Economics One

At yesterday’s hearing before the Senate Banking Committee, Fed Chairman Ben Bernanke talked about monetary policy rules in response to a series of questions by Senator Pat Toomey. First, the Chairman stated that the Taylor Rule calls for interest rates “way below zero” and that this justifies methods such as quantitative easing. This is puzzling because I have reported for months that the Taylor Rule (see 1993 paper) does not call for an interest rate below zero. Second, when Senator Toomey then asked if Taylor believed the Taylor Rule called for rates below zero, Chairman Bernanke didn’t answer directly, but instead claimed that in 1999 I preferred a different rule to the one I published in 1993; he then said that the 1999 rule gives a much different rate. Senator Toomey then pressed on and specifically said the Taylor Rule called for rates higher than we have now, at which point Chairman Bernanke changed tack and argued that there were other policy rules that call for below-zero interest rates. Here is the relevant part of the transcript.

MR. BERNANKE: … The Taylor Rule suggests that we should be, in some sense, way below zero in our interest rate, and therefore we need some method other than just normal interest rate changes to —
SEN. TOOMEY: Do you know if Mr. Taylor believes that?
MR. BERNANKE: Well, there are different versions of the Taylor Rule, and there’s no particular reason to pick the one that he picked in 1993. In fact, he preferred a different one in 1999 which, if you use that one, gives you a much different answer.
SEN. TOOMEY: My understanding is that his view of his own rule is that it would call for a higher Fed funds rate than what we have now.
MR. BERNANKE: There are, again, many ways of looking at that rule, and I think that ones that look at history, ones that are justified by modeling analysis, many of them suggest that we should be well below zero. And I just would disagree that that’s the only way to look at it.
But anyway, so I think there are some — there is some basis for doing that.

There are several issues raised by this back-and-forth exchange.

Most important, at least from my perspective, is that contrary to what was claimed in the hearing, I did not say that I preferred a different policy rule in 1999 rather than the rule I originally published in 1993. I am not sure where this idea of my preferring another rule came from; I went back and looked at the academic papers I published in 1999 (here is a list); the paper on this list that Chairman Bernanke may have been referring to is A Historical Analysis of Monetary Policy Rules where I looked at two different policy rules during different periods of U.S. history. However, as I said in that paper (page 325), one rule was the “policy rule I suggested” and the other one was what “others have suggested.” The “others” were people at the Federal Reserve so for completeness I included that rule in the historical comparison. I did not propose or prefer an alternative rule in that 1999 paper, and it is hard to see how one could interpret the paper that way. This is not just a matter of academic niceties and citations; it is important to correct the record because the “others have suggested” rule has a much larger coefficient on the GDP gap and is therefore more likely to generate negative interest rates and be used to rationalize discretionary actions such as quantitative easing.

Second, the exchange between Chairman Bernanke and Senator Toomey suggests that the Fed is unclear about what monetary policy strategy it is using for the interest rate. Is it the Taylor Rule, as in the first response? Is it the rule incorrectly attributed to me in 1999, as in the second response? Is it some estimated rule, as in the third response? Or is it something else? It would be useful to know what the strategy is. Greater transparency about the strategy would add greatly to predictability and would help markets understand whether quantitative easing will be extended or when the interest rate will break out of the 0-.25 percent range.

For example if the strategy was reasonably well described by the Taylor Rule the interest rate would equal about 1.5 times the inflation rate plus .5 times the GDP gap plus 1. The most recent quarterly data (through the 4th quarter of 2010, released by Bureau of Economic Analysis on February 25, 2011) show that the inflation rate is about 1.4 percent (change in GDP deflator over the last four quarters). According to the average of the most recent survey by the Federal Reserve Bank of San Francisco, (January 28, 2011, Williams-Weidner) the GDP gap is about 4.4 percent. This implies an interest rate of 1.5 X1.4 + .5X(-4.4) + 1 = 2.1 + -2.2 +1 = 0.9 percent, or about 1 percent, which suggests that the Fed should be raising the rate sometime soon, perhaps before the end of this year. But if it is one of the other rules mentioned by the Chairman we might have to wait longer.

