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View related content: Monetary Economics
One hundred years after its founding, the Federal Reserve’s policy activities are proving to be quite different than originally envisioned. Although the Fed’s original purpose was primarily to provide liquidity during financial crises and ensure a low and stable rate of inflation, it is now expending more energy on targeting lower unemployment and higher growth. Monetary policy, however, is ill-suited to achieving these goals. The next Fed chair needs to turn the rising tide of dissatisfaction with Fed policy by returning it to its primary purpose of controlling inflation and reducing uncertainty.
Key points in this Outlook:
Five years after the 2007–08 financial crisis, as underscored by the Federal Reserve’s “surprise” September 18 no-tapering decision and the confusion that has followed it, an important basic question has emerged: what now for monetary policy? More specifically, what should be the Fed’s goals, how should they be achieved, and how much of the Fed’s policymaking machinery should be revealed to the public? It is fitting to ask these questions 100 years after the Fed’s 1913 founding.
These questions have arisen more urgently as the Fed has struggled to right the US economy after the financial bubble that burst in September 2008 with the collapse of Lehman Brothers, a highly leveraged investment bank. This collapse wiped out 20 percent of American household assets and elevated economic uncertainty to a degree that, independent of the economic hardship tied to the daunting wealth loss, has been shown to have penalized economic growth.
Frustration has been increasing over the last five years with the Fed, its methods, and its performance—in markets and Congress, not to mention the general public. (One sees “End the Fed” posters plastered to barns in Maine.) This contrasts with the period of unqualified adulation from 1985 to 1999, perhaps culminating in Bob Woodward’s widely read paean to Alan Greenspan, Maestro: Greenspan’s Fed and the American Boom. Inside the Fed, these happier times were described as “the Great Moderation,” a term applied to the period that began around 1985 of lower, more-stable inflation; lower unemployment; 3 percent GDP growth; and shorter recessions.
The period of stability and growth emerges clearly from any picture of macro data covering the last 60-plus years, from the 1950s to the present (figure 1).
Now, with the Great Moderation having been disrupted by a global financial crisis and a five-year period of virtual policy extemporization by the Fed, with mixed results at best, the time has come to ask: what should and can we expect from monetary policy? The answers may disappoint some.
The Good Ol’ Days
The Fed was founded in 1913 primarily as a means to provide liquidity during financial crises. The need for such liquidity provision was underscored by the Panic of 1907, which was stemmed largely by the efforts of JP Morgan. The Fed’s “lender of last resort” role was emphasized.
At that time, the roles of monetary policy, as espoused by the long-established Bank of England, were to ensure an elastic supply of credit in times of financial crisis and a stable price level. The central bank undertook policies aimed at producing a low and stable level of inflation to provide a benign backdrop for business.
The onset in America of the Great Depression in October 1929, brought on by the bursting of a stock bubble, found the Fed largely unprepared to deal with a financial crisis. The Fed’s passivity in the face of a collapsing money supply precipitated, in 1932, a sharp drop in real output and a surge in unemployment that produced a broadly dispirited American public. The Fed struggled in the aftermath of economic collapse in 1933 to stabilize the economy. A major instrument of stabilization was a sharp 1933 US dollar devaluation, which helped end deflation and, for a time, reduce US unemployment. The onset of World War II left the Fed in a position largely of expediting government borrowing to finance the war. The Fed’s passive role as an expediter of Treasury financing ended with the Treasury-Fed Accord in 1951.
The post-accord period until the mid-1960s was a relatively uneventful one for the Fed. It conducted its activities largely in private, the economy grew, and inflation was moderate.
The era of the Fed’s struggle to contain inflation began in 1967 when Lyndon Johnson’s “guns and butter” program put pressure on the Fed to increase the money supply to accommodate a large government borrowing program. Inflation pressures continued to rise through 1972, enhanced by the highly accommodative monetary stance of then–Fed chairman Arthur Burns. The sharp increase in oil prices during 1973–74 gave inflation more momentum, which was largely accommodated. Inflation pressure was augmented even further by the Full Employment Act of 1978, which mandated that the Fed should seek full employment in addition to price stability. Persistent accommodative monetary policy aimed at dealing with persistently high unemployment after 1974 worsened inflation pressure.
