Yellen ally pours cold water on rule-based monetary policy

30 Aug 2015 | Author: | No comments yet »

A Cautionary History of US Monetary Tightening.

For much of her tenure as head of the Federal Reserve, Janet Yellen has been pressured by Republican lawmakers who want the U.S. central bank to adopt a monetary policy rule, a straightforward formula connecting unemployment and inflation to a benchmark interest rate. On Saturday a Yellen ally and former adviser at the Fed delivered a provocative retort: the economic models underpinning those simple rules don’t work that well, and the best policy decisions come when central bankers look beyond those models to the unexpected forces shaping the economy. Former Fed Chair Alan Greenspan famously did it in the 1990s when he argued against a rate hike at a time when rising productivity was holding down inflation, and arguably failed to do it when he ignored the impact of the tech and housing bubbles, Johns Hopkins University economics professor Jon Faust said in a paper presented at an annual Fed conference here.

As the Fed prepares to tighten monetary policy once again, an examination of this history – and of the current state of the economy – suggests that the United States is about to enter dangerous territory. In each case the point is the same: it was the extraordinary events outside of the basic inflation and output models used by central bankers that ultimately mattered most, argued Faust, who served as a special adviser to the Fed’s board of governors until September 2014.

That approach “brings fears of ‘seat-of-the-pants’ policymaking and, for the more excitable, of barbarians at the central bank gates,” Faust wrote. His expectation was that by controlling the amount of money in circulation, the Fed could bring about larger reductions in inflation with smaller increases in idle capacity and unemployment than what traditional Keynesian models predicted. But after reviewing the statistical models that try to separate underlying economic trends from other factors, Faust said he concluded it is those other factors that policymakers often need to understand and reflect in their decisions – something that can’t be done through a rule. “Normal cyclical dynamics … have played a distinctly minor role in both the successes and failures” of monetary policy, Faust wrote. “Understanding … confounding dynamics has always been the key to good policymaking and failure to understand those dynamics has played a key role in major policy mistakes.” Sophisticated econometric models of inflation, for example, may include “extra wiggles” in the forecast as inflation moves from its current rate to a long-run average, but on the whole do no better than a “mindless” line drawn between the two points, he said. His argument has bearing for the push by Republicans in Congress and possibly by the party’s eventual 2016 presidential nominee to tie the Fed to a policy rule.

Furthermore, this period of monetary tightening had unexpected consequences; financial institutions like Citicorp found that only regulatory forbearance saved them from having to declare bankruptcy, and much of Latin America was plunged into a depression that lasted more than five years. Between 1993 and 1994, Greenspan once again reined in monetary policy, only to be surprised by the impact that small amounts of tightening could have on the prices of long-term assets and companies’ borrowing costs. Fortunately, he was willing to reverse his decision and cut the tightening cycle short (over the protests of many on the policy-setting Federal Open Markets Committee) – a move that prevented the US economy from slipping back into recession. Neither Greenspan nor his successor, Ben Bernanke, understood how fragile the housing market and the financial system had become after a long period of under-regulation. The US unemployment rate may seem to hint at the risk of rising inflation, but the employment-to-population ratio continues to signal an economy in deep distress.

Indeed, wage patterns suggest that this ratio, not the unemployment rate, is the better indicator of slack in the economy — and nobody 10 years ago would have interpreted today’s employment-to-population ratio as a justification for monetary tightening. Meanwhile, given the fragility – and interconnectedness – of the global economy, tightening monetary policy in the US could have negative impacts abroad (with consequent blowback at home), especially given the instability in China and economic malaise in Europe. After all, commercial banks’ business model works only when the banks can earn (via passive and relatively safe long-term investments) at least 3% a year more than they pay depositors.

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