Talking more about the policy rules…is appropriate’ to guide future bond purchase programs and improve their impact.”

Perhaps concern about the proposed Policy Rules Legislation in Congress in 2017-18 led the Fed to talk more openly about policy rules in the Monetary Policy Report.

And finally, there are more people kibitzing about policy, but often without a monetary framework. Rules-based policy analysis provides an explicit and accountable answer to those critics.

There are key features of the revival: Monetary policy rules are usually stated in terms of policy instruments. Generally, they are not “forecast targeting,” which is specific about the goals, such as 2% inflation, but not about the policy instruments.   There are very few rules which assume the instrument is QE. An exception is Sims and Wu (2019), who propose a Taylor rule for QE. Perhaps this aversion to rules with QE is due to doubts about impact of QE.  Bordo and Levin (2019) say that “Our empirical analysis indicates that QE3 was not an effective form of monetary stimulus,” and Hamilton (2019) argues that QE had little effect.

Another feature is that recent policy rule research, such as in Fed’s Monetary Policy Report, assumes the Taylor principle with the coefficient on inflation greater than 1. As stated in the Report:  “One key principle is … the policy rate should be adjusted by more than one-for-one in response to persistent increases or decreases in inflation.

To sum up, there is evidence of a revival of research on rules for the policy instruments whether at conferences, in research papers, and in Fed publications. Possible explanations include revealed preference by policymakers, the need to deal with the effective lower bound, disappointments with past departures from rules, and threats of legislation.

Thus far there has been little work on policy rules with QE as the instrument, perhaps because of doubts about the effect of QE. In any case, there is a great need in this revival for more robustness studies and for international monetary models.

Posted in Uncategorized

Currencies, Capital, Central Bank Balances — 5th in a Series

The most recent book, Currencies, Capital, and Central Bank Balances, in a series on monetary policy has just been published. As the line-up of covers below shows, it is the 5th in a series of volumes emerging from conferences on monetary policy held each spring at the Hoover Institution. The series started during the Federal Reserve Centennial. The conferences at that time did not, in our view, portray a full range of views about policy. So we decided to start a conference series with a bigger range of views, and it has been popular. Next May 3 we will have the 6th conference and a book will likely emerge.

Currencies, Capital and Central Bank Balances focuses on several pressing issues in monetary policy with a tilt toward international issues. One issue concerns the international flow of money and capital and exchange rate volatility.  The key policy question is whether the IMF’s increasing use of capital flow management through government restrictions on cross-border flows can reduce capital flow and exchange rate volatility without creating growth-reducing market distortions and other sources of instability. Jonathan Ostry of the IMF argues for such controls, while Sebastian Edwards points out the problems. In my paper I argue that a rules-based international system of monetary policies is a better approach.

Another policy issue is the size of central bank balance sheet and its use as a separate monetary policy instrument in addition to the interest rate. The key question is whether central bank balance sheets should stay large or whether they should be reduced to a level in which interest rates are market-determined. Lorie Logan, Mickey Levy, Bill Nelson and Peter Fisher all weight in on the issue.

These issues are related because central bank balance sheet operations affect exchange rate and capital flow volatility. Both issues are currently on the policy agenda. The G20 Eminent Persons Group just made recommendations about policy toward capital flows, and the Fed is now making key decisions about the ultimate size of its balance sheet.

The book can be down loaded or purchased. There is much to be learned from  the many contributors including policy makers, academics and market participants: Adrien Auclert, Raphael Bostic, John Cochrane, Sebastian Edwards, Peter Fisher, Esther George, Gita Gopinath, Oleg Itskhoki, Robert Kaplan, Mickey Levy, Lorie Logan, Prachi Mishra, Bill Nelson, Jonathan Ostry, Kyle Palermo, Monika Piazzesi, Charles Plosser, Randy Quarles, Raghuram Rajan, Tom Sargent, Martin Schneider, George Shultz, Paul Tucker, Kevin Warsh, and  John Williams.


