Brookings: Topics - Monetary Policy

Financial Market Confusion and Pessimism Do Not Mean The Fed Is Wrong on Monetary Policy

Douglas J. Elliott — Wed, 19 Jun 2013 15:00:00 -0400

The financial market reactions to today’s Fed announcement about monetary policy are in line with its responses to Fed comments over the last few weeks – a mix of uncertainty and pessimism. But, market uncertainty and some pessimism are not necessarily good reasons to back away from the policy that the Fed is signaling, which is an eventual reduction in monetary stimulus.

Many commentators have been blaming the Fed for the uncertainty, but this seems mostly unfair. First, the Fed itself does not know how the economy will perform over the next year or two and therefore how it may choose to react over the next few months. The Fed never knows for sure what the economy will get up to, but we are in extremely unusual times, particularly in terms of monetary policy. Second, the Fed needs to be cautious about tying itself to specific targets, since no one statistic or pair of statistics will be accurate enough to pinpoint the state of the economy. We want them to make the right decisions based on the full range of data, not lock themselves into a mistaken choice because overly simplistic measures gave a misleading picture. Third, a substantial part of the uncertainty comes from the markets themselves. We do not know how much investors may have been over-relying on the drug of cheap money to goose their investment performances, either out of greed or fear of failing to hit their return targets. Some of the sharp reaction to Bernanke’s May 22^nd testimony may have reflected investors guessing that other investors would realize they were too far out on a limb and would start cutting back on riskier investments.

Some market pessimism is also justified, for this same reason. The Fed has gotten more optimistic about the economy, which means it is likely to reduce the degree to which it stimulates the financial system more quickly than it would have otherwise done. Cheap money tends to push up financial markets, indeed it is one of the main reasons central banks use stimulus, since the increased willingness of investors to take risks increases economic growth by making it easier for businesses and families to finance investments and consumption.

Authors

Douglas J. Elliott

Image Source: © Gary Cameron / Reuters

Fed Policy, Stock Markets and Japan

Douglas J. Elliott — Thu, 13 Jun 2013 08:45:00 -0400

The 6.4% fall in the Japanese stock market overnight, and the general retreat in global stock markets since late May, underline the importance of monetary policy for financial markets. There’s a reason for the old Wall Street saying that you should “never fight the Fed.” Monetary policy is a major determinant of economic activity and therefore of the value of the stocks and bonds of companies, since they are all affected by the level of economic growth. It also affects the cost of funding investment activities; lower interest rates make virtually all investments more attractive. Securities purchases by the Fed and other central banks around the world have a similar effect by bidding up prices. Further, the level of a country’s interest rates has a major impact on currency rates, with money tending to flow to where it can earn the highest interest and away from where it can be borrowed most cheaply. (The so-called “carry trade” focuses specifically on borrowing in currencies with cheap money and investing in currencies with higher interest rates.)

The Japanese are engaged in a massive exercise of monetary loosening in an attempt to increase asset prices and lower exchange rates in the anticipation that both factors will spur economic growth. This has led to sharply higher Japanese stock prices over the last half year, a gain that is being partially unwound as new doubts arise about how fully effective the new policies will be. The big question is whether this is (a) simply an adjustment to a more realistic view of policies that should remain quite supportive of the markets and economic growth or (b) a realization that the policy may be ineffective or ultimately counterproductive. I suspect that the answer is (a), but that the adjustment has further to go, since hopes have been quite inflated and there was insufficient recognition of the dangers and costs of the approach. That said, Japanese stock prices were massively beaten up over the last two decades and it may be that they are responding substantially to a reduction of an excessive and pervasive pessimism.

Markets around the world are also responding to the likelihood that the Fed will begin tightening monetary policy soon. For more on the implications of this, please see my recent presentation at an investor conference.

Authors

Douglas J. Elliott

Image Source: © Toru Hanai / Reuters

Quantitative Easing Withdrawal: How Bad Will it Hurt?

Douglas J. Elliott — Wed, 12 Jun 2013 16:09:00 -0400

The Fed's quantitative easing program and ultra-low interest rates will eventually come to an end, with purchases of new securities by the Fed potentially being reduced as early as this autumn. Financial markets are very focused on how this will occur and what effect it will have on securities of all kinds and on the economy as a whole. Economic Studies fellow Douglas Elliott recently gave a presentation to an investor conference on this issue. These slides are adapted from that presentation.

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QE Withdrawal: How Bad Will it Hurt?

Authors

Douglas J. Elliott

Image Source: © Brendan McDermid / Reuters

Time to Start Experimenting with Macroprudential Regulatory Policy

Douglas J. Elliott — Tue, 04 Jun 2013 10:36:00 -0400

I firmly believe that the U.S. needs to use macroprudential tools as a way of reducing the harm from cycles in the financial system. The traditional options—monetary policy and standard safety and soundness regulation—have real weaknesses. Monetary policy is generally too blunt a tool, since forcing interest rates up or down for the whole economy is an inefficient way to deal with issues specific to the financial system. On the other hand, traditional financial regulation is so focused on each individual financial institution that it often misses larger trends in the system as a whole. Macroprudential tools have the corresponding advantages of operating on the financial system as a whole, but without doing unnecessary collateral damage to the rest of the economy.

The recent study that I did with Greg Feldberg and Andreas Lehnert solidifies my view that macroprudential policy is valuable, but that we also must be aware of its limits and of the need to develop a better framework for understanding the tools and how best to use them. Our comprehensive review strongly suggests that the macroprudential actions of American authorities over many decades achieved their purposes, at least in part. To be fair, the analysis shows a relatively weak effect and the results are not always statistically significant. However, this is the first study to provide such a comprehensive analysis and it is very likely that more refined approaches to analysing the data will find clearer results. We see promising ways to improve the analysis and doubtless other researchers will find even more. Our collective understanding of macroprudential theory is also much better now than it was a few decades ago, which should allow us to optimise our actions in ways that we did not do in the past.

While I’m confident that macroprudential policy is useful, it is critical not to overstate what it can achieve or the ease with which it can be implemented effectively. We are in the early days of macroprudential policy, akin perhaps to where monetary policy stood in the 1950s. We need more refined theory, better statistics, and, unfortunately, we will also need to learn by experimentation. The good news is that any moderately intelligent macroprudential policy is likely to be better than our de facto policy of recent decades, which was never to use these tools, effectively leaving their setting at “off” even in the midst of the biggest credit bubble in history.

Macroprudential policy may be particularly helpful in the next decade or two, because the other choice is likely to be the blunt application of monetary policy. Non-intervention will not be politically viable in the wake of the financial crisis. Some may argue that the quantitative easing belies this, with authorities deliberately creating a bubble, or at least risking one. Whatever one’s views of the value of QE, the current situation is a transitional one and there will be a need to counteract any credit boom, or to prepare for the consequences of its eventual reversal, whether that boom is in process now or is a future contingency.

American policymakers generally view macroprudential policy favorably, but we do not have a good governance structure for it and the resources being put into considering it are far less than those devoted to implementing Dodd-Frank, for understandable reasons. We do not need to instantly get the macroprudential policy framework right, but we should be shifting our attention increasingly to that topic. It may not be all that long before we have to choose whether and how to use macroprudential tools. The tools to be considered should include the core tools of counter-cyclical capital buffers, counter-cyclical liquidity buffers (after we settle on the base liquidity rules and have some experience of them), and limits on loan-to-value (LTV) ratios for mortgages or capital requirements that vary with LTV ratios. We may also wish to consider setting minimum collateral requirements or haircuts for transactions involving the repurchase agreements and securities lending.

Authors

Douglas J. Elliott

Publication: The Economist

Image Source: © Brendan McDermid / Reuters

Europe on a Slippery Slope

Thomas Wright — Wed, 17 Apr 2013 00:00:00 -0400

Editor's note: This article originally appeared in the International Herald Tribune.

Throughout the euro crisis, observers have been asking if the euro zone will disintegrate — as if it is a decision that will be made by its leaders at some point in the future. This holds out the prospect of a great historic choice: Europeans can choose to properly unite and overcome their crisis or they can choose dissolution. We wait with bated breath for the next summit or the latest “most crucial month in the euro’s history,” which now seems to come several times a year.

