Monday, November 19, 2012

The Future of Federal Reserve Policy

If the rumors are correct, Ben Bernanke is likely to leave his post when his term ends on January 31, 2014. Bernanke's likely successor is Janet Yellen, who is currently Vice-Chairman (official title - not sure why they haven't dropped the "man") of the Federal Reserve Board, and former President of the San Francisco Fed. How does Janet Yellen think? We can get some ideas about that from her most recent speech.

Yellen's speech is primarily a defense of mainstream views on the FOMC, and I find some of those views troubling. Yellen argues that, in contrast to the bad old days of central bank secrecy, we are now in an age of Fed transparency. What the Fed says matters, and she is on board with policies that use Fed statements about its future policy actions - forward guidance - to influence the behavior of private economic agents. With regard to policy goals, Yellen favors a "balanced approach," whereby unemployment matters as much as inflation to Fed decision-makers. But what would that mean for policy decisions? This gives you an idea:
Put differently, the purpose of providing greater clarity about the FOMC's longer-run inflation goal is to anchor inflation expectations more firmly. These more firmly anchored expectations in turn free the Committee's hand to more actively and effectively stabilize short-run fluctuations in economic activity. The Committee can act in this way because the FOMC can tolerate transitory deviations of inflation from its objective in order to more forcefully stabilize employment without needing to worry that the public will mistake these actions as the pursuit of a higher or lower long-run inflation objective.
So given that the Fed is now so transparent and able to speak directly and honestly to the public about its goals for long run inflation, it is free to do almost anything in the short run to influence real economic activity. This seems like an excuse for perpetual postponement of decisions to come to terms with inflation.

For Yellen, the Phillips curve is alive and well:
...the essence of the balanced approach, is that reducing the deviation of one variable from its objective must at times involve allowing the other variable to move away from its objective. In particular, reducing inflation may sometimes require a monetary tightening that will lead to a temporary rise in unemployment. And a policy that reduces unemployment may, at times, result in inflation that could temporarily rise above its target.
We know where those ideas led us.

What would Yellen's "balanced approach" imply for economic policy over the foreseeable future? She's quite specific, particularly in how she evaluates policies:
...I need to rely, as I noted, on a specific macroeconomic model, and, for this purpose, I will employ the FRB/US model, one of the economic models commonly used at the Board.
That the FRB/US model is "commonly used at the Board," and that Yellen takes its policy implications seriously, is shocking. We don't know exactly what is in the FRB/US model, but my best guess from this 1996 publication (and it's pretty poor that the latest documentation on this thing is 16 years old) is that the FRB/US model looks much like the large-scale macroeconometric models that existed in 1970. These are basically elaborate, pseudo-dynamic IS/LM models, which were debunked as policy tools by the mid-1970s.

What does the FRB/US model have to tell us?
The optimal policy to implement this "balanced approach" to minimizing deviations from the inflation and unemployment goals involves keeping the federal funds rate close to zero until early 2016...
I should note here that, in addition to being a poor policy tool at any time, FRB/US knows absolutely nothing about quantitative easing, interest on reserves, how the world works when the Fed holds a very large stock of long-maturity Treasury bonds and mortgage-backed securities, what happens when there is a very large stock of reserves outstanding, or how a financial crisis matters. But Janet Yellen wants us to take this model seriously.

With regard to forward guidance, Yellen is all for publishing more detailed Fed forecasts, and being more explicit about the "liftoff" date.
the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range. For example, Charles Evans, president of the Chicago Fed, suggests that the FOMC should commit to hold the federal funds rate in its current low range at least until unemployment has declined below 7 percent, provided that inflation over the medium term remains below 3 percent. Narayana Kocherlakota, president of the Minneapolis Fed, suggests thresholds of 5.5 percent for unemployment and 2.25 percent for the medium-term inflation outlook. Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.
This is a rather foolish idea. To be well understood, a liftoff rule has to be simple. It has to contain specific numerical goals, in terms of a few economic variables. But that is the liftoff rule's fatal flaw. Sensible central banking policy requires that policymakers look at everything. Unforeseen contingencies arise that would make it obvious that the liftoff rule should be abandoned, with an ensuing loss of credibility for the Fed. As well, the unemployment rate is a poor summary statistic for economic welfare, and the unemployment rate fluctuates for many reasons that the Fed should want to ignore.

To bring us down to earth, this speech by Charles Plosser, President of the Philadelphia Fed, is helpful. Janet Yellen thinks that monetary policy is a powerful tool for influencing real economic activity, but Plosser reminds us that modern economics tells us that it ain't so:
The ability of monetary policy to influence employment has long been recognized as tenuous at best. Indeed, the current workhorse models in macroeconomics rely on some form of wage or price stickiness to generate real effects of monetary policy. As wages and prices adjust, the effects of monetary policy on the real economy dissipate; in other words, the effects are transitory. In addition, the experience of the 1970s clearly demonstrated that attempts to use monetary policy to pursue an employment or unemployment target can lead to extremely poor economic outcomes, jeopardizing both employment and inflation.
People seem to forget this simple point. Outside of multiple-equilibrium models, which are not the "current workhorse models" taken seriously by central bankers, all models of short-run monetary non-neutrality involve transient real effects from monetary policy actions. Further, those real effects become smaller the more sophisticated economic agents become at seeing through central banking policy. Janet Yellen would like you to think that economic agents are so unsophisticated that they can't figure out how to adjust wages and prices in response to an announced future monetary policy, yet so sophisticated that they can predict the effects of the announced future monetary policy - for wages and prices. Further, she wants us to believe that the financial crisis - which happened in 2008 - will have lingering effects that need to be corrected by monetary policy, until 2016!