Posted in Uncategorized

A Different Kind of Revisiting the 2008 Financial Crisis

During the past few months, John Cochrane and I organized a series of workshops on the 2008 financial crisis. Monika Piazzesi, George Shultz, Niall Ferguson, Caroline Hoxby, and Darrell Duffie joined us in making presentations and, along with other colleagues who attended, turned the series into a vigorous and informative discussion. We defined each workshop by topic: Causes, Panic, Recession, and Lessons, and posted papers or summaries by each presenter as well as full transcripts of each of the four workshops:

An enormous amount of research on the crisis during the past ten years is found in these links, so we also had an overview session where the presenters gave 5-minute summaries and took questions from an audience where 300 showed up.  Here’s a transcript and a video of that overview session. It reveals a revisiting that challenges in many ways conventional wisdom recently emanating from journalist summaries, memoirs of public officials, and even other anniversary events recently held at BrookingsCATO, and AEI. Here is a quick overview of that overview:

I started off by reviewing the empirical evidence on the role of “monetary policy in causing, in bringing about, the financial crisis…because that [interest] rate was so low, with excess risk taking to get a higher rate, excesses that spread to the housing market.” I also noted that Monika Piazzesi, who could not be at the overview session, “explored in great detail the excesses in the housing market, that brought a housing boom on a scale that had never been seen before, and an ultimate collapse.” Of course, that monetary policy explanation is not stressed by Fed officials in recent revisits of the 2008 crisis. I also discussed why the fiscal “stimulus packages…really didn’t do much good. Money just went in people’s pockets, and there really wasn’t much effect on the economy.”

George Shultz then noted, more basically, that the crisis was the result of violating “three fundamental principles that need to be kept in mind. One is accountability. From the ground up, there was no accountability. Number two is the sense of competence. Are the people competent running things? That was violated. Number three: trust. You have to have trust that the people doing things know what they’re doing, and that was violated. So, I think the net of all this was a very bad episode, and we still pay the price for it…” The view is quite different from recent revisits that focus in the clean-up operation rather than on these basic problems.

Niall Ferguson then mentioned other policy problems: “undercapitalization of banks” and “the way that structured financial products like collateralized debt obligations proliferated, and rating agencies insisted that they were AAA rated when they really were nothing of the kind…. Monetary policy…had been loose for most of 2002 to 2004 in a way that really wasn’t defensible. There was funny stuff, as George Shultz has mentioned, going on in the US real estate market….a whole bunch of rather opaque contingent liabilities that hadn’t been there before. And finally, I think you have to include in the explanation China, and what we used to call global imbalances….”

Caroline Hoxby sensibly focused on labor markets as a reason for the very slow recovery from the crisis. She noted that “…labor markets really did not adjust quickly…leading to a much longer recovery, a much slower recovery, and in many ways a recovery that has never completely occurred. Despite the fact that we have low unemployment rates…The labor force participation rate fell very sharply during the Great Recession, immediately following the financial crisis, and it has never really recovered.” Citing government policies relating to disabilities and education, she then concluded that “I’m less optimistic than most of my fellow economists here, because I am very concentrated very much on the labor market, where I see a lot of indications that the Great Recession to some extent still continues.”

Darrell Duffie and John Cochrane concentrated on lessons for financial markets and banks. Duffie discussed the problem of “too-big-to-fail” at the time of the crisis. The “banks correctly assumed at the time, that if one of these banks were to fail, that it would cause a crater on the economy…. And creditors before the financial crisis said to themselves, ‘They’d never let that happen. The government wouldn’t let that happen. The government, if necessary, will bail out these banks, because surely they wouldn’t cause a crater on the economy.’ ” While he argues that more could still be done, including reforming the bankruptcy law, he also notes that “Since then, things have changed. The idea that the government will bail out a large bank has been disposed of, or at least in the minds of the creditors; they no longer give credit to the idea that they will get bailed out if the bank gets in trouble.”

