Wednesday, June 13, 2018

Sovereign Money, Narrow Banks, Digital Currency, etc.

The recent Vollgeld (full money) or sovereign money referendum in Switzerland, which was just voted down, is quite interesting, as it raises several fundamental issues in monetary economics and central banking. What's money? Is "money" a useful concept to be bandying about? Who should have the right to issue money? What's a bank? Are banks inherently unstable? What's a central bank for anyway?

I read a few blog pieces and news reports on Vollgeld. Some of the blog pieces, like David Beckworth's, contained essentially nothing I could agree with. Others, like one by Morgan Ricks, were pretty interesting.

What was the Vollgeld proposal? In Switzerland, as you may know, they like referenda. These are conducted for all three levels of government, and there are typically several a year at the federal level. If you're upset about something, and can get enough people to sign a petition, the initiative is sent to the electorate (you won't have to wait for an election), and it's either voted up and made law, or voted down. This specific initiative - Vollgeld - was a proposal that would have banned private banks from the retail payments business. Under Vollgeld, a private bank could still issue various liabilities - long-term debt, short-term paper, savings accounts, for example, but presumably not accounts subject to payment by debit card or check. What was the reasoning? Apparently, we shouldn't trust private banks. They're risky - I assume in both the institutional and systemic sense. And there seems to be some notion that giving a private financial institution the right to issue "money," is giving it monopoly power. Why should we be endowing these elite bankers with special privileges?

But what are people to do if the banks can't provide them with transactions services? The Vollgeld proposal was to transfer that provision to the central bank, which would be then be in the business of setting up accounts, issuing debit cards, making sure accounts aren't overdrawn, filling ATMs with cash, etc. And why not, the Vollgeld proponents might say. After all, those elite bankers have had checking accounts (i.e. reserve accounts) with the Swiss National Bank since that institution was set up. Surely it would be more democratic if reserve accounts were available to everyone.

On the face of it, Vollgeld seems not so different from traditional narrow banking proposals, which have been around for a coon's age. The weird thing is that narrow banking proposals usually came from the right wing, while Vollgeld appears to be a lefty proposal. Milton Friedman, for example, had a narrow banking proposal - the 100% reserve requirement. Friedman thought that controlling the stock of money is everything, and if each unit of transactions deposits were backed by one unit of central bank reserves, the central bank could perfectly control the total stock of money - reserves plus transactions accounts plus central bank-issued currency. So, with Friedman's proposal the private banks could still issue the transactions accounts, not the central bank, but it's effectively the same as a Vollgeld-type proposal. And the rationale isn't so different. The Vollgeld people are concerned that a private institution is issuing what they think is a public good - money - and Friedman agrees, basically (or would if he were still with us).

Narrow Banking in its extreme form has from time to time entered the realm of economic quackery. Murray Rothbard, for example, not only did not trust private banks to create money, he didn't trust the central bank either. Rothbard apparently had some influence on Ron Paul and the End the Fed movement. Basically, Rothbard wanted to re-establish the gold standard, and have a 100% reserve requirement - in gold.

The typical benefits attributed to narrow banking - other than what Friedman had in mind - can be found in some of the concerns of the Vollgeld proponents. Banking is sometimes thought to be inherently unstable - an idea that might occur to you if you were a student of US banking history, for example. A remedy for this problem, instituted first in the United States, is deposit insurance. But, we know that deposit insurance breeds another problem - moral hazard. Banks will take too much risk, if they're not somehow prevented from doing so. So one regulatory intervention breeds others - capital requirements for example. Solution: Adopt narrow banking and transactions deposits are safe - you can do away with deposit insurance.

What's the problem with that? Well, in typical narrow banking proposals, a concern is that the legal restriction on banks makes financial intermediation less efficient. That is, through the wonders of asset transformation, conventional private banks convert illiquid loans and other illiquid assets into liquid transactions deposits. This intermedation process is an efficient way to channel savings into productive investment. If people are forced to hold their transactions balances in accounts backed by central bank or government liabilities, then real interest rates will be higher on loans and other private debt instruments, and there will be less capital accumulation.

The other problem is that narrow banking rules, including Vollgeld, can be skirted by private financial intermediaries. This is a standard game in the financial sector. Some regulator puts restrictions on some type of financial intermediary activity, and some enterprising banker finds a way to design a financial product that performs roughly the same function as what is being regulated, but the new product falls outside of the regulation. In the United States, money market mutual funds came into being because of regulations on transactions deposits at commercial banks. Sweep accounts were devised to get around reserve requirements and the prohibition of the payment of interest on demand deposits. The shadow banking sector grew because costs were lower than in regulated commercial banking.

A curious feature of Switzerland is that, if the Swiss National Bank were to issue transactions accounts, this would actually not be narrow banking in the usual sense. To illustrate why, consider Canada (if you dare). In Canada, for example, most of the assets held by the Bank of Canada are obligations of the government of Canada, and the balance sheet is small, at 6.5% of GDP. So, if the Bank of Canada issued transactions accounts to consumers, that would be a narrow banking activity, provided nothing changed in the composition of the Bank's asset portfolio. The Swiss National Bank, by contrast, holds a portfolio that includes a large amount of equity, and the majority of the portfolio is not denominated in Swiss currency. The Swiss National Bank holds the sovereign debt of other countries in Europe, North America, and Asia, and it holds private debt. Further, the balance sheet of the Swiss National Bank is very large, at 117% of Swiss GDP at the end of 2017.

So, if Vollgeld had passed, what the SNB would be doing would not be narrow banking as traditionally envisioned. In fact, the Swiss National Bank, given its large and unusual asset portfolio, wouldn't look like any bank I know of under Vollgeld. It would have been some sort of stock mutual fund/foreign currency-denominated bond fund offering transactions accounts. Though the Swiss National Bank is currently well-capitalized, I doubt if it would pass the regulatory scrutiny of any bank regulator. In any case, the Swiss National Bank campaigned actively against Vollgeld.

Another curious aspect of Vollgeld was that the movement was driven in part by the idea that banking should be democratized. Somehow private banks were thought to be falling short in the public service department. But the residents of Switzerland already have the option of holding transactions accounts - and savings accounts too - in a government financial institution. If you've been to Switzerland, you should know what this is - it's the Swiss post office, Swiss Post. From their web site, it appears that Swiss Post also offers financial services related to pensions and real estate. Wikipedia says Swiss Post is the country's second-largest employer, and Post Finance, its financial arm, is the fifth largest retail financial institution in Switzerland. So, given that there is already a government-owned option in retail payments services, why would the Vollgeld people want to take the extra step of banning private retail payments outright? Beats me.

