How Well-Structured Is Our Federal Reserve, Anyway?


Jackson Hole 2015 Weblogging: Over at Equitable Growth: The highly-estimable Tim Duy is doing what he does best once again: worrying about the Federal Reserve's conduct of monetary policy:

Tim Duy: Some Thoughts On Productivity And The Fed: "Yellen is leaning in the direction of taking the productivity numbers at face value...

...and seeing low wage growth as consistent with the view that the productivity slowdown is real.... The unobserved component approach suggests that productivity growth decelerated to an annualized pace of just 0.82 percent by the second quarter of this year... [in line with] Fed staff estimates of potential GDP growth range from roughly 1.6 to 1.8 percent through 2020.... Yellen might think back to the 1990’s, when a surprise rise in productivity growth temporarily lowered the natural rate of unemployment... [and] reverse that logic now and think that the arguments for tighter policy are stronger.... READ MOAR

The bond market, with ten-year Treasury yields hovering between 2 and 2.5 percent, appears to be fiercely discounting the lower-for-longer story consistent with low productivity growth. Furthermore, low TIPS-based inflation expectations and a modest expected path for short rates also suggest little need for the Fed to tighten policy to avoid a 1970’s style inflation. The FOMC, however, has a more hawkish view.... San Francisco Federal Reserve President John Williams argued the Fed needs to engineer a substantial slowdown in growth next year. But the FOMC has yet to act on that relative hawkishness...

Let me step back and try to think through the issues from the very beginning:

When we think about what the Federal Reserve is doing right now, we need to consider four questions, only one of which which Tim Duy addresses here:

  1. Is the Federal Reserve properly implementing the monetary policy strategy the FOMC has decided upon?

  2. Is the monetary policy strategy the FOMC has decided upon the right strategy given the beliefs and values of the committee and the baton the Congress has given to it?

  3. Has the Congress given the Federal Reserve the right baton--that is, is the mandate calling for price stability, maximum feasible employment, moderate long-term interest rates, and financial stability the right mandate?

  4. Has Congress created the right institutional structure--that is, given the FOMC the proper membership and orientation?

I would argue that the answers to all four of these questions are: "No."

It is true that over the past three decades the U.S. Federal Reserve has been the best-performing central bank of any in the North Atlantic. And it is likely that the U.S. Federal Reserve is the best-structured central bank in the North Atlantic. But, may I say: "that is a low bar"? I believe we ought to be doing considerably better.

Take my four questions in reverse order, briefly:

  • The Federal Reserve was supposed to be a people's central bank--controlled not, like other central banks, by New York money-center bankers and financiers, but by a combination of president-appointed and senate-confirmed regulators in Washington, and with some banker voice but outnumbered by representatives of "agriculture, commerce, industry, services, labor, and consumers" in the twelve regional Federal Reserve Bank cities, only one of which was New York. Its Rube Goldbergian institutional structure is a Progressive-Era and New-Deal attempt to keep it from being the victim of regulatory capture by money-center banking and financial interests. But success has been, at best, very partial.

  • The Congress has handed the Federal Reserve a mandate that overweights the importance of price stability. The Fed recognizes this--it was Republican Mandate Alan Greenspan who declared and made stick that the general welfare calls not for price stability but for an average inflation rate of 2%/year. But as Larry Summers and I argued upstairs back in 1992, the balance of evidence is that the economy works better for America with a 4%/year than with a 0%/year average inflation rate. And as IMF chief economist Olivier Blanchard has noted, history since is pretty clear that at least 4%/year is better than 2%/year.

  • The Federal Reserve is not living up to even Alan Greenspan's redefinition of its mandate. As former Obama Chief Economist Christina Romer said to me as I left Berkeley for here: "Tell them that even Greenspan said 2%/year thinking it was the right inflation rate on average, but the current Federal Reserve is treating it as a ceiling".

  • It is more likely than not that the current Federal Reserve policy path will not even get the inflation rate up to 2%/year. In the past year inflation was 0.2%. It is true that we expect it to climb up toward the 1.8%/year current core inflation rate--but not all the way, only about 3/4 of the way. And both the prime-age employment rate and manufacturing capacity utilization have been drifting down since last fall. Add on economic turmoil in Europe and approaching economic turmoil in China, and this does not seem to be a good time to start raising interest rates. Or, rather, it seems like a good time only if you think the official unemployment rate is the only reliable source of information about the real state of the economy.

Remember: the last four times the Federal Reserve has started raising interest rates, it has had no clue where the economic vulnerabilities lie:

  • In 2005-2007, neither Greenspan nor Bernanke had any idea how fragile mis- and un-regulation had left housing finance and the New York money-center universal banks.

  • In 1993-1994, Alan Greenspan had no clue how much of an impact what he saw as small policy moves would have on long-run financing terms--but fortunately he shifted policy and stopped raising interest rates in midstream (over the protests of many on his committee).

  • In 1988-1990, Alan Greenspan had no clue how much of an impact it would have on the balance sheets of southwestern S&Ls. The federal government had to give three months of total Texas state income to Texas S&Ls and their depositors who had been chasing high yields in order to clean that up.

  • In 1979-1982, Paul Volcker did not realize that raising interest rates would bankrupt not only Latin America but also leave Citibank and others as zombies--things that were bankrupt, and that ought to have been shut down, but that were allowed via promises of government rescue if necessary to earn their way out of bankruptcy over the next five years.