Plosser goes on in his speech to discuss the risks associated with current accommodative Fed policies. He sees those risks as associated with "moral hazard, future inflation, and loss of institutional credibility." On moral hazard, here's an interesting point:
By engaging in targeted purchases of housing-related securities, the Fed has affected expectations about what monetary policy will do in the future should the housing market take a sharp downturn. Will market participants price housing-related assets with the expectation that the Fed will protect the market from significant losses? Will investors in other markets expect similar treatment and therefore be encouraged to take excessive risk?
Those are useful points. Whether the Fed can move mortgage rates more - if at all - by purchasing mortgage-backed securities than long-maturity Treasuries, the perception is that it can. If firms and consumers take into account that the Fed will bail out their sector in the event of adverse events, this causes problems. Those firms and consumers will take on more risk than is socially desirable, and in the event that the Fed does not act as expected, the damage will be worse.

Here are Plosser's fundamental principles:
The first principle is to be clear and explicit about the goals and objectives of policy. And in so doing, policymakers must acknowledge what policy can and cannot achieve.

The second principle is for policymakers to make a credible commitment to their goals by describing how they will conduct policy in a way that is consistent with those goals. One way to do this is for the central bank to articulate a reaction function or rule that will guide policy decisions.

The third principle is to be clear and transparent in communicating to the public the policy actions that are taken.

The fourth principle is to strive to ensure central bank independence.
It's important to note that those principles aren't so different from Yellen's. That's important. A given statement of principles can lead you in entirely different directions.

In contrast to Yellen's "balanced approach," Plosser favors a "systematic approach," which again does not differ so much from what Yellen has in mind. Plosser likes "robust rules," which includes the class of Taylor rules. The Taylor rule of course takes account of both sides of the dual mandate. I'm not sure exactly what Plosser wants. He could mean a public announcement of a specific policy rule, or he could mean simply clear statements about the reasons for Fed policy decisions, which allow the private sector to deduce what the FOMC is up to. It matters which. The former type of systematic policy seems prone to the risks that Plosser is worried about.

Finally, Plosser appears to have no sympathy for liftoff targets.
In my view, this threshold approach could cause some long-lasting confusion, especially if the thresholds are misinterpreted as the FOMC’s longer-run policy goals. But how do you decide on the right numerical values? Moreover, if numerical thresholds were provided as a way to convey forward guidance for the fed funds rate, a numerical stopping rule would also be needed to convey when QE3 asset purchases could be expected to end. This means we may have multiple thresholds associated with multiple tools. It would be difficult to describe all the various conditions necessary for this multi-faceted strategy and communicate them to the public in a comprehensible and credible fashion. I am concerned that we would create more confusion than clarity.
This is an important point. In the Fed's attempt to be more transparent about the future, it may have only sown confusion. There are now multiple facets to the Fed's forward guidance. If even the most sophisticated financial market participants have figured this out, I would be very surprised.


  1. Stephen, are you saying that there is no dynamic tradeoff between inflation and unemployment, or that Yellen believes in the naive Phillips curve?

    1. Yellen's speech makes it clear that she's aware of developments in macroeconomics since 1970. Theories of monetary nonneutrality typically give you a Phillips curve tradeoff. There is no problem with Yellen saying the tradeoff exists. The problem is that Yellen thinks that exploiting the tradeoff is a key part of monetary policymaking. Some theories say exploiting the Phillips curve gets you into big trouble. In Lucas's 72 model, we're worse off if the Fed exploits the tradeoff, and if it does so the tradeoff becomes worse - you have to sacrifice more inflation to get the same effect on output. But we don't take Lucas money surprises too seriously any more. But many people take New Keynesian models seriously. In some versions of those models, price stability is actually an optimal policy - you don't want to exploit the Phillips curve tradeoff, just as in Lucas's model. And, if New Keynesians allowed pricing decisions to be affected by changes in the policy regime (as they should), you would get changes in the slope of the Phillips curve with changes in the policy regime, just as in the Lucas model. Where Phillips curves really go haywire is when people think they can use the Phillips curve idea to forecast inflation. Output gaps, however measured, are of no use in forecasting inflation.

    2. Actually, I think there is a valid component in Yellen's remark. Bringing inflation down does require a sacrifice in GDP (and higher unemployment).

      But there is a cryptic part about tolerating higher inflation to bring unemployment down to its natural rate. To the best of my knowledge, in New Keynesian models inflation tends to fall when unemployment rises above its natural rate so reducing the output gap should simply prevent inflation from falling below its target. I am not sure why it would actually push inflation up, above its target. I wonder what model Yellen has in mind.

  2. Shouldn't the Fed at a minimum get interest rates off the 0% floor before declaring 2008 to be irrelevant ancient history?

    I mean, it seems strange to say that the economy has returned to normal, except for interest rates being permanently at financial crisis levels. You would have to believe in a very odd coincidence.

    1. 2008 is of course not irrelevant ancient history. But you have to understand exactly why the world does not look "normal" now, and what the Fed can do about that lack of normality, before you start flailing around with a load of unprecedented and risky policies. The predominant view at the Fed seems to be that the lack of normality is due to wage and price rigidity. I don't see it.