For all central banks in the world, changing technology, and evolution in retail payments has become an important issue - if not the key issue for the future of central banking. Central-bank-issued currency is losing ground to debit and credit cards in retail payments, in spite of the fact that currency outstanding has in some instances increased. Here's the currency/GDP ratio for the US:
So, that bottomed out at about 4.1% in the 1980s, and currently stands at 8.1%. But, about 80% of that is in $100 denominations. As people like Ken Rogoff like to point out, the primary liability of most central banks - what finances the asset portfolio of a small-balance-sheet central bank like the Bank of Canada - is being used as a means of payment and store of wealth by criminals. Getting rid of large denominations, or withdrawing all currency from circulation, would increase the cost of committing crime, and might make us all better off (except the criminals of course).

But, currency is still used intensively, in legitimate ways, by a significant fraction of the population, who tend to reside in the bottom tail of the income distribution. And currency can be useful when everything else fails - computer networks go down, or the power fails altogether. We don't want to shortchange the poor (literally), or shoot ourselves in our collective foot. A possibility is that central banks could issue some form of digital currency, which is what most people are considering, I think, when they discuss "sovereign money," not the more draconian Vollgeld approach.

So, if central banks were to issue a new type of liability, what form could that take? Well, it could be a kind of cryptocurrency. As with Bitcoin, for example, central banks could issue a liability that could be exchanged in decentralized fashion, on a distributed ledger. While central banks may be able to correct some of the potential stumbling blocks associated with cryptocurrencies, what we know about blockchain technology currently suggests that it can't handle a large volume of transactions, and that it is far too costly - in pure energy costs - to provide the correct incentives. So, a central bank digital currency would have to be centralized - a stored-value-card technology for example. But then the central bank would have to provide an interface whereby value could be downloaded and uploaded at decentralized locations. Possibly this could be done through the private banking system, and possibly central bank digital currency could compete with privately-issued digital currencies.

But why should the central bank be in the business of retail payments at all? Why not leave that entirely to the private banking system? Indeed, there were historical instances of stable and successful private money systems. For example, before 1935 in Canada, retail means of payment consisted of small denomination government of Canada paper notes and coins, larger denomination paper notes issued by private chartered banks, and transactions deposits at those same chartered banks. If currency is an anachronism, we could do away with it, and leave the retail payments market to private financial institutions, perhaps with some constraints requiring that basic services be provided to low-income people.

What would monetary policy be in a world in which the central bank doesn't issue liabilities that Milton Friedman would recognize as "money?" Here, it's helpful to get away from the idea that there is some stuff we should call "money," and that such stuff is produced through magic - creation from "thin air," apparently. Those ideas - propagated sometimes by otherwise-respectable economists - aren't helping us much, and are seriously misleading. In reality, assets exist on a multidimensional spectrum, and the central bank's ability to execute what we think of as monetary policy - inflation control, crisis intervention, smoothing of financial conditions to enhance real economic activity - could be unimpeded even if the central bank does not issue a retail payments instrument.

Central banking works because the central bank is transforming assets - its a bank after all, which has assets and liabilities that differ according to maturity and liquidity. As long as the asset transformation is something that can't somehow be undone by private actions, it works. Governments issue interest-bearing debt for which close private sector substitutes don't seem to exist. For example, in the US, the repo market loves Treasury securities. So, we might imagine central banks issuing an array of interest bearing obligations - from overnight assets like the reverse repos issued by the Fed, to three month bills, to 10-year bonds - to finance a portfolio of government debt. In principle, those central banks should be able to target short-term market interest rates, just as they do now.

I've touched on a host of questions that central banks need to know the answers to, and there is some urgency in providing answers. Unfortunately, we can't get the answers by running a regression, as these are fundamental questions having to do with institutional design and technologies that we have little or no experience with. This is where theory comes in, and part of why it's useful - sometimes the only game in town. Get out your models, monetary theorists!

Monday, May 21, 2018

Inflation, Interest Rates, and Neo-Fisherism In Turkey

In most respects, President Erdogan of Turkey is not known for his progressive instincts, but in economic policy he may be the only convinced Neo-Fisherite on the planet who potentially has any power over monetary policy decisions. Erdogan has been at odds with the Central Bank of Turkey, and seems intent on changing the Bank's approach to inflation policy. In a recent interview in the UK, and recent speeches, Erdogan has made clear that he thinks that high nominal interest rates are the cause of high inflation in Turkey, and that disinflation can be achieved if the Central Bank reduces its policy rate.

Erdogan's views have been derided by market participants, and some panic ensued, manifested in a depreciation in the Turkish currency. But, apparently Erdogan's ideas aren't coming out of thin air, as his economic advisor Cemil Ertem has written a defense of Erdogan's views, which does a good job of finding the relevant supporting evidence. He cites John Cochrane's work, and speeches by central bankers, including Jim Bullard, that support neo-Fisherite ideas.

So, what's been going on in Turkey? Here's the time series of CPI inflation rates:
Turkey had very high inflation from the early 1980s until 2002, with the inflation rate sometimes exceeding 100% per annum. But, there was a large disinflation, with the inflation rate falling from a peak of 73% in 2002 to 7% in 2004. Since 2004, inflation has been much lower than over the previous 20 years, and much more stable. However, if we compare the path of recent inflation in Turkey with the United States, the picture looks like this:
So, inflation in Turkey is still considerably higher than in the United Stages, averaging about 8% since 2004, and it has recently been creeping up above 10%. Further, the Turkish central bank has had inflation targets that it has been persistently overshooting for more than 10 years:

What has the Turkish central bank been doing, and what does it propose to do in an attempt to hit its inflation target? From the central bank's most recent Inflation Report:
Given a tight policy stance that focuses on bringing inflation down, inflation is projected to converge gradually to the 5-percent target...
And:
...the disinflation process will continue in 2018 due to the decisive implementation of the tight monetary policy and convergence of economic activity and loan growth to a milder growth path.
So, that seems like boilerplate central banking. "Tight" monetary policy, i.e. a high nominal interest rate target, will lower inflation, and this disinflationary process will get some help from the Phillips curve, i.e. "a milder growth path" will reduce inflation, according to the central bank.

This is the Turkish central bank's inflation forecast:
So, in a little over two years' time, the central bank thinks it will have inflation down to its 5% target. Of course, that's what it thought in 2016:
In contrast to that optimistic forecast, inflation went up, not down, in the intervening period, and is currently well outside what was denoted the "forecast range" in the 2016 forecast.

So, you might conclude that the Turkish central bank is not capable of reducing inflation. But that's a puzzler. A central bank that could reduce inflation by about 66 percentage points in a two-year period from 2002 to 2004 can't get inflation down from 7% to 5% from 2016 to 2018? What's that about? Well, what did the central bank do to produce the 2002-2004 disinflation? Let's look at the path for short-term interest rates and inflation over the same period as in the first chart. Here I'm using an overnight interbank nominal interest rate (the only short-term interest rate I could find for Turkey - if you know where to find other interest rate data, please let me know):
So, in that chart we're seeing a typical Fisher effect - higher inflation is associated with higher nominal interest rates. The spikes in the overnight rate occurred during 1994 and 2001 financial crises in Turkey. Next, let's focus on the disinflationary period and after:
As we all know, if central banks can do nothing else, they are at least capable of pegging short-term interest rates. So, the path we see in the above chart for the overnight rate was determined by the central bank of Turkey. Did the central bank engineer a disinflation by keeping the nominal interest rate high? No. Monetary policy acted to reduce short-term nominal interest rates, and the inflation rate fell.