But, this may be the wrong way of looking at the euro crisis. Integration and disintegration are not just the products of deliberate decisions. They are both processes, set in motion by actions regardless of the stated intentions of leaders. Once underway, each process takes several election cycles — probably a decade or so — to reach completion. Only one will prevail in the end, but it is possible that in the early stages these two processes can coexist even as each vies for supremacy.

Looked at this way, the euro zone is in serious trouble. The events of the past six months are consistent with a process of disintegration, while the process of integration has steadily weakened. The question is no longer, “Will Europe unravel?” We should be asking, “Can European disintegration be reversed?”

The trigger that brought integration to a halt and set disintegration in motion is surprising. In July 2012, the European Central Bank chief, Mario Draghi, declared that he would do whatever it takes to save the euro, and in August he kept his promise by introducing a program of Outright Monetary Transactions to finance troubled member states, thus bringing down the price of sovereign debt. The temporary lull led José Manuel Barroso, president of the European Commission, to confidently declare that “the existential threat against the euro has essentially been overcome.”

But Barroso could not have been more mistaken. The E.C.B.’s actions, while welcome, had a major unintended consequence. European governments became complacent and stopped pushing the policies needed to save the euro. The German government now believes that a quantum leap toward deeper fiscal and political integration through treaty change (the only way it could be done) is no longer necessary. At the December summit meeting, it was taken off the table. Instead, the Germans will push for incremental steps to increase coordination. Banking union has been watered down to the point where it is grossly insufficient. The euro zone is proposing a common supervisory mechanism, but banking debt will remain primarily a national concern.

The optimists say that the small steps the euro zone has taken are the first in a long journey, but this assumes that it will be easier to accomplish extraordinarily difficult goals later. Unfortunately, European politics are becoming polarized in a way that makes further progress unlikely. The core member states have run out of patience with the periphery and do not want to take on new commitments, such as a real banking union. Voters in the periphery are turning toward politicians who will say no to German austerity, as Italians recently demonstrated.

As integration stalled, the euro zone experienced its first major act of disintegration. The spectacularly botched rescue of Cyprus formally created a two-tier euro zone. Deposits are safer in Germany than in the periphery and this has enormous implications. We should expect large-scale capital flight if markets fear that other states will need a bailout. With capital controls in place, Cyprus itself is half in and half out of the single currency.

The next decisive moment may be when a member state on the periphery elects a government with a cast iron mandate to say no to a German government that has a cast iron mandate not to buckle. This almost happened in Greece in June of 2012, and it may yet happen in Italy in a couple of months. This could cause a withdrawal of E.C.B. support and an escalation that will lead to new acts of disintegration.

Winston Churchill once said: “It is not enough that we do our best; sometimes we have to do what’s required.” All European leaders should have this advice engraved onto a plaque and then affix it to their desks. Throughout the euro crisis, they have sought credit for good intentions and effort. They continually point out that the euro zone has moved far further and faster than anyone could have imagined before the crisis.

They are right, but it is completely irrelevant.

There are other forces at work and at the moment they are prevailing. Europe’s leaders need to be honest about the steps necessary to reverse a long spiral of disintegration. If they can’t do that, they need to ask how they can manage the process in the least damaging way possible.

Authors

Thomas Wright

Publication: International Herald Tribune

Image Source: © Kai Pfaffenbach / Reuters

April 2013 Update to TIGER: Tracking Indices for the Global Economic Recovery

Eswar Prasad and Karim Foda — Thu, 11 Apr 2013 13:30:00 -0400

Editor's Note: In collaboration with the Financial Times (FT), Eswar Prasad and Karim Foda of Brookings have developed a set of composite indexes which track the global economic recovery. The Financial Times has produced the Tracking Indexes for the Global Economic Recovery (TIGER) interactive map, which appears on the Financial Times Web site.

The global economic recovery remains stuck below takeoff speed, unable to achieve liftoff and facing the risk of stalling. Half-hearted fiscal austerity measures are proving to be a drag on growth, and monetary policy continues to shoulder the burden of limiting downside risks.

The Brookings-FT TIGER index shows that growth momentum remains weak in nearly all major advanced and emerging market economies. Click a country name below the global Overall Growth Index to view charts for the main TIGER indexes by country and charts for the indicators that make up the indexes, which are broken down by real activity, financial and confidence indicators.

Learn more about the recovery in advanced and emerging markets (PDF) »

Click a country name below to view charts for the main TIGER indexes for that country and charts for the indicators that make up the indexes, which are broken down by real activity, financial and confidence indicators.

As well as tracking country performance, the TIGER indexes also track the performance of key indicators across groups of advanced economies, emerging markets and a composite total. Click on the following links to view the updated charts for the following key indicators:

Real Activity Indicators

Financial Indicators

Confidence Indicators

For detailed information on the composition and construction of the indexes and a comprehensive description of the data and source information, please refer to the updated technical appendix.

Read the full analysis and commentary: Global Economic Recovery Stuck Below Takeoff Speed »

Authors

Eswar Prasad
Karim Foda

Image Source: © Jo Yong hak / Reuters

Currency Wars: This Time, Is It for Real?

Jacques Mistral — Wed, 10 Apr 2013 14:03:00 -0400

In his presidential campaign in 1928, Herbert Hoover promised to help impoverished farmers by increasing tariffs on agricultural products; after the election, he also asked Congress to reduce tariffs on industrial goods. In April 1929, well before Black Thursday, U.S. Representative Reed Smoot, a Republican from Utah, introduced a bill that passed the House in May. The bill increased agricultural and industrial tariffs at levels that had not been seen for a century. This was a relatively benign beginning of what would become one of the most tragic policy measures of the 1930s. Within a few months of the bill being passed in the Senate as the Smoot-Hawley Tariff Act, other countries in response raised their own trade barriers, which started a vicious circle of contracting world trade flows and economic activity, and rising unemployment from 1930 to 1933.

There are three main lessons from the policies mentioned above:

“Beggar-my-neighbor” policies are bad.
Bad policies can have tragic consequences.
Beware of benign measures that can ignite uncontrollable chain reactions.

Indeed, these lessons have been in every policymakers’ mind since the Lehmann Brothers failure. In fact, the creation of the G-20 was a spectacular effort by the major economies of the world to cooperatively answer the challenges raised by the most severe financial crisis since the 1930s. The G-20 coordinated the management of strong macroeconomic policies, including huge deficits and easy monetary policies. These were bold decisions but not radical, and those who condemned government intervention have been rebutted by the urgency of these measures. And it is now widely acknowledged that these unconventional measures successfully avoided the transformation of the Great Recession into another Great Depression.

In the U.S., the recovery is at best shaky, unemployment is artificially reduced by the growing number of discouraged workers who have stopped looking for work, and the median income is dramatically lagging.

Today, there are reasons of hope that have been eloquently described by Roger Altman [1]: it can be argued that in the U.S., and to a lesser degree in Europe, the crisis has inspired significant reforms that have pushed the economy closer to a sound and sustainable growth trajectory. However others rightfull so object that enormous challenges are still facing the populations and their respective governments. The price paid for curing the damages of the global financial crisis is extremely high everywhere. In the U.S., the recovery is at best shaky, unemployment is artificially reduced by the growing number of discouraged workers who have stopped looking for work, and the median income is dramatically lagging. In Europe, austerity is the name of the game in every country except Germany and despair is growing among the populace. Japan has been stuck for two decades in deflation. Many citizens around the world feel that the efforts have gone too far, yet the benefits and retribution have benefitted too few. Electoral frustrations are on the rise as demonstrated in Italy where Mario Monti’s wise policies have been followed by the success of the Five Stars Movement of Beppe Grillo. Italy turning ungovernable is a bad sign for democracies. Could we see a comeback of desperate national policy experiments like the ones that democracies were progressively pushed to adopt after facing insurmountable difficulties in the early 1930s?

Now, a really radical policy experiment is already taking shape in Japan with the introduction of what has been named “Abenomics” after the name of the newly-elected prime minister, Shinzo Abe. It has taken only one election and one nomination at the head of the Bank of Japan to really revolutionize monetary policy. This revolution can be qualified in two ways, one benign, one threatening.

