The Fed Gets What It Wants: A 1%-2% Inflation Target Corridor

So it is finally time for lift off. The Fed is poised to raise short-term interest rates over the next few days after seven long years of ZIRP. Exciting as this development may be, it is important to keep in mind that the guiding principle behind the Fed's decisions during this time has not suddenly changed. This principle says that no matter what happens--whether it be ZIRP, QE, forward guidance, the changing winds of fiscal policy, or the normalization of monetary policy--the Fed must always act in a manner to keep core PCE inflation within a 1-2 percent inflation corridor. 

Yes, even though the Fed has an official 2 percent inflation target revealed preferences indicate the real force shaping Fed policy has been a 1-2 percent inflation target corridor over the past seven years. Once you understand this point all other Fed mysteries begin to clear up. For example, why did the Fed sterilize its lending to banks between December 2007 and October 2008? Or, why did it introduce IOR just as the markets were imploding or make the asset purchases under QE temporary? The answer is that it did not want rapid growth in nominal spending--even though it was sorely needed--for fear of pushing inflation too high.  The Fed, in other words, was willing to sacrifice the economy at the altar of the inflation target corridor. This framework is likely to continue going forward.

But don't take my word for it. Let's look to the data and let the FOMC's revealed preferences speak for themselves. 

Consider first the central tendency consensus forecasts of core PCE inflation by FOMC members.  The figures below show these forecasts for the current year, one-year ahead, and two-years ahead horizons. A clear pattern emerges from these figures as you expand the forecast horizon: 2 percent becomes a upper bound. FOMC officials, therefore, have been consistently looking at an upper bound of 2 percent for core PCE inflation. If we add to this fact that the FOMC has meaningful influence on inflation several years out, then these revealed preference are saying Fed officials actually want and expect to get an inflation upper bound of 2 percent. This inflation corridor is a choice.

 

 

Now consider the actual performance of core PCE inflation since the crisis started. This is where the 1 percent lower bound on the corridor becomes evident. The Fed seems ready to pull the monetary trigger if core inflation drifts too close to this lower bound. Currently, core inflation has stabilized around 1.3 percent but should it start falling again I would not be surprised to see the Fed getting trigger happy once again.

These revealed preferences of the Fed have begun to affect the public's long-term inflation expectations.The figure below shows the annual average inflation forecast over the next 10 years from the Survey of Professional Forecasters. I would not call these forecasts unanchored, but they are gradually drifting down. In the past we worried about expectations becoming unanchored as inflation expectations drifted upward. Now it seems they are drifting in the other direction, though presumably anchored by a lower bound.

The low inflation environment of the past few years seems entirely in line with the revealed preferences of FOMC officials. There is nothing mysterious about it. Fed officials are getting what they want. Unfortunately, aiming for a inflation corridor of 1-2 percent does guarantee macroeconomic stability. This inflation target range could be either be too tight or too easy depending on the state of the economy. It would be far better for the Fed to simply stabilize the growth path of aggregate spending. Until then, expect the Fed's decisions to be guided by the inflation target corridor. 

P.S. See Russ Robert's interview of George Selgin on EconTalk for an interesting discussion where some of the Fed's mysterious actions over the past seven years are discussed.

Update: Janet Yellen, made this point in the press conference following the December 2014 FOMC meeting (my bold):

But it’s important to point out that the Committee is not anticipating an overshoot of its 2 percent inflation objective (p.13).

Upgrading to Abenomics 2.0

What has the 'monetary arrow' of Abenomics accomplished? To answer this question, recall that this part of Abenomics called for the Bank of Japan (BoJ) to double the monetary base and raise inflation to 2%. On the former goal the BoJ has been successful. On the later goal it is still a work in progress, though inflation has been trending upward. 

Assessing the Abenomics inflation record is a bit tricky because the 2014 sales-tax hike in Japan put upward pressure on the inflation rate. Nonetheless, after accounting for the tax hike inflation is overall  moving up. This can be seen in the next two figures. The first one shows the core inflation rate since 2000. The second zooms in on the past few years and shows core inflation with and without the tax hike. An upward trend is apparent in this figure. Core inflation is now around 1%, the highest it has been since the late 1990s. So inflation is being pushed up, albeit at a slower paced than originally envisioned under Abenomics. 

More generally, Abenomics has been mildly successful at reflating the economy. The figure below shows nominal Japan's NGDP with the Abenomics period highlighted in red. It has risen relatively rapidly.

The figure also highlights NGDP during Japan's QE program of 2001-2006. It was comparatively flat and was supported by what turned out to be a temporary expansion of the monetary base. This suggests that at least some part of the monetary base expansion under Abenomics is expected to be permanent.  

So the monetary  arrow of Abenomics has been moderately successful at reflating the economy. This reflation, however, has not done much for the real economy. It could do a lot for Japan's debt burden if Abenomics were to continue raising NGDP. And that, in turn, could help reinvigorate the economy. Maybe that is why Prime Minister Shinzo Abe seems so intent on upgrading to Abenomics 2.0.

What is Abenomics 2.0 you ask? It is the Prime Minister's plan to explicitly raise the level of NGDP from its current value of approximately ¥500 trillion up to ¥600 trillion. No, the Prime Minister has not gone all Market Monetarist on us. He is not asking for a growth path target for NGDP, but a one-time 20% increase in the level of nominal spending. Just how ambitious is this goal? Below is a figure plotting out three hypothetical paths to ¥600 trillion NGDP. The five-year path appears to be most in line with Japan's Cabinet Office time frame, as noted by James Cox. By historical standards, this path would be very ambitious for Japan.

Prime  Minister Abe first called for this this goal in September and spoke to it again last week. Here is the Nikkei Asian Review on his latest speech:

TOKYO--Raising Japan's nominal gross domestic product to 600 trillion yen ($4.9 trillion) is a reachable goal, Prime Minister Shinzo Abe told a group of economists in Tokyo on Tuesday.

