Wednesday, November 18, 2015

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. 


  1. David, easy to understand the freakout: The Fed would be held responsible. They don´t even take responsibilty for good outcomes (Greenspan Memoirs Chat 20), let alone bad outcomes (Bernanke´s Memoirs, Arthur Burns, John Williams in 1937)

    1. Yes, but it is really a non-binding rule so we are talking about just a little bit more accountability. It is amazing they would get so worked up over it.

  2. The FOMC prefer the protection of those long and variable lags. Anything that they target that doesn't come about can be blamed on external events popping up in the intervening, and very conveniently long and variable, period after they set a course.

  3. Great post...yet a truth comes out. The rules can be set so they are relatively stimulative or restrictive.
    Also the targets should define policy, not rules.

  4. Actually many Fed employees lost a lot of sleep during the financial crisis. People were sleeping in their offices and going days and sometimes weeks without seeing their kids. And Fed staff and leadership have devoted serious time and effort to the questions around the recession, the balance sheet, and the way forward. Go read Bernanke's memoir. The premise of your post is stupid and suggests that you actually know very little about the nuts and bolts of central banking. You just keep playing armchair quarterback while others are actually in the arena trying to do the right thing.

    1. Anonymous, ever heard of satire? Relax.

      And yes, I realize Fed officials lost sleep during the crisis. What they didn't do during that time is go all postal in public like they are now over the FORM Act. That is the difference.

    2. Maybe they're not looking forward to getting dragged before congress after every FOMC meeting so that politicians can get on their soapboxes on CSPAN. In what world have you been living for the last 10 years if you think giving politicians more opportunities to shout at Yellen will improve monetary policy? A person need not be enamored of Fed policymakers to think that the status quo is much better than FORM.

  5. Anonymous: "dragged before the FOMC after every FOMC meeting"? Now who's exaggerating? According to the proposed law as David describes it, the FOMC has no reason to fear having to account for itself before Congress unless it clearly failed to conform to its own self-assigned rule, or unless it wished to justify changing the rule. To suggest that even this much accountability is "too much" is...well, it's what one might expect from government officials who'd rather not be held accountable at all, but it hardly seems to be a reasonable position for any ordinary citizen, concerned about the risk of having an extremely powerful government-created body abuse that power, would be well-advised to take.

    The Fed showed the same sort of "circle-them-wagons-boys!" mentality when the idea of regular Fed "audits" were being proposed--that is, GAO inquiries concerning the efficacy of various Fed practices--nobody was talking about ordinary accounting audits so spare me the "we're already audited" line. All the talk about the threat such audits posed to the Fed's independence was so much hogwash: The GAO itself had for decades made clear that its reports would in any case steer clear of second-guessing the stance of monetary policy. (That would still leave plenty for it to look into--repos, IOR, etc. etc.) The GAO is free to audit the Defense department, yet so far as I know know no general has ever complained that by doing so it interfered with their overall determination of the nation's defense strategy.

    The point is that the Fed is in fact obsessed about being able to do...just about anything that isn't clearly at odds with its vague twin mandate, and without having to fear answering for its mistakes. Right now, were I a Congressman, I'd like to it answer for its decisions to engage in sterilized lending up to Sept. '08, and to pay interest on reserves after that, with the express purpose in both instances of making sure its asset acquisitions and loans _didn't_ serve to encourage a revival of bank lending, and hence in overall spending. The fact that many people stayed up late to come up with such misguided policies only makes the need for stricter oversight--and for curtailing their discretionary powers--seem all the more obvious.

  6. Do you support the bill? (I ask because I haven't known whether I should support it in conversations with friends, and in this case I plan to follow the lead of economists like you.)