There is first reason to rejoice. After two decades of failed policies, it’s finally good to see bold politicians ready to do whatever it takes to extract Japan from its deflationary trap. Should Mr. Abe succeed, he would unclench the domestic brakes to economic growth, which deflation has so lengthily opposed: declining prices in effect are discouraging consumption (goods will be better and cheaper tomorrow, why spend now?) and investment (facing massive excess capacity of production and weak final demand, why invest now?). The new mission of the governor of the Bank of Japan is to raise inflationary expectations to 2 percent, which would make Japan converge with the world average inflationary trend and monetary policy. Demand would restart and Japan would contribute to an improved global economic outlook. This is the view that the IMF chief recently endorsed. As expected, Mr. Kuroda last week unveiled a much more aggressive package of quantitative easing than what we have previously witnessed, with a view to double the monetary base. Japan’s central bank will buy more long-term government bonds, pushing private investors to invest more in risky assets. Since the election, the Nikkei has risen 34 percent. Different polls and surveys suggest that the public is positively reacting to Mr. Abe’s promises.

Is success already underway? That would be good news for Japan and for the world. But it is clearly too soon to celebrate because this virtuous circle can simply fail to happen. No central bank until now has ever tried to raise inflationary expectations and no one knows if this can turn to be a practical and manageable reality. Inflationary expectations could also easily turn out of control. Before exercising traction on the economy, they could impose higher interest rates that would have devastating consequences for the Japanese Treasury in the management of a huge public debt (more than twice the size of the GDP). But there is something worse than the risk of Abenomics having poor or adverse domestic consequences.

The other side of Abenomics is currency management, a much less propitious theme for a government to communicate in the weeks leading up to the IMF Spring Meetings in Washington. This aspect of the policy is not only bold, it’s actually radical. As a candidate, Mr. Abe made extremely clear that he was willing to help the manufacturing sector by depreciating the yen and that monetary policy would be designed with this goal in mind. Remember that Japan, despite all its woes, remains a formidable exporter with an external surplus close to ¥650 billion in February (approximately $6.5 billion). As my fellow economists at Brookings have recently shown [2], the Japanese bilateral surplus with the U.S., which is $23 billion according to reported trade statistics, would dramatically increase by 60 percent and reach $36 billion if measured in added-value terms. Mr. Abe’s message was well received by investors who quickly after the election started to short the yen. As a result, the yen has slumped 21.5 percent in the past five months— the worst (or the best?) performance among the currencies of the developed economies. Following last week’s announcement that the Bank of Japan was really acting to debase monetary policy, the yen weakened beyond 99 yen per dollar and dropped against 15 major currencies.

A weakening yen also poses challenges for China, complicating the China’s strategy to reach its 8 percent target growth for this year; it could also trigger huge capital flows into China destabilizing the delicate control of financial stability

This is where Mr. Abe and Mr. Smoot cross ways: both are local politicians inspired by the difficulties facing their countries; both are willing to use every available policy tool to soften these difficulties; neither is willing to shock the global economy, which has never been the case when arguing in favor of protectionism or competitive devaluations. But these measures are nonetheless radical because they have the potential to ignite uncontrollable chain reactions. South Korea for one already declared itself very concerned by this aggressive policy, which is totally understandable. For instance, when Toyota and Sony take some advantage of Abe’s policy, the ones that would likely be first to suffer are Hyundai and Samsung. South Korea has vital interests at stake and, over In the last five months, it has been struggling with a pernicious appreciation of its currency. A weakening yen also poses challenges for China, complicating the China’s strategy to reach its 8 percent target growth for this year; it could also trigger huge capital flows into China destabilizing the delicate control of financial stability; SAFE, the financial institution that manages China’s huge official reserves, last week published its yearly report for 2012. Commenting on the global environment, the report emphasized that “a yen’s depreciation can’t solve Japan’s structural problem, … [but] could turn out of control and trigger a suspicion about its sustainability,… and finally have dangerous spill-over-effects”[3]. Chinese officials at the Boao Forum also expressed similar concerns.

We still don’t know the end. Hope is that we could see the positive interpretation of a bold Japanese policy experiment contributing to a better functioning world economy. Experience should nonetheless make us cautious. What the movement by the Bank of Japan does is to increase an already huge excess liquidity, inundating global markets. In addition, the Japanese government has added a dangerous touch of currency manipulation. Both aspects should be alerts for the IMF rather than too quickly fuel the artificial satisfaction of promises regarding higher inflationary expectations and increased domestic demand. In the end, competitive devaluations always prove inefficient and dangerous because they inevitably provoke reactions and retaliations. “Currency wars” have made headlines from time to time in the recent years but these were skirmishes. This time it could be for real, and this should be a major concern for the United States. It is a great thing that Japan recently expressed interest in joining the Trans-Pacific Partnership, but these are words with long delayed potential results. A more constructive and immediate task is to continue the cooperative global approach of exchange rate policies and to strongly discourage any temptation of national radical policy experiments. This should be a central issue next week during the IMF Spring Meetings in Washington.

[1] Roger C. Altman: “The Fall and Rise of the West”, Foreign Affairs, January-February 2013

[2] Kemal Dervis, Joshua Meltzer and Karim Foda: “Value-Added Trade and its Implications for International Trade Policy”, Brookings Opinion, April 2, 2013

[3] http://www.safe.gov.cn/resources/image/076044004f1fb34a9da59ff675a23beb/1365377817854.pdf?MOD=AJPERES&name=2012年中国国际收支报告.pdf

Authors

Jacques Mistral

Image Source: © Issei Kato / Reuters

The Fed's Trying To Get the Party Started, So Why All the Criticism?

George L. Perry — Mon, 18 Mar 2013 15:02:00 -0400

Fed bashing has a long history. The Fed has a dual mandate of achieving both high employment and low inflation, and pursues those aims by raising short term interest rates when aggregate demand threatens to become excessive and lowering rates when aggregate demand needs a boost. But while the mandate is symmetric, the popularity of raising and lowering rates is not. Politicians and Wall Street pundits have often criticized the Fed when it tightened policy because higher interest rates were seen as bad for jobs, profits and the stock market, and disliked by borrowers. As Bill Martin, Fed chairman in the ‘50s and 60s, observed, the Fed is unpopular because its job is to take away the punch bowl just when the party is getting good.

So why are some politicians and financial observers criticizing the Fed today when it is just trying to get the party started? In the typical postwar business cycle, high interest rates brought on recessions and then low short term interest rates helped start expansions that restored high levels of employment. This time the recession was brought on by a financial crisis that made it deep and stubborn, and conventional monetary easing-reducing short term rates by buying short term Treasury securities-was not sufficient. Short term rates have been zero for an extended period, yet the expansion has been slower than everyone wanted.

To its great credit, the Fed has innovated its policy by buying sizable amounts of long term treasury securities and government backed mortgage securities in order to reduce long term borrowing costs more directly. And it has committed to continue this policy of quantitative easing until specific targets for the expansion are met. But precisely because these steps are unprecedented, the consequences are less predictable than they would be with conventional policies, and critics can speculate more freely.

Are today's critics on to something? One of their complaints is that the great liquidity the policy has produced will lead to inflation. Someday, inflation could become an issue, but not soon. Along with the rest of the advanced economies, the U.S. problem today is how to boost aggregate demand to expand employment, not how to contain it to resist inflation. Wage costs—a key element of any sustained inflation—are rising so slowly that they are impeding the growth of consumption, a key element of demand growth in the economy. This situation will change only very gradually, giving the Fed plenty of time to respond if it needs to.

Other skeptics suggest the Fed will have trouble unwinding its positions in government and agency bonds in an orderly way. Bond prices may well fall sharply once market participants believe the Fed is starting to reverse course. And that could cause stock prices to drop, too. But markets often adjust abruptly, and these changes would be consistent with the Fed's changed policy aims. If market movements achieve the desired change in rates without much selling by the Fed, the Fed is under no compulsion to continue selling.

Finally, some critics believe the Fed's easy monetary policy-both quantitative easing and ultra low short term borrowing rates-is creating bubbles in stocks and possibly other assets. Stocks have had a long rise since the market bottom in 2009, and a sharp rise over just the past several weeks. But profits have risen sharply over the long period and price to earnings ratios are generally near the middle of their historical range, not the top.

A correction in stocks can happen with no apparent reason and the Fed's aggressive easing will not be responsible when the next one comes. The present easing will benefit the stock market in the longer run by continuing to promote economic expansion. Just compare stocks in Europe, where economic expansions have faltered, with stocks in the U.S.