John Cochrane focused on having enough capital and on preventing runs.  “…we’re finally figuring out the one central answer is not: send in a bunch of regulators to make sure the assets are even safer, so you can finance them 30 to 1 with overnight debt. The answer is, risky investments need to be financed like the tech stocks, with investors’ money, where if it’s a risky adventure that loses value, if your statement goes down in price and you can’t run and say, ‘Give me back my money now,’ and you can’t do it instantly, you’re out of business. That’s the mechanics that caused the crisis. So, capital is the salve of all wounds, and I think we’re figuring that out…. So, where are we now? Capital’s a good deal higher. It’s, rough numbers, from five percent, it’s now ten percent. In my view, ten percent is nowhere near enough. Ten percent is good enough for a while,” and he worries that political forces are again moving in the wrong direction.

In sum, while there was by no means full agreement, the series brought attention in different ways to the central unifying fact that many economic policy issues still need to be addressed–from accountable top-level leadership to underlying legislative changes–if we are to prevent crises and keep the economy growing  smoothly in the future.

Posted in Financial Crisis

Now They’re All Saying “It’s Time to Write Chapter 14 into Law”

Yesterday the Senate Judiciary Committee held an important hearing entitled “Big Bank Bankruptcy: 10 Years After Lehman Brothers.” Originally scheduled for October, but postponed because of the debate over the Kavanaugh confirmation, the hearing concentrated on legislation that would create a new “Chapter 14” of the bankruptcy code under which large financial institutions could go into bankruptcy without spreading the crisis to the rest of the financial system. The idea came out of research by the Resolution Project at Stanford’s Hoover Institution, books such as Bankruptcy Not Bailout: A Special Chapter 14, and many suggestions, including by the witnesses at this hearing.

The hearing was significant because there was so much support expressed in favor of Chapter 14.  Here is a video and written testimony. All three witnesses—Donald Bernstein of Davis Polk & Wardwell, Mark Roe of Harvard Law School, and Stephen Hessler of Kirkland & Ellis—were basically in favor of Chapter 14.  This support follows endorsement by the Administration in a thorough Report issued last February by the US Treasury. It also builds on  unanimous support by the House Judiciary Committee after hearings held there last year. Significantly, most experts are now fine with passing Chapter 14 without also repealing Title II of Dodd-Frank. Repeal had previously been an impediment to bi-partisan support in the Senate. Now Title II can stay in the law, even if it will not be used much with Chapter 14 there.

In any case, there is now no serious obstacle to passing Chapter 14 legislation, and while national attention on yesterday’s hearing was nowhere near that on the Kavanaugh hearings, the issue is no less important. As Emily Kapur shows in a counterfactual, having a Chapter 14 reform of the bankruptcy code could prevent the catastrophic meltdown experienced 10 years ago which devastated many people’s lives and left wreckage which we are still clearing up after ten years.

Posted in Financial Crisis, Regulatory Policy

Three Attributes of a Sustainable Open and Stable Global Order

The IMF/World Bank meetings were held in Bali last week. In addition to the many good beaches there were many good panels including one I was on with Mark Carney and Agustin Carstens. It was organized by the Group of Thirty, led by Jacob Frenkel and Tharman Shanmugaratnam, and focused on “Sustaining an Open and Stable Global Order,” a broad topic, within which I focused on the global monetary and financial system in the following way:

A long-held view of mine—based on solid economic theory and much empirical evidence—is that a global monetary and financial system conducive to a stable global order has three attributes: (1) open capital markets, (2) flexible exchange rates between countries or blocs and (3) a predictable and transparent, or rules-based, monetary policy.

To be sure this is a goal, and we are not there yet, though I think we have very recently started moving in that direction.  One of the three attributes—open capital markets—was just recommended as a long-term goal in a Report by the G20 Eminent Persons Group (EPG) on Global Financial Governance on which I served. The idea of open capital markets carries through intellectually and practically to goods markets. The current emphasis on “capital flow management measures” or restrictions on capital flows easily carries over to restrictions on goods flow which we all want to reduce and avoid.

