This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics.
There has been considerable discussion recently that some members of the Federal Open Market Committee (FOMC) have been discussing new strategies for conducting monetary policy, and the likelihood the FOMC will adopt one. The search for a new strategy is just the latest attempt at a monetary policy metamorphosis. This one is motivated by the thing that motivated all previous metamorphoses—the ineffectiveness of the previous policy.
Post-war activist monetary policy began in March 1951 when the U.S. Treasury and the Federal Reserve reached an agreement to separate government debt management from monetary policy. This event coincided with the rise of Keynesian economics. The British economist John Maynard Keynes (1936) argued that an economy could be managed by activist monetary and fiscal policies. Keynes argued the monetary authority could do this by reducing interest rates. However, Keynesian economists circa the 1950s and 1960s believed this would be ineffective because investment and consumer spending was not very sensitive to changes in interest rates. Consequently, they considered monetary policy to be essentially useless and focused on fiscal policy.
Inflation began to accelerate in the late 1960s. Despite the Fed’s efforts to control inflation by focusing on the interest rates, inflation continued to accelerate. A group of economists known as monetarists argued that inflation could be brought under control by slowing the rate of growth of the money supply. On August 6, 1979, Paul Volcker became Chairman of the Fed. With the inflation rate above 10% and accelerating, Volcker realized that the Fed would have focus all of its efforts on bring down the inflation rate. He knew this would not happen unless the Fed did something drastically different than it had been doing for more than a decade. While not a monetarist, on November 6, 1979, Volcker announced that the Fed would use a new nonborrowed reserves operating procedure with the objective of slowing the rate of growth of the money supply. Volcker’s monetary policy metamorphosis was successful. Inflation peaked in April 1980 at 14.5% and began to decelerate. By July 1983, the annual inflation rate had dropped to 2.4%, a level not seen since April 1967.
Volcker’s monetary policy success prompted Keynesians to alter their view. Keynesians now saw monetary policy as very powerful. However, they argued its success was due to extremely high interest rates rather than to slower money growth: The federal funds rate peaked at over 19% in 1980. Of course, monetarists were just as convinced that the success was due to controlling the growth rate of the monetary aggregates.
The monetarists’ euphoria was short lived. The relationship between the monetary aggregates and output or inflation that monetarists touted during the 1960s and 1970s unraveled completely in the early 1980s. This prompted another metamorphosis that occurred in late 1982 when the FOMC replaced the nonborrowed reserves operating procedure with the borrowed reserves operating procedure. Economists and market analysts were suspicious the FOMC had returned to the operating procedure that produced the so-called Great Inflation. The FOMC attempted to disguise its interest in the federal funds rate by setting target growth rate ranges for the monetary aggregates in its “domestic policy directive,” and by not mentioning the federal funds rate in its domestic operating directive.
That the FOMC didn’t want to be seen as returning to a failed monetary policy is reflected the Fed’s reaction to a paper that I published in the Federal Reserve Bank of St. Louis’ Review in January 1988. My analysis showed that the Fed was paying more attention to the federal funds rate than to the money supply. At the time, papers authored by Regional Federal Reserve Bank economists were routinely reviewed by staff economists of the Board of Governors prior to publication. Usually, this amounted to little more than a few comments and/or suggestions. The response to my paper was much different. I was accused of making technical/analytical errors with the strong recommendation that the paper not be published. The manuscript was returned to me with hand written comments by three different individuals—all disparaging of the author. In spite of the fact that none of the comments was substantive, I responded to all of them. This made the paper much longer and it now had two appendices. The reviewers no longer had any objections my analysis or disparaging words about the author, but the Board of Governors still strongly recommended (requested) the paper not be published. The decision to publish rested with the President, Tom Melzer. President Melzer had been made aware of the situation on the receipt of the initial comments. After reviewing all of the Board’s objections and my responses he approved the papers’ publication (here).
