Hiding in here is a good lesson for anyone who thinks that your graduate school education is an indoctrination. For example, some people seem to think that MIT (in the old days anyway) sends you off to the far left, and Chicago sends you off to the far right (again, in the old days). Eric Rosengren and I entered the PhD program at the University of Wisconsin-Madison in 1980, and we were both teaching assistants in Don Hester's undergraduate money and banking course. The funny thing is that one of the responsibilities of Don's TAs was to run a computer-simulated banking game. The students ran banks, and the TA played the role of central banker. Apparently Eric took this job very seriously, as this ended up being his chosen career. Another one of our classmates, who had shown up the previous year on campus was Jeff Lacker, now also a Fed President (Richmond). Eric and Jeff could not have more different ideas about how to run a central bank. While Eric is very much into intervention and guiding the economy, Jeff is very much into market solutions, and is highly skeptical of intervention. Obviously these guys are independent thinkers.
In his speech, Eric makes clear at the outset what he has in mind:
In short, policymaking has been effective at stabilizing the economy, but the recovery remains far too weak to restore what we consider full employment with the speed I would like to see.Clearly, his primary focus is on the real side of the economy, not inflation (though more about that later), he thinks he knows how aggregate empoloyment should be behaving, and he thinks monetary policy can help in making it behave better than it is.
Eric is dismissive of the the notion that sectoral reallocation (which I have discussed here and here) is an important phenomenon that we should be thinking about. He says:
To me, this does not suggest that the driver is structural change in the economy increasing job mismatches – although no doubt some of that exists – but instead I see here a widespread decline in demand across most industries.Eric's arguments are the usual ones coming from Old Keynesians, i.e. production and employment dropped across all sectors during the recession; sectoral reallocation is no more important and probably less important in the current recession than in other recessions; the currently low level of employment and high unemployment rate are due to "deficient demand." If this Econ-101 aggregate-demand-management vision of the world were correct, then the unemployment rate in Canada should be about 11.5%, instead of 8.1%, as it is now. What Eric and others are ignoring are the peculiarities of this recession related to the housing sector, which we have to trace back to the year 2000, and perhaps earlier. The incentive-problem-induced boom in housing construction from 2000 to 2006 distorted the allocation of resources in the U.S. economy, and the subsequent housing bust created a need to reverse that reallocation. Housing construction will not be recovering any time soon, and that is a key anomalous feature of the current recession - housing construction typically leads the recovery.
What is surprising about Eric's views is that, given those views, it is likely that he was one of the architects of the Fed's purchase of more than $1 trillion in mortgage-backed securities (MBS). This is a sectoral intervention if there ever was one. If sectoral reallocation is unimportant in the current recession, why did the Fed need to buy MBS, in the process reallocating credit, and resources, to the housing sector? Why didn't the Fed just buy $1 trillion in long-term Treasuries instead, which would have at least been sector-neutral, in some sense. Note further that the Fed's MBS purchases worked against the sectoral reallocation that was taking place, and that needed to take place.
Eric goes on to discuss policy options. Here, he starts by taking an approach that appears to be common currency in parts of the Federal Reserve System.
A simple Taylor Rule calculation, shown in Figure 10, relates movements in the federal funds rate to deviations in inflation and unemployment from their targets. The far right section of the chart highlights that given the very low level of inflation and the very high level of the unemployment rate, the Fed would have continued to reduce the funds rate over the past two years, but for the zero lower bound.Figure 10 is a picture I have seen before. The idea is that you fit a Taylor rule to the data (presumably linear in this case). Out-of-sample, this Taylor rule predicts a nominal interest rate of about -6% or -7% currently. Then, the typical argument seems to be that, if the Fed were doing what it was doing before (which we all know was the "correct" policy), it is going to be constrained by the zero lower bound on nominal interest rates from doing the right thing, which justifies doing other stuff. That other stuff includes quantitative easing (QE) - purchases of long-maturity Treasuries by the Fed.
Now, implicit in this idea is that the Fed should be claiming property rights over both the unemployment rate and the inflation rate. The Taylor rule policy that it was apparently pursuing in the past is claimed (in particular by John Taylor, see this) to have been a great success, witness the "Great Moderation," for example (the period after the 81/82 recession and before the financial crisis). Of course, if the Fed has property rights over the unemployment rate and the inflation rate, and the Taylor-rule policy was such a great success, what was the financial crisis and the current recession all about? Eric, and others at the Fed, want to claim that the financial crisis was a triumph of central banking, but if we take Eric's views seriously, this episode should be considered a disaster.
I do not think that the Fed's behavior had much to do with the causes of the financial crisis. I know that some people think that low interest rates during Greenspan's tenure contributed to our financial problems, but I don't put much stock in those arguments. The danger in having the Fed claim too much credit for economic successes, particularly on the real side of the economy, and in attributing too much power to the Fed over real activity, is the property rights problem. Congress, and the public at large, come to believe that the Fed owns the real economy, and is responsible, not only for the real successes, but for the real failures as well. This is a dangerous threat to the Fed's independence.
Eric goes on to discuss quantitative easing (QE): the purchase of long-maturity Treasuries by the Fed. This is the most commonly discussed potential intervention the Fed could undertake in the near future. Eric says:
Now some concerns: While purchases of Treasury securities have the advantage of not directly “allocating credit” to a particular industry, they have the disadvantage of only indirectly affecting the private borrowing rates that more directly affect private investment spending. In addition, Treasury purchases raise for some a concern that the Fed intends to monetize the federal debt, using monetary policy to accommodate the financing of fiscal policy. I can assure you that we have no desire or intention whatsoever to do so.So, a QE program involves changing the structure of the outstanding debt of the consolidated governnment (Fed and Treasury). The Fed is swapping outside money for long Treasuries, which is literally monetizing the debt - shortening the average maturity of the debt, and making it more liquid. How can you say you have no intention of doing something you are literally doing?
It is looking increasing likely, given the public statements of various Fed officials, that, barring some surprises in new data coming in, the FOMC will decide on some change in their strategy - likely some QE - at its next meeting. Likely the Keynesians and non-Keynesians can agree, based particularly on the inflation data, that more expansion is needed. In spite of what Eric thinks (i.e. the key risk is deflation), there is still inflation risk associated with the large quantity reserves in the system and the maturity structure of the Fed's balance sheet. This will be exacerbated by any further QE.