When policy moves closer to those three attributes, as in the 1980s and 1990s for the advanced countries and more recently for emerging market countries, the economy does well, growing in a stable manner. When policy deviates from those three, as U.S. monetary policy did going into the tragic global financial crisis, the economy does poorly. And continued deviations in many of the past 12 years have led to poorer performance, competitive devaluations of exchange rates, and complaints of currency manipulation. These claims diminish when there is greater transparency about monetary policy.

How do we get from here to there? We need an international policy framework in which each central bank follows its own rules-based monetary policy, and in doing so contributes to a global rules-based system. In my view the framework should embody those same three attributes as a goal. There is no need for one central bank to tell another central bank what to do except to be transparent about its strategy or rule. The IMF, the FSB, and the BIS could all be involved in monitoring the rules-based policy, which should be a key part of their new integrated “coherent global risk map” role also recommended by the EPG.

The most practical way forward is for one or more central banks to “just do it,” to start to move in a rules-based direction.   It appears that the Fed has begun to normalize in this way. This can be seen in the past year and a half in actions, appointments, publications, and speeches.  Actions include the transparent well-telegraphed move to normalize the policy interest rate and reduce the size of the balance sheet. Appointments at the FOMC include more people who have thought of policy in terms of rules, including Randy Quarles and Rich Clarida as vice chairs, and the move from San Francisco to New York by John Williams. Publications include the quantum shift in the semiannual Monetary Policy Report which now has whole sections on policy rules and how the Fed uses them.  Speeches include Janet Yellen’s January 2017 speeches describing the Fed’s strategy for the policy instruments (“When the economy is weak…we encourage spending and investing by pushing short-term interest rates lower….when the economy is threatening to push inflation too high down the road, we increase interest rates…”), comparing Fed strategy with the Taylor rule and other rules, and explaining the differences. Also in February of last year, Stanley Fischer gave a talk with a similar message, comparing actual policy with monetary rules and explaining how rules-based analyses feed into FOMC discussions to arrive at policy decisions. In February of this year, Jay Powell, in his first testimony as Fed Chair, talked about making monetary policy with policy rules, saying that “In evaluating the stance of monetary policy, the FOMC routinely consults monetary policy rules that connect prescriptions for the policy rate with variables associated with our mandated objectives. Personally, I find these rule prescriptions helpful. Careful judgments are required about the measurement of the variables used, as well as about the implications of the many issues these rules do not take into account.”

This emphasis on rules and strategy did not go unnoticed by those who follow policy: As Larry Kudlow put it before he moved to the White House: “I’ve never seen that in any testimony before….and I think that’s progress.”  More recently, President Donald Trump said: “We’re normalizing money, and that’s good,” though he added that “I think we don’t have to go as fast.”

Other central banks need to follow in a global normalization. It will not be easy, so it is important to be predictable and gradual.  We are beginning to see such changes at the ECB, and the BOJ may be next, with small open economies, many represented at these meetings, moving when they can.

There are risks, of course, but an international policy framework will help if it is based on those three attributes: Rules-based monetary policy at each central bank, flexible exchange rates between countries or blocs, and open capital markets. Those are the keys to a sustaining a more open and stable global financial order.

Posted in International Economics, Monetary Policy

Econ 1, Tiger Woods, and the Crisis@10

Today is the first day of the fall quarter at Stanford, and I begin teaching Economics 1, the introductory economics course, and the course after which this blog is named. The first day is always exciting, especially with many first-year students in class as is the case with Economics 1.

With Tiger Woods just winning the Tour Championship, I have a wonderful example today of opportunity costs. Tiger took my course in 1996. He was the best economics student: As I have often said, he learned opportunity costs so well that he left Stanford and joined the pro tour.

