A James Alexander post
Although Governor Tarullo is actually on the Board Governors of the Fed to take responsibility for banking regulation he often talks more sense than anyone at the FOMC about monetary policy. His July 6th interview with the WSJ, referenced in Tim Duy’s Bloomberg article contained this choice quote:
… if markets do regard economic prospects as only modest to moderate going forward, then raising short-term rates is almost surely going to flatten the yield curve, which generally speaking is not good for financial intermediation and in some sense could actually exacerbate financial stability concerns. So, as I say, I think the observation is a reasonable basis for paying more attention to financial stability issues, but it doesn’t translate into therefore raise rates and all will be well.
It is worth stopping to think just how good is this answer.
- He thinks markets are well worth listening to about the economy. He’s humble about his own forecasting skills. He is almost suggesting that the Fed should be led by market expectations about the economy.
- Raising short term rates could flatten the yield curve. He’s almost saying that raising rates when the market thinks it inappropriate will lead to rates falling, especially at the long end at first, especially relative to the short end. And maybe lower rates at the short end too after a while.
- Raising rates too early, against the market, could lead to financial instability. He’s suggesting that raising rates to burst bubbles or whatever can cause the financial instability it seeks to prevent.
- HILSENRATH: You’re not worried about bubbles right now?
- TARULLO: Well, no, I’m not. I mean, there are always going to be asset prices that may be above historic norms. I think everybody should be a little bit humble about thinking you can identify in each market where a price is sort of out of line and think that you can then dial it back. What we should probably be looking at is to see whether, across a broad range of assets, first, prices are above—probably significantly above historic norms. But secondly, you know, when you’re thinking about financial stability, you really do want to look at how the assets are being funded because to the degree that there’s leverage, particularly short-term leverage, you’ve got greater risks. To the degree that there isn’t, there may be money lost if assets prove not to have the value that the market currently assigns to them, but that is the way a market economy is supposed to function.
He is then very explicit about how the urge to “normalize” rates by raising them is wrongheaded:
But I think my—I think it’s useful to give a little context here. I don’t think of this as a normalization process. You know, people sometimes write about it, talk about it, using the term “normalize” or “normalization.” And I don’t believe that there’s some target that the Federal Reserve should be moving towards. What the right level of interest rates is depends upon the manifold factors that are affecting the economy in the short term and over the longer term. So, for me, it is a judgment as to how—taking a pragmatic look at things, how we can best pursue the dual aims of maximum employment and price stability.
Maximum employment, means just that, not a certain set level of unemployment:
Now, in current circumstances, what does that mean? Well, I think, first, it’s worth focusing on the maximum employment goal. The statute—the Federal Reserve Act says we’re to pursue maximum employment; not some abstracted concept of full employment, but maximum employment that is consistent with price stability. And I think, as we’ve seen, that even though—you know, for nine or 10 months now some people have said we’re at or close to full employment, and yet during that period we’ve created 800,000 or 900,000 jobs with the unemployment rate essentially stable, except for last month when the participation rate brought it down. That tells me that there was more slack in the economy. That tells me that we have the opportunity to create more jobs. That is obviously good for those 800,000 or 900,000 Americans. That’s almost surely good for those who are more on the margins of the labor force. It’s almost surely good for groups, like African-Americans and Hispanics, who traditionally have had higher unemployment rates.
It’s neither the 1970s with a hot economy, and the Fed’s current tool set is biased towards tightening, not easing.
So I look at this as an opportunity for greater maximum employment in a context, moving to the second point, in which inflation is not at our stated target, not near our stated target, and hasn’t been so in quite some time. This is not an economy that’s running hot. This is not the late ’70s. This is an economy that has been moving forward in a gradual recovery, modestly above trend for some time now, but as I said a moment ago surely not running hot. And it’s also an economy in which we probably are not actually providing as much stimulus as people may think. The neutral rate of interest has surely come down a good bit since the pre-crisis period, probably because of slower productivity, slower demographic growth, probably a bit because of the global environment. But for all those reasons, the neutral rate is lower, which means we’re not as far away.
And finally I think, as many people have observed, the risks we face present us with an asymmetric set of tools. Were the economy to pick up more rapidly, which would be, I think, a welcome development, we have the tools to respond appropriately. But were things to slow down, we obviously would face a more limited set of tools.