Economics One

A year and a half ago when the Fed’s extraordinary quantitative easing (QE) was shifting from emergency liquidity programs to large scale asset purchases, we convened a conference at Stanford’s Hoover Institution to discuss the shift. Jim Hamilton, of UC San Diego, in his talk Concerns about the Fed’s New Balance Sheet and Peter Fisher of Blackrock in his talk The Market View expressed serious concerns about the extraordinary policies and the use of the Fed’s balance sheet to finance them. Don Kohn, then Fed Vice-Chair, attended and defended the Fed’s position

One concern expressed at the time (March 2009) was that such extraordinary measures would become a “new normal” for monetary policy, in which the Fed would not restrict its massive doses of QE to times of panics and other emergencies. Such a new normal would likely breed uncertainty and reduce the Fed’s independence, eventually leading to economic instability and inflation. I put it this way in my paper in the book, Road Ahead for the Fed, which came out of the conference:

“The danger I see is that as the recovery begins, or after we are a couple of years into it, people may feel that it’s not fast enough, or there is an unpleasant pause. Either could generate heavy pressure on the Fed to intervene…. Why would such interventions only take place in times of crisis? Why wouldn’t future Fed officials use them to try to make economic expansions stronger or to assist certain sectors and industries for other reasons?”

Many Fed officials dismissed the concerns about such a scenario, saying that the crisis was unique. Yet this is exactly the scenario that is now playing out. Sure enough, the recovery paused, and lo and behold, there is a QE2 in the works.

Today’s Roubini Global Economics newsletter is ominous. It predicts that after QE2 the Fed will “announce QE3 (and eventually even QE4).” After Road Ahead for the Fed we published another book Ending Government Bailouts as We Know Them. Perhaps the title of the first book should have been The End of Monetary Policy as We Know It

The effects of exchange market interventions are frequently estimated by looking at what happened on the day of the announcement of the intervention or of the intervention itself. But my observation—based in part on experience running the international division of the U.S. Treasury and engaging in financial diplomacy with Japan and other countries—is that announcement effects can be very misleading as an estimate of the overall effect of interventions because the impacts can wear off with no announcement or reverse interventions. The recent experience with the September 14 announcement of an exchange market intervention by the Bank of Japan is an important case in point as clearly indicated by this chart of the yen-dollar exchange rate. The yen did noticeably depreciate against the dollar on the day that the intervention was announced and took place, but that has already been reversed.

This is one of the reasons why I think it is unwise to rely on announcement effects to assess the impact of central bank asset purchase programs as in Gagnon et al. Better to look over longer periods of time where you can control for other factors as in this paper with Johannes Stroebel.

I recently had the pleasure of reading, and then writing a review of, Allan Meltzer’s monumental A History of the Federal Reserve, Volume 2 which is published in Book 1 and Book 2. The lesson from this thorough 2,112-page history (volumes 1 and 2 together) deserves careful consideration by policymakers today.

It is a history of policy successes and policy failures. The failures are the Great Depression of the 1930s, the Great Inflation of the 1970s, and the Great Recession of recent years. The successes are the Great Disinflation of the early 1980s and the Great Moderation which succeeded it. What caused these successes and failures? Meltzer focuses on two types of policy errors: (1) succumbing to “political interferences or pressure” and (2) basing policy on “mistaken beliefs.” Failure comes from making one or both of these errors; success comes from avoiding them.

He argues that the Great Depression was mainly the second source of error: mistaken beliefs about the real bills doctrine. The Great Inflation was a combination of both types of errors, but failure to resist political pressure dominated because when beliefs changed in the 1970s, policies did not. The Great Disinflation was marked by an absence of both types of errors as Paul Volcker regained independence and restored basic monetary fundamentals about the impact of changes in the money supply and interest rates. The Great Moderation was a period where independence was solidified and rules-based policy, grounded in fundamentals, was followed. The Great Recession was a return to a combination of both kinds of errors, a departure from rules-based policies that worked in the Great Moderation and a loss of independence as the Fed engaged in fiscal and credit allocation policy.

Meltzer’s historical research thus leads him to conclude from the past that “Discretionary policy failed in 1929-33, in 1965-80, and now,” and to recommend for the future that “The lesson should be less discretion and more rule-like behavior.” While I registered some disagreements with parts of Meltzer’s history in my review article, I think his overall conclusion and recommendation are largely correct.