Authors

George L. Perry

Publication: Real Clear Markets

Image Source: © Mike Stone / Reuters

Time to Call a Truce in the Currency Wars

Michael W. Klein — Fri, 01 Mar 2013 00:00:00 -0500

Yes, the yen has weakened and the pound has gotten pounded, but worries about an all-out currency war may be overblown.

There's a perception that some countries' economies are being harmed by currency movements that have been undertaken to gain an unfair advantage.

That may be a bit misguided.

In the United States, the threat of a fiscal contraction due to sequestration has prompted the Federal Reserve to take actions that could weaken the dollar.

Signals suggest that the new head of the central bank in Japan will pursue a more expansionary policy in an effort to stimulate that country's long-moribund economy.

These actions are taken for purely domestic reasons, but they could have consequences for currencies.

In anticipation of frictions that could arise, there was an agreement by the G-20 nations at the recent Moscow summit to refrain from so-called competitive devaluations.

But, since then, governments such as South Korea and New Zealand have signaled a desire to pursue explicit policies to weaken currencies, or even to impose capital controls.

Read the rest of the opinion at cnn.com »

Authors

Michael W. Klein

Publication: CNN

Image Source: © Toru Hanai / Reuters

Italy’s Post-Election Chaos Isn’t What You Think

Carlo Bastasin — Fri, 01 Mar 2013 00:00:00 -0500

No parliament, no government, no president of the republic. And now not even a pope. The situation in Italy resembles a house of cards in a perfect storm.

It’s not just a matter of politicians, scenarios and furniture flying all over the place until the storm subsides. The problem is deeper than that. The new Italian Parliament has three minorities that are unable to form a majority. It is a power game in which Pier Luigi Bersani, the electoral winner, is the political loser, and the electoral losers, former Prime Minister Silvio Berlusconi and ex-comic Beppe Grillo, are the political winners.

Consider this. Almost half of those Italians who cast their ballots for one of the traditional parties switched their vote this time. You think Americans are fed up with Congress? In Italy, trust in the government stands at 5 percent, and trust in Parliament at 8 percent. The rate of abstentions is high. The party holding the majority of seats in the Chamber of Deputies -- 54 percent, as required by law -- won the support of just 20 percent of the electorate.

On top of all this, the timeline to form a new government is tight. The Parliament convenes for the first time March 15. Amid all the confusion, the parties must agree within 10 days on the leaders of the Chamber of Deputies and the Senate. Then they have to nominate a prime minister, who must form a government and take an oath in front of the president of the republic. All this before April 15, when the Parliament meets to elect a new president of the republic.

Against Everything

So I can sympathize with those who despair and say Italy has chosen nihilism, or who say, in effect, that Italians voted against everything -- including Europe and austerity, which they had come to believe in before the debt crisis. I understand why people are saying Italy could bring down the whole euro project. But I disagree with them.

Italians remain pro-European, and fewer people than you would suppose are seriously thinking of relinquishing either the euro or the economic-policy commitments that come with it.

Discontent is focused, above all, on taxes. They are among the highest in the euro area. Taxes on business are the highest of any euro member, and they are severely hurting a weakened economy. Italians see excessive taxes mainly as the consequence of bad political management. It’s not that they object to Europe and austerity. Rather, they are angry about the tax increases introduced under the banner of Europe and austerity.

If austerity means fiscal discipline, Italians actually want more of it. This is why New York Times columnist Paul Krugman is wrong to say Italians shunned an intelligent and credible man such as Prime Minister Mario Monti because he was “the proconsul installed by Germany to enforce fiscal austerity on an already ailing economy.”

In Italy’s case, however, the argument about fiscal stimulus just misses the point. A bigger budget deficit wouldn’t do much to stimulate demand, because the real problem is the breakdown in Italy’s supply of credit. From the beginning of the euro crisis three years ago, Italy has seen a faster shrinkage in total credit supply than most euro-area countries, as foreign banks have repatriated their loans. This widespread lack of credit has crushed the private economy. Businesses and households can’t get loans and are cutting investments and consumption at an unprecedented rate.

Effective Answers

Reviving the market for credit is the first job. This would be far more effective than delivering a new fiscal stimulus. In fact, continued budget discipline is vital in ending the credit crunch. The new government must negotiate a deal with the European Union and with the European Central Bank, so that the ECB can support the Italian banks. But this can’t happen unless the ECB is sure that it has a reliable partner in the Italian state and that Italy will remain as fiscally stable as possible.

Italians understand this, and so the political crisis may be a little easier to resolve than many think. Under the pressure of markets, Italian parties are likely to close ranks behind another technical prime minister, just as they did in November 2011 behind Monti. They will nominate someone familiar with financial issues -- some high official at the Bank of Italy, or maybe even Monti himself. They will call it an “institutional government” and ask it to make the political system more honest and functional, reining in the anger and recrimination of the citizens.

It’s a strange way to run a country -- but don’t write off Italy.

Authors

Carlo Bastasin

Publication: Bloomberg

Image Source: © Tony Gentile / Reuters

Would Congress Care if the Federal Reserve Lost Money? A Lesson from History

Sarah A. Binder — Tue, 26 Feb 2013 00:00:00 -0500

Chairman Ben Bernanke addressed critics today before the Senate Banking Committee, as he delivered the Federal Reserve’s Semiannual Monetary Policy Report. Bernanke’s testimony comes on the heels of a prominent monetary policy conference last week, in which participants speculated about the political fallout that could ensue once the Federal Reserve begins to unwind the unconventional policies it put in place during and after the Great Recession. Because the Fed could incur losses when it eventually raises interest rates and sells off assets from its ballooned balance sheet, many expect that by the end of the decade the Fed might no longer generate sufficient earnings to return profits to the Treasury. After a decade of rising profits remitted to Treasury (topping out at nearly $89 billion last year), many wonder whether Fed losses could trigger aggressive push back from Congress.

Questions about how legislators might respond to future Fed losses are worth pondering, not least because Bernanke himself raised the prospect of potential Fed losses in his testimony today. A few thoughts on the political challenges faced by the Fed, after a brief historical detour.

Contrary to most news coverage, the Federal Reserve Act (FRA) does not require the Fed to remit profits to Treasury. Congress imposed a franchise tax on the Fed in the original FRA in 1913—requiring the Fed to remit 100 percent of its earnings after paying expenses and dividends, lowering the tax in 1919 to ninety percent. But Congress stopped taxing the Fed in 1933, swapping the franchise tax for a one-time Fed payment to help capitalize the newly-created Federal Deposit Insurance Corporation. Only after the Fed became profitable in the wake of World War 2 did Congress did consider re-instating the franchise tax. In response, the Fed pre-empted Congress in 1947 by reinterpreting an obsolete anti-inflationary provision of the FRA that had been designed to empower the Fed to charge interest on its reserve banks’ holdings of Federal Reserve currency. The Fed simply choose a rate that generated revenue equal to what would have been collected by a franchise tax and then remitted most of that revenue to Treasury. Today, an internal Fed policy still guides remittances, absent a statutory mandate.

The Fed seemed to have several motivations for moving independently of Congress in 1947 to formalize a remittance policy. First, the Fed sought to pre-empt congressional critics angling to reinstate the franchise tax. Moving first allowed the Fed to protect its independence and flexibility over the level of profits returned to Treasury. Second, beating Congress to the punch empowered the Fed in its efforts to negotiate with Treasury an increase in the fixed interest rate that the Fed paid on government debt during wartime. As FOMC meeting notes from 1946 hint, by promising to send profits to Treasury, the Fed would subsidize the increased borrowing costs faced by Treasury once the Fed raised rates. By promising remittances and avoiding a statutory mandate, the Fed’s solution preserved the Fed’s flexibility and independence over monetary policy. In fact, some years later the Fed exploited its flexibility to increase the level of profits returned to Treasury.

Why care about the history of Fed remittances? With caveats given the differences between then and now, the 1947 episode offers a glimpse of potential legislative landmines should Fed profits turn to losses.

First, the Fed still prizes its independence and would oppose any congressional efforts to reinstate the franchise tax. Even if there is no practical difference between the Fed’s internal policy and a mandated franchise tax, the Fed would no doubt oppose a statutory mandate to hand over future profits on the grounds that such a mandate would infringe on the Fed’s conduct of monetary policy. Still, historical precedent for the franchise tax might undermine the Fed’s persuasiveness.