The next metamorphosis occurred in the late 1980s, circa May 1988 (see the evidence here) when the FOMC began using the federal funds rate as its policy instrument, i.e., the FOMC began setting a specific numerical target for the federal funds rate. As with the previous metamorphosis, this one did not occur because the FOMC believed it was the best way to implement monetary policy. It occurred because the FOMC saw no alternative, as Greenspan made clear at the July 1997 FOMC meeting, saying:
I think we were all aware of what would happen when we shifted to an explicit federal funds rate target. As you may recall, we fought off that apparently inevitable day as long as we could. We ran into the situation, as you may remember, when the money supply, nonborrowed reserves, and various other non-interest-rate measures on which the Committee had focused had in turn fallen by the wayside. We were left with interest rates because we had no alternative. I think it is still in a sense our official policy that if we can find a way back to where we are able to target the money supply or net borrowed reserves or some other non-interest measure instead of the federal funds rate, we would like to do that. I am not sure we will be able to return to such a regime and in the process create a whole new army of Fed watchers who interpret what we are doing, but the reason is not that we enthusiastically embrace targeting the federal funds rate.
Greenspan could be frank because by this time everyone knew what the FOMC had been doing. If they didn’t, the FOMC’s August 1997 domestic policy directive removed any ambiguity: “In the implementation of policy for the immediate future, the Committee seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5-1/2 percent…a somewhat higher federal funds rate would or a slightly lower federal funds rate might be acceptable in the intermeeting period.”
Greenspan and most of the other FOMC participants were well aware of the limitation of using the federal funds rate as its policy instrument. These limitations were well articulated by Greenspan’s successor, Ben Bernanke in a famous paper (5272 citations) co-authored with Mark Gertler, titled Inside the Black Box: the Credit Channel of Monetary Policy.” Specifically, he said:
Of course, conventional views of how monetary policy works are readily available. According to many textbooks, monetary policymakers use their leverage over short-term interest rates to influence the cost of capital and, consequently, spending on durable goods, such as fixed investment, housing, inventories and consumer durables. In turn, changes in aggregate demand affect the level of production. But the textbook story is incomplete in several important ways.
One problem is that, in general, empirical studies of supposedly “interest sensitive” components of aggregate spending have in fact had great difficulty in identifying a quantitatively important effect of the neoclassical cost-of-capital variable [the interest rate]. Indeed, the most common finding is that non-neoclassical factors—for example, “accelerator” variables such as lagged output, sales or cash flow—have the greatest impact on spending…Empirical studies that have tested the neoclassical model in its equivalent “Tobin’s q” formulation have generally been no more successful.
Beyond the problem of weak cost-of-capital effects in estimated spending equations, there is a presumption that monetary policy should have its strongest influence on short-term interest rates. For example, the federal funds rate, the most closely controlled interest rate, is an overnight rate. Conversely, monetary policy should have a relatively weaker impact on long-term rates, especially real long-term rates.
These gaps in the conventional story have led a number of economists to explore whether imperfect information and other “frictions” in credit markets might help explain the potency of monetary policy. Collectively, the mechanisms that have been described in this literature are known loosely as the credit channel of monetary transmission. In this article, we summarize our current view of the credit channel and its role inside the “black box” of monetary policy transmission [monetary policies’ effectiveness].
Bernanke and others were hoping the credit channel would provide evidence for monetary policies’ effectiveness, but it failed. The failure stemmed in large part because its effectiveness was based on the idea that policy actions to reduce the supply of bank reserves would reduce bank’s lending. In a Review article I published in 1994 (here), I pointed out that financial innovation and deregulation of the 1970s and 1980s significantly weakened, if not eliminated, the so-called bank lending channel of the credit view of monetary policy. Indeed, in a speech he gave in 2007 (here) Bernanke acquiesced to this fact saying, “financial innovation and deregulation imply that borrowers in the market for a mortgage or consumer credit have numerous nonbank financing alternatives, blunting any direct impact of changes in bank lending.” The effectiveness of policy was once again seen as depending solely on the Fed’s ability to influence the overnight federal funds rate.
