Daniel Tarullo: The Fed’s Market Monetarist?

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.

  1. 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.
  2. 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.
  3. 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.
  4. HILSENRATH: You’re not worried about bubbles right now?
  5. 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.

What is it about 2% and the Bank of England?

A James Alexander post

The Bank of England published its quarterly Inflation Report for November 2015 last week. The fact that the BoE is missing its 2% inflation target by more than 1% set in train the usual mini-flurry of letters to and from their political masters at the UK finance ministry, aka The Treasury. While reading the Treasury reply I spotted that there had been an “evolution in UK monetary policy”, I was forced to read on.

In fact the gap to the 2% target was back to the largest for some time at a negative 2.12% thanks to the most recent CPI itself coming in at a negative 0.12%. Of course, sophisticates prefer one of the numerous measures of “core” CPI, excluding food and/or energy, and/or housing, etc, etc.

JA Target Misses

Market Monetarists prefer to pay no attention to CPI since it is not a proper macroeconomic statistic, but a political one, since it is never revised. All proper economic statistics have to go through numerous revision processes over time – that is what makes them robust measures of the actual economy. No reliable macro number can be perfect first time. Only faith-based economists look for certainty.

But the Treasury and the BoE are, by statute, stuck with headline CPI as their official target, and the BoE has to explain why it is missing this target by such a wide margin. The correspondence is often quite revealing about what the BoE or the politicians are actually thinking or targeting and the fallacies on which these thoughts are based. All the usual ones were trotted out:

Fallacy 1: The long and variable lags

From the BoE Governor letter to the Treasury 

The peak effect of monetary policy on inflation is generally estimated to occur with a lag of between 18 and 24 months.

There is little recent evidence of 18-24 month lags. US monetary policy immediately crashed the world economy in 2008 after the Lehman bankruptcy. The Bank of England was busy doing the same in 2007 and 2008 with its extremely grudging, and therefore massively confidence-sapping and counter-productive, response to a run on its banks. The ECB immediately crashed the Euro Area in mid-2011 when it raised rates twice.

Monetary policy has supposedly been “highly accommodative” as Janet Yellen constantly reminds us, for nearly seven years. It is actually quite destructive of central bank credibility this refrain, and gets repeated by so many really quite smart people. But this supposedly “ultra loose” monetary policy has only engendered the slowest recovery in the post-war years, showing that: a) it hasn’t been very accommodative and b) that the supposed 18-24 month lag are faith rather than being evidence-based.

Fallacy 2: The “spare capacity” theory of monetary policy

From the BoE Governor letter to the Treasury

The MPC judges it appropriate to set policy in order to ensure that growth is sufficient to absorb the remaining spare capacity to return inflation to the target in a sustainable manner in around two years and to keep it there in the absence of further shocks.

We have already commented on central bankers really targeting the two-year out inflation that their macro models generate, and that these models are based on the false Philips Curve theory: that inflation and unemployment are inversely correlated. These central bankers need to look at the track record of both the Great Moderation and the last seven years, abandon the theory as false, and move back to orthodox monetary economics (that monetary policy determines nominal growth), or better Market Monetarism (that expectations of nominal growth are the monetary policy and thus drive actual nominal growth).

Fallacy 3: Consistently missing the 2% inflation target (on the upside) would court disaster

From the Treasury’s reply

In line with the requirements in the MPC remit, your letter provides a clear assessment of considerations and trade-offs guiding decisions from the MPC when considering the appropriate approach to, and horizon for, bringing inflation back to target, including implications for output volatility and risks of possible financial imbalances. The Government’s commitment to the current regime of flexible inflation targeting, with an operational target of 2% CPI inflation, remains absolute.

Trying to ignore the humour in an absolute commitment to a flexible policy, there is nothing special about 2%. The figure was plucked out of the air one day by central bankers as an ad hoc number around which to organise their weapons to fight much higher inflation. It worked for a while in bringing down inflation from those higher levels, and helped create the space for the Great Moderation. But Inflation Targeting’s time has come to an end as it has become a ceiling and started to interfere with optimal monetary policy. Monetary policy should be set to secure stable nominal income growth along a trend level, not “inflation”. There would be no disaster if we all just stopped talking about “inflation”.

To be fair the Treasury did try to make clear in their letter that the “target is symmetric: deviations below the target are treated the same way as deviations above the target.” I find that a bit hard to believe given the hand-wringing in the commentariat when CPI is above target is only matched by much the same hand-wringing when it is below target but could soon rise above target – according to the false theory in Fallacy 2.

That “evolution”: what is it about 2%?

From the BoE Governor letter to the Treasury

As described in the Inflation Report published today, the MPC’s preference is to use Bank Rate as the active marginal instrument for monetary policy, and expects to maintain the stock of purchased assets at £375 billion until Bank Rate has reached a level from which it can be cut materially. The MPC currently judges that such a level of Bank Rate is around 2%. This is a further evolution of the Committee’s forward guidance framework, which included guidance on the APF, originally announced in August 2013.

We now seem to have two 2%’s in the UK. The flexible inflation target and now some sort of natural 2% rate of interest at which the BoE can “materially” unwind its Asset Purchase Facility (“QE”) and do more than just not reinvesting proceeds from maturing bonds but sell them off too.

Is this really what they talk about at the Monetary Policy Committee? A sort of Fantasy Football League chat about what the future level of interest rates might possibly mean for the economy. Sure, if nominal growth is robust at over 5% and “inflation” bobbing along regularly above 2% then rates might be higher. But why set yourselves up as hostages to fortune and declare that a 2% Bank Rate is the right level to aggressively unwind QE? And why do both the BoE and the Treasury declare this an “evolution” of monetary policy guidance. At the end of the day the rate setters have to talk about something and Fantasy Football League is fairly harmless, I suppose.

The Stein legacy

If you want to understand why economic growth has been “shrinking” for more than one year

Quantitaty Change

Read Leaning, then toppling (by Ryan Avent, March 2014):

IF YOU want to know why the Federal Reserve is undershooting both its inflation target and its maximum employment mandate, cast your eye toward Jeremy Stein. Mr Stein is a Harvard economist and Fed governor. And since assuming his role at the Fed in 2012, he has led the intellectual charge within the Federal Open Market Committee to place more emphasis on financial stability as a monetary policy goal. For a glimpse of Mr Stein’s handiwork, have a look at his most recent speech, where he says:

I am going to try to make the case that, all else being equal, monetary policy should be less accommodative–by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level–when estimates of risk premiums in the bond market are abnormally low. These risk premiums include the term premium on Treasury securities, as well as the expected returns to investors from bearing the credit risk on, for example, corporate bonds and asset-backed securities. As an illustration, consider the period in the spring of 2013 when the 10-year Treasury yield was in the neighborhood of 1.60 percent and estimates of the term premium were around negative 80 basis points. Applied to this period, my approach would suggest a lesser willingness to use large-scale asset purchases to push yields down even further, as compared with a scenario in which term premiums were not so low.

Mr Stein is effectively taking ownership of the Fed’s move toward tapering. Long-term unemployed Americans should address their letters accordingly.