Second, Congress likely cares about Fed profits and will question underlying policies if they generate losses—even if such losses ensue from an exit strategy designed to stem inflation. Congressional Republicans, who never liked the Fed’s asset purchases in the first place, could use potential losses to hammer the Fed’s conduct of monetary policy. Democrats, counting on the Fed to secure its statutory mandate of maximum employment, could accuse the Fed of prematurely unwinding its unconventional policies. In sum, both parties could exploit potential losses to criticize the Fed’s policy choices. If the economy had indeed strengthened, then perhaps lawmakers would give the Fed a pass: Congress tends to ignore the Fed when the economy is in good shape. More likely, Congress would pounce. Even if a franchise tax were to be off the table, Fed losses could re-fuel the audit-the-Fed movement, on the grounds that Congress needs to know more about the details of the Fed’s exit strategy. Already today, half of the Senate Republicans have signed onto Senator Rand Paul’s audit the Fed bill. (Like father, like son.) Continued polarization reduces the chances of congressional action. But imposing more transparency on the Fed might have bipartisan appeal.

Ultimately, much uncertainty pervades projections about potential Fed losses in coming years, as suggested recently by Fed economists. And overall, economic growth stemming from the Fed’s unconventional policies would presumably increase tax revenues flowing into Treasury’s coffers, offsetting losses from the Fed. Still, as one former Fed governor said at Friday’s conference, “Politicians have very short memories…They’re going to focus very much on the fact that the Fed is no longer pulling its weight in terms of producing remittances for the federal government.” If Fed profits plummet, lawmakers’ myopic eyesight reduces the chances that Congress will see the big picture.

Authors

Sarah A. Binder

Publication: The Monkey Cage

Image Source: © Jason Reed / Reuters

A Trillion Dollar Coin Would Compromise the Federal Reserve

Ted Gayer — Mon, 14 Jan 2013 12:06:00 -0500

Perhaps nothing reflects the absurdity of the current state of governance than the seriousness accorded to the idea of the Treasury issuing a $1 trillion platinum coin. The idea is for Treasury to mint the coin, ship it to the Federal Reserve, which then pays for it by crediting $1 trillion into the Treasury's deposit account at the Fed, which is then available to finance our government obligations. As the Treasury spends the money, bank reserves rise, but that's not inflationary now with the economy still weak. Ultimately, as explained by Greg Ip of the Economist, the Fed can stem inflation by raising the interest rate it pays on bank reserves. The end result is that we would no longer need to raise the debt ceiling (since we don't need to borrow this $1 trillion), and thus a government default is averted. When (if?) the ceiling is raised, the process is reversed and the coin is melted.

The sole virtue of the platinum coin idea is that it is better than hitting the debt ceiling, which could happen as soon as mid-February and would leave the government unable to fund about 40 percent of its obligations. As Chairman Ben Bernanke said, this "would no doubt have a very adverse effect very quickly on the recovery. I'm quite certain of that."

But this was still a very bad idea, and Treasury was right to rule it out as an option. It would have involved the Fed in direct, off-market, financing of the government, compromising its independence. It would have relied on a loophole in a law designed to allow Treasury to issue coins of any denomination for commemorative purposes. It may or may not have held up in court, but it likely would have been challenged, creating legal uncertainty and perhaps even a Constitutional crisis if Congress challenged what would have been, in effect, the president’s usurping control of monetary policy. The result would have been market turmoil, broad economic harm, and evidence to the world of our inability to govern ourselves.

I also agree with Tyler Cowen and Scott Sumner that the more this idea is put on the table, the more likely the Republicans are to not vote to raise the debt ceiling. If the choice is between raising the debt ceiling and economic calamity, public opinion and its effect on political self-preservation will lead Congress to choose the former (albeit, only after a period of brinksmanship). If, on the other hand, the president embraces a bizarre idea of dubious legality, it makes political sense for the Republicans to not raise the debt ceiling and let the president pay the political consequences of the resulting legal and economic market turmoil.

Authors

Ted Gayer

Publication: US News & World Report

Image Source: © Kevin Lamarque / Reuters

Comments on “The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn’t Matter”

Donald Kohn — Sat, 05 Jan 2013 00:00:00 -0500

Editor's Note: These comments on the paper "The Most Dangerous Idea in Federal Reserve History: Monetary Policy Doesn't Matter" (PDF) by Christina D. Romer and David H. Romer were presented at the American Economic Association Annual Meeting on January 5, 2013.

This is a very interesting and thought-provoking paper. I recommend it highly, not only to all who are interested in Federal Reserve history, but also to those seeking an interesting perspective on recent monetary policy.

The Romers ascribe lack of forceful enough action in the 1930s and 1970s to excessive policymaker humility about the power of monetary policy to address the most important problem of the time. Another way to characterize the same thing is that the timidity of action reflected policymakers perceptions of the relative effect of policy on output and inflation—and hence on the balance of costs and benefits of policy actions. In the 1930s policymakers saw little benefit for lowering unemployment of further ease and large potential costs in terms of higher inflation. In 1970s they saw little effect on inflation from tighter policy but large potential costs in terms of lost output. We can see in retrospect that these assessments were incorrect and based on misunderstandings of underlying economics—of how much slack there was in the economy, the relationship of slack to inflation, the effect on slack of policy actions, and the importance of expectations in shaping the response of the economy to policy actions.

The Romers raise the question of whether recent monetary policy has also been influenced by insufficient confidence in the power of policy actions to deliver net benefits in terms of reducing unemployment. They are concerned that the Federal Reserve has not acted as forcefully as it could have or should have over the past few years because of misperceptions about the relative costs and benefits of actions. An important handicap in making such a judgment is that we are in uncharted waters---both in the behavior of the economy and the nature of the monetary policy response. We don’t have the luxury of 20-20 hindsight to determine what misunderstandings might have been unnecessarily holding back policies. We are in the middle of the situation now and are highly uncertain about what forces are holding back economic growth. That uncertainty is compounded by the use of new policy tools. We have little or no empirical basis for making judgments about the effects—costs or benefits—of large scale asset purchases, huge increases in the FR balance sheet, and increasingly detailed interest rate guidance.

My comments are framed around the following points: We need to be humble about what we know as economists under any circumstance—but especially now; but policymakers can’t let that humility freeze them into inaction, and we need to think about techniques to move forward in such circumstances; then we can examine how the Federal Reserve’s approach to policy has stacked up relative to these techniques for operating under uncertainty.

The last 10 years have highlighted just how little we know about how the economy works. Both policymakers and private agents should have been more humble in the years leading up to the crisis. The so-called “great moderation” led to complacency and overconfidence in both the private and public sectors. There was overconfidence about the self-correcting properties of private markets—how self-interest would limit financial and economic fluctuations. We overestimated the extent to which new financial instruments had led to the diversification of risk across markets and participants. We were overconfident about ability of monetary policy to steer the economy— to avoid major bouts of inflation or deflation and all but the mildest recessions and to counter financial collapses. Especially egregious was tendency to ignore longer-term financial and credit cycles and the intricacies and nonlinearities of the financial sector and its interactions with the real economy. We missed the significance of the buildup of leverage in both the financial and nonfinancial sectors, and their tendency to reinforce each other. And both the private and public sectors paid insufficient attention to tail risk in asset prices and its interaction with leverage and maturity transformation.

Our understanding and the models that embody it not only didn’t see the crisis coming, we didn’t see or fully understand the dynamics of the financial system and its interactions with the economy during the crisis, and we don’t understand why the recovery has been so slow. To gauge our lack of understanding on this last point, I looked at the projections of FOMC participants in June 2010—the last time I contributed to them. All the key relationships were off. We’ve seen much less growth than expected then, despite a more expansionary monetary policy; the unemployment rate is only a little higher than expected, even with the much lower growth, so that relationship was off as well; and inflation has turned out significantly higher than expected, even with less growth and a slightly higher unemployment rate.

A major complexity in understanding recent developments is the interaction of the shortfall in demand with needed structural shifts and realignments of demand and production and the recovery of balance sheets—the layering of a shorter-term business cycle on top of longer-term structural shifts. We have only limited guidance from history about how this is going to play out in context of the current US financial system and the widespread adjustments in the global economy.

