The Most Important Thing to Remember as the Federal Reserve Counts Down Toward Liftoff...

Some Perhaps Cogent Thoughts on the Structure of the Fed, on Productivity Trends, and on Macroeconomic Policy: The Honest Broker for September 14, 2015

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....

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:


Four Questions to Ask with Respect to the Federal Reserve:

When we think about what the Federal Reserve is doing right now, we need to consider four questions, only one of 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.

Expanding:

Has Congress created the right institutional structure--that is, given the FOMC the proper membership and orientation? No.

During the Progressive Era the US Congress decided--almost surely correctly--that the absence of a central bank was harming the American economy. The inelasticity of the currency that the absence of a central bank produced enforced grinding long-term deflation on the U.S. economy, and left it excessively vulnerable to financial crises. When those financial crises came, the absence of a central bank meant that they could not properly be handled via Bagehot's Rule. In the crisis of 1907 the work of central banking in a crisis had been done--but done by J.P. Morgan & Co. It had been a near-run thing: only because the solvency of J.P. Morgan & Co. was not in question had it been possible for it to constitute itself plus the New York Clearinghouse as a pick-up central bank. Moreover, the House of Morgan and its friends had used the leverage its role in 1907 had produced to pick up some very nice properties at truly fire sale prices--AT&T; Westinghouse; Tennessee Coal, Iron and Railroad. And so the Congress passed and President Woodrow Wilson signed the Federal Reserve Act, and so the Beast from Jekyll Island was born.

The Congress that passed the Federal Reserve Act worried much about what it was doing. Hitherto, central banks had been located in financial capitals, drawn their personnel from the high financial oligarchy, dazzled elected politicians with their financial wizardry, and so run Central banking for the benefit of high finance and rich bondholders: hard money, the acceptance of deflation-induced redistributions as part of the natural order, limitation of easy access to credit to those with solid collateral (which meant the already-rich), but also with ample provision for rescue and support of financiers in a financial crisis. Central banks thus did their job at managing the monetary system to promote the general welfare only to the extent that there was a divine coincidence--only to the extent that the interests of the bankers of high finance and of rich bondholders were actually the interests of the public.

The congressional authors of the Federal Reserve Act hoped to avoid this capture of what was in essence a public, governmental regulatory function by the industry it was to spend most of its time regulating. Thus the 1913 Federal Reserve Act set up a two-part system: a Washington Federal Reserve Board and twelve regional Federal Reserve Banks.

The Federal Reserve Board was to be not in the financial capital of New York but in the political capital of Washington. The Federal Reserve Board was to be composed of political appointees: chaired by the Secretary of the Treasury, seconded by the Comptroller of the Currency, with five President-appointed and Senate-confirmed members to round out the Board. Fourteen-year terms for Board members were to make sure that the Board took a long-run economic national prosperity rather than a short-run political view of monetary policy.

The twelve regional Federal Reserve Banks--two in Missouri--Boston, New York, Cleveland, Chicago, Philadelphia, Richmond, Atlanta, St. Louis, Dallas, Kansas City, Minneapolis and San Francisco--were built to answer the populist criticism that even a Washington-based central bank would be too-easily captured by the high-financial oligarch-plutocrats of New York. For each regional Federal Reserve Bank, the large, medium, and small banks of its district were each to select two for the regional bank's board of directors, one of whom ("Class A") was to be a banker to represent the banks, the other of whom ("Class B") was to be neither "an officer, director, or employee of any bank" and was to "represent the public with due but not exclusive consideration to the interests of agriculture, commerce, industry, services, labor, and consumers". Each regional bank's board was then to be rounded out by three members ("Class C") chosen by the Federal Reserve Board tone again be neither " an officer, director, employee, or stockholder of any bank" and again "represent the public, and with due but not exclusive consideration to the interests of agriculture, commerce, industry, services, labor, and consumers", and these nine directors would then choose a president subject to approval by the Washington Board.

When President Franklin Delano Roosevelt and his first two congresses revisited the structure of the Federal Reserve, they made adjustments. They decided the Washington Board was too political, so the Secretary of the Treasury and the Comptroller of the Currency came off and a president-appointed and senate-confirmed Chairman went onto the Board. The Federal Reserve Bank of New York had turned out to be too powerful--it was, after all, the arm of the Federal Reserve that was actually intervening in the open market. So the Federal Open Market Committee was built to guide and coordinate actual monetary policy actions so that they would be the decisions of the system as a whole, rather than the unilateral actions of the President of the New York regional bank.

Meetings of the FOMC were to have 19 participants--the 12 regional bank presidents and the 7 members of the Federal Reserve Board. The Chair of the Board would chair the FOMC. The President of the New York regional bank would be vice-chair of the FOMC. Even though FOMC meetings would have 19 participants the FOMC would only have 12 voting members. The vice-chair and the other six members of the Board would always be voting members. And four other regional bank presidents--on a rotating basis: one of Kansas City, Minneapolis, and San Francisco; one of St. Louis, Dallas, and Atlanta; one of Boston, Philadelphia, and Richmond; and one of Cleveland and Chicago--would join them as not just participants in the meeting but full members of the FOMC.