I'd say President Erdogan isn't as nutty as people are making him out to be - at least in the inflation policy realm. And Turkey is a very interesting example, as it appears to be following the orthodox central banking rulebook: Phillips curve, Taylor rule. There are plenty of countries - Japan being the most extreme - where inflation has been chronically below central bankers' inflation targets, so if Turkey is following the standard rulebook, why is inflation chronically above the inflation target there? Well, that's exactly what mainstream theory predicts. A central banker who blindly follows a Taylor rule (with the Taylor principle in place - more than one-for-one response of the nominal interest rate to changes in inflation) reduces the nominal interest rate target when inflation is low, believing that this will increase inflation, but inflation falls, and the central banker gets stuck in a low-inflation policy trap. Similarly, a Taylor rule central banker who sees high inflation increases the nominal interest rate target, believing that this reduces inflation, but inflation goes up. If the central banker followed the Taylor rule blindly, then inflation would increase indefinitely. But in Turkey's case that may not happen, even without President Erdogan in the mix, due to public resistance to higher interest rates.

There's a lesson here for countries like Canada and the United States, where central bankers are currently hitting their inflation targets. The Bank of Canada and the Fed avoided becoming Japan - falling into the low-inflation policy trap - because they either kept nominal interest rates off zero (Canada), or lifted off from zero (US). But interest rate hikes can be overdone - the risk as that you become Turkey.

Wednesday, May 9, 2018

Natural Rates

The natural rate of unemployment is not something we hear a lot about in academic circles these days, and it's out of fashion even in some central banks. I was out of town when this happened, but when I was working for the St. Louis Fed, Larry Meyer showed up at the Fed to talk to economists in the Research Department. One of things he wanted to know was our estimate of the natural rate of unemployment. Meyer seemed offended, apparently, that we had never thought about it. He didn't know that it's hard to find anyone at the St. Louis Fed who would take the Phillips curve, let alone the natural rate of anything, seriously.

I was reading Paul Krugman's blog, and he is saying that recent evidence "seems to have brought skepticism about the natural rate to critical mass." That sounds promising, so I thought I would like to understand what Krugman is getting at.

Krugman thinks that the "natural rate hypothesis," which he attributes to Milton Friedman, was an influential idea that we should re-assess. So, what did Friedman actually have to say about this? If you read Friedman's "The Role of Monetary Policy," you'll find that the natural rate hypothesis is no more nor less than the long-run neutrality of money. Friedman argued that the central bank could control nominal quantities - the nominal quantity of central bank liabilties outstanding, the price level, inflation, for example - but that it would fail in any attempt to permanently control real magnitudes. To get that idea across, Friedman told a story. That is, there exists a natural rate of unemployment - roughly, the rate of unemployment that would exist in the long run in the absence of aggregate shocks - and if the central bank endeavors to force the unemployment rate to be higher or lower than the natural rate then this would lead to ever-decreasing or ever-increasing inflation, respectively (though in the ever-decreasing case, presumably there would be a lower bound due to the lower bound on the nominal interest rate). A key part of the story is a theory of the short-run nonneutrality of money. For Friedman, this is a theory of money surprises, relying on adaptive expectations. Workers supply labor based on the real wage they expect, so if higher-than-anticipated money growth causes growth in nominal wages and prices to exceed what is expected, then workers supply more labor, thinking their real wage is higher, and firms hire more labor, as they know that real wages have fallen. That's a theory of Phillips curve correlations. Money surprises cause output and inflation to move in the same direction.

Lucas constructed a closely related theory of money surprises and nonneutrality, and in the process introduced rational expectations to the macro profession. Lucas has a theory of Phillips curve correlations, and can also say something about how the Phillips curve shifts with the monetary policy rule. For example, the slope of the curve changes with the degree of noise in the policy rule. New Keynesian (NK) models can of course produce Phillips curve correlations as the result of sticky prices. Expectations are rational in such models (the baseline ones anyway), and there is no imperfect information about aggregate shocks, but monetary policy is not neutral because some prices are locked in from past decisions. Unanticipated monetary expansions then lower relative prices for firms which cannot change prices in the current period, and those firms increase output to meet demand.

In principle all these Phillips curve models - Friedman, Lucas, NK - can give rise to the process Friedman describes, i.e. a process by which monetary policy can mess things up when the central bank attempts to peg real quantities. In NK models this would require some work. But the idea might be to have pricing rules respond to observed central bank behavior. The central bank tries to peg the path for aggregate output, but then firms change their pricing behavior in response, and this leads to either increasing or decreasing inflation.

In any case, I cannot find any evidence in Friedman's work that he thought measuring the natural rate of unemployment would be a useful thing to do, or that shocks independent of monetary policy causing movements in the unemployment rate would necessarily lead to movements in the inflation rate in the opposite direction. So those ideas are coming from somewhere else, and they are well-entrenched in the thinking of central bankers. Paul Krugman believes this too, as he says:
I’d say that the preponderance of evidence still supports the notion that high unemployment depresses inflation, low unemployment fosters inflation.
That's a particularly poor way to think about inflation. As David Andolfatto likes to tell us, unemployment does not cause inflation. Some shocks to the economy cause unemployment and inflation to move in opposite directions, for example in the Spanish example that Krugman shows us in his post. In other cases - for example during most of the post-2009 period in the United States - inflation and unemployment move in the same direction, more often than not.

Further, the prevalent idea in central banks currently is that, once the unemployment rate falls below the natural rate, inflation will take off. This idea is built on a misunderstanding of Friedman's thought experiment in his 1968 paper. The results of a monetary policy experiment don't tell us how inflation responds to other types of shocks that could be moving the unemployment rate around.

Saturday, May 5, 2018

Neo Fisherism: Look, it Works!

We know that Neo-Fisherism works in our models. In baseline macroeconomic models in which money is neutral, increases in inflation and increases in nominal interest rates go hand-in-hand. If we incorporate standard types of frictions that give rise to monetary non-neutralities in our models, for example New Keynesian sticky prices or segmented markets, an increase in the central bank's nominal interest rate target will in general raise inflation - in the short run and in the long run. See for example Cochrane (2016), Rupert and Sustek (2016), and Williamson (2018). And note that these theoretical predictions don't come from some freakish concoction of a demented neo-Fisherian, but from the mainstream modern macroeconomic models widely used by academics and central bankers.

But these predictions run afoul of standard central banking practice. I have yet to meet a policymaking central banker who thinks that inflation goes up if the central bank "tightens," in the usual sense in which that word is used. Standard central banking practice is of course enshrined in basic Taylor rules, which dictate increases in the central bank's nominal interest rate target when the inflation rate increases. In fact, the "Taylor principle" implies a more-than-one-for-one increase in the nominal interest rate target in response to an increase in the inflation rate.