Paul Volcker was appointed Fed chairman in 1978 and faced with stagflation, or rising inflation and high unemployment. By the time of Volcker’s appointment, inflation had reached over 10 percent, and the dollar’s global role was threatened. Volcker’s chairmanship started a period of aggressive Fed measures to contain inflation, notwithstanding the new mandate from the Full Employment Act. The Fed sharply reduced the funds available to the banking system and allowed interest rates to rise to above 20 percent during the summer of 1980. This was roughly the reverse of today’s quantitative easing (QE) and zero interest rate policies (ZIRP) the Fed is employing to preempt deflation and promote growth and employment.
Volcker’s stringent policies succeeded in containing inflation by 1982, and the Fed signaled more accommodation until 1984, when it once again had to remind markets that it would not tolerate higher inflation. Thereafter, with lower inflation and a rise in productivity after 1985, the US economy entered the era of the Great Moderation. The Volcker battle against inflation kept inflation expectations low, and sound underlying conditions kept growth averaging around 3 percent as the unemployment rate, found to be consistent with price stability, drifted down toward 5 percent.
The bursting of the technology bubble in 2000 briefly discomforted markets, but growth had recovered by 2003 and households had, ominously as it turned out, decided that the way to build wealth was to invest heavily in real estate. The Fed continued to eschew any effort to identify bubbles before they burst.
Many factors encouraged the housing boom, such as modest interest rates, broadly accommodative Fed policy, tax incentives, and the platforms of both political parties to get on the homeownership bandwagon (as real estate agents would say to hesitant buyers with the temerity to doubt their ability to pay mortgage charges). The balance of the story is well-known. Real estate speculation and the creation of derivative securities tied to rising real estate eventually resulted in a financial bubble that burst with the Lehman collapse in September 2008.
The Fed’s problems with bubbles had begun prior to the tech bubble when then–Fed chairman Alan Green-span asserted in 2002 at the Fed’s annual Jackson Hole Conference that it was impossible to identify a bubble and, therefore, that the Fed should let bubbles rise and clean up the mess after they burst. The effects from the bursting of the 2000 tech bubble were manageable, but the aftermath of the bursting of the housing bubble in 2007–08 was not.
Early in the housing bubble period, during 2007, the Fed and Chairman Ben Bernanke asserted that the crisis was largely contained to subprime mortgages and was therefore manageable. As late as June 2008, the Fed was forecasting a second-half 2008 recovery in the wake of its rescue of Bear Stearns in March of that year. (See last month’s Economic Outlook.) The collapse of Lehman and the ensuing sharp contraction of the real economy set the stage for the Fed to extemporize radically in its monetary policy.
The Bad New Days
It is probably fair to say that Bernanke, given his performance after the collapse of Lehman Brothers, was the real Fed “maestro” of monetary policy. Extemporizing to save the financial system from total collapse in the midst of considerable political and financial turmoil clearly fits the definition of a maestro’s performance. By early October 2008, Bernanke and the heads of all other major US central banks issued a statement that no financial institution would be allowed to fail as a result of the Lehman crisis, preventing massive runs on otherwise shaky financial institutions.
“The collapse of Lehman and the ensuing sharp contraction of the real economy set the stage for the Fed to extemporize radically in its monetary policy.”Having stemmed the panic, the Fed turned to containing the economic collapse that had emerged during the last months of 2008 while the federal government was largely in limbo during the transition from Bush to Obama. The Fed rapidly cut interest rates to near zero and continued to provide assurances that no financial institutions would be allowed to fail. Most notably, when one of the largest money market mutual funds “broke the buck” following a run on its assets in October 2008, the Fed stepped in to reassure depositors that their funds were safe.