All this impressive Rube-Goldbergosity was to make it be a people's central bank rather than the captive of New York high finance. Even William Jennings Bryan, then-Secretary of State and leader of the populist soft-money free-silver wing of the Democratic Party, endorsed its structure.

Has the Congress given the Federal Reserve the right baton--that is, is the mandate for price stability right? No.

The Congress has handed the Federal Reserve a mandate that overweights the importance of price stability. The Fed recognizes this--it was Republican Randite 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.

Moreover, 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.

Even given the membership, beliefs, and values of the Federal Reserve, and the baton the Congress has given it, is the monetary policy strategy the FOMC has decided upon the right strategy? No.

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".

Is the Federal Reserve properly implementing the monetary policy strategy the FOMC has decided upon? No.

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.


What Are the Implications of These Four Answers?:

Should the Federal Reserve be raising interest rates right now?

  1. Does it forecast that if interest rates stay where they are for the next six months, and thereafter optimal policy is followed, two years from now the labor market will be tight, with actual inflation above the 2%/year target, running ahead of expectations, and climbing?

  2. Does it see asset prices right now above fundamentals in markets that are leveraged enough to be a dangerous source of systemic risk, have all practical steps to curb asset bubbles via prudential regulation already been taken, and would hire interest rates materially curb the dangerous leverage?

Unless you can answer (1) or (2) with a "yes", then interest rates should stay where they are--or be reduced.

Www federalreserve gov monetarypolicy files fomcprojtabl20150617 pdf

The answers to both (1) and (2) are "no".


Memo: Tim Duy:

Tim Duy: Some Thoughts On Productivity And The Fed: "Will flagging productivity growth trigger a hawkish response from the Fed?...

...That is a question I have been asking myself since Federal Reserve Chair Janet Yellen discounted the cyclical influences of low wage growth in her July 10 speech:

The most important factor determining continued advances in living standards is productivity growth, defined as the rate of increase in how much a worker can produce in an hour of work. Over time, sustained increases in productivity are necessary to support rising household incomes…Here the recent data have been disappointing. The growth rate of output per hour worked in the business sector has averaged about 1‑1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth. 

Goldman Sachs economists led by Jan Hatzius hypothesize that productivity growth is low only because growth is mis-measured, undercounting the value of free or improved software and digital content made possible by information technology (although see Greg Ip’s opposing view). It seems that 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.

Indeed, the productivity trends may be even grimmer than 1-1/4 percent that Yellen cited in her speech.... [An] unobserved component approach suggests that productivity growth decelerated to an annualized pace of just 0.82 percent by the second quarter of this year. That is interesting because it must be somewhat similar to the Fed staff estimates. The accidentally released Fed staff estimates of potential GDP growth range from roughly 1.6 to 1.8 percent through 2020. That is exactly what you might expect with productivity growth of around 0.8 percent and labor force growth in the between 0.8 to 1.0 percent (roughly the recent range). It seems the Fed staff have adopted the pessimistic view of the productivity numbers. It is not about measurement error.

What are the implications for policy? Yellen might think back to the 1990’s, when a surprise rise in productivity growth temporarily lowered the natural rate of unemployment. Slow wage adjustment meant higher than expected productivity growth had a disinflationary impact on the economy, allowing for then Federal Reserve Chairman Alan Greenspan to hold interest rates relatively low. Yellen might reverse that logic now and think that the arguments for tighter policy are stronger. Hence another reason why low wage growth is not an impediment to raising rates.

Any increase in the natural rate of unemployment, however, would be temporary. After wage growth adjusts, we would expect the equilibrium real interest rate to fall in response to lower productivity growth. Lower productivity growth reduces the expected return on capital, thus requiring lower interest rates to maintain neutral policy. 

The trick then is determining whether we are still in the short-run or already in the long-run. It may be that wages have already adjusted.... Real wage growth – using core-PCE as the deflator – was high as wages adjusted during the recession, but then remained high even when unemployment was above six percent. Now real wages are running low. Could it be that the wage adjustment to lower productivity growth occurred during the recession? If so, the Fed would be in error to believe that now is the time to tighten policy in response to low productivity growth. In effect, the zero bound unintentionally did that job for them. Not only did wage growth adjust, but any potential inflationary impacts were overwhelmed by the disinflationary impacts of the recession.

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, anticipating a more aggressive policy over the next few years. The Fed staff split the difference in their forecasts. The direction the FOMC ultimately takes could be the difference in an expansion that last four more years or only two.

Bottom Line: Fed policy increasingly reflects the view that the productivity growth slowdown is real. We see it in falling estimates of potential GDP growth, falling expectations for the terminal federal funds rate, and now we see it as a reason to anticipate low wage growth. The first and third reactions seem to have had a hawkish impact on policy - not only is low wage growth not an impediment to raising rates, but 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; to date they have moved in the direction of market participants. Indeed, while I suspect the odds favor a September hike, we don’t even know they will raise rates this year at all! The question is whether they would be quick to act on that hawkishness in the face of any unexpectedly high inflation or wage growth numbers. I am thinking low-productivity growth coupled with memories of the 1970s may prime FOMC members in that direction.

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