Standard theory is pessimistic about the ability of a Taylor-rule central banker to successfully control inflation. Given a fixed inflation target, the Taylor-rule central banker can get stuck in a policy trap in which the nominal interest rate is as low as the central banker wants it to go, inflation is lower than the inflation target, and low inflation continues in perpetuity. But apparently real-world central bankers don't follow a rigid Taylor rule. For example, central bankers in the United States and Canada have recently raised their interest rate targets in the face of inflation that was falling below the inflation target. The Fed and the Bank of Canada, in their public statements, have both used what an Incipient Inflation Argument (IIA) in order to extract themselves from the low-inflation policy trap. That is - as they argue - inflation may not be high today, but given a tightening labor market, the Phillips curve will surely reassert itself, and we have to get ahead of the curve. If we don't get ahead of the curve then, as the argument goes, we'll have to tighten at a higher rate later on, with dire consequences.

The IIA allows the central banker to do the right thing - the neo-Fisherian thing, basically - while not abandoning the Phillips curve in some obvious way. To quote yours truly from September 2015:
What are we to conclude? Central banks are not forced to adopt ZIRP [zero interest rate policy], or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP produces low inflation. We should also not be surprised that NIRP produces even lower inflation. Further, experience with QE should make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world's central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target - zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than having a nominal interest rate target well above zero, on average. To get there from here may require "tightening" in the face of low inflation.
At the time, there was no shortage of opinion to the contrary. As Larry Summers wrote in the Washington Post in August 2015:
The Fed, like most central banks, has operationalized price stability in terms of a 2 percent inflation target. The dominant risk of missing this target is to the downside — a risk that would be exacerbated by tightening policy.

In December 2015, as you may recall, the Fed in fact began tightening in the face of low inflation. Here's what happened:
So much for downside risk. It took a while, but raising the Fed's nominal interest rate target coincided with an increase in inflation, to the point where the Fed has now hit its 2% PCE inflation target. So, the Fed's policy moves have been a success, and those who feared that interest rate hikes would take the US economy over a cliff should have calmed down and slept more soundly. After six 25-basis-point increases in the fed funds rate target range, the unemployment rate has fallen from 5.0% to 3.9%.

Should central bankers just declare neo-Fisherism a success, throw away their Phillips curves, and move on? Phillips curves should have of course been thrown out long ago, but we want more evidence to convince people that changing the sign in the policy rule (increasing the nominal interest rate target when inflation is below target) is the right thing to do. The recent US experience is only one episode, and there are many factors other than monetary policy (oil prices, factors affecting the real rate of interest) that affect inflation over the short term and the long term.

What has happened in other countries over this same period (2012 to present)? Here's Canada:
The Bank of Canada has a 2% inflation target, in a range of 1-3%, so as you can see the Bank has not been outside its target range much in the last six years. Average inflation has been below 2%, but the current inflation rate in Canada is currently at 2.3%. In terms of interest rate hikes, the Bank is one behind the Fed, with its target rate at 1.25%, as compared to the ON-RRP rate in the US (the comparable secured overnight rate), which is pegged at 1.5%. The Bank of Canada was one of the first central banks in rich countries to increase its policy rate after the financial crisis, though the interest rate target dropped after the fall in oil prices (associated with a drop in real activity in Canada). Overall, inflation performance in Canada relative to the US is consistent with neo-Fisherism. After the financial crisis, the Bank of Canada didn't set its nominal interest rate target as low for so long as did the Fed, and inflation has been on average somewhat higher in Canada.

In most of the other rich countries in the world, central banks have kept their nominal interest rate targets close to zero or below zero for a considerable time. I've selected five key ones: the European Central Bank, the Bank of England, the Swiss National Bank, the Bank of Japan, and the Swedish Central Bank. Here are the inflation time series (from 2012) in those countries:
In this picture, the UK stands out as having inflation above the 2% Bank of England inflation target for more than a year. Of course the Pound has also depreciated by about 20% against the US dollar since 2014, for reasons having little to do with monetary policy. In Sweden and the Euro Area, inflation has at times been at the 2% target, though inflation is now softening in those jurisdictions, particularly in the Euro area. Inflation has come up in Switzerland and Japan, but is still well short of 2% in both countries. As well, we could look at a scatter plot of inflation vs. the overnight nominal interest rate in each of the seven countries we have been looking at:
So, that's a nice neo-Fisherian picture. If good labor market performance produces high inflation, why is inflation so much lower in Japan and Switzerland than in Canada? If unconventional monetary policies make inflation go up, why are the countries with the most extreme unconventional policies (negative nominal interest rates, quantitative easing) - Japan, Switzerland, and the Euro area - the ones with the lowest inflation in the picture? Canada, which didn't indulge in any unconventional policies, but has a higher short-term nominal interest rate than all these countries but the US, has an inflation rate of 2.3%. How come? Neo-Fisherite policy works, that's why.

But I think (in part because I've been told) that central bankers are skeptical that they could ever sell a neo-Fisherite monetary policy rule to the public. No one gets excited about higher interest rates, and the average layperson has been conditioned by decades of central banker dialogue about heating the economy up, cooling it down, taking away the punch bowl, etc. It's much easier to swallow higher interest rates if your neighborhood central banker is telling you that this keeps the economy from overheating. We know what happens when things overheat. They break down and explode. In some theories (New Keynesian models, old money surprise models) you can have too much output, but in practice I think this is nonsense. The unemployment rate can't be too low, unless there's some long-run inefficiency at work. The overheating economy is simply part of the IIA argument. That is, a tight labor market is excellent cover for interest rate hikes, which are going to bring inflation up to target. Jim Bullard likes to say: "tighten on good news."

So what's the harm in using the IIA argument, if it's just carrying out the neo-Fisherite program in a more palatable way? First, there are circumstances in which it would be optimal to increase inflation, even if real activity is sub-par. The right thing to do could be to raise the interest rate target, but if the economy isn't "heating up," the IIA argument can't be used. Second, central bankers can run through the story so many times that they believe it. In current circumstances, the risk is that central bankers end up exceeding their inflation targets because of a misunderstanding of the effects of their policies. For example, officials at the Bank of Canada and the Fed think of their current policy settings as "accommodative." From the April 18 Bank of Canada statement:
Inflation is on target and the economy is operating close to potential. That statement alone underscores the considerable progress seen in the economy over the past 12 months. That said, interest rates remain very low relative to historical experience. This is because the economy is not yet able to remain at full capacity on its own.
And from the May 2 FOMC statement:
The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.
Policymakers at the Bank of Canada and the Fed think in very similar ways. In both places, policymakers think of policy in terms of a neutral nominal rate of interest (NNRI) which is thought to be in the range of 2.5-3.5%. According to their thinking, if the central bank's nominal interest rate target is less than the neutral rate, this puts upward pressure on the inflation rate and downward pressure on the unemployment rate. So, the ultimate goal is to raise the nominal interest rate to the NNRI, at which point the economy will be operating at potential and inflation will be at its target.