"We are aiming to achieve a virtuous cycle of growth and redistribution with our 'Society in Which All Citizens are Dynamically Engaged' plan. This is our proposal for a new socioeconomic system," the Prime Minister told the group.

"We will aim to build a diverse society where anyone can succeed. That will lead to new ideas, which will lead to further growth. Through growth and redistribution, I believe our target of achieving nominal GDP of 600 trillion yen is well within our reach." Japan's current nominal GDP is around at 500 trillion yen.

Abe told the gathering that the government is putting together a 3.5 trillion yen supplementary budget and that he hoped to use around 1 trillion yen of the extra money on his "Dynamic Engagement" project.

[...]

Bank of Japan Gov. Haruhiko Kuroda, speaking at the same forum, gave Abe a vote of confidence, saying the number of "people who say Japan is in deflation has decreased. The bank will continue with its aggressive monetary policy to support corporations' efforts, and, if necessary, will not hesitate in making adjustments."

Delivering multiple speeches on this ¥600 trillion NGDP level target suggests that Prime Minister Shinzo Abe is serious about upgrading Abenomics. It is reminiscent of the fireside chats in the 1930s where FDR was signaling his desire to raise the price level. In both cases leaders were trying to reflate their economies. FDR was partially successfully with reflating, but botched up on the supply side. Prime Minister Abe is trying to get both right with his monetary and structural reform arrows. Here is hoping he succeeds.

P.S. These developments do not bode well for Neo-Fisherism.

Update: Scott Sumner says Abenomics is working even better for the real economy and inflation than I portray in this post. On the latter, he suggests looking to the GDP deflator. It does paint a better picture.

How Consequential Was the Fed Tightening in 2008?

So Senator Ted Cruz's claim that Fed policy was too tight in 2008 and my ringing endorsement of it has generated some interesting conversations. Paul Krugman says I should taper my enthusiasm, while Scott Sumner and Ramesh Ponnuru say it is okay. The Washington Examiner and Quartz seem to agree.

Other observers like Kevin Drum, Jeff Spross, Cullen Roche, and Sudeep Reddy are underwhelmed by Senator Cruz's critique.They acknowledge the Fed should have cut interest rates at its August and September 2008 FOMC meetings, but they question how consequential this inaction was to the Great Recession. After all, the Fed could only cut interest rates from 2% to 0% during this time.

This rather benign assessment of Fed policy in 2008 misses an important point. The Fed's tightening of monetary policy was not just about a failure to cut short-term interest rates from 2% to 0%. It was also about the Fed signalling it would raise interest rates going forward because of inflation concerns. The Fed, in other words, was tightening the expected path of monetary policy during this time. 

To see this consider the next two figures. The first one shows the 1-year treasury interest rate minus the 1-month treasury interest rate. Standard interest rate theory tells us that this spread equals the expected average short-term rate over the next year.¹ That is, if the spread goes up in value then the market is expecting the short-term treasury rate to rise over the next year and vice versa. This figure shows a sustained surge in the expected short-term interest rate over the next year from April to November 2008. It especially intensifies in the second half of the year. Only in December does the spread really begin to fall. For most of the year, then, the market increasingly expected a tightening of policy going forward.

The second figure shows the 3-month treasury bill interest rate forecast from the Philadelphia Fed's Survey of Professional Forecasters. It compares 1-quarter, 2-quarters, 3-quarters, and 4-quarters ahead forecasts for the second and third quarters of 2008. It clearly shows at every forecast horizon that professional forecasters raised their forecasts of short-term interest rates between the second and third quarter of 2008. They expected more monetary policy tightening in the third quarter 2008.

Again, the Fed tightening in 2008 was not just about the absence of a 2% interest rate cut. It was about an expectation that the Fed was going to raise rates going forward, even though the economy was weakening. This development was huge because current spending decisions are shaped more by the expected path of interest rates than by current interest rates. 

So why did the public expect this tightening? Because the Fed was signalling it! Among other places, this signalling was clear in the August and September 2008 FOMC statements. Here is a gem from the August FOMC meeting (my bold): 

Although downside risks to growth remain, the upside risks to inflation are also of significant concern to the Committee.

And from the September FOMC meeting we get a similar warning:

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee

This was forward guidance at its worst and points to a far more intense tightening cycle than is apparent by looking only at the current policy interest rate. The Fed was willing to strangle the already weak economy over inflation concerns and the market knew it.

It was this severe tightening of monetary policy that turned an otherwise ordinary recession into the Great Recession. As I noted before, this tightening of policy occurred before the worst part of the financial crisis in late 2008.  Recall that  many of the CDOs and MBS were not subprime, but when the market panicked in late 2008 a liquidity crisis became a solvency crisis for all. Had the Fed not tightened during the second half of 2008 the financial panic probably would have been far less severe and the resulting bankruptcies far fewer. So no, it is not obvious that a severe financial crisis was inevitable. 

P.S. The Fed was not the only central bank to tighten in 2008 because of inflation concerns. The ECB did as well and repeated the mistake two times in 2011. These experiences illustrates the the limits of inflation targeting and why it is a monetary regime that has outlived its expiration date.

¹Technically, the theory says that long-term interest rates equal the average of short-term interest rates over the same horizon plus a risk premium to hold the longer term security. Since the long-term security here is a 1-year treasury, we are looking at changes in the expected short-term interest rate over the next year. Also, this short-term horizon means the risk premium is small and inconsequential to our story.

Book for the Holidays

If you are looking for some holiday reading I highly recommend Scott Sumner's new book, The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression. Here is a summary:

Economic historians have made great progress in unraveling the causes of the Great Depression, but not until Scott Sumner came along has anyone explained the multitude of twists and turns the economy took. In The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression, Sumner offers his magnum opus—the first book to comprehensively explain both monetary and non-monetary causes of that cataclysm.  

