Tuesday, October 18, 2011

The Two Sides of FOMC

There were two interesting speeches by Fed Presidents posted yesterday, one by Charles Evans, Chicago Fed President, and one by Jeff Lacker, Richmond Fed President. These are representative, I think, of the two opposing views on the FOMC.

Evans, as is well-known by now, is a hard-core Keynesian. Yesterday's speech is consistent with a previous one he gave, but there are more details in the most recent one. In response to the criticism that he is setting us up to repeat the monetary policy mistakes of the 1970s, he tells us about the 1970s, and also about the policy mistakes of the 1930s. From his point of view, we should be more worried about making the policy mistakes of the 1930s than repeating the 1970s. Why?
Consider another metric for interest rates, the well-known Taylor Rule, which captures how monetary policy typically adjusts to output gaps and deviations in inflation from target. Its prescriptions would call for the federal funds rates to be something like –3.6 percent now, well below the zero lower bound the funds rate is currently stuck at. Our large-scale asset purchases have provided additional stimulus, but by most estimates not enough to bring us down to the Taylor Rule prescriptions.
This is by now a well-worn argument in the Fed system for more monetary policy accommodation. Fit a Taylor rule to the data, without taking into account that it is not feasible to violate the zero lower bound on the fed funds rate. Then, under the assumption that past Fed behavior was optimal, or that we want the Fed to behave consistently with past behavior so as to maintain credibility, plug current observations for the output gap and inflation into the estimated rule. The rule tells us the fed funds rate should be negative. What's the conclusion? You might be thinking that we should re-estimate the Taylor rule taking into account the zero lower bound. Wrong. Some people in the Fed system, including Evans apparently, think that the conclusion is that we are not doing enough, and the Fed should find some other way to ease, such as buying some long Treasury bonds.

This of course is nonsense. In the New Keynesian model underlying Evans's thinking, there are no banks holding reserves, nor a central bank with a balance sheet that includes Treasury bonds, mortgage-backed securities, and Treasury bills. There is nothing that can capture what quantitative easing, of any type, is about. Why would Evans think that his model is telling us anything more than that we are at the zero lower bound and he has nothing more to say about it?

Now, why should we not be worried about making the monetary policy mistakes of the 1970s?
Other critics raise the specter of 1970s-like structural changes in the economy. Such changes, they argue, have reduced our productive potential, in particular the mechanisms by which resources — most notably labor — move from declining to expanding sectors of the economy.[3] I am acutely aware of the costs of making such an error. No central banker wants to repeat the painful experiences of the 1979–83 period. Indeed, the FOMC discussed this issue at great length (see the minutes of our January 2011 meeting).[4] However, I have yet to see empirical evidence based on a modeling framework that successfully captures U.S. business cycle dynamics that shows such supply-side structural factors can come close to explaining the huge shortfalls in actual GDP from trend and the high level of unemployment.
It's good that Evans wants a serious model to explain why unemployment is so high and the recovery is so sluggish. Maybe he could also supply us with a serious model of how quantitative easing works.

Evans has been highly supportive of the two recent policy decisions regarding forward guidance and Operation Twist. But he wants more. In particular, he is calling for conditionality in Fed statements, of the following sort:
I think we should consider committing to keep short-term rates at zero until either the unemployment rate goes below 7 percent or the outlook for inflation over the medium term goes above 3 percent.
Yikes. The Fed should not be making explicit statements that make policy actions contingent on things, such as the unemployment rate, for which we could argue the primary determining factors are not monetary policy. Suppose the Fed made such a commitment, and there were significant sectoral changes in the US economy over the next two years that caused the unemployment rate to increase. What then?

If Evans's views dominated on the FOMC, I would be very worried. Fortunately, there are other voices. Jeff Lacker says:
My reading of the evidence is that the strength of this recovery is going to be relatively independent of our monetary policy choices from here on out. The factors likely to be restraining growth — from empty houses to prospective tax rates — are nonmonetary and largely beyond the power of the central bank to offset through easier monetary conditions. History has repeatedly demonstrated that if a central bank attempts to add monetary stimulus to offset nonmonetary disturbances to growth, the result is higher inflation that can be difficult and costly to eliminate. This is why I opposed the Maturity Extension Program — popularly known as "Operation Twist" — in which the Fed will buy long-term Treasury securities and simultaneously sell short-term Treasury securities. The effect of these operations is uncertain, but likely to be relatively small. My sense is that the main effect will be to raise inflation somewhat rather than increase growth.
I pretty much agree with that, and it's roughly consistent with Plosser's views. The only thing I disagree with here are the prospects for inflation. I don't think that the Operation Twist program has any consequences at all - for quantities or prices.

Lacker also takes a shot at Barney Frank:
The fact that diverse and independent views are brought to bear on important policy questions is attributable in part to the unique federated structure of the Federal Reserve System. When the Fed was founded in 1913, Congress deliberately rejected the monolithic model of the European central banks of the time. By chartering 12 distinct banks, each with a board of directors that appoints their Reserve Bank president (subject to approval by the Board of Governors), they deliberately sought to insulate policymaking from election-induced swings that can distort decision-making by diminishing the focus on long-run considerations. And while the Reserve Bank presidents are subject to oversight from both their own boards of directors and the Board of Governors in Washington, their distinct policy views are informed by both regional economic information and the independent research of Reserve Bank economists. This is why legislation that aims at stifling dissent by removing the presidents from the FOMC would be so harmful. By limiting the diversity of independent views around the table, such measures would undermine the historic strength of the System.
Good for Jeff. One of the strengths of the Fed system relative to other central banks is the semi-independence of the regional Feds from the Board of Governors in Washington, which creates healthy competition in ideas. In recent history, the average level of expertise in economics has been much higher among the regional Fed presidents than among the Governors. It would be too bad to lose that.

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