Third, the exchange shows how it would be quite feasible and useful to restore some of the reporting and accountability requirements which were removed from the Federal Reserve Act in 2000. As I have proposed, with such requirements the Fed would establish and report to Congress its strategy or policy rule for monetary decision making. If it later deviated from that strategy it would have to provide an explanation to Congress in writing and at a public congressional hearing. With such a reporting requirement, the testimony at such a hearing would be like this exchange between Chairman Bernanke and Senator Toomey with the very important exception that the Congress and the American people would have some idea of what the Fed’s basic strategy was.

The Atlanta Fed, through its “macroblog,” has joined the discussion about reform of the Federal Reserve. It’s a good discussion to have. David Altig, Senior Vice President of the Federal Reserve Bank of Atlanta and main blogger, wrote the latest entry on my Wall Street Journal article of last week which offered proposals to return to sound fiscal and sound monetary policy. Macroblog has no quarrel with the proposals for sound fiscal policy but, as in past posts, disagrees with the analysis of monetary policy.

The latest macroblog entry starts by appealing to a paper from New Zealand which shows that an “estimated” Taylor rule indicates that interest rates were not too low for too long in 2003-05 as I have argued. But the “estimated” policy rule in that paper doesn’t looks anything like what I proposed and given that there are already scores of existing models I fail to see the advantages of another model from New Zealand. For example, at the Federal Reserve Bank of Kansas City, George Kahn shows that deviations from a policy rule were a major reason for the housing price boom and bust. A chart from his paper which I copy below shows clearly that policy without the Taylor Rule deviation (TRDEV1) would have avoided the boom and bust.

The Atlanta Fed’s macroblog post also argues that the Fed has already laid out an exit strategy for reducing its balance sheet, and it gives a link to minutes of the FOMC with a list of tools. However, as I explained in testimony to Congress last year, a list of tools is not a strategy. A strategy is a path or contingency plan for the balance sheet over time. I gave an example in the tesimony. If it is good to lay out a path to reduce the federal debt as a share of GDP, then why not lay out a contingency path to reduce the Fed’s balance sheet?

Regarding my proposals to restore the Fed’s reporting and accountability requirements removed in 2000, I think macroblog post’s reference to Ben Bernanke’s speech at the American Economic Association last January supports my point rather than refutes it. If there had been such reporting requirements in place in 2003-05, then the Fed would have been required to report the strategy at the time in Congress, not 7 years later at the AEA. Also if you look back at the FOMC transcripts at the time you will see that the Fed was intentionally holding rates extra low for an “extended period” and only increasing them at “measured pace,” which does not seem consistent with policy as usual. In my view if the Fed had laid out its strategy at the time, then there would have been a more informed public discussion.

Then there is the question of the Fed’s multiple mandate. The record shows that explicit mention of the term “maximum employment” entered the FOMC Statement for the first time only last fall, after more than thirty years of no such mention since the mandate was put into legislation way back in 1977. So the connection between the mandate and QE2 seems most evident based on the record. In my view, the rate of inflation and the level of GDP last year justified an interest rate near zero, but not QE2. The Atlanta Fed macroblog post argues that QE2 was effective. But any connection between QE2 and its purported effects is tenuous when long-term Treasury securities, which the Fed has been purchasing, have declined in price, gone in the wrong direction.

The recent post by David Altig ends by referring to the Financial Crisis Inquiry Commission, which seems to have chosen a “perfect storm” explanation of the crisis where everyone shares some blame. In that report, the Fed shares blame, but mainly because of a failure to enforce existing regulations. The debate over interest rates seems to have ended in a draw in the Commission with short reviews of arguments made by Ben Bernanke, Alan Greenspan, and me. The conclusion of the minority that U.S. monetary policy may have contributed to the credit bubble is about as far as one could expect from such a commission and should be enough incentive to look for policy reforms to improve monetary policy in the future.

