What I Wish That I Had Said on the DeLong-Posen-Rose "Foreign Affairs" Monetary Policy Conference Call
My parts of http://www.cfr.org/monetary-policy/foreign-affairs-media-call-adam-s-posen-j-bradford-delong-federal-reserve-policy/p31078 edited--with typos, wordos, thinkos, and mindos removed:
It's not clear to me why the Federal Open Market Committee is following the strategy it is following right now, indeed, that it has followed for the past six years.
I would have expected Ben Bernanke--student of the Great Depression, the kind of person who in the 1990s would say hat Japan needs much more monetary stimulus--to react to the financial crisis and the subsequent collapse of risk tolerance in financial markets by saying:
The problem right now is that the private sector wants to deleverage, and it cannot deleverage without the government issuing debt--leveraging up. Since the willingness of Congress to issue more debt is limited, the private sector will either be persuaded not to deleverage (a) by long-term interest rates so low as to make deleveraging financially unattractive, or (b) by a persistent depression that makes the private sector so poor as to make deleveraging unaffordable. We don't want the first, (a). It is the job of the Federal Reserve to drive long-term interest rates low enough so that we get the second, (b).
But that is not what Bernanke did.
If I may drop into Wicksell-Koo mode, the problem is that, in the economy as a whole, there cannot be a debt without a credit, there cannot be a debtor without a creditor. So when somebody decides they want to deleverage--become more of a creditor--someone else has to decide that they want to leverage up--to become more of a debtor.
The first-best right thing to do right now would be for the federal government and for other credit-worthy sovereigns worldwide to be accommodating private-sector desired deleveraging by becoming even more of a debtor than it is. That would allow the rebalancing of the U.S. and the world economy at high employment, with stable inflation, and normalized interest rates that did not create financial distortions that may be storing up trouble for the future. But, given that the federal government is not going to do that--thanks primarily to the 2010 and 2012 congressional elections, but also thanks to the fact that Obama went with the Geithner-Bernanke "we've done enough and it's recovery summer" rather than with the Romer-Summers wing of his advisors in starting in late 2009--the first-best is politically unattainable. Thus given that we don't want (b), semi-permanent depression, the only way to get a properly rebalanced economy with high employment is option (a): for the Federal Reserve to get long-term interest rates down so low that people as a whole no longer wish to deleverage because they are happy with the asset portfolio structures that they have.
Bernanke has taken a number of steps toward this option (a) over the past six years. But he and his committee have not done it. At each stage for more than half a decade now they have made overoptimistic forecasts of employment and overpessimistic forecasts of inflation. Now they have gone further: now it appears that the Federal Open Market Committee has decided to pull in their horns, and say:
We've gone way out as far with unconventional monetary policy as we can possibly go. Don't expect us to take additional steps. The fact that the economy is still depressed is the fault of the Congress and the president--the fault of the fiscal authorities--and we need to stop worrying about what additional stimulative measures we could take to try to boost employment and worry, instead, about long-run financial stability which is, in some way, compromised by having the Federal Reserve's balance sheet grow and stay too large.
Now it is not clear to me exactly how and why long-run financial stability is compromised by the Fed having a very large balance sheet. It does not seem to me to be necessarily bad for the Fed to drive long-term interest rates down to where the market really wants them to be--to levels consistent with full employment, with labor market balance. But the FOMC has made that decision. And in response to its recognition of that decision, the financial market has pushed expectations of real interest rates over the next decade up by a full 1.3% points and expectations of inflation over the next decade down by a full 0.4% points since last winter.
I would like to hear Adam Posen talk some more, because I want some more insight into Mervyn King's thinking. I have even less insight into Mervyn King's thinking over the past six years than into Ben Bernanke's. Mervyn is an extremely smart guy. Mervyn is the last person I would have imagined who would have told the government back in the Spring of 2010: "what Britain really needs right now is a lot more short-term fiscal drag."
Brad, I'm curious: I have lefty friends who feel that the real story is not just ideological disagreement about the proper course of monetary policy, but who feel that behind these policies--whether it's austerity or the restrictive monetary policies--is a hidden agenda to restructure the economy and shift the balance of political-economic power. Do you think that's going on here?
