Is Stanley Fischer too complacent?
By Scott Sumner
Stanley Fischer is one of the world’s most thoughtful monetary economists. And now he is also vice chairman of the Federal Reserve Board. He recently gave a speech on monetary policy, which as you’d expect contained many wise observations. However I was also deeply troubled by some of his comments:
The Federal Reserve responded aggressively to the crisis.4 By the end of 2008, the Federal Open Market Committee (FOMC) had reduced the target federal funds rate from 5-1/4 percent to, effectively, zero. The Fed also acted forcefully as the lender of last resort–in its traditional role of providing short-term liquidity to depository institutions, and also by providing liquidity directly to borrowers and investors in key credit markets.5
In addition, the worldwide scope of the crisis called for concerted international action. Because of the global nature of dollar funding markets, the Fed authorized dollar liquidity swap lines with major central banks, beginning in December 2007. In October 2008, central bankers coordinated reductions in policy rates and the Group of Seven agreed to use all available tools to prevent the failure of systemically important financial institutions.6 The next month, the Group of Twenty announced a broad common strategy, including fiscal expansion.
These steps likely prevented a second Great Depression, but they were not sufficient to avoid a severe global contraction.
The Fed takes credit for good macroeconomic outcomes when aggregate demand grows at a smooth rate, producing low inflation and stable growth. So why shouldn’t it be blamed for periods where AD is highly erratic? In the 1930s and the 1970s the Fed denied responsibility for highly unstable movements in AD. Today even the Fed admits it was to blame for those two episodes. But why does it take so long?
The key monetary policy mistakes were made in 2008, when we were not even at the zero bound. Why can’t the Fed just admit that monetary policy was far too tight, and that this tight money policy greatly worsened the fall in AD? Why no soul-searching?
Going forward, there is every reason to believe we’ll again hit the zero bound in the next recession. Is the Fed prepared? What does this sound like?
For over six years, the federal funds rate has, effectively, been zero. However it is widely expected that the rate will lift off before the end of this year, as the normalization of monetary policy gets underway.
The approach of liftoff reflects the significant progress we have made toward our objectives of maximum employment and price stability. The extraordinary monetary policy accommodation that the Federal Reserve has undertaken in response to the crisis has contributed importantly to the economic recovery, though the recovery has taken longer than we expected. The unemployment rate, at 5.5 percent in February, is nearing estimates of its natural rate, and we expect that inflation will gradually rise toward the Fed’s target of 2 percent. Beginning the normalization of policy will be a significant step toward the restoration of the economy’s normal dynamics, allowing monetary policy to respond to shocks without recourse to unconventional tools.
I see absolutely no justification for this optimistic scenario. The Fed’s belief (hope?) that inflation will soon normalize is based on macro models that have repeatedly proven to be inadequate over the past 6 years. And there is no reason to assume that interest rates will rise to a level that allows monetary policy to respond to recessionary shocks “without recourse to unconventional tools.” BTW, part of the problem here is that the Fed views printing money as “unconventional,” whereas it is actually normal monetary policy. Control of the monetary base is what the Fed does. It’s how they control AD.
There are a number of effective methods of controlling AD when rates are at zero:
1. NGDP targeting, level targeting.
2. Price level targeting.
3. “Whatever it takes” QE, enough to target the forecast.
4. Negative IOR
The Fed has adopted none of these techniques, and seems unaware that anything is wrong, that its “conventional” techniques simply won’t work in the 21st century.
I was also concerned by this suggestion of mission creep:
As discussed in the FOMC’s statement titled Policy Normalization Principles and Plans, which was published following the September 2014 FOMC meeting, we will use the rate of interest on excess reserves (IOER) as our primary tool to control the federal funds rate.16 We also plan to use an overnight reverse repurchase agreement (ON RRP) facility, as needed. In an ON RRP operation, counterparties may invest funds with the Fed at a given rate, possibly subject to a cap on the aggregate amount invested. Because ON RRP counterparties include many money market participants that are not eligible to receive IOER, the facility can be a powerful tool for controlling money market interest rates. Indeed, testing to date by the New York Fed suggests that ON RRP operations have generally established a soft floor for such rates.17
However, an ON RRP program also has certain risks. For example, a large and persistent program could have unanticipated and adverse effects on the structure of money markets. In addition, in times of stress, demand for the safety and liquidity of ON RRPs with the central bank might increase sharply, potentially exacerbating disruptive flight-to-quality flows.18 To mitigate these risks, the FOMC has agreed that it will use an ON RRP facility only to the extent necessary and will phase it out when it is no longer needed.
In addition, the Fed has been discussing and testing other supplementary tools, such as term reverse repurchase agreements and term deposits, and can use these tools as needed to help support money market rates.
The Fed does not need additional tools; they need to use their already adequate tools more effectively. They do not need to put more emphasis on controlling interest rates; they need to instead let the markets determine interest rates. The Fed’s job is to stabilize the monetary system.
Many readers will inevitably view this post as being hopelessly naive. They’ll say the Fed caters to special interest groups, and doesn’t care what academics thinks. All I can say is that you are wrong. Back in 1980 you would have ridiculed academic suggestions that the Fed adopt inflation targeting. You would have said political pressure made that impossible, that the Fed was biased towards inflation to bail out this group or that, or perhaps to create jobs. And of course you would have been wrong. The Fed did decide to target inflation, and succeeded in bringing it down to an average of 2% since 1990. That doesn’t happen by accident, it happens because the Fed takes the best ideas from the world of monetary research, and adopts them. It happened before and it WILL happen again. That’s why I keep blogging.
HT: Jim Glass