And to this relatively mysterious economic structure, the Federal Reserve is applying unprecedented policy actions. Efforts to drive down longer-term interest rates with unconventional policy actions are natural extensions of the short-term rate policy adjustments of more normal times and should work through the same policy channels, but the new actions are naturally very hard to calibrate. What effects are purchases or interest rate guidance having on financial conditions? What effect are changes in financial conditions having on spending and inflation? To what extent does it matter whether long-term rates are reduced by a change in expectations because of guidance versus a change in the term premium because of purchases? Will there be costs, especially down the road on exit? There is very little history to use to judge the costs and benefits of these actions.

But uncertainty about the economy doesn’t necessarily have to imply caution or paralysis in policy. For example, one could simply adjust policy to make the desired outcome the most likely—even if the distribution of possible outcomes was relatively flat and not well understood. But as the Romers highlight, the natural human tendency is to hold back when uncertain about the system and the effects of policy action—about the balance of costs and benefits to bolder action. How can policymakers counter such an impulse? We can draw on past experience with policymaking for a few suggestions.

The first technique is to use “risk management”. Weigh the costs and benefits of missing to one side or the other of your inflation and output objectives; identify the most important problem relative to those objectives—the one that would reduce public welfare the most if policy were overly cautious; and take some chances to deal with that problem. This approach is especially attractive if the likelihood and cost of missing other objective is seen as relatively small. So, this would imply extra effort to deal with unemployment in the 1930s relative to inflation and with inflation in the 1970s relative to unemployment. Of late, high unemployment or low output would appear to embody a greater cost and risk to public welfare than rising inflation, given the evident slack in the economy and low inflation; of course, this could change in the future.

Second, learn and revise as you go. Policymakers need to be ready to update their understanding as they gain experience with the prevailing economic situation and the effects of policy, which should help gradually clarify the costs and benefits of their policy choices. This implies flexible policy implementation and a willingness to revise the policy setting and the plan going forward. In my view, a time of great uncertainty about underlying economic structures is not well suited to policy rules, especially rules based on recent economic data. The implications of incoming data for future economic performance—when changes in policy will have their effect-- will need to be updated frequently, and lessons learned about the effects of policy settings on the economy. These circumstances would seem to embody the classic case for gradualism in policy implementation—for slowly altering the stance of policy as you learn about its effects. It is critical under these circumstances to make the framework for actions and revisions very clear to the public so agents and markets understand how the central bank is processing information and can anticipate its actions as well as possible, increasing the odds that spending and pricing decisions will reinforce central bank action.

How do we evaluate recent monetary policy experience in the context of heightened uncertainty and the possible techniques to deal with it? The Romers have three issues with the language of Federal Open Market Committee participants that they fear may be indicative that the Committee is not being as bold as it should be. First is the argument made by the FOMC that the benefits of added easing are limited and declining—and relatedly that monetary policy is “no panacea” for the problems of the economy. Second, they highlight the argument that there are potential costs to unconventional policies that may be significant and rising. And third, they cite the gradual evolution toward more aggressive policies as proof that the Federal Reserve should have been more aggressive to begin with.

In my view the FOMC has in fact followed the prescriptions for overcoming inertia and excessive caution. With respect to risk management it has clearly identified long-term unemployment as its major concern—so long as inflation is not likely to stray very far from its objective. Especially in the criteria it has put forth for considering when to begin tightening policy, it has shown a willingness to take risks on the inflation side to make progress on unemployment. Partly this reflects the level of unemployment and inflation relative to objectives, but part of the reasoning surely is that we know more about how to control inflation than how to boost employment with monetary policy, so if inflation overshoots persistently the FOMC can be confident it has the tools to bring it back down. Notably, the quotes the paper views favorably from former chairmen about taking bold actions are about controlling inflation—not about raising output.

I would judge that the actions of the FOMC evidence a learning process as well. Policy has evolved as the FOMC learned about the evolution of the economy—just how sluggish the recovery would be; and as it has learned about inflation—just how little inflation and inflation expectations have been affected by unconventional policies and increases in the Federal Reserve’s balance sheet, an oft stated worry of those opposed to bold action. Consequently, it has become more willing to use its unconventional tools over time, even when its forecast has only changed marginally, consistent with gradualism in the face of uncertainty. Moreover, it has increasingly spelled out its policy approach in public. Some of the added discussion has been tactical—using dates of possible first tightening to guide rate expectations down—but some has helped to elaborate the strategy better, including the January 2012 document about the framework for policy and the added information in December about the economic conditions that would guide its consideration of first tightening.

Moreover, I don’t think you can dismiss the possibility that as the operations scale up, the benefits of added unconventional measures are limited and declining, or that the costs are increasing, as reflected in the comments of FOMC officials. On the benefit side, the marginal effect of lower longer-term interest rates in bringing increasing amounts of consumption and investment from the future to the present may well decline the deeper into the pile of possible future projects you dig. And the income effect of lower rates damping the spending of savers may gather force relative to the substitution effect inducing greater saving the longer rates are expected to be quite low. On the cost side, the greater the purchases the higher the risk that market functioning may be impaired or that the eventual unwinding of the portfolio will have adverse consequences for financial stability. And the larger the portfolio, the more questions are raised about the fiscal risk the Federal Reserve is taking and about complications when it’s time to exit—to raise rates and roll back the portfolio.

Importantly, these concerns have not stopped the Federal Reserve from taking increasingly bold actions over time. But in this context, warnings from the Federal Reserve that monetary policy is “no panacea” for what ails the economy are understandable and justified. Can monetary policy restore full employment before the benefit and cost lines cross? And even if it can, wouldn’t the return to full employment be faster and more certain if other government policies were working in the same direction?

Finally, people point to the Volcker disinflationary episode as an example of how humility about what we know about the economy doesn’t have to imply timidity in action, and how forceful action can overcome pessimism about the effectiveness of policy. Monetary policy under Volcker’s leadership was decisive, bold, and effective at promoting the longer-run welfare of the US economy. For sure, Paul Volcker didn’t believe we knew much about how the economy and inflation worked—for example he largely ignored staff forecasts in light of their poor track record over the 1960s and 1970s. But he knew inflation had been very costly and could be reduced with monetary policy, with a one-time cost in output of unknown dimensions, but long-run gains. And he was willing to innovate in the conduct of policy in order to get that done.

It’s important to recall, however, that, his action followed years of failed efforts to tame inflation with policy gradualism and nonmonetary policies. Like the current Federal Reserve, he talked a lot about other governmental policies that he thought might make his efforts more difficult; he worried and spoke out forcefully on the risks he saw from the fiscal and current account deficits of that time; he’s not present to speak for himself, but I suspect he would be comfortable with the “no panacea” language the current Federal Reserve uses. And he was willing to back off in the fall of 1982 with inflation still above his objective but recession deepening and financial stability threatened. That is, he was willing to update his cost/benefit calculation as circumstances changed.

In the current situation the FOMC has said unemployment is very costly; it has signaled it is willingness to take risks on inflation to boost resource utilization; it has innovated in numerous ways; but it can’t and shouldn’t ignore its calculation of costs and benefits and adjust policy as needed. In sum, I’m not sure it’s justifiable to argue that the FOMC has missed its “Volcker moment” or has been less forceful than warranted in real time policymaking.

Authors

Donald Kohn

Publication: American Economic Association Annual Meeting

Federal Reserve Independence in the Aftermath of the Financial Crisis: Should We Be Worried?

Donald Kohn — Fri, 04 Jan 2013 00:00:00 -0500

Editor's Note: The following comments were delivered on a panel of the National Association for Business Economics at the American Economic Association Annual Meetings on January 4, 2013.

We are going through extraordinary period in business cycles and central banking. The too-calm, too-confident, veneer of the so-called Great Moderation was shattered by the worst financial crisis in 80 years. The Federal Reserve, indeed central banks all over the industrial world, have taken extraordinary actions in response to make sure this crisis not followed by an economic result like that of the 1930s.