Drawing on financial market data and contemporaneous news stories, Sumner shows that the Great Depression is ultimately a story of incredibly bad policymaking—by central bankers, legislators, and two presidents—especially mistakes related to monetary policy and wage rates. He also shows that macroeconomic thought has long been captive to a false narrative that continues to misguide policymakers in their quixotic quest to promote robust and sustainable economic growth. 

The Midas Paradox is a landmark treatise that solves mysteries that have long perplexed economic historians, and corrects misconceptions about the true causes, consequences, and cures of macroeconomic instability. Like Milton Friedman and Anna J. Schwartz’s A Monetary History of the United States, 1867–1960, it is one of those rare books destined to shape all future research on the subject.

Order your copy here. 

Time Traveling with the Fed

Imagine we travel back in time to the second quarter of 2009. We stop by the Federal Reserve and reveal to Fed officials that the recession has now bottomed out. They are elated until we disclose that the Great Recession will be followed an anemic recovery for the next seven years. We share how ZIRP, forward guidance, and successive rounds of QE will fail to create an robust recovery and this leaves Fed officials aghast.

Reeling from shock, they ask what they should do instead of these policies. We inform them of the argument for a NGDP level target made by Scott Sumner, Christina Romer, and Michael Woodford. We also inform them that they should signal the seriousness of their intent to do so by making an arrangement with the Treasury Department to back up their actions with contingent 'helicopter drops' should the Fed fail to hit the NGDP level target.

The Fed agrees with our assessment and decides to spend its political capital on the NGDP level target proposal--instead of using it on ZIRP, forward guidance, and QE programs--and gets the backing of Congress and the Treasury Department. The great macroeconomic experiment begins.

So what would happen next in this counterfactual history? How would the economy respond to these combined efforts of monetary and fiscal policy starting in mid-2009? No one can answer these questions with certainty, but it is likely that at a minimum there would be temporarily higher inflation.

The two figures below lend support to this understanding. They come from a paper I am currently working on where I run a counterfactual forecast of inflation starting in mid-2009. The forecasts are based on three different paths of NGDP returning to its pre-crisis trend: a two-year path, a three-year path, and a four-year path. The first figure shows the three NGDP return paths and the second figure shows the inflation forecasts associated with these paths:

Although temporary, inflation is notably higher than both the actual inflation rate that occurred and the 2% target rate under each of the counterfactual NGDP return paths. The inflation rate would get as high as 3.8% for the two-year path and 3.2% for four-year path. Over all counterfactual paths inflation would average around 2.5% since mid-2009, compared to actual average of 1.5%. 

These numbers are just counterfactual forecasts, but they demonstrate a key reason why the current monetary regime could never have generated the 'catch-up' aggregate demand growth needed to offset the 2008-2009 crash in nominal spending and return it to its pre-crisis path: it would require higher than 2% inflation for a few years. And that is simply intolerable in the current environment. 

The Fed, Congress, and the body politic at large have come to view 2% or less inflation as the norm for advanced economies. Any violation of it--even if temporary and part of a systematic approach like the NGDP level target above--would be viewed as an egregious affront to civilization. Just look at some of the flack former Fed Chair Ben Bernanke got on this issue or the exchange (see last part) between him and former Senator David Vitter on the question of raising the inflation target.

This means that no matter how much QE or forward guidance the Fed engaged in, it would always be done in a way that kept inflation and, as a result, aggregate demand growth in check. This is the Fed's dirty little secret. This understanding also means that no matter how much fiscal policy was done, it too would only be effective up to the 2% inflation threshold. This is the Penske problem with modern macroeconomic policy: it relies on an engine governor rather than cruise control to regulate the speed of the economy. It is time for level targeting. 

Related
The Right Goal for Central Banks
Monetary Regime Change

Yes, the Fed (Passively) Tightened in the Fall of 2008

Fed Chair Janet Yellen went before the Joint Economic Committee of the U.S. Congress today. She gave her report on the economy and then took questions from members. Probably the most interesting question came from Senator Ted Cruz:

Thank you, Mr. Chairman. Chair Yellen, welcome. In the summer of 2008, responding to rising consumer prices, the Federal Reserve told markets that it was shifting to a tighter monetary policy. This, in turn, set off a scramble for cash, which caused the dollar to soar, asset prices to collapse, and CPI to fall below zero, which set the stage for the financial crisis.

In his recent memoir, former Fed Chairman Ben Bernanke says that, the decision not to ease monetary policy at the September 2008 FOMC meeting was, quote, "In retrospect certainly a mistake."

Do you agree with Chairman Bernanke that the Fed should have eased in September of 2008 or earlier?

This question is interesting because it presents a more subtle understanding of the Great Recession than is found in the standard narrative. In fact, it may be too subtle since it seemed to have caught Janet Yellen off guard. It also seemed to have tripped up the usually sharp Wall Street Journal reporter Sudeep Reddy in his live blogging of the hearing. Both seemed incredulous that Cruz would imply the Fed actually tightened monetary policy in the fall of 2008. But that is exactly what the Fed did, though to see it one has to understand the notion of a passive tightening of monetary policy.

A passive tightening of monetary policy occurs whenever the Fed allows total current dollar spending to fall, either through a fall in the money supply or through an unchecked decrease in money velocity. Such declines are the result of firms and households expecting a worsening economic outlook and, as a result, cutting back on spending. In such settings, the The Fed could respond to and offset such expectation-driven declines in spending by adjusting the expected path of monetary policy. But the Fed chooses not do so and this leads to a passive tightening of monetary policy.