The key problem with this reasoning is that, if the central bank holds the nominal interest rate constant for a long time, policy ceases to be "tight" or "loose." For example, if the Bank of Canada had pegged its interest rate target to 2% in 2009 and kept it there, real economic activity in Canada today would be indistinguishable from what we're seeing. But inflation would be higher. In Canada and the US, nominal interest rates have been low for going on 10 years, and those interest rates are moving up. So the Bank of Canada and the Fed aren't removing accommodation - they're tightening. And tightening means a negative effect on real economic activity and a positive effect on inflation. The Bank of Canada is achieving its goals. The Fed is achieving its goals. Time to stop tightening.

Sunday, April 15, 2018

The FOMC: Inflation Theory and Inflation Control

In this post, I'm going to attempt to answer 3 questions:

1. What does the FOMC think it's doing?
2. Given what it thinks it's doing, is the FOMC consistent?
3. What should the FOMC be doing, given its stated goals?

What does the FOMC think it's doing?
The easy part here is what most of us know by heart. The FOMC has a statement, most recently amended in January, which says that the Fed is targeting headline PCE inflation at 2%, that it cares in the same way about deviations from that target on the up side as on the down side and, consistent with its Congressional dual mandate, the FOMC is concerned about labor market performance. There is a hint in the statement that this concern might be reflected in greater Committee unhappiness the larger is the deviation of the unemployment rate from the natural rate of unemployment.

But the FOMC's statement of longer-run goals, by design, tells us nothing about how the FOMC intends to achieve its goals. To figure that out, we need to watch what the FOMC does, and what the Committee members say. FOMC policy currently has two dimensions: (i) a target range for the fed funds rate; (ii) balance sheet policy. But, balance sheet policy is effectively on autopilot now. Last year, the FOMC decided to phase out its reinvestment policy, and thus allow a very gradual reduction in the size of the currently-very-large Fed balance sheet. There could be changes in balance sheet policy in the future, but no one expects that, as far as I know. So, FOMC actions currently consist of decisions about the target fed funds rate range, aimed at controlling inflation and unemployment (roughly).

But, to form views about how a target for the fed funds rate range might affect inflation and unemployment, FOMC participants need a theory. What is it? One element in the theory is the neutral nominal rate of interest (NNRI). What's that? Janet Yellen helps us out on this one. The NNRI is
... the level of the federal funds rate that is neither expansionary nor contractionary when the economy is operating near its potential.
I've also heard the NNRI described as the level of the policy rate when the central bank is achieving its goals. So, it seems safe to say that Nirvana is achieved for the FOMC when headline PCE inflation is 2%, the unemployment rate is equal to the natural rate, and the nominal fed funds rate is equal to the neutral rate. But Yellen has left the NNRI ill-defined - probably deliberately, in typical central bank fashion - by not telling us what an "expansionary" or "contractionary" nominal interest rate might be.

Another key element in the FOMC's theoretical framework is the Phillips curve. The Fed formally reviewed its reliance on Phillips curve theory as recently as the January 30-31 FOMC meeting, where
Almost all participants who commented agreed that a Phillips curve-type of inflation framework remained useful as one of their tools for understanding inflation dynamics and informing their decisions on monetary policy.
This view was not universal, however, as there were a couple of malcontents:
A couple of participants questioned the usefulness of a Phillips curve-type framework for policymaking, citing the limited ability of such frameworks to capture the relationship between economic activity and inflation.
While the minutes for the January meeting suggest that the Phillips curve is "one of the tools for understanding inflation dynamics," there is no indication that FOMC participants have any other such tools. Indeed, in Jay Powell's first speech as FOMC chair, the section on inflation is exclusively a defense by Powell of Phillips curve reliability.

To cut to the chase, here's how the average FOMC participant thinks about monetary policy and inflation. Given the Phllips curve framework, the primary avenues through which monetary policy affects inflation, according to the Committee, are the output gap and inflation expectations, and we can measure the output gap using the natural rate of unemployment. If inflation is above (below) 2%, then the Committee should raise (lower) its fed funds rate target, which will lower (raise) spending, raise (lower) unemployment, and reduce (raise) inflation, due to the output gap effect in the Phillips curve. According to the Committee, as long as the Committee is doing its job in this respect, inflation expectations remain "anchored" - that is, expected inflation does not deviate from 2%. Occasionally, however, anchoring expectations may require some reassuring words from FOMC participants.

But, the FOMC's view of what it is doing seems to be more complicated than that. In Powell's speech he says:
While uncertainty around the long run level of these indicators is substantial, many of them suggest a labor market that is in the neighborhood of maximum employment. A few other measures continue to suggest some remaining slack.
Also, from the minutes for the March FOMC meeting:
Most participants described labor market conditions as strong, noting that payroll gains had remained well above the pace regarded as consistent with absorbing new labor force entrants over time, the unemployment rate had stayed low, job openings had been high, or that initial claims for unemployment insurance benefits had been low. Many participants observed that the labor force participation rate had been higher recently than they had expected, helping to keep the unemployment rate flat over the past few months despite strong payroll gains. The firmness in the overall participation rate--relative to its demographically driven downward trend--and the rising participation rate of prime-age adults were regarded as signs of continued strengthening in labor market conditions.
So, it has become increasingly difficult to say that the FOMC has not achieved its labor market performance goal, though some people on the Committee still have a hard time admitting it. Note, in particular, that in their March projections, the median FOMC participant seemed to think the long-run unemployment rate should be about 4.5%, which we can take to be an FOMC estimate of the natural rate of unemployment. The March unemployment rate, 4.1%, is well below that. So I think it's fair to say that the Fed has achieved its labor market goal - it's hard to see why Congress couldn't be convinced to be happy about 4.1% unemployment.

How is the Fed doing on the inflation front? The headline PCE inflation reading for February was 1.8% - essentially at the 2% target, as inflation targeting goes. So, if a fed funds rate range of 1.5%-1.75% could be deemed "neutral," and the FOMC is as close as it might ever get to achieving its goals, Nirvana is here! So, the FOMC must be planning on doing nothing for the foreseeable future, right? Wrong. The March FOMC statement contains the following, which has been in the statement for a considerable time:
The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.
Apparently we're not at the neutral rate yet. That's consistent with what is stated elsewhere in the March press release:
The stance of monetary policy remains accommodative...
So, the Committee thinks that the current fed funds rate range is not consistent with achieving its goals. In terms of its Phillips curve framework, FOMC participants must be thinking that its current "accommodative" policy rate range will produce lower unemployment and higher inflation in the future, and it needs to be less accommodative. How much less accommodative? Well, the March FOMC projections tell us the median FOMC participant thinks the NNRI is about 2.9%, so we have some ways to go, apparently. This year, John Williams says there could be three or four rate hikes, so I would bank on that - his opinions will carry a lot of weight, particularly after he assumes the NY Fed President's job in June.