The Federal Reserve expanded access to the discount window for banks, and it opened credit facilities to nonbanks for the first time since the 1930s, including in a few cases to help stabilize or facilitate the takeover of systemically important institutions at risk of failure that would have further destabilized the financial system. The Federal Reserve aggressively reduced short-term rates to zero and then, to spur growth, has worked to reduce intermediate- and long-term rates even further by greatly expanding its balance sheet with purchases of long-term securities and by issuing guidance about the future path of short-term rates. And it has addressed perceived clogs in the transmission of monetary policy by intervening directly in government guaranteed mortgage market—taking a hand in credit allocation where markets are not functioning well. Other central banks in industrial countries that have been hit by crisis in recent years have taken comparable, unconventional, steps to stabilize markets and encourage growth. We are in uncharted territory—both in our understanding of economic developments and of the policy response.

Naturally, understandably, and appropriately, these circumstances have increased the scrutiny of central banks, including the Federal Reserve, raising questions about the goals, governance and accountability of these institutions. This panel has been asked whether we should we be worried that this scrutiny will result in an erosion of independence. To foreshadow my answer: these actions should not and need not lead to a loss of monetary policy independence, but we need to be vigilant because risk factors have increased.

When discussing central bank independence, it’s important to draw two key distinctions about what we mean. The first distinction concerns functions performed by the central bank. With regard to independence, our main focus has been on the setting of monetary policy, not regulatory policy. In this regard, the Federal Reserve has always lived with a bifurcated regime. The Regulatory functions of the Federal Reserve have involved a very high degree of cooperation and coordination with other agencies. Major decisions are arrived at jointly by several agencies. And those decisions are subject to examination and oversight by the General Accountability Office of the Congress.

The cooperative character of bank regulation is made necessary by the balkanized US regulatory system, with many different agencies having a hand in regulation and supervision of the financial system. It also reflects the nature of the actions taken. Regulation is necessary to offset the moral hazard created by the safety net and deal with externalities. But it involves elements of credit allocation, it constrains private decisions, and it affects the relative positions of individual firms. And it can have consequences for the public purse if regulation and supervision are not effective enough at constraining risk. Some degree of independence from political pressure is helpful in carrying out these tasks, but they may not lend themselves to the same arms-length relationship to elected representatives as does monetary policy.

The conduct of monetary policy has enjoyed considerably more, but still limited, independence. Within monetary policy, it is useful to distinguish goal from instrument independence. Goals for policy are and should be set in the democratic process by elected representatives. But independence is critical in the setting of the instruments to achieve these goals. Central banks should be held accountable for outcomes, not inputs. Instrument independence is necessary to overcome the short-term perspective of politicians, who are more interested in boosting growth for the next election and less focused on the longer-term inflationary consequences of such actions; across time and countries there is plenty of evidence that less independence is correlated with higher inflation.

Even instrument independence not absolute. Instrument settings will always be subject to political pressure and discussion. Moreover, some control is exercised through the appointments process, which for the Chairman occurs every four years. But an independent central bank—one that has been insulated from these pressures--doesn’t need to follow the politicians’ instructions; it should resist where those desires are inconsistent with its own views of how to achieve the objectives it has been given.

In considering whether Federal Reserve independence is likely to be threatened by the nature and aggressive character of its recent actions it’s important to keep in mind that there is no necessary connection between recent actions and future loss of independence. This is a decision for Congress to make legislatively, and it needs to understand the costs and benefits from any erosion of independence. Moreover, concern about a potential mistake by Congress in this regard is not a reason for the Federal Reserve to hold back on using the tools Congress has given it to accomplish the objectives Congress has set. The Federal Reserve needs to keep explaining why it considers its actions to have been consistent with furthering its objectives, and that that any fiscal risk incurred or credit allocation affected by its actions has been necessary to achieve its legislated objectives and has been a temporary function of an extraordinary situation. We can see from what is going on in Japan right now that perceptions of timidity and caution also have the potential to threaten independence.

But a number of risk factors suggest extra vigilance will be called for over coming years to preserve the appropriate degree of Federal Reserve independence. First, an era of polarization of political discourse has not proven conducive to a reasoned discussion of monetary policy and the pros and cons of independence. Exhibit one in this regard would be the debates in the Republican primaries with candidates competing as to how rapidly they would “fire” Ben Bernanke, with one characterizing a policy disagreement as “almost treasonable”. Also discouraging was the unprecedented letter from Republican congressional leaders to the Federal Reserve in September 2011 trying to dictate an instrument setting—the management of its portfolio. And, as I’ll underline in a second, we haven’t yet heard from the forces that might eventually be aroused by exit from these policies.

Second, the Federal Reserve has had some powers trimmed in Dodd-Frank, suggesting an erosion of trust and deference by lawmakers. The restrictions apply to its authority to lend to non-bank institutions under 13-3 of the Federal Reserve Act, and include an obligation to get the approval of the Secretary of the Treasury even for widely available facilities. In addition, against the recommendation of the Federal Reserve, the Congress mandated the publication of the names of all borrowers at the discount window—bank and nonbank-- no later than two years after they borrow. So far, the instrument independence of the Federal Reserve in monetary policy per se has not been abridged in any way, but it may be that the Federal Reserve’s views carry less weight than they did before the crisis.

Third, although in recent years the political blowback mainly has come from those who say they are worried about inflation, the major challenge to independence is likely to come from those concerned about unemployment as the Federal Reserve exits from unconventional policies. At some point the Federal Reserve will need to tighten policy to keep inflation from rising persistently above its price stability target. It will need to raise rates and begin returning its portfolio towards its prior plain vanilla size and composition. The turn toward tightening is always a difficult decision—and subject to second-guessing in the political sphere—but it will be even tougher after long period of weak growth and unprecedented policy actions.

It will be a complex exit involving many steps—with lots of opportunity for kibitzing and objecting over a long period. It will ultimately involve a sharp correction in long-term rates—a reversal of a negative term premium as well as upward adjustment in expected short-term rates. It will entail withdrawal of special support for the mortgage market. As long-term rates rise the Federal Reserve will have mark to market loses on its balance sheet. These loses are not a threat to the Federal Reserve’s ability to tighten or its independence so long as cash flow is positive, but the loses could be used as a political weapon. The main tightening tool will be increases in the interest rate paid to banks on their deposits at the Federal Reserve, further damping Federal Reserve profits; this is a tool well known in other jurisdictions, but is new for the US. The size of the portfolio shouldn’t impede ability to tighten, given this new tool, but a huge volume of reserves could make control over the federal funds rate less precise than it has been in the past. Finally, in light of the apparent inability of the Congress and administration to deal with longer-term budget issues, the rise in rates could be occurring in context of still-unsustainable path for budget and debt, and higher rates will underline that issue and make it worse. This will be another source of unhappiness in political sphere.

Fourth, the Federal Reserve, like many other central banks, has been given added responsibilities in regulation and supervision. These responsibilities include a key role in macroprudential regulation, with responsibility for protecting the overall stability of the financial system. Carrying out this regulation already involves a differential impact on some organizations—those identified as systemically important. It could also entail tightening up when credit is growing too fast and imbalances are seen to be developing—another form of taking away the punch bowl as the party gets going—for example through raising the countercyclical capital buffer under Basel III. This will not be popular with those drinking the punch. In the years leading up to the crisis we saw considerable political resistance to even mild forms of tighter policy, for example with respect to commercial real estate lending. The risk is that greater scrutiny and criticism of this aspect of Federal Reserve activity could spillover to monetary policy. It is important to retain the bifurcation—the differences in governance and accountability for regulation and monetary policy.

But macroprudential policy could also protect monetary policy independence. It reduces the need for the Federal Reserve to use monetary policy to deal with bubbles, imbalances, or a build up of leverage. It now has another tool to apply to these. Monetary policy can be focused on price stability and maximum employment and more readily held accountable for those less diffuse goals than for “financial Stability”. More focused goals and accountability should support retaining monetary policy independence.

The most immediate threat to appropriate independence now would seem to be the proposal to allow GAO to audit of monetary policy—to remove the exemption for monetary policy that has existed since the 1970s. The expanded GAO audit authority would be another avenue to bring pressure on the Federal Reserve’s monetary policy—perhaps trying to delay actions pending a GAO study. Of course, such pressure can and should be ignored when the Federal Reserve is convinced it is doing the right thing to accomplish its legislated objectives. But extending the GAO audit moves the needle, however slightly, in the wrong direction when it will be important to protect the Federal Reserve’s instrument independence for exit. And it erodes that distinction between the governance of regulatory and monetary policy functions that seems so useful to make.