Following the financial crisis, it is understandable that central bankers want better advice from economists and their economic theories, as Mojmir Hampl of the Czech central bank writes this week in the European Opinion section of the Wall Street Journal. But Princeton economist and recent president of the American Economic Association put it best when he said “economic theory came out of this better than policy practice did.”

The Wall Street Journal’s choice of a headline for my op-ed last Friday “A Two-Track Plan to Restore Growth,” was a great way to pair the proposed fiscal reform with the proposed monetary reform. The Congress and the President would lay out the fiscal track to reduce the exploding debt and then nail down the track with the golden spike of entitlement reform. In parallel the Fed would lay out the monetary track to reduce its exploding balance sheet and then nail down the track with the golden spike of reporting and accountability reform. In each case reform is needed: for fiscal policy entitlement reform is needed to provide incentives to control spending growth and improve the quality of services; for monetary policy, reform is needed to provide incentives to follow more rules-based policies.

Hearings at the House Financial Services Committee last Wednesday covered many of these same issues in detail with new members of Congress asking good questions. Witnesses were Don Kohn (former vice chair of the Fed) and I who focused on monetary policy, as well as Bill Poole and Hal Scott who focused on fiscal policy and regulatory policy, respectively. There was also a good second panel with witnesses from the private business sector.

Somewhat surprisingly, Don Kohn agreed that reporting and accountability about monetary policy decisions could be improved, as I had argued in my testimony and in the op-ed, though he was not sure whether legislation was needed. In my view Congress should restore the Fed’s reporting requirements which it removed in the year 2000 in a little-known section of the American Homeownership and Economic Opportunity Act of 2000. Don emphasized that the congressional committees could ask better questions and thereby hold the Fed more accountable even without restoring the former type of requirement.

Two other related policy matters from last week:

Bob Heller (like Kohn and Poole, a former member of the FOMC) spoke out forcefully against recent Fed policies. According to Bloomberg News: “While most critics of the Federal Reserve are investors and market pundits, one noteworthy individual was a former member of the U.S. central bank. Robert Heller, Federal Reserve Governor from 1986-1989, described the Fed’s second round of quantitative easing, QE2, as ‘dangerous’ and ‘misguided’ in a Bloomberg interview.”

Ron Paul reintroduced a bill to repeal the law (31 USC 714(b)) which now prevents GAO from auditing certain monetary policy activities at the Fed. The Bill would delete the following language “Audits of the [Federal Reserve] Board and Federal Reserve banks may not include— (1) transactions for or with a foreign central bank, government of a foreign country, or nonprivate international financing organization; (2) deliberations, decisions, or actions on monetary policy matters, including discount window operations, reserves of member banks, securities credit, interest on deposits, and open market operations; (3) transactions made under the direction of the Federal Open Market Committee; or (4) a part of a discussion or communication among or between members of the Board and officers and employees of the Federal Reserve System related to clauses (1)–(3) of this subsection.” Other legislation related to the Fed is likely on the way.

The phrase in the headline above concludes Amity Shlaes’s “amazingly thorough” article (quoting AEA President Orley Ashenfelter here) on the long cyclical swings between rules and discretion which I documented in a speech at the annual AEA-AFA luncheon in Denver on January 7. Given that the previous period of discretion (in the 1960s and 1970s) lasted nearly two decades, a continuation of the normal cycle means that it might take another dozen years to get back to more stable rules-based monetary and fiscal policies, which is the length of time Amity Shlaes suggests. She also suggests that a law could move the balance back toward rules much sooner. I think that’s why we are beginning to see renewed interest in legislation to modify the Federal Reserve’s mandate and add reporting requirements and accountability for its monetary strategy.