The financial crisis ushered in the next monetary policy metamorphosis. Markets became aware of the crisis on August 9, 2007, when a large French bank suspended redemption of three of its investment funds. The recession began four month later in December 2007. During this interval, the FOMC reduced its funds rate target by 100 basis points, from 5.25% to 4.25%. The target was reduced 2% on May 8, 2008, to no effect. The financial crisis and recession intensified and on September 15, 2008, Lehman Bros. announced the largest bankruptcy in U.S. history. Lehman’s announcement generated an enormous panic in financial markets further intensifying both the financial crisis and recession. The Fed responded by making massive loans to banks and other financial institution. The resulting increase in the supply of reserves effectively forced the FOMC to reduce the funds rate target to zero (evidence here and here), which it did on December 16, 2008.
Unable to reduce the federal funds rate further and aware that spending wouldn’t increase unless long-term rates declined significantly, Bernanke engaged in three policies with the objective of reducing long-term rates. The policies are quantitative easing (QE), forward guidance, and maturity extension. Strictly speaking, forward guidance and maturity extension had been used before; the former for a brief period from 2003 to 2005 and the latter in 1961 under the name “operation twist.” QE had never been used; the others had never been employed aggressively.
My research (here) and (here) shows that that QE had essentially no effect on long-term yields. In a recent paper (here), Jim Hamilton has also questioned the effectiveness of QE. In any event, as I pointed out in my last essay (here), the effect of these policies on output, inflation, and employment has been anything but impressive. During the current expansion, employment has grown at a 1.1% rate—the second slowest in post-war recoveries. Output growth has averaged an anemic 2.2% rate and inflation has been persistently below the FOMC’s 2% target.
This lack-luster outcome has motivated policymakers to consider news strategies (approaches) for conducting policy. The principal strategies under consideration are: nominal gross national product (GDP) targeting, price-level targeting, and average inflation targeting (which is similar to price-level targeting). These discussions are pointless because the Fed will not adopt any of these strategies.
There are a number of reasons the FOMC will not adopt these strategies that I discuss in a chapter I have written for The Oxford Handbook of the Economics of Central Banking (here). An important reason is these strategies work well only in economic models. They work well in economic models for two basic reasons: (1) Models have a fixed, unchanging structures. (2) Models are structured so the Fed’s monetary policy actions have the desired effect on output, inflation, and employment: Neither holds in the real world. The only thing constant about economies is they are constantly changing. New technologies and products drive out the old. Events elsewhere in the world affect domestic output, employment, prices, interest rate, and a host of other economic variables. Demographics change over time and for a variety of reasons. Some effects show up slowly over time. Others occur quite quickly. Events such as wars, debt defaults, hyperinflations, economic crises, etc. may have very persistent, bordering permanent, effects.
Moreover, policy actions that appear to have been very effective may suddenly become much less effective or completely ineffective. This can happen for a variety of reasons, not the least of which is economies are constantly changing. Economists are well aware of this. In 1976, Nobel Prize recipient, Robert Lucas, pointed out (here) that relationships that appear in historical data should not be considered structural, i.e., unchanging. But macroeconomists and policymakers have routinely ignored this warning. A prime example is the relationship between inflation and unemployment rate known as the Phillips curve. A variant of the Phillips curve plays a prominent role in the models policymakers routinely use in spite of the fact that one of its leading advocates, Alan Blinder, noted in the WSJ on May 3, 2018, (here) “Since 2000, the correlation between unemployment and changes in inflation is nearly zero.” A more accurate statement is it has never really worked well.
In any event, I believe that policymakers will come to understand implementing these strategies will be difficult, if not impossible. They might even come to realize they if they adopted one, it would ultimately fail. Hence, I believe they will continue to do what they’ve been doing. Moreover, they do it for exactly the same reason—they won’t know what else to do!
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.