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.


  1. Great article. Thorough and well-written. I agree that lagging the inflation goal by 0.3% matters very little; however, Ms. Yellen seems to argue that certain transitory factors (such as pricing of phone data plans) have kept inflation lower than the inflation target. If this is the case, inflation could rise higher than the 2% inflation target in the not so distant future. Shouldn't the federal reserve continue to further adjust interest rates gradually to remain close to its target?

    1. There are many factors that cause inflation to move around in the short run, including crude oil prices. Not sure about phone plans. The Fed might want to make adjustments based on what factors it thinks are permanent, and which are transitory, but that's very difficult to do. The best approach seems to be to move gradually in the direction that makes inflation move toward the target. But in this case, I think Yellen has the sign wrong (as most central bankers do). Being a little below target should justify increasing the nominal interest rate target a little. Yellen would say that if the Fed doesn't increase interest rates that inflation will be too high - she thinks in terms of Phillips curves. But we all know that Phillips curve thinking doesn't make any sense. The Fisher effect is very dependable.

    2. I should add that I'm not quarreling with one more 25 basis point increase next meeting, say. I can't see the argument for three increases this year.

  2. ``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.''

    How large should the size of the central bank's balance sheet be? The Fed has increased the size of its balance sheet till the economic recovery is completed. However, this statement confuses me in a way that economic recovery is a relative notion rather than an absolute notion. What are the principles that should determine full economic recovery and the size of the balance sheet?

    To put these questions in perspective, I use a New Monetarist model with including federal deposit insurance fee (f) and the capital requirements (r). As usual, there is a consolidated government with passive fiscal policy and active monetary policy.

    S = c + z^m m + z^o o,
    V = S + z^b b,
    where S is the size of the central bank's balance sheet, V the consolidated government debt, c is the currency, m is the reserves, o is the reverse repurchase agreements and b is the government debt. To put it simple, the general incentive constraint satisfies

    F(x) = V + S*{f - r/[(1-r)*u'(x)]},

    where x is the quantity of DM goods, F is a continuous increasing function. It has similarities with Wiliamson (2016) ``Interest on Reserves, Interbank Lending, and Monetary Policy'' but the difference is that a decrease in S increases welfare provided that x is sufficentlly large. If the inefficiency is overwhelming, then the central bank should increase the size of its balance sheet for larger welfare. There is a threshold level of DM consumption x** such that u'(x**) = r/[f*(1-r)]. That is, if xx**, then it is a good thing. The deposit fee is key such that reducing the balance sheet size is always welfare improving without the fee. In reality, the size of the central bank's balance sheet had reached its maximum at $4.1 trillion in 2015. It has been gradually decreasing since then. The model determines what the central bank should do by comparing the level of DM consumption to the threshold value x**. Can this information be used to make conclusion about how/when the Fed should employ the tightening money policy? The drawback of the model is that x** depends on (i) limited commitment friction, (ii) deposit fee, and (iii) capital requirements. I am not sure if (i), (ii), and (iii) can explain why the total Fed liabilities had gone up to $4.1 trillion but not $3.7, $4.4 trillion or any other figure.