New empirical research establishes a strong relationship between very low interest rates set by the Fed, as in the period 2002-2005, and a risk-taking search for yield. This policy-induced lessening of risk aversion has been emphasized by Raghu Rajan and others as a key factor bringing on the financial crisis. The new empirical support for this view is reported in the working paper “Risk, Uncertainty and Monetary Policy” by Geert Bekaert, Marie Hoerova, and Marco Lo Duca.

The basic evidence is the pattern of correlations over time which can found by looking carefully through the following bar graphs and table drawn from the paper.

Last June the central bank of Norway hosted a fascinating conference in Oslo on the use of monetary policy rules in small open economies. The Norges Bank is a remarkably transparent central bank. As with the Swedish Riksbank, it announces not only its most recent interest rate decision, but also the likely path for its interest rate decisions in the future. While some have criticized publishing future interest rate forecasts, the experiences in Norway and Sweden show that there are advantages of such increased transparency. For example, consider the debate at the Risksbank earlier this month about the path of interest rates in the next two years. The Riksbank minutes (which provide much more detail than FOMC minutes) reveal a substantive debate between some, such as Deputy Governor Lars Svensson, who preferred an interest rate path in which rates were held low for a long time and others who wanted to increase rates more rapidly.

As explained in the minutes, the debate was in part over forecasts of monetary policy rate decisions abroad: “Given statements made by the Federal Reserve and the ECB, …low policy-rate expectations must be regarded as very realistic. The differential between Swedish and foreign interest rates is currently moderate. If the repo-rate was to become credible and policy-rate expectations for Sweden were to shift up to the repo-rate path, the expected differential in relation to other countries would be considerable. This would trigger substantial capital flows and lead to a dramatic appreciation of the krona. Both higher market rates and a stronger krona would entail a drastic tightening of actual monetary policy.”

More light is shed on the effect of lower interest rates abroad on policy by the experience of the Norges Bank; the effects can be illustrated using charts from their Monetary Policy Reports. Consider the decision to lower the path of interest rates in Norway earlier this year. The lower path is shown by the red line in this picture:

The Norges Bank explained this change with their useful (and very transparent) “interest rate accounting” bar chart. Observe that a big reason for the rate cut was that foreign interest rates were expected to be lower.

Further evidence is shown in the Norges Bank efforts to use monetary policy rules in their decision-making. As shown in the third graph, their interest rate path is lower than a Taylor Rule without the foreign interest rate and about the same as a policy rule in which the foreign interest rate is added to a Taylor Rule. Whether such adjustments are good or bad was the subject of my keynote address at the conference, but whatever the answer, we should be grateful for their high level of transparency which helps us research the question.

For years economists and policymakers in the United State have been expressing fears that America would enter a Japanese-style deflation and thereby experience a lost decade like Japan in the 1990s. One of the earliest examples was the October 1999 Woodstock Vermont conference (later published in the Journal of Money Credit and Banking) on how to avoid deflation, which may have been an impetus to the Fed’s decision to hold interest rates so low in the period from 2003-2005. In his recently published history of the Federal Reserve Volume 2, Allan Meltzer reports, based on conversations at the time, that “Chairman Alan Greenspan believed and said that the country faced risk of deflation” during this period. Concerns about deflation are clearly on the minds of members of the FOMC as they meet next week.

It was therefore very helpful and quite refreshing that Bank of Japan Governor Masaaki Shirakawa’s chose to address this issue in a speech this week at the Bank of Japan, Uniqueness or Similarity? Japan’s Post-Bubble experience in Monetary Policy Studies. Hearing from a person in a top leadership position who can reflect on the experience of dealing with deflation is very useful right now. I heard the speech in person and can report that many in the audience (including me) were very positive about the interesting ideas, the clarity of the exposition, and the many helpful charts. The most discussed chart, reproduced here, suggested an eerie similarity between the United States and Japan.

Other interesting points in the speech were that the recent Japanese-style deflation has been remarkably mild compared to the Great Depression and that “Empirical studies on Japan mostly show that quantitative easing produced significant effects on stabilizing the financial system, while it had limited effects on stimulating economic activity and prices.”