A passive tightening of monetary policy is no less harmful to the economy than an active tightening. The Fed, therefore, should be no less culpable for passive tightening than it is for active tightening. One way to see this is to imagine the Fed as a school crossing guard. If the Fed failed to prevent a child from crossing into a busy street would we be any less indignant than if it instructed the same child to cross into the busy street? Both mistakes are equally dangerous and the result of choices made by the crossing guard. It is no different with monetary policy. 

So how does this play into Cruz's comments about 2008? The answer is that the Fed began to passively tighten during the second half of 2008. It had actually done a decent job stabilizing aggregate demand for the two years leading up to this point despite a housing recession occurring during this time. But in mid-2008 it allowed a passive tightening to emerge. Arguably, this passive tightening sowed the seeds for the financial panic that erupted later in 2008 and ultimately is what turned an otherwise ordinary recession into the Great Recession. 

Okay, that is story. What evidence do we have for this understanding of the Great Recession?

First, here are two figures that demonstrate the Fed contained the housing recession for roughly two years. They show that employment and personal income outside of housing related sectors actually grew at a stable rate up until about mid-2008. Kudos to the Fed during this time.

But something clearly changes in mid-2008. My argument--echoed by Senator Cruz today--is that the Fed inadvertently allowed a passive tightening of monetary policy. This can be seen in the next few figures.

The first two figures shows the 5-year 'breakeven' or expected inflation rate. It shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. This was an unusual sharp decline and was screaming "Trouble ahead!" 

One way to interpret this decline is that the bond market was signalling it expected weaker aggregate demand growth in the future and, as a result, lower inflation. Even if part of this decline was driven by a heightened liquidity premium on TIPs the implication is still the same: it indicates an increased demand for highly liquid and safe assets which, in turn, implies less aggregate nominal spending. Either way, the spread was blaring red alert, red alert!

The FOMC allowed these declining expectations to form by failing to signal an offsetting change in the expected path of monetary policy in both its August and September FOMC meetings. The next figure shows where these two meetings fell chronologically during this sharp decline in expectations.

As noted above, this passive tightening in monetary policy implies there would be a decline in the money supply and money velocity occurring during this time. The Macroeconomic Advisers' monthly nominal GDP data (i.e. NGDP = money supply x velocity) indicates this is the case:

The Fed could have cut it policy rate in both meetings and signaled it was committed to a cycle of easing. The key was to change the expected path of monetary policy. That means far more than just changing the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time and signalling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was highly worried about inflation and that the expected policy path could tighten. 

On the financial panic side, note that the Fed kept aggregate demand stable during the early stages of the panic in 2007. Again, job well done. Only in late-2008 after the Fed had allowed passive tightening (as seen by the decline in NGDP) does the financial panic spike. This can be seen in the figure below:

So the worst part of the financial crisis took place after the period of passive Fed tightening. This is very similar to the 1930's Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed. 

So it is completely reasonable for Senator Ted Cruz to ask his question today about the Fed's mistake at the September 2008 FOMC meeting. I would only add that this mistake was already in play by that meeting. The September meeting served to confirm the market's worst fear that the Fed was more concerned about inflation than the collapsing economy.

This understanding of the Great Recession is not unique to Senator Ted Cruz, Scott Sumner, or myself. Robert Hetzel of the Richmond Fed has written an entire book that makes this argument (he also has an journal article). So even a Fed insider acknowledges this possibility.

Update: George Selgin shows how the Fed's sterilization in 2008 contributed to the passive tightening of monetary policy.

P.S. This post draws heavily from earlier ones that make the same point. Also see Scott Sumner's arguments for this view: here and here.

Going All Natural at the Fed

Has the market-clearing or 'natural' short-run  interest rate been negative over the past seven years? The answer to this question would go a long ways in ending much confusion about Fed policy. If the answer is yes, then the Fed has not been 'artificially' suppressing interesting rates as many have claimed. If the answer is no, then then Fed has been keeping monetary policy too loose. In other words, one cannot use interest rates to talk about the stance of monetary policy unless one compares them to their natural rate level.

There is a problem, however, in making this comparison. The natural interest rate is not directly observable, it has to be estimated. Michael Darda, chief economist of MKM Partners, provides one estimate of it and is reproduced in the figure below. Darda's estimate illustrates how knowing both the actual interest rate and the natural interest rate allows us to think more clearly about the stance of monetary policy. It shows that the Fed was a bit too easy during the boom period (the actual interest rate was less than the natural rate) and too tight during bust period (the actual interest rate was above the natural rate). Darda's estimates also shows that the gap between the actual and natural has only slowly converged since 2009, a pattern consistent with the slow recovery from the Great Recession. Other estimates tell similar stories such as the one from Robert Barsky et al (2014) published in the American Economic Review.

While these estimates are nice, it would be immensely helpful if the Federal Reserve published its own monthly estimate of the short-run natural interest rate. The Fed has a huge research staff, lots of resources, and is capable of providing this important information. It would be in the Fed's own best interest if it did so. Imagine if the Fed could point to a figure like the one above whenever someone accused it of artificially suppressing interest rates. It would make everyone's life much easier. 

Well, today we learned from the October 2015 FOMC minutes that this information is being produced by the board of governors staff (my bold):

The staff presented several briefings regarding the concept  of an equilibrium real interest rate—sometimes labeled the “neutral” or “natural” real interest rate, or “r*”—that can serve as a benchmark to help gauge the stance of monetary policy. Various concepts of r* were discussed. According to one definition, short-run r* is the level of the real short-term interest rate that, if obtained currently, would result in the economy operating at full employment or, in some simple models of the economy, at full employment and price stability. The staff summarized the behavior of estimates of the shortrun equilibrium real rate over recent business cycles as well as longer-run trends in real interest rates and key factors that influence those trends. Estimates derived using a variety of empirical models of the U.S. economy and a range of econometric techniques indicated that short-run r* fell sharply with the onset of the 2008–09 financial crisis and recession, quite likely to negative levels. Short-run r* was estimated to have recovered only partially and to be close to zero currently, still well below levels that prevailed during recent economic expansions when the unemployment rate was close to estimates of its longer-run normal level.