Early 2009 saw unprecedented efforts with expansionary fiscal and monetary policy to revive the economy. An $800 billion fiscal stimulus package was passed early in 2009. In March, the Fed undertook its first round of quantitative easing, stepping in to purchase Treasury securities directly. The unprecedented monetary and fiscal stimulus was rewarded later in 2009 with a sharp recovery in financial markets and a stabilization of US growth.
In 2010, we saw the onset of a European financial crisis tied to the incipient insolvency of southern European governments, accompanied by a deflation scare in the United States. In response, Bernanke announced a second round of QE that November. Financial markets again surged while the economy continued to grow at only a moderate pace and without inflation, even given additional stimulus from repeated rounds of tax cuts and additional government spending.
Markets were again unnerved in mid-2011 by the debt-ceiling fiasco that brought about threats of a US debt default. The default was ultimately averted, and markets rallied in relief, though the US credit rating was downgraded. When Congress unexpectedly failed to reach a long-term solution to the debt-ceiling crisis, it by default passed the sequester
legislation, which went into effect in March of this year and cut $1.2 trillion from discretionary federal spending over the next decade. Many in Congress, not to mention the president, were shocked and disappointed. Now, all bad things, from mass shootings to slow tax refunds are blamed on the sequester.
Prior to this year, we saw continued slow and uneven economic growth, with a disquieting drop to 0.1 percent growth in the fourth quarter of 2012. Then, this year began with tax increases and sequester-mandated spending cuts that introduced a fiscal drag not seen in the US economy since before the financial crisis, though they did cut annual federal deficits to about half of their 2009–12 totals.
Meanwhile in September 2012, the Fed had introduced a third round of QE, whereby it in effect promised to buy $85 billion per month of Treasury- and mortgage-backed securities until the economy improved and, in particular, until the unemployment rate had fallen at least to 6.5 percent. In so doing, the Fed, somewhat ironically, helped to sow the seeds of dismay that sprouted a year later with its surprise September 18 decision not to taper, after it had reinforced the widely held postcrisis belief that the Fed could use QE to boost growth and reduce unemployment.
The Need to Redefine Monetary Policy
The year 2013 marked an inflection point in the Fed’s role as the steward of monetary policy. The unambiguous need to rescue the financial system from collapse that emerged immediately after the Lehman crisis has evolved over the past five years to a perceived need for the Fed to assure faster growth and lower unemployment while maintaining a low and stable inflation rate at or below 2 percent.
“By having continued to target faster growth and lower unemployment, even after the acute phase of the financial crisis ended, the Fed has made promises that it probably cannot keep.”The Fed has paid extra attention to avoiding disinflation, something that is always a threat after a financial bubble bursts, especially in view of the US experience during the Great Depression and Japan’s experience after its real estate bubble burst in 1990. Since both current aims, pushing down the rate of unemployment and avoiding disinflation, call for easier money—more QE and zero interest rates—they have presented no conflicts with the Fed’s
The major problem for the Fed as it seeks to “normalize” monetary policy is its commitment to continue quantitative easing and/or zero interest rates until the unemployment rate falls at least to 6.5 percent. That commitment implies that the Fed’s measures can, in fact, stimulate growth and lower unemployment. With that questionable notion reinforced by a drop inthe unemployment rate from about 10 percent last September to just above 7.5 percent this May, Bernanke and the Federal Open Market Committee (FOMC) began to signal the possibility of tapering Fed purchases ofTreasury bonds, which was to be conditional on an improvement of the economy that has not materialized. That lack of improvement forced the Fed to its September 18 no-tapering decision.
There have been two problems with the Fed’s implicit targeting of a lower unemployment rate. The most basic is that little evidence exists that monetary policy can produce a sustained impact on the rate of unemployment. In the short run, extreme monetary easing can certainly boost growth and eventually produce a transitory reduction in the rate of unemployment, but the sustained impact is by no means assured. Indeed, one can ask why, if monetary policy can affect growth and unemployment in the long run, should we ever have anything but high growth and low unemployment? The answer is that, pursued too far, easy money will produce inflation in normal times.