Is the FOMC Consistent?
In general, I think the answer is yes. But, consistency is achieved, often as not, through vagueness and slippery changes in the terms of reference. Natural this and neutral that are words that carry authority. They have the ring of science and precision, but are anything but. If it can't be precisely defined and measured, it's wide open for abuse in policy discussion. For example, a policymaker looking for slack can find it somewhere - if not in U3, it's in U6, or in the participation rate, or in the participation rate of prime-aged workers, or in epop - whatever. What's a neutral nominal interest rate? Apparently we're there when the FOMC says we are.

What should the FOMC be doing?
Since the core of the FOMC's theory of inflation is a Phillips curve framework, I thought I would go back to the source of some of those Phillips curve ideas: Friedman's 1968 paper "The Role of Monetary Policy," which I had not read in a long time. It's a 17-page paper with a lot packed in. Friedman articulates a theory of theory of Phillips curve correlations, coins the term "natural rate of unemployment," discusses the monetary policy problem, and makes a very specific policy recommendation. Given what we have learned since then, we would not take some of what he wrote seriously - in particular the recommmendation that central banks could solve all our problems if they pegged the growth rate in some arbitrarily-chosen monetary aggregate at some arbitrarily-determined constant. But, in other ways, what Friedman wrote in 1968 is still being taken seriously. Famously, he described the natural rate of unemployment as
...the level that would be ground out by the Walrasian system of general equilib­rium equations, provided there is imbedded in them the actual struc­tural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor avail­abilities, the costs of mobility, and so on.
We can excuse Friedman for calling the model he would use to determine the natural rate a "Walrasian system," as of course he hadn't seen a Mortensen-Pissarides search model in 1968. Otherwise, he understands that such a model would have to have frictions of some sort, and that labor market tightness would have something to do with firms posting vacancies in order to attract unemployed workers. Friedman makes it clear that the natural rate fluctuates, and that it should not enter into policy decisions. So, if anyone thinks that Friedman's ideas justify how the natural rate is used in current policy discussions, they are wrong.

But here's my favorite passage from Friedman's article:
As an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy-in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all gener­ally taken for granted.

Paradoxically, the monetary authority could assure low nominal rates of interest-but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy. Similarly, it could assure high nominal interest rates by engaging in an inflationary policy and accepting a temporary movement in interest rates in the opposite direction.
So, there you have it. Friedman was a neo-Fisherite. He understood that "the broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted." Apparently not much has changed. The financial community and academic economists - not to mention central bankers - all generally take for granted that raising the short-term nominal interest rate lowers inflation. But it ain't so.

In Friedman's article, he lays out a theory of the Phillips curve, based on departures of actual inflation from what is expected. Money growth increases, inflation goes up, people work harder because they think their real wages are higher, and firms produce more output because they observe that the real wages they are paying have gone down. In Friedman's telling, expectations appear to be adaptive, but Lucas later formalized the idea and introduced rational expectations to macroeconomists in the process. The Phillips curve of course appears later in the New Keynesian (NK) literature. In a typical NK model, a Phillips curve arises due to a different friction - sticky prices. However, the mechanism at work is not so different from what Friedman and Lucas had in mind. A firm subject to Calvo pricing sets its price in anticipation of what might happen before it receives another opportunity to change its price, so price increases will reflect anticipated inflation. But, if inflation is unexpectedly high, then the relative prices of the firms that cannot change their prices are unexpectedly low, and demand for their output is also unexpectedly high. So we observe high output when inflation is high relative to what was expected.

So, if the FOMC is a committee of Phillips curve believers, and they think that a fed funds rate in the 1.5%-1.75% range is accommodative, while a fed funds rate at 2.9% is neutral, then they must think that the average American is currently surprised that inflation is so high. As far as I can tell most people - including our central bankers - seem to be surprised that inflation is so low. So, even given the FOMC's preferred theory, their policy makes no sense. And the policy rate path they are planning is not without harmful potential consequences. The Committee actually believes that the way to bring inflation down is to produce more unemployment. What could happen is that - through Friedman's neo-Fisher effect - a higher fed funds rate produces inflation above 2%, and more unemployment to boot.

But it gets even worse. Not only is the FOMC mis-applying theory, it's mis-applying bad theory. The Phillips curve does a poor job of explaining inflation, and of predicting where it's going. That knowledge has been with us for at least 40 years, with no discernible effect on what central bankers put in their models. Further, standard models that contain Phillips curve mechanisms generally give effects "precisely in the opposite direction from what the financial community and academic economists have all generally taken for granted." That is, such models typically predict that hiking interest rates makes inflation go up.

Just to make sure you get the idea, here's the recent data on unemployment and vacancies:
The labor market is as tight as its ever been since this vacancies data has been collected. The Fed has achieved its labor market goal, by any reliable measure. On the inflation front:
This shows four conventional measures, including the inflation measure that the FOMC claims to be targeting - headline PCE inflation. All of these measures are moving up, including the most recent CPI inflation measures. I expect the next PCE inflation number to be even closer to 2%. There's nothing in the inflation data inconsistent with neo-Fisherian ideas. In particular, headline inflation has gone up since the Fed began hiking rates in late 2015. There are other factors at work of course (oil prices), but nothing that would make you think that higher interest rates cause lower inflation.

If there is a sensible voice on the FOMC, it's Jim Bullard's (and that's not just me being loyal to my ex-boss). Bullard thinks that the FOMC should stick with its current policy settings. As Jim has stated publicly, those are his dots at the bottom of the chart in the FOMC projections. Jim is also well-known for dissing the Phillips curve in public. So, wise up FOMC, and listen to the guy from St. Louis.

Monday, February 5, 2018

Panic Over Inflation?

The S&P 500 has dropped about 6% since last Thursday, so people are looking for reasons why. Given the proximity to Friday's US jobs report, could there be something in there that looked like bad news to market participants? Some think this has something to do with news about inflation. For example This FT article, this one in the Guardian, and this one in Quartz piece together the following narrative:

1. Wage growth was up in the jobs report.
2. More wage growth causes higher inflation.
3. Higher inflation causes the Fed to increase its interest rate target.
4. Even with the same FOMC composition as we had last week, we might anticipate tighter monetary policy in the future on Friday's news.
5. With dovish Janet Yellen gone from the FOMC, and with a (possibly slightly) less dovish Powell as chair, hawkish regional Fed presidents voting in 2018, and the addition of hawkish Governors (Quarles, Goodfriend, and whoever else gets nominated and confirmed to the empty Governor slots) we could get four 25-basis-point interest rate target increases in 2018.
6. Higher interest rates reduce output.
7. If future output is expected to be lower, that lowers current stock prices.

Does that make any sense?