The Fed staffers are producing estimates of the short-run natural interest rate so why not share it with the public? Why not add it to Fed's collection of statistics that publishes on its website?  It sounds like the Fed has a range of estimates so it could report point estimates along with confidence intervals surrounding it. So how about it Janet Yellen? Why not go all natural at the Fed?

Related

A Plea to My Fellow Free Marketers

The Fed Did Not Enable the Budget Deficits

Saver's Real Problem

How to Trigger a Panic Attack at the Fed

What does it take to create a panic attack at the Fed? How about a large credit and housing boom that wreaks havoc on household balance sheets? Nope, been there, done that with no loss of sleep. What about experiencing the sharpest recession since the Great Depression? Sorry, that too is a real yawner for the FOMC. How about the national tragedy of the long-term unemployed? Boring. Okay, what about that dramatic expansion of the Fed's balance sheet and complications it makes for the normalization of monetary policy. No worries here either. Well, how about the Fed leaks that led to insider trading? Lame, nothing to see, move along. There is not much the ruffles the Fed's feathers.

But ask the Fed to set its own benchmark rule against which it and others can evaluate FOMC decisions in a non-binding manner and suddenly this happens to Fed officials:

Yes, Janet Yellen and the Fed have finally found something to freak out about, the Fed Oversight and Modernization (FORM) Act.  In various media accounts, Yellen "slammed" the bill, "warns loud against it", and has "stepped up opposition" to it. What is so freakworthy about this bill? Janet Yellen explains in a letter to congress (my bold):

I am writing regarding the House of Representative’s consideration of H.R. 3189, the Fed Oversight Reform and Modernization (FORM) Act. The FORM Act would severely impair the Federal Reserve’s ability to carry out its congressional mandate to foster maximum employment and stable prices and would undermine our ability to implement policies that are in the best interest of American businesses and consumers.This legislation would severely damage the U.S. economy were it to become law.

There are a number of harmful provisions in the FORM Act, but the provisions concerning the conduct of monetary policy are especially troubling. Section 2 of the bill would require the Federal Reserve to establish a mathematical formula or “directive policy rule” that would dictate how the Federal Open Market Committee (FOMC) adjusts the stance of monetary policy at every FOMC meeting. The Government Accountability Office (GAO) would be responsible for determining whether the rule adopted by the FOMC met all the criteria in the legislation. Any time the FOMC was judged not to be in compliance with the GAO-approved rule, the GAO would be required to conduct a full review of monetary policy and submit a report to the Congress. 

Does this really warrant a Fed panic attack? To answer this question, let's recap the highlights of section 2 in the bill, some of which are missing in Janet Yellen's letter.

• First, the bill requires the Fed to chose on its own a "directive policy rule", a reaction function that prescribes how it would respond to different economic scenarios. In other words, congress would not be forcing a specific rule on the Fed, only asking it to set up a benchmark rule based on the Fed's own preferences. The Fed could change this rule over time. 

• Second, the bill requires the Fed to explain and justify how its preferred rule is different than the "reference policy rule", which happens to be the 1993 Taylor Rule.

• Third, the GAO would report to congress whether the Fed was following its own rule and whether it changed the rule. This is the 'audit' part, since it would require the GAO to investigate why the Fed deviated from or changed the rule.

• Fourth, the Fed chair could be summoned before congress to discuss the GAO findings. 

Sorry folks, but this is definitely not freakworthy. The bill does not change the dual mandate and it does not prescribe how the Fed should conduct monetary policy. All it does is ask the Fed to set a benchmark approach for monetary policy that can be used to evaluate monetary policy in retrospect. The Fed can still deviate from it, it just has to explain why. 

I don't see how this would politicize Fed policy any more than it is already. Janet Yellen already testifies before congress and meets with political activists. If anything, having a benchmark rule would make congressional hearings on the Fed more intelligible. Both the chair and congress would be speaking from the same reference point.

This could actually help the Fed since it chooses the benchmark rule under this law. It could easily adopt a Taylor Rule where the equilibrium real rate part is not constant, but endogenous to current economic conditions. Most estimates of the Taylor Rule that take this approach show the Fed has not been easy. One of the greatest confusions over Fed policy is the belief that it has kept interest rates 'artificially' low. This bill would give the Fed a chance to show otherwise. The Fed should see this as an opportunity.

So this Fed panic attack is an overreaction. The Fed is not being constrained and, if anything, it is being given the ability to shape the conversation on monetary policy. Other countries already have quarterly reports on monetary policy that do something very similar. The Fed should get out in front of this bill and run with it. 

Fact Checking the Fact Checkers

The fourth GOP debate was last night and the economy was an important part of the conversation. Much was said last night that deserves commentary, but I want to focus on one claim that really surprised me. It surprised me because it went against the standard GOP narrative about the Fed. So what was this claim and who said it?

The claim was that the Fed tightened monetary policy in the third quarter of 2008 and this tightening contributed to the Great Recession. This view implies the Fed should have done more to avert the crisis, both in late 2008 and afterwards. It came from none other than Senator Ted Cruz. Someone has done their homework. This is a subtle, but important point that many of us have been making for the past seven years. So kudos to Senator Ted Cruz for recognizing it. 

Sadly, some observers still miss this insight and this sometimes includes the fact checkers of the debate. The latest example of this is Isaac Arnsdorf of the Politico Wrongometer, which is supposed to "truth squad the Republican debate." Here is Arnsdorf's response to Cruz:

But what did the Fed do in 2008? It wasn't tightening money. The Fed actually cut rates repeatedly in 2008. Some economists have argued policy makers didn’t cut rates fast enough given the economic conditions. But that's only "tightening" if you measure it against the demand for liquidity and market expectations. It doesn't reflect the Fed's actual policy moves.