The second problem arises in a postcrisis period. As John Maynard Keynes suggested, the precautionary desire to hold cash at zero interest rates, often coupled with the uncertainty abounding among households and businesses after a financial crisis, means that printing money leads only to higher holdings of money—not increased spending or reduced unemployment. Further, if a liquidity trap (absolute preference for cash at zero interest rates) combines with atrophy of aggregate demand due to either fiscal drag or slower liquidity growth (tapering in the present context), disinflation can become outright deflation. More deflation boosts the demand for cash, which in turn boosts deflation further. Avoiding this deflation spiral is a prime objective of postcrisis monetary policy, as Bernanke has frequently noted.
It is also important to recognize that the unemployment rate can send false signals about labor’s true condition. Much of the reported drop in the rate is due not to an improvement in labor market conditions as much as to a drop in the participation rate in the labor force, a sign of dispirited workers giving up their search for employment. As unemployed workers leave the labor force, a constant number of employed workers produces a higher employment rate, mirrored in turn by a lower unemployment rate.
The initial “success” of Fed monetary policy in containing the financial crisis and stabilizing growth and unemployment has led to the expectation, in markets and at the Fed, that further quantitative easing can reduce the rate of unemployment, provided inflation does not rise. In fact, disinflation has characterized the past year, leaving the Fed comfortable with the primary focus on the unemployment rate even though the evidence is waning that its efforts through QE and ZIRP can produce further progress in enhancing growth and reducing unemployment. Growth remains weak compared to past recoveries (figure 2), and the unemployment rate remains unusually high (figure 3).
The rising disenchantment with the Fed this past summer is tied to the persistence of tepid growth and weak labor markets that has followed its May–June hints to initiate tapering conditional on expected improvement in the economy. The tapering hints Bernanke put forward in May, reinforced by the FOMC meeting in June, turned out to be both self-defeating and misleading given the September 18 decision. Self-defeating because hints of tapering caused interest rates to rise by over a full percentage point, threatening the very recovery the Fed was predicting, especially in the housing sector. Misleading because the diminishing effectiveness of quantitative easing, along with fiscal drag and higher interest rates, have produced a situation where the economy is, if anything, decelerating as 2013 passes.
Consider the 2013 growth arithmetic. US growth averaged 1.8 percent during the first half of the year and is on track for a slower 1.4 percent pace during the third quarter, which ended September 30. Given that backdrop, the fourth-quarter growth rate will have to be 3.8 percent, well above even the most optimistic forecast, to meet the modest 2.2 percent 2013 Fed growth forecast. By having continued to target faster growth and lower unemployment, even after the acute phase of the financial crisis ended, the Fed has made promises that it probably cannot keep. This uncomfortable reality is underscored by two things: the apparent slowdown of growth during the second half of this year and the Fed’s decision not to taper, which acknowledges its mistake in expecting improved economic performance.
More broadly, the Fed has persistently overestimated economic growth, with 2013 an embarrassing case in point. A year ago, as it began implementing QE3, the Fed was predicting a 3 percent growth rate for 2013. A year later, the prediction for 2013 growth, almost three-quarters of the way through the year, has dropped down to 2.2 percent. That level, too, looks highly unrealistic based on figures already on hand, as I have noted.
The no-tapering decision has also sharply undercut the Fed’s efforts to offer markets forward guidance. In June of this year, the Fed suggested that, conditional on its optimistic forecast of the economy, it might begin tapering in September. Three months later, the Fed was indicating that its conditional forecasts of the economy were wrong and that it was not going to begin tapering. Perhaps it would have been better to say nothing in May and June. It certainly would have been better not to have had four months of endless speculation about tapering and its negative effects on the economy, including more uncertainty and a sharp rise in interest rates—both of which have harmed growth.
What Can We Expect from Monetary Policy?
One thing is clear as we continue to struggle to revive the economy and its animal spirits in a post–financial crisis period: markets and Congress are expecting too much from the Fed. In the immediate aftermath of the crisis, the Fed admirably fulfilled its responsibility of lender of last resort by preventing a liquidity collapse that would have sharply exacerbated financial turmoil and threatened a global economic collapse. However, it is becoming increasingly clear that, after having performed its essential function, the Fed is now expected to produce sustained higher growth and sustained lower unemployment without inflation. This is happening in a period when the persistence of a liquidity trap makes it highly unlikely that expansionary monetary policy will help boost economic growth.