Federal Reserve monetary policy independence will be critical to preserve over next few years. There’s just too much history behind the concern that less independence leads to higher inflation over time. I hope all economists can agree on this—whatever they think of the actual policy actions that have been undertaken. The views of economists could be important in any discussion of this subject that might occur.

Authors

Donald Kohn

Publication: American Economic Association Annual Meeting

Monetary Policy in 2012: Further Disappointments in Growth; Further Innovations in Monetary Policy

Donald Kohn — Thu, 20 Dec 2012 14:09:00 -0500

Economic growth again disappointed in 2012. Around this time in 2011, the policymakers at the Federal Reserve were predicting the economy would grow in 2012 around 3 percent or a bit above; it now appears that economic growth this year will be 2 percent or a bit below. Nonetheless, the unemployment rate did fall a little more than Fed policymakers were predicting—from 8.5 to 7.7 percent—but this was not as good news as it seems because the drop was due to disappointing productivity growth and people dropping out of the labor force, in part as they grew discouraged looking for work.

Headline inflation numbers reflected the rise and fall of energy and other commodity prices in 2012, but considerable slack in the labor market and the economy more generally kept a lid on price increases. Wage and compensation growth remained very sluggish—real wages and unit labor costs for businesses were about unchanged over the year—reflecting the intense competition for jobs. Inflation actually slowed over the year, falling from 2.4 to 1.7 percent overall on the Fed’s preferred PCE chain price index (through October, latest data available) and from 1.9 to 1.6 percent for the core measure that abstracts from volatile food and energy prices.

With inflation subdued and showing no signs of picking up, unemployment still well above the Federal Reserve’s estimate of its long-term sustainable value, and concerns intensifying that cyclical unemployment could turn into structural unemployment permanently reducing the economic potential of the U.S. economy, the Federal Reserve kept its policy focus firmly on what it could do to boost growth to improve labor market conditions more quickly. In the past, under conditions like these, it would have lowered its target federal funds rate, and that action would have reduced intermediate and longer-term borrowing costs, raised asset prices and weakened the dollar, all three channels inducing businesses and households to buy more U.S. produced goods and services. But short-term interest rates are already at zero, so the Federal Reserve must operate more directly on intermediate and longer-term rates, which in turn should feed through to asset prices and the dollar as well as lowering borrowing costs. It has developed two techniques to do this: buying longer-term securities; and stretching out the time that market participants expect short-term rates to be near zero by giving guidance on how long the Fed itself expects short-term rates to remain at these extraordinarily low levels.

It used both of these techniques in 2012, adding innovative spins late in the year. Importantly it started the year by spelling out a bit more clearly its approach to pursuing its dual legislative objectives of “maximum employment and stable prices.” Two points were critical: First, it explicitly adopted a long-run inflation target of an increase of 2 percent in the PCE chain price index; it was hoping that the target would help to anchor inflation expectations more firmly and thus would enable it to adopt more aggressive policies to boost employment without endangering achievement of its price stability mandate. Second, it enunciated a “balanced approach” to pursuing its two objectives such that if they ever appeared to be in conflict they would give greater weight to the goal they were missing by more, taking more time to achieve the other goal. In the current context the “balanced” approach implies that if inflation is expected to run a little over target while unemployment is still quite high they wouldn’t withdraw policy accommodation right away but would approach the price stability goal slowly while continuing to make faster progress on unemployment.

Through the first nine months of the year, the Federal Reserve extended policies and techniques it had adopted in 2011 to reduce longer-term interest rates. It continued the maturity extension program popularly known as “Operation Twist” in which it sold shorter-term treasury securities and bought longer-term Treasury debt to put downward pressure on long-term rates. And it adjusted its estimate of how long near zero short-term rates would need to be maintained from “at least through mid 2013” to “at least through late 2014.”

Then at its September, October, and December meetings the Federal Reserve became more aggressive and more innovative. It restarted its program to expand reserves and its own balance sheet by buying mortgage backed securities in order to reduce mortgage rates and help the housing market and by converting its “twist” acquisition of Treasury securities into outright purchases financed by reserve creation. And it extended its expected period of near-zero interest rates to “at least mid 2015.” But in addition it innovated by tying the two types of policies—purchases and low interest rates—to evolving economic conditions rather than to a given amount of purchases or a date for raising rates. It will continue its purchases so long as the outlook for the labor market does not improve substantially. And it will not consider raising rates so long as unemployment is above 6.5 percent while projected inflation is below 2.5 percent, though to be sure they left themselves some wiggle room by noting that they will be looking at a variety of indicators of labor market tightness and inflation pressures.

The shift to economic conditions and the particular economic conditions chosen to act as thresholds for considering changing policy have several important implications. They reinforce the primary focus on labor markets—the maximum employment part of the dual mandate in the current and expected circumstances of still-high unemployment and still-low inflation. To that end, they imply continued downward pressure on interest rates through purchases so long as the labor market doesn’t look like it will be approaching a much better place in the future. And they make more explicit the willingness to take inflation risks—indeed to tolerate inflation a little over the new 2 percent target for a time —in order to get that labor market improvement, before raising interest rates. One of the objectives appears to have been to reassure households and businesses that the Federal a Reserve will not tighten prematurely and that they can plan on the Fed continuing to support growth for some time. And the shift to economic conditions implies that markets will be able to adjust interest rates with less explicit guidance from the Fed because market participants should better understand how the Federal Reserve itself will respond to evolving economic conditions.

Although financial market reactions to these late-year announcements were muted—except for a notable decline in mortgage rates-- most observers agree that the actions of the Federal Reserve have been transmitted through the financial markets in the forms of easier financing conditions for a variety of borrowers and of higher asset prices. As such they should help to boost spending at least a little, though the extent of the improvement is not expected to be large. It’s difficult to see their effect on confidence in an environment that is dominated by discussions of fiscal policy and where the difficult negotiations between the administration and Congress appear to have had a negative effect on household and business attitudes.

As we exit 2012, the growth outlook is highly dependent on the outcome of those fiscal negotiations as well as on developments overseas, where many industrial economies are stagnant or in recession. The Federal Reserve has spent 2012 laying out a framework for monetary policy to respond to evolving economic conditions, whatever the source of change. The consensus economic forecast for 2013 is for another year of moderate growth and only slow progress in lowering the unemployment rate, even with a favorable resolution of the fiscal difficulties that reduces uncertinaty while not front-loading restraint. Under these circumstances we could expect the Federal Reserve to continue buying securities and keeping rates at very low levels for some time. As to whether the fertile brains of Chairman Bernanke and his colleagues will come up with further innovations to speed this process along, we’ll just have to stay tuned.

Authors

Donald Kohn

The Future of the CEMAC CFA Franc

Julius Agbor — Tue, 11 Dec 2012 11:55:00 -0500

EXECUTIVE SUMMARY

A total of 80 currency boards have come into existence at some point since the mid-19th century, but to date only about 15 of them still exist, among which is the CFA franc monetary zone. The future sustainability of the CFA franc zone, to which the CEMAC CFA franc belongs, is increasingly questioned in the light of increasing asymmetries in exposure to external shocks, differential speeds of adjustment of the real exchange rate following shocks, differential impacts in economic fundamentals, and low levels of intra-regional trade and financial flows between CEMAC and WAEMU. For the CEMAC bloc of countries in particular, the future sustainability of the fixed exchange regime depends crucially on continued oil exports, which currently represent about 90 percent of export revenues and 40 percent of GDP. Should oil reserves deplete in the near future or oil prices decline significantly, a substantial source of foreign reserves would be lost, thereby exposing the regime to collapse. Even without resource depletion, continued volatility in global financial markets is increasing the risks of collapse of the fixed exchange regime as oil and commodity price swings ignite currency speculation as well as render reserves much more volatile. Against this backdrop, the present study examines the stakes facing the CEMAC CFA franc, discusses the exit options from the currency board and makes recommendations towards a sustainable monetary policy framework for CEMAC countries going forward. The analysis points to the imperative of pursuing a full monetary union with a single CEMAC franc pegged to the U.S. dollar and further suggests that, like the experience of the eurozone, the CEMAC monetary arrangement can be best implemented only by complying with the principle of political union.

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Authors

Julius Agbor

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