Someone is trying too hard here. Monetary policy can tighten even if the Fed does nothing. It is called a passive tightening of monetary policy. It occurs whenever the Fed passively allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in velocity. The damage done by a passive tightening is no different than that of an overt tightening. 

But don't take my word for it, just ask Ben Bernanke.  Back in late 2010, he acknowledged the possibility of passive tightening and used it as a justification for stabilizing the size of the Fed's balance sheet (my bold):

Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome. In response to these concerns, the FOMC agreed to stabilize the quantity of securities held by the Federal Reserve by re-investing payments...By agreeing to keep constant the size of the Federal Reserve's securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred...

In short, the FOMC was concerned that a failure by the Fed to reinvest its mortgage receipts, which would amount to a reduction in the monetary base, would be contractionary. So for the FOMC, a passive tightening of policy is just as serious as an active one.

Okay, let's apply this notion of passive tightening to the fall of 2008. As I have noted before, both inflation expectations and nominal demand had been falling since mid-2008. Normally such actions would would lead to an easing of monetary policy. But the Fed decided against easing in its August and September 2008 FOMC meetings. By doing nothing at these meetings it was passively tightening.

The September decision not to ease was especially egregious given that the collapse of the financial system was happening at the very same time. Note only did the Fed not ease, but it indicated it was just as worried about inflation as it was about the real economy. In other words, the Fed was signaling it was just as likely to tighten policy going forward as it was to ease. This was probably the worst forward guidance the Fed ever gave.

So Senator Ted Cruz was absolutely right. There was a major tightening of monetary in mid-to-late 2008. And in my view, it was this tightening and the failure to correct it later that turned what would have been an ordinary recession into the Great Recession. This may be a new insight for some observers. It should not, though, be a new insight for a fact checker criticizing a candidate.  

PS. Yes, Senator Ted Cruz did go on to advocate a gold standard. He is, however, interested in a rules-based approach and I suspect would be open to a NGDP level target based rules framework. So let's be gracious and acknowledge the big insight on Fed policy that Cruz alone noted last night. 

PPS. Dr. Ben Carson said he was a long-time friend of Janet Yellen and likes her. He also said he wants to see the dollar tied to something. May I suggest a market-driven NGDP futures contract?

No, the Fed Did Not Enable Large Budget Deficits--You Did!

As a follow up to my last post, I want to repeat a point I have made before. Not only is the Fed not responsible for the low interest rates during the past seven years, but it is also not responsible for enabling the large budget deficits that occurred during this time.¹ 

But how can this be? Was not the Fed involved in massive asset purchase programs of government debt? For some it is obvious that through these programs the Fed was the 'great enabler' of the run up in government debt since 2008. Here, for example, are two former Fed officials making this claim a few years ago at a conference:

Mr Warsh and Mr Poole (who was filling in for Allan Meltzer) made a sharp distinction between the “legitimate” efforts to fight the crisis and the subsequent easing actions that were, allegedly, unjustified by the economic fundamentals. According to them, the interventions of 2007-2009 were required to ensure that “the markets could clear”, as Mr Warsh put it, while the second round of easing was done to satisfy “political masters” by monetising the debt. In fact, Mr Warsh said that the Fed was being actively unhelpful by “crowding in” Congress’s supposedly poor policy choices.

Yes, the Fed did engage in several rounds of 'quantitative easing' (QE) where it bought up a large number of treasury and agency securities. The amounts, however, were not that large relative to the total amount of securities outstanding. The Fed, therefore really was not much more than a bit player in the market for these securities.

To see this, take a look  at the absolute dollar amount of the Fed's treasury and agency assets relative to total for 2015:Q2. Of the approximately $12.67 trillion in marketable treasuries, the Fed owned $2.46 trillion. Similarly, of the roughly $8.71 trillion in mortgage-related securities the Fed ownsed $1.72 trillion. In both cases that amounts to about 19% of the total.  That is not quite the image of a 'great enabler' now is it?

This point is even more clear in the figure below. It shows the most of the run up in marketable public debt since 2008 was not due to the Fed. The black sliver in the figure represents the Fed's share of the total.

If we take the data from the figure above and put the Fed's share a percent of the total we get the following figure. Note that the Fed's current 19% is not that different from where it was in the decade prior to the crisis. Yet, we did not hear people making the 'great enabler' claims back then.

If we zoom in on this figure we see something rather remarkable. There was a sharp reduction in the Fed's share of marketable treasuries in 2007-2008. The Fed critics, however, only seem to notice the QE periods. Where were they during the 2007-2008 period?  They fail to see that the QE programs effectively reversed the 2007-2008 reduction of treasury holdings by the Fed, which itself was not all that much in the grand scheme of things. 

Finally, let me conclude with the following figure. It shows 10-year yields on government  bonds for the United States, Germany, United Kingdom, and Japan--all countries whose treasury securities are considered safe assets. Note that all of them see their yields start to drop in mid-2008 as the panic kicks and they have yet to return. Moreover, they all fell in a similar fashion. Surely, this has to be more than just the Fed at work. It has to do with a surge in risk-aversion that has yet to fully return to normal levels.

So who is ultimately responsible for the low interest rates? Like I said in my last post, market forces are responsible for the low interest rates. And who is the market? You,  me, our financial intermediaries, and foreigners. If you want to blame anyone for low interest rates start by looking in the mirror.

Update: Using SIFMA statistics, I constructed a pie chart to show who the current holders of treasury debt are as of 2015:Q2. Using this data, the Fed holdings come out a bit less than the 19% calculated above using the financial accounts data. Also, financial intermediaries include mutual funds, banking institutions, insurance companies, and pension funds.

¹Okay, if pressed I would say the Fed actually is indirectly responsible for the low rates for allowing the crisis to emerge and then not doing enough to end it promptly. This, though, is a very different argument than the one that says the Fed directly caused the low interest rates.