First, let's look at year-over-year increases in nominal wages, from the Friday jobs report:
So, there was a big increase in wage growth relative to last month. But wage growth is not much higher than it was two years ago. Further, if we look at the real wage (measured as the average hourly wage divided by the personal consumption deflator) and productivity (real GDP divided by total hours worked), here's what we see:
In the chart, I've normalized by setting each variable to 100 at the start of the last recession. Productivity, by this measure, has been close to flat since the end of the recession, but the real wage is still catching up to it. Economic theory tells us that productivity growth should determine growth in the real wage, and that seems roughly consistent with the chart.

And inflation (year over year PCE inflation) looks like this:
So, the Fed's preferred measure of inflation has been increasing toward the 2% target, though still falling somewhat short. Further, if we look at the PCE levels, relative to a 2% trend, from the beginning of 2007, we get the following chart:
If the Fed had been following a price level target rather than an inflation target, there would be a lot of ground to make up - relative to base period of January 2007, the PCE deflator would now be 4.5% below the 2% trend path. This reflects the sense in which the FOMC is not achieving symmetry in its inflation targeting procedure. Inflation targeting with symmetry, i.e. caring as much about positive as about negative deviations from the 2% inflation target, should achieve roughly the same outcomes as price level targeting.

The financial media seems also to be making a big deal of recent increases in nominal bond yields. For good measure, let's look at the 10-year nominal bond yield and the 10-year TIPS (inflation-indexed) yield:
So, there is a small increase in the 10-year real bond yield, and a larger increase in the 10-year nominal bond yield. Thus, we can infer that the primary driver of the increase in nominal bond yields is anticipated inflation. Qualitatively, we can see something similar at a five-year horizon, but the the increase in the five-year nominal Treasury yield is larger than for the 10-year. To summarize, the key movement is in the breakeven rate (nominal bond yield minus TIPS yield), so I'll show that for both the five-year and the ten-year Treasury yields:
So, the 10-year breakeven is above 2%, and the 5-year is under 2%, but close to it. For the Fed, this is good news, as it says that market participants expect the Fed to hit its inflation target (roughly) on average for the next five years, and for the next 10 years. TIPS are indexed to the consumer price index, which is upward-biased measure of inflation, so we might be a little more comfortable if these measures were 10 or 20 basis points higher, but this is pretty good.

There has also been some concern recently with the slope of the Treasury yield curve. Usually people look at the 10 year yield minus the 2-year yield as a summary measure, but I'll go even shorter, and look at the 10-year bond yield minus the 3-month T-bill rate:
As is well-known, the yield curve tends to be flat or negatively sloped leading a recession. One reason for this could be that monetary policy moves slowly, and the markets see a recession coming before the Fed cuts rates significantly. But the markets anticipate that the Fed will cut interest rates during the recession, and this then is reflected in long bond yields. So the yield curve flattens, or short-term interest rates might even exceed long-term rates. The slope of the yield curve right now is just short of its average in the sample shown in the chart. The average is 1.55%, while the current value is 1.38%. So the yield curve is definitely not flat currently, and if we relied on yield curves to predict recessions, we wouldn't be predicting one anytime soon.

What's the conclusion? There's not really any sign of excessive inflation in the data. There are indeed signs that inflation, and anticipated inflation, are very close to what is consistent with a 2% inflation target, for the indefinite future. So, I'm having trouble drawing any connection between the behavior of inflation, the behavior of the Fed, and the drop in stock prices.

There is potential risk in terms of monetary policy decisions, though. As I discussed in my last post, the Fed is as close as it typically gets to achieving its goals. But the FOMC has been getting up a head of steam for interest rate increases. As I've mentioned before, I think they have the sign wrong. That is, consider the following chart:
Inflation has been coming up recently, as nominal interest rates have gone up (that's the 3-month T-bill rate in the chart). That's consistent with Neo-Fisherian logic - increase the nominal interest rate if you want more inflation. Of course, inflation was low in 2014-2015 in part because of a fall in the price of crude oil. Nevertheless, some people were arguing that inflation would go down as a result of the Fed's interest rate hikes, and that certainly hasn't happened. The problem is that the Fed could continue to increase interest rates when this is not warranted, overshoot inflation, and continue to hike, thus overshooting even more. Fortunately, that's a politically difficult route to take, so I doubt it happens.


Wednesday, January 31, 2018

Janet Yellen: Performance Review

Janet Yellen has now attended her last FOMC meeting as Chair of the Committee. What has she accomplished, since she took the job in February 2014?

To start, we need to review what Ben Bernanke passed on to Yellen four years ago. As I wrote in the St. Louis Fed Review in mid-2014, the key elements of Bernanke's eight-year stint were:

1. Inflation Targeting: In January 2012, the FOMC wrote a "Statement on Longer-Run Goals and Monetary Policy Strategy" intended to make explicit the FOMC's intentions for addressing the dual mandate specified by Congress. Bernanke was well-known for his enthusiasm for inflation targeting, and the Statement includes an explicit 2% inflation target, measured as headline PCE inflation. In an addendum the FOMC clarified that this was a symmetric goal - the FOMC says it cares as much about misses on the high side as it does about misses on the low side of 2%.

2. Forward Guidance: Under Bernanke, FOMC statements became much more wordy and, post-financial-crisis, these statements contained more messages about the FOMC's future intentions. For example, after the financial crisis, forward guidance took the form of evolving statements about the length of time that the Fed's nominal interest rate target would stay low - extended period of low rates, low until at least some future date, low until some thresholds were met in terms of unemployment and inflation, etc. Bernanke also started doing press conferences after FOMC meetings - but only at alternate meetings: March, June, September, and December.

3. Quantitative Easing: After the financial crisis, the Fed engaged in large-scale asset purchases - three rounds of purchases of long-maturity Treasury debt and mortgage-backed securities, with an intervening swap of short-maturity government debt for long-maturity government debt. In February 2014, QE3 had not yet concluded - the Fed was still expanding its balance sheet.

4. Normalization: The FOMC began making normalization plans as early as 2011. FOMC members seemed to agree that the Fed's nominal interest rate target should ultimately rise to more "normal" levels from a fed funds target range of 0-0.25%, and that the size of the Fed's balance sheet should be reduced. Eventually, the Committee agreed that the policy interest rate target would rise first, followed by a balance sheet reduction. At a minimum, the Committee would eventually stop its reinvestment program, which replaced assets on the Fed's balance sheet as they matured, and the Committee reserved the right to sell assets outright.

First, under Yellen, normalization started to happen. Asset purchases ended in October 2014, though reinvestment stayed in place. And the FOMC began increasing its policy target rate in December 2015. Here is the course of the fed funds rate for the last four years:
Rate increases were slow at first - a year elapsed from the first 25 basis point increase to the second, but 2017 saw three 25 basis point increases, with the target range for fed funds now 1.25%-1.5%.