10 years ago your lefty friends would have been saying the same thing. They would have been saying that there are two key institutions driving for austerity--wage cuts and union destruction--and plutocracy--a further shift of income in the direction of the princes of finance. They would have said that the two key institutions pushing for this are Goldman Sachs spearheading the lobbying of the investment banks on the one hand, and the International Monetary Fund on the other.
But today it is the International Monetary Fund that is saying:
Hey! Wait a minute! Austerity has been a horrible mistake! When we advocated it we gave bad advice! In the short-run what the world economy needs is more reflation, bigger budget deficits by credit-worthy sovereigns, less austerity in the periphery, and easier monetary policies.
The International Monetary Fund right now is smack on the left end of the policy spectrum.
And it is Jan Hatzius, the chief economist of Goldman Sachs, who has been out saying the Federal Reserve should take its balance sheet up to $6 trillion immediately. And the firm has not reined him in--both because they trust Jan Hatzius to do a good technocratic job as a macroeconomist, and because Goldman Sachs is a creditor and creditors are no better-served by universal bankruptcy than anybody else.
So if it were a conspiracy, why are the two big institutions that have for the past two generations been named as the leaders of this conspiracy of plutocrats arguing against austerity? That's a question your lefty friends haven't managed to wrap their minds around. And because they haven't managed to wrap their minds around this fact, they're chasing down rabbits that don't exist.
Certainly the Federal Reserve did not expect long-term real interest rates to jump up by more than a full percentage point. That was not what they wanted the impact of their communication strategy to be. So it is clear their communication strategy has gone substantially wrong--wrong in, I think, a quite destructive direction. The world doesn't need higher long-term interest rates on safe assets right now, for that means that the unemployment rate come the middle of 2015 will probably be 0.3% points higher in the United States than it would otherwise have been, and that's a bad thing.
I do think Bernanke added to confusion. The adoption of Charles Evans's state-dependent policy rule that the Federal Reserve was not going to seriously think about raising federal funds rates until inflation got above X or unemployment got below Y convinced the markets that the Federal Reserve say in economy in which inflation seemed stuck below X and unemployment stuck above Y was an economy in need of further stimulus. And yet now the Fed, by saying that it is anxious to begin the "taper", has said that even though inflation is stuck below X and unemployment stuck above Y we are not contemplating additional stimulative measures. That appears to have been a shock to markets. That appears to have caused some real uncertainty out there.
If the Fed were to declare that it was going to look not just at the inflation and unemployment rates that the Evans Rule looks at but also at other variables--at the employment-to-population ratio, at housing prices and housing construction, at indicators of financial froth-- and here is how all these things enter into FOMC thinking, I believe that would be wonderful It would add to predictability. But that is not what the June communications effort turned out to do.
And, of course, in addition there is policy uncertainty created by the question of the Bernanke succession.
The FOMC has been worrying about levels of asset prices. Jeremy Stein especially has been concerned with incentives banks are being given to reach for yields. Banks face costs of 3 cents per year on every dollar of liabilities. They cannot pay negative interest rates. They have to report profits, or their CEOs get fired. And, Jeremy Stein and company think, that creates a situation in which they have to take risks they and we don't understand. There has been a lot of chatter about if not bubbles, then froth. There has been chatter about how the Federal Reserve should not be in the business of owning every single risky asset issued or guaranteed by the government. When I listen to that, I translate that into a long-run worry about financial instability. If it turns out that is not the worry underlying this chatter and these concerns, then I don't know how to understand them.
The real economy is linked to the financial economy. Stock prices up make people more willing to kind of take risks and undertake investments that they hope will produce equity value that the market will recognize in the future. Bond yields down does make it easier to borrow.
I think the big problem is--and here I wish we had Joe Gagnon from Adam Posen's shop on this call--the part of investment that is not happening in America today is housing investment. To the extent that what quantitative easing was doing was lowering mortgage rates, that housing investment does not seem to be terribly responsive to mortgage rates right now would make nonstandard monetary easing more ineffective. That is a reason why expansionary fiscal policy right now is probably the stabilization policy tool of choice. But our chances of having that went out the window in the United States with the congresses produced by the 2010 and 2012 elections.
I thought that "structural problems" meant that when you took steps to boost nominal GDP, the boost would show up as an increase in inflation rather than as an increase in real growth. To say that there's a structural problem when both real growth and inflation are coming in well below your forecasts--that's not a definition of structural problem that I believe I had heard before 2010.