On the first day, I of course focus on the central idea that economics is about choices people make when faced with scarcity and the interaction between people when they make these choices. That interaction is emphasized as markets bring ideas and people together. We modify slightly the Stanford motto, “The Winds of Freedom Blow” (Die Luft der Freiheit Weht) to get the Economics 1 motto: “The Winds of Economic Freedom Blow.  This year we have a lot of good lecturers joining with me:  Mark Tendall on how to run firms & interact with people in markets, Caroline Hoxby on economics of education & income inequality, Pascaline Dupas on how to bank the unbanked in Africa, and Chad Jones on how to raise economic growth & reduce global poverty.

We continue teaching the whole principles course in one term combining micro and macro. I think this approach makes economics more interesting for students, and is especially needed when discussing key topics like the financial crisis of ten years ago. The crisis along with the slow recovery and other associated changes can only be understood with a mix of micro and macro. As I wrote earlier, “One must know about supply and demand for housing (micro), interest rates that may have been too low for too long (macro), moral hazard (micro), a stimulus package (macro) aimed at such things as health care (micro), a new type of monetary policy (macro) that focuses on specific sectors (micro), debates about the size of the multiplier (macro), excessive risk taking (micro), a great recession (macro), and so on.” It you look at any explanation of the crisis and the slow recovery, you’ll see a mix of micro and macro.

I think a combined micro-macro approach works no matter what your view is of the crisis and the policy response. In my view the problem was that economic policy deviated from basic economic principles which had worked well. The result was a financial panic, a great recession, and a slow recovery. The deviations included a monetary policy which set interest rates too low for too long. The good news for the economy is that economic growth and stability are being restored as new policies are being implemented.

Of course there are different views, but the heated disagreement among economists about economic crises, their causes, and their effects, presents a great opportunity to make economics more interesting.

Posted in Financial Crisis, Monetary Policy, Slow Recovery, Teaching Economics

Stiglitz, Summers, Secular Stagnation, and the Supply Side

Joe Stiglitz recently published an attack, “The Myth of Secular Stagnation,” on Larry Summers’ hypothesis of secular stagnation, a revival of a term used by Alvin Hansen decades ago. Larry first presented his secular stagnation hypothesis at a conference jointly hosted by the Brookings Institution and the Hoover Institution on October 1, 2013, during the fifth anniversary of the financial crisis. It has gone viral since then.

In his critique, Stiglitz argues that Summers was wrong to say that the slow growth was secular; there was nothing secular about it, Stiglitz argued: if there had been a counterfactual larger demand-side stimulus package, there would have been a faster recovery without stagnation.  In his response, Summers lumps the Stiglitz  critique in with earlier critiques of secular stagnation, including mine “The Economic Hokum of ‘Secular Stagnation’” WSJ Jan 2014, which suggested, in Summers words “that secular stagnation was a fatalistic doctrine invented to provide an excuse for poor economic performance during the Obama years.”

I think that Summers’ critique of what Stiglitz writes is good.The irony is that I and other critics of secular stagnation have a completely different view from Stiglitz, who argues that the problem was insufficient demand and that a larger discretionary stimulus package would have avoided stagnation.  But my empirical research along with John Cogan, Tobias Cwik and Volker Wieland  shows that the demand-side stimulus packages were not successful. A larger package of those types would have done no better. In a 2011 Journal of Economic Literature article I wrote: “Some argue that the economy would have been worse off without these stimulus packages, but the results do not support that view….Others argue that the stimulus was too small, but the results do not lend support to that view either.”

Instead, the alternative view, outlined in my book First Principles, and elsewhere was that tax reform, regulatory reform, monetary reform and budget reform would increase economic growth by raising productivity and labor force participation. These supply side reforms–especially lowering marginal tax rates on investment and reducing costly regulations–were meant to provide incentives to do the things that would raise economic growth. I agree with Stiglitz that there was nothing secular about the stagnation we were seeing when Summers wrote. But the problem with slow growth was the lack of policies on the supply side, not the lack of larger demand-side discretionary stimulus packages.

With the tax reform and regulatory reform of the past two years we are seeing a marked improvement in economic growth. The economy is beginning to roar, as predicted, as these policies are being put in place.

Posted in Regulatory Policy, Slow Recovery, Stimulus Impact