The FOMC was even more skittish about reducing the Fed's balance sheet, with the Committee agreeing as late as June 2017 - eight years after the end of the last recession - to a fairly timid plan for gradually eliminating reinvestment, with no plans for outright asset sales. You can see what is going on here:
So far, any reduction in the Fed's securities holdings is hardly perceptible. To see what the Fed is up against here, it's more useful to measure securities held outright as a fraction of GDP:
So, securities held by the Fed have fallen significantly, to 21.5% of GDP, as real GDP and prices have risen. But to see how far the Fed has to go, we need to look at currency as a fraction of GDP:
If the Fed wants to return to implementing policy as it did prior to the financial crisis, it will have to reduce the balance sheet to the point where there is a very small quantity of interest-bearing liabilities. Roughly, currency would be financing the whole asset portfolio. So, the further reduction needed is, roughly, the difference between 21.5% of GDP and 8% of GDP, or about $2.6 trillion worth of assets that need to mature. This could take perhaps 5 years, depending on how the demand for currency grows and on inflation. Of course, the FOMC might decide that "normal" is a large balance sheet. More about that later.

But, in terms of its ultimate goals, how is the FOMC doing? Here's the path for headline PCE inflation since February 2014:
There's a period of low inflation in 2015 and 2016 that we can blame on a fall in the price of crude oil, but otherwise that's not bad, as inflation targeting goes. With inflation at 1.7%, the Fed is very close to its target, though consistently missing on the low side of 2% is not consistent with the FOMC's commitment to symmetry. To be doing a perfect job, inflation should be 2% on average, but this is quibbling. 0.3 percentage points in inflation at an annual rate matters very little.

What about the real economy? Though the FOMC makes no specific commitments to goals for unemployment or real GDP growth, for example, the dual mandate matters, and Fed economists firmly believe that monetary policy is important for real economic activity. For them, policy is definitely not just about controlling inflation. Real GDP growth in the whole post-WWII time series looks like this:
Here, we're looking at year-over-year real GDP growth. Growth since the last recession ended has been lower than the post-WWII average of about 3% - closer to 2%. But the current growth rate is up to 2.5%, which isn't bad, especially given performance in other parts of the world. Europe, for example, took a long time recovering from the financial crisis.

What about the labor market?
So, in terms of the unemployment rate and vacancy rate, the labor market is as tight as it's been since the BLS began collecting vacancy data. With the labor force growing at between 0.5% and 1.0% per year, it's not possible for employment to grow at more than about 1% per year, rather than close to 2%, as has been the case recently. Unemployment cannot fall much further, so unless productivity growth picks up dramatically, real GDP growth will continue to be lower than the historical average, and perhaps lower.

Thus, in spite of relatively low (but OK) GDP growth, to the extent that monetary policy can do anything about the real side of the economy, it's already done it. This economy is growing at potential. Conclusion: Inflation looks pretty good, and there's no good reason to think there's some inefficiency in the US economy left for monetary policy to correct. So Janet Yellen should declare victory, and sail off into the sunset.

But, we shouldn't let her off the hook that easily. Why?

1. Yellen's last FOMC statement, from today, doesn't reflect the actual state of the economy. First, it says:
The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12‑month basis is expected to move up this year and to stabilize around the Committee's 2 percent objective over the medium term.
Why are further adjustments needed? The Fed is currently meeting its goals. We're already "around" the 2 percent objective. Then, further on in the statement, there's some more detail:
The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.
What's expected to change from here on in that would warrant further interest rate increases? Why should higher nominal interest rates prevail in the longer run? Again, we're there. Why should the FOMC be expecting that they have to do anything next meeting, or this year?

2. What about that large balance sheet? The Committee has been dragging its feet on this one. One would have expected that, since the Fed first dropped interest rates in the financial crisis, then expanded its balance sheet, that it would unwind the policy in reverse - reduce the balance sheet and then raise interest rates. Indeed, this would have been the most politically astute approach to normalization. Raising short rates with a large balance sheet of low-yield long-maturity assets risks reaching a state where the Fed stops sending transfers to the Treasury, because it is paying out more on its liabilities than it is earning on its assets. While not economically important, some people in Congress would jump all over this. It can still happen. Further, it seems likely that large-scale asset purchases will be used again in the future - though at least one newcomer to the FOMC, Marvin Goodfriend, isn't a big fan of QE. But it's not clear the Fed understands the effects of QE - why it may or may not work - any better than it ever did. QE is basically a move by the central bank to engage in debt management, the usual province of the fiscal authority. Without some agreement that this is a job assignment for the central bank, and effort to coordinate with the fiscal authority, it's not going to work properly, if it works at all. And, there's good reason to believe it doesn't work, or that it could be detrimental. For example, the Bank of Japan has tried in vain with massive QE to raise inflation, without success. QE may accomplish nothing more than reducing the efficiency of financial markets by swapping mediocre collateral (reserves) for good collateral (government debt).

3. Under Yellen, communication with the public has not been so great. It's well known that she doesn't like public appearances, and tends to avoid them. There wasn't a lot of Yellen speech-making. Further, she continued Bernanke's practice of giving press conferences only at the March, June, September, and December FOMC meetings. What this meant was that nothing every happened at the other meetings. Go back and look. Yet, Yellen always insisted that every meeting was a live one. That was a lie, and everyone knew it. I've been told by experienced central bankers that the FOMC should tighten on good news. The reason is that raising the interest rate target is never going to get a round of applause. Good economic data will give the Fed cover to hike rates, and it's sometimes necessary to do that. After all, how can you lower rates if you never raise them? But there's a lot of noise in economic data, so the central bank needs to take advantage of good news when it gets it. And, if 4 of 8 meetings in a year are off the table, that's a lot of potential missed opportunities. But maybe that was part of Yellen's strategy? Maybe she wanted a gradual normalization come hell or high water, and going to 8 press conferences a year would have allowed the rest of the Committee to thwart that goal. Yellen's usually given credit for being collegial, but maybe she's more devious than she looks.

4. It seems nothing has been resolved in terms of the long-term operating strategy for Fed policy. The FOMC already missed one opportunity for useful change when "liftoff" occurred in late 2015. At the time, the FOMC decided to stick with targeting the fed funds rate in a range. Due to quirks in US financial markets, that does not make a lot of sense, particularly with a large Fed balance sheet. It would be easier, and more effective, if the Fed targeted an overnight repo rate - in some sense it does that already, as it pegs the rate on overnight reverse repurchase agreements. But, the reverse repo facility should be larger, for various reasons. The FOMC never really got a handle on this issue, and it's stuck with an outdated fed-funds-rate targeting procedure. Further, it's unresolved whether the Fed stays with its large-balance-sheet system (or floor system) for pegging interest rates, or goes back to pre-financial crisis implementation, where it kept excess reserves essentially at zero (a channel system).

All that said, the one time I saw Janet Yellen in action - at the one FOMC meeting I attended - she was doing a first-rate job of running what could have been a very unwieldy decision-making process. There are 19 people on the FOMC (at full strength), and they all want to have their say. Greenspan was well-known for being somewhat dictatorial, but in the meeting I saw, Yellen stayed in the background, didn't dominate the discussion, but had a firm hold on the flow of ideas and decisions. She's a skilled leader, and it's hard to say that there was anyone else out there four years ago who could have done it better.