A Plea to My Fellow Free Marketers

As a free-market loving individual, it pains me to see so many of my fellow travelers claim the Fed has artificially suppressed interest rates since the onset of the crisis. Recently, I was disappointed to see George Will and Bill Gross repeat these claims. They have made these claims before, but I was hoping after all these years they would begin to question the premise of their views. But alas, it did not happen. Here is George Will's latest volley on this issue :

[S]even years of ZIRP — zero interest-rate policy — have not restored the economic dynamism essential for social mobility but have had the intended effect of driving liquidity into equities in search of high yields, thereby enriching the 10 percent of Americans who own approximately 80 percent of the directly owned stocks. Also, by making big government inexpensive, low interest rates exacerbate the political class’s perennial disposition toward deficit spending. And little of the 2016 federal budget’s $283 billion for debt service will flow to individuals earning less than the median income.

And here is Bill Gross in his latest newsletter:

So the Fed has chosen to hold off on their goal of normalizing interest rates and... and the investment community wonders how long can this keep goin’ on. For a long time I suppose, as evidenced by history at least. Ken Rogoff and Carmen Reinhart have meticulously documented periods of “financial repression”[.]

There is no doubt the low interest rates over the past seven years have caused many problems: they have harmed individuals living on fixed income, incentivized unusual reaching for yield by investors, and made it easier to run large budget deficits. But are the low rates behind these developments really the Fed's doing?

What I wish George Will, Bill Gross, and other free market advocates would consider is the possibility that the Fed itself is not the source of the low rates, but simply is a follower of where market forces have pushed interest rates. That is, the Great Recession and the prolonged slump that followed  caused interest rates to be depressed and the Fed did its best to keep short-term interest rates near this low market-clearing level.

But there is more to this story. The crisis was so severe that the market-clearing level of short-term interest rates was pulled down well below 0%. That is a natural consequence of the sharp collapse in business and household spending. The Fed,  however, cannot push short-term nominal interest rates very far past 0% because people would start hoarding cash rather than earn negative interest. So instead it was forced to keep short-term interest rates near the zero lower bound (ZLB) while the actual market clearing interest rate level slowly worked its way back up toward zero as the economy healed.

The irony of this is that the free marketers of the world, like George Will and Bill Gross, should be sympathetic to this story. They believe in the power of prices to clear markets so they should be open to the possibility that sometimes--in severe crises like the Great Depression or Great Recessions--interest rates may need to go negative in order to clear output markets. If so, it is incorrect for them to ascribe the low interest rates to Fed policy since it was simply chasing after a falling market-clearing interest rate level. 

They should also be aghast at the ZLB. For it serves as price floor on interest rates that keeps markets from clearing. Any good capitalist worth his or her salt should be in favor of abolishing this price floor and allowing prices to work. It therefore really pained me to see Senator Rand Paul make this statement about Bernanke in a CNBC interview:

If you ask Ben Bernanke or any of the other so-called free-market economists whether or not they're for price controls of eggs or potatoes or bacon, they'll say, "Oh no, price controls cause a distortion. They lead to shortages or abundance or food rotting on the shelves." But then you ask them about money and they're like, "Oh no, we should control the price of money." It's a fallacy in their argument. If price controls are bad for the market, they're also bad for the money. 

But it is not the Fed! It is the ZLB that is the distortion here. It is preventing capitalism from working. This is why folks like Miles Kimball want to introduce ways to eliminate the ZLB and let markets do their magic.

I am not saying Fed policy has been great over the past seven years. Far from it. It has been incredibly ad-hoc and was done in such a way as to prevent a rapid recovery in spending. What I am saying is that we free marketers need a more nuanced understanding of what has kept interest rates so low and what can be done about them. Here is one practical solution from the conservative National Review magazine.

I really wish folks like George Will, Bill Gross, and Rand Paul would reconsider their views on this matter. They would be better capitalists for doing so.

People's QE Has Been Tried Before and Failed

I am seeing more and more people get excited about "People's QE", the brainchild of UK labor party leader Jeremy Corbyn. For example, Roger Farmer sees it as similar in spirit to his own preferred approach, Ambrose Evans-Pritchard says "it is exactly what the world may soon need" and Matthew C. Klein argues "the core idea is sound and has an impressive intellectual pedigree." With endorsements from such thoughtful people, this QE must be something special. So what exactly is it?

The People's QE is a program where the Bank of England (BoE) would engage in large scale asset purchases of debt used to finance investment spending in infrastructure. The issuers of the debt would not be the central government, but local governments and other agencies in the UK that fund investment spending. One advantage of this approach, according to its advocates, is that it would be politically easier to implement since it would not explicitly create bigger budget deficits (even though implicitly it would be doing so). More importantly, supporters argue this form of QE would send the newly created money directly to people and institutions that actually spend the money. More bang for your  buck! So what could go wrong?

A lot, actually. For this approach is nothing more than a monetization of debt--a helicopter drop. It is widely recognized that helicopter drops will have no effect on aggregated demand if the monetary injections are perceived as temporary. And monetary injections will always be perceived as temporary without a credible commitment from the government to reflate the economy. In practical terms, this means a helicopter drop needs to be accompanied by a higher inflation target or a price (or NGDP) level target high enough to create some reflation. Otherwise, the helicopter drop will be all for naught. But don't take my word for it, ask Paul Krugman or the list of notable economists found here.

To  make this understanding concrete, let's imagine Jeremy Corbyn becomes Prime Minister and the BoE engages in People's QE with its current 2% inflation target. Investment spending would initially begin to grow, but quickly run up against the inflation target and force the BoE to either pull back on or start sterilizing its purchases. The UK economy might eke out a few more basis points of aggregate demand growth, but not the kind needed for full employment or envisioned by advocates of the People's QE. Contrary to claims of its advocates, then, QE would not pack more of a punch simply because the money went directly to infrastructure spending. No matter who spent the money, the economy would run up against the 2% inflation constraint. This is what I have called the Penske Problem. 

