This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics.
My friend Charlie Calomiris published a nice op-ed in the Wall Street Journal on August 16 noting correctly that Alan Greenspan and Ben Bernanke “presided over major expansions of the Fed’s regulatory and supervisory authority” that “made the Fed more powerful,” and more political.
He also noted that Ben Bernanke and Janet Yellen crossed the line between monetary and fiscal policy by purchasing trillions of dollars in mortgage-backed securities and, thereby, directly allocating credit to the mortgage market. If the credit allocation was warranted, the President and/or Congress should have directed the Treasury to undertake the appropriate actions. Hence, it is somewhat ironic that Bernanke, Yellen and Greenspan teamed up with Paul Volcker in an op-ed piece in the WSJ (here) extolling the need for a politically independent Fed.
I believe that the thing that most politicalized the Fed was the Greenspan Fed’s decision to use the federal funds rate as a policy instrument and its decision, somewhat later, to be increasingly transparent about its federal funds rate target.
In a paper published last year (here), I showed that the Fed began using the federal funds rate as its policy instrument in the late 1980s, with the most likely date being May 1988, the date when the statistical relationship between the federal funds rate and the 10-year Treasury rate, which had be reasonably strong before, broke down completely and permanently.
For reasons that are explained in the paper, this change wasn’t noticed until Greenspan’s famous conundrum observation. In his February 1995 congressional testimony, Alan Greenspan observed that the 10-year Treasury yield failed to increase in spite of the fact that the federal funds rate had increased 150 basis points. He considered several possible explanations, including Ben Bernanke’s world-saving-glut hypothesis. Rejecting all, he called it a conundrum.
My analysis showed that increased transparency improved the Fed’s control over the federal funds rate significantly, and tightened the relationship between the funds rate and Treasury rates with maturities out to three years. However, these gains came at a high price. The public and the media now believe the Fed is responsible for determining most, if not all, interest rates. Those who want lower interest rates to fuel stock prices or believe that lower rates will stimulate economic growth want the Fed to pursue a policy of perpetually low interest rates.
Moreover, the belief that the Fed controls interest rates gives politicians, like President Trump, someone to blame if the economy slows or goes into recession. If this happens, the problem is the Fed; they didn’t reduce interest rates enough or fast enough, or keep rates low long enough. If the economy improves, it was the tax cut not the Fed that made it happen; things would be much better had the Fed acted sooner. The belief that the Fed controls interest rates (which the Fed has done nothing to dispel) has turned the Fed into a political whipping boy.
The Fed’s dilemma, which this quote from Alan Greenspan at the July 1-2, 1997, Federal Open Market Committee (FOMC) meeting makes clear, is the Fed doesn’t know what else to do.
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...but the reason is not that we enthusiastically embrace targeting the federal funds rate. We did it as an unfortunate fallback when we had no other options (emphasis added).
Nothing has changed.
Targeting the federal funds rate, or some other interest rate, is still the Fed’s only option. This is why I have suggested the Fed adopt what I call economic reality-based policy (ERMP). My ERMP approach allows the FOMC to continue to use the federal funds rate as its policy instrument, while dampening criticism for not moving the rate in the direction that the markets and politicians would find most advantageous, or keeping it there long enough. You can find out how ERMP works (here).
I don’t believe ERMP would completely de-politicalize the Fed, but it would be a big step in that direction. Releasing the Fed from much of it supervisory and regulatory responsibilities, as Calomiris suggests, would help too.
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.