The FOMC seems to be doing a considerable degree of keying off of the employment rate rather than the employment-to-population ratio at a time when those two are saying very different things about how much slack remains in the economy.
There has been a striking change in what "bullish macro outlook" means. Back in 1975 or 1983 or, indeed, at the end of 2009, a bullish macro outlook would be for 5%+ per year real growth. Now "bullish macro outlook" means growth not far below 3% for the next two years, on the low side. That is a huge change in what we think the American economy is capable of in a recovery. We should not forget that today's ideas of "bullishness" suffer from the soft bigotry of low expectations.
I was brought up in the "job of the Fed is to stabilize inflation and unemployment" tradition: the Fed wants to keep inflation expectations well-anchored, and as long as inflation expectations are well-anchored, the Fed wants interest rates low enough to produce high employment. That means that the FOMC wants to react very aggressively if it looks like expectations of inflation have or may become unanchored.
But that also means that as long as inflation expectations are well-anchored and there is ample slack, there is no downside to doing more stimulative monetary policy--it makes people thinking about undertaking long-term investments more confident as they become more certain that the downside risk of a large, prolonged depression with high unemployment isn't really there. Thus the principal risks are both that nominal GDP will exceed its proper ceiling and that it will fall below its proper floor. Yet the FOMC does not seem to be sufficiently worried about the second--it seems to be worried, instead, that too big a balance sheet on its part will be a source of risk.
Now, one of the risks that Jeremy Stein, Esther George, and company fear is that if the Federal Reserve buys up all the safe, long-term paper that banks needing to report profits so their CEOs can keep their jobs will have a hard time making the three cents per dollar of liabilities, and they will do things we won't understand and take risks we don't understand until it's too late, and then they will get into big trouble. And, this time, the political political climate will besuch that we cannot bail out the banks again. And then we have Great Depression II. That is the risk that the Stein wing is trying to insure against.
Or such is my inference. But I don't know whether that's the tail risk that is driving Federal Reserve decisions right now or not--they aren't being terribly communicative. And if that is not the risk that is driving their decision-making, I don't see what significant tail risk from the Federal Reserve having a larger balance sheet is. If people get sick of holding cash, it can always raise the interest rate on the reserves by a little bit. I the prices of the bonds it holds fall, it can always hold them to maturity--it is the ultimate, patient, long-term investor.
Thus I have a problem understanding where these fears of the larger Federal Reserve balance sheet are coming from--understanding what is supposed to happen.
Now, I did understand the fears back in 2008 and 2009--the people who said the federal budget would get out of control, and once markets saw the debt trajectory they would demand a high term premium, and then the federal debt would explode, and the U.S. would become Greece-like. I thought those fears were empirically wrong. But I understood them.
By mid-2010, however, it was very clear that U.S. Treasury bond was in fact the safest asset around--that the U.S. possessed exorbitant privilege, that increases in risk in other countries pushed Treasury prices up rather than down, that the fear that the U.S. might become Greece-like was simply wrong. It ought to have gone away. But other fears have replaced it. And those are the ones I don't understand. Why does the Federal Reserve think it has to talk about when it will begin to paper? Why doesn't it simply say: our estimates for real GDP growth and for inflation have both undershot what we thought they would be a year ago, therefore, if anything, the policies we adopted a year ago were insufficiently expansionary, we should be thinking about increasing the pace of quantitative easing rather than about tapering?
There has to be some big risk they see coming from some set of macrofinancial events that they are scared of. Yet I do not see anywhere that what they are scared of has been identified--if it is not this Stein-George "banks reaching for yield" fear.
I think Obama should already have designated a successor to Bernanke.
If you look over the past five years, Obama has been singularly bad--has been at least two standard deviations below the average president--in making timely appointments. It's not just that the Republican minority in the Senate has blocked cloture or that the Senate has failed to vote or failed to confirm. It is also that Obama has failed to nominate.
In a good world we would have a successor-designate already in place. People would be relatively happy. Uncertainty would be minimized.
As to what the FOMC will do with a new chair, was it Larry Meyer who said that the first rule of the FOMC is that the governors vote with the chair, and thus that the FOMC does what the chair wants subject to the constraint of the chair not wanting too many explicit dissents from too many bank presidents. Bank presidents only have a significant role to play in monetary policy when they dig in their heels and warn that they will publicly and officially dissent from the chair's policies.
And I think that there will be somewhat less of that in the future than there has been in the past.