The hugely under appreciated point here is credibility. As Paul Krugman noted in his 1998 paper, the government has to credibly commit to a permanent expansion of its liabilities, but that is very hard  to do because the resulting reflation will be seen as irresponsible by the public. Another way of saying this is that the BoE 2% inflation target is not just a central bank commitment, but a government commitment to low inflation. Until you can credibly commit to changing that via a higher inflation target or a level target a helicopter drop will not matter.

This is not just a theoretical story. People's QE has been tried before and failed miserably. Between 2001 and 2006 Japan conducted the original QE program while running large deficits, as can be seen in the figures below. 

  

Japan, in other words, was engaged in helicopter drops just like the UK would be under the People's QE. As the figures above show, the monetary base increase was eventually reversed. And what did this do to aggregate demand growth in Japan? Not much:

This notion that doing helicopter drops without any monetary regime change will make a meaningful difference is an economic zombie that needs to be laid to rest. If you want robust aggregate demand growth you have to reanchor your economy to either a higher inflation target or some kind of level target such as a NGDP level target. Otherwise, an economy will be spinning its wheels.

The Courage to Act in 2008

Ben Bernanke's memoir is now out and is unapologetically pro-Fed. It is titled "The Courage to Act" Here is the cover quote:

The main point of Bernanke's book is that absent the Fed's interventions over the past seven years the U.S. economy would have undergone another Great Depression. Thanks to him and his colleagues at the Fed the world is a much better place.

There has already been some push back on this Bernanke triumphalism. George Selgin, for example, notes that the recovery under Bernanke's watch was anemic. Inflation consistently undershot the Fed's target and the real recovery was weak. We may not have experienced another Great Depression, but we sure did get a long slump. Ryan Avent makes a similar point by observing that Bernanke had a chance in late 2011 to do something bold by endorsing a NGDP target, an action that could have jolted the economy from its doldrums. But alas, Bernanke failed to muster up the courage to have what Christina Romer called his "Volcker Moment". 

Expect more push back along these lines from a book with such a bold title. One strand of criticism that many observers miss, but I hope will be considered in future reviews of Bernanke's book is the role the Fed played in allowing the crisis to emerge in the first place. Could the Fed have done more to prevent the recession from becoming as severe as it did? Maybe a recession was inevitable, but was a Great Recession inevitable? These are the questions first raised by Scott Sumner and echoed by others including me. Our answer is no, the Great Recession was not inevitable. It was the result of the Fed failing to act aggressively enough in 2008. 

This understanding draws upon the fact that the housing recession had been going on for about two years before a wider slowdown in economic activity occurred. As seen in the two figures below, sectors of the economy tied to housing began contracting in April 2006 while elsewhere employment growth and nominal income continued to grow. This all changed in the second half of 2008. 

So what went wrong in the second half of 2008? Why did a seemingly ordinary recession get turned into a Great Recession? We believe the Fed became so focused on shoring up the financial system and worrying about rising inflation, that it lost sight of stabilizing aggregate demand. Based on theses concerns, especially the latter, the FOMC decided to abstain from any policy rate changes during the August and September 2008 FOMC meetings. But by doing nothing at these meetings the FOMC was doing something: it was signaling the Fed would not respond to the weakening economic outlook. The FOMC, in other words, signaled it would allow a passive tightening of monetary policy in the second half of 2008.

A passive tightening of monetary policy occurs whenever the Fed allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in money velocity. The decline in the money supply and velocity are the result of firms and households responding to a bleaker economic outlook. The Fed could have responded to and offset such expectation-driven developments by properly adjusting the expected path of monetary policy. 

The figures below document this monumental failure by the FOMC. The first one shows the 5-year 'breakeven' or expected inflation rate. This is the difference between the 5-year nominal treasury yield and the 5-year TIPs yield and is suppose to reflect treasury market's forecast for the average annual inflation rate over the next five years. The figure shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. That is a decline of 1.23 percent over the two and half months leading up to the September FOMC meeting. This forward looking measure was screaming trouble ahead, but the FOMC ignored it.

One way to interpret this figure is that the treasury market was expecting weaker aggregate demand growth in the future and consequently lower inflation. Even if part of this decline was driven by a heightened liquidity premium the implication is the same: it indicates an increased demand for highly liquid and safe assets which, in turn, implies less aggregate nominal spending. Either way, the spread was blaring red alert, red alert!  

The FOMC allowed these declining expectations to form by failing to signal an offsetting change in the expected path of monetary policy in its August and September FOMC meetings. The next figure shows where these two meetings fell chronologically during this sharp decline in expectations.

As noted above, this passive tightening in monetary policy implies there would be a decline in the money supply and money velocity occurring during this time. The Macroeconomic Advisers' monthly nominal GDP data indicates this is the case:

The Fed could have cut it policy rate in both meetings and signaled it was committed to a cycle of easing. The key was to change the expected path of monetary policy. That means far more than just the change  in the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time and signalling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was worried about inflation and that the expected policy path could tighten. 

Recall that Gary Gorton provides evidence that many of the CDOs and MBS were not subprime, but when the market panicked a liquidity crisis became a solvency crisis. This is especially true in late 2008. Had the Fed responded to the falling market sentiment in the second half of 2008 the financial panic in late 2008 may have been far less severe and the resulting bankruptcies fewer. Again, the worst part of the financial crisis took place after the period of passive Fed tightening. This is very similar to the Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed. 

So had Fed had the courage to act in 2008 the economy would be in a very different place today. Future reviewers of Bernanke's book should keep that in mind.

P.S. For a more thorough development of this view see the book by Robert Hetzel of the Richmond Fed.