By tying the conduct of monetary policy and its new instruments, QE and ZIRP, to the unemployment rate, the Fed has reinforced the notion that these measures can lower the unemployment rate on a sustained basis. There is little support for this notion, and the disillusionment that is resulting from the Fed’s inability to increase growth and employment is sharply eroding confidence in the Fed’s stewardship of the economy and, in particular, in its ability to communicate its intentions to the public. This has left the Fed in the awkward position of being “out of bullets” well before its economic goals have been achieved and while disinflation, rather than inflation, is emerging in the economy. (See figure 4 on the unusual persistence of disinflation over the past two years.)
The new Fed chairman or chairwoman needs to address these issues. The Fed needs to lower expectations about its ability to solve all of the economy’s problems. It has overstepped its role as a lender of last resort and has gone on to promise, in effect, to be the agent of enhancing faster growth and lower unemployment. But disaffection has set in, and the time has come for a new Fed chairman to remind markets that the Fed’s primary responsibility going forward is to ensure low and stable inflation, and to avoid deflation, while reducing the uncertainty that still plagues the economy. Promises beyond that run the risk of producing disappointment and even exciting political efforts to further restrict the Fed’s independence.
Moving forward, efforts to improve the economy should come from Congress. Having somewhat reduced the budget deficit, Congress needs to focus on tax reform that will encourage growth and entitlement reform that will also encourage growth by reducing uncertainty about prospective deficits and the way they are financed.
The new Fed chairman needs to deliver a major address early in 2014 on the Fed’s goals, methods, and ways of communicating with the market and public. The goals should be modest: primarily, maintaining low and stable inflation and a continued readiness to serve as lender of last resort. The Fed should specify that its tools include adjustments to both the money supply and interest rates, aimed primarily at maintaining a low and stable rate of inflation. The inflation target should be set at 1.5 percent, with allowed deviations in the short run over a 0.5 to 1.5 percent range. This is lower and more specific that the Fed’s current 2 percent objective, but the unambiguous pursuit of low and stable inflation benefits the economy and reduces the market’s persistent fear of inflation risks.
The Fed’s communication of its methods and goals should be confined to official FOMC statements, with the only amplification coming at the chairman’s press conference after each meeting of the FOMC. Other FOMC members and regional Federal Reserve Bank presidents should express their views freely and forcefully at FOMC meetings and feel
free to dissent from FOMC decisions as a way to express strongly held minority views. But other public comments, save those offered by the chairman in emergency situations after consultation with the FOMC, should be eliminated.
Frequent postmeeting press conferences and speeches by FOMC members have undercut efforts to communicate clearly to markets the direction of Fed policy. Those needing verification need only look at the front pages of major newspapers in the days following the Fed’s September 18 no-tapering decision. The cacophony of second-guessing from FOMC members was deafening and contributed to another—counterproductive—rise in uncertainty about the future paths of monetary policy. Enough!
1. See John H. Makin, “The Global Financial Crisis and American Wealth Accumulation: The Fed Needs a Bubble Watch,” AEI Economic Outlook (August 2013), www.aei.org/outlook/economics/monetary-policy/the-global-financial-crisis-and-american-wealth-accumulation-the-fed-needs-a-bubble-watch/; and John H. Makin, “Financial Crises and the Dangers of Economic Policy Uncertainty,” AEI Economic Outlook (November 2012), www.aei.org/outlook/economics/monetary-policy/financial-crises-and-the-dangers-of-economic-policy-uncertainty/.
2. Bob Woodward, Maestro: Greenspan’s Fed and the American Boom (New York: Touchstone, 2000).
3. Alan Greenspan, “Economic Volatility” (remarks at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002), www.federalreserve.gov/boarddocs/speeches/2002/20020830/.
4. Makin, “The Global Financial Crisis and American Wealth Accumulation.”
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