This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.

3 Critical Questions On The Fed's Monetary Policy  - DTX6oBnWAAAFdAD

A good friend of mine and economist, Peter Clark, always sends me interesting and useful comments on my essays. Peter agreed that my last essay (Reasons to Question the Effectiveness of the Fed’s Interest Rate Policies) showed that the FOMC responded increasingly aggressively to the last three recessions and he raised three questions that deserve answers. Specifically:

  1. Why did the Fed change its policy response?

  2. What are the likely adverse consequences of this change?

  3. What is the alternative?

This essay is an extended and more detailed version of the answers I gave Peter.

Why did the Fed change its policy response?

Policymakers know that longer-term rates are most important for spending decisions and the very short-term interest rates such as the one-day-term federal funds rate is not likely to have a significant impact on spending.

Consequently, they understood that reducing the federal funds rate alone wouldn’t be effective. But since the early 1980s monetary policy has been focused on interest rates. Before that, some policymakers believed that monetary policy was best reflected by the growth rate of the money supply. Two things changed this view. First, as I discuss in The Limits of Monetary Policy, there was little evidence that the Volcker Fed brought inflation under control in the early 1980s by reducing money growth. However, the federal funds rate went to a high of near 20%. Because there was no evidence of a significant contraction of the money supply many economists, including several who were money supply advocates (monetarists), came to believe that Volker talked more about money growth in order to disguise the fact that he was driving the federal funds rate to new heights.

Second, the relationship between money and nominal GDP, which economists call “the velocity of money,” suddenly became unstable and no one could explain why (see Solving the 1980s’ Velocity Puzzle: A Progress Report). This reinforced the perception that inflation was brought down because Volcker drove the federal funds rate to historically high levels. Monetary policy became solely about interest rates and it’s been this way ever since.

Concerned that reducing the federal funds rate alone would be insufficient to stimulate spending, and their belief that monetary policy was solely about interest rates, policymakers kept the federal funds rate target lower for longer in the belief that this would make their interest rate policy more effective.

At the October 1992 FOMC meeting, Edward Boehne, President of the Philadelphia Fed, made this statement which seems to capture the FOMC’s rationale:

It’s an article of faith for anybody who has taken one or certainly two economics classes that lower interest rates are going to be a positive [for] growth, and I’m not quarreling with that orthodoxy. But when one goes out and talks with people in the business community and consumers, one almost invariably runs into the view that lower rates are not the [solution]. If I probe that, an answer I frequently get is: “If I thought interest rates were going to stay down, then lower rates would help. But if you lower interest rates now, I know you’ll have to raise them a few months or a year down the road. Just knowing that rates are going to be down for a short period doesn’t help me because I’m going to have to finance whatever I’m going to buy with this [loan] for 5 or 8 or 10 years.

—The Verbatim Transcript of the October 6, 1992, FOMC meeting, page 8. 

The idea that the Fed’s interest rate policy will be more effective if they keep the federal funds rate at a low level longer was facilitated by the wide-spread belief among many in economics and finance that the long-term interest rate is determined by market participants’ expectation for the short-term rate over the holding period of the long-term security—the so-called Expectations Hypothesis (EH). Policymakers simply ignored these facts: 1) Empirical tests of the EH massively reject it using a variety of long-term and short-term interest rates (including the federal funds rate, see Test of the EH using the federal funds rate. 2) The EH requires market participants to be irrational in that they price the long-term security based on their expectation of the future short-term interest rate, which a mountain of evidence shows they cannot possibly predict, see Predictions of Short-Term Rates and the Expectations Hypothesis.

Policymakers’ conclusion: Keep the federal funds rate lower longer. Of course, this has a chance of working if and only if the slow growth in output is due to a temporary (cyclical) lull in spending. However, if the slow growth is due to the fact that the long-term growth rate of output has trended down, output growth will remain slower no matter what the Fed does. As I pointed out in The Limits of Monetary Policy: Can the Fed Affect Economic Growth?, the growth of output depends on things that monetary policy cannot affect; specifically, the growth rates of labor and capital (man-made factors of production), and technological innovations. Trying to affect long-run economic growth with either lower interest rates or faster money growth is a fool’s errand!

It appears FOMC participants were not aware of the fact that the growth rate of real GDP had been trending down (see Economic Growth). Otherwise, then Governor, Janet Yellen wouldn’t have said “we’re in the midst of a very severe recession—it’s unlikely to end anytime soon” at the March 2009 FOMC meeting (Verbatim Transcript of the March 2009 FOMC meeting, p. 201) just three months before the recession ended (June 2009). Policymakers apparently believed that the slow growth they observed was due to inadequate spending and not to structural changes for which monetary policy is useless. Consequently, they pursued increasingly aggressive interest rate policies in a mistaken attempt to stimulate the economy’s growth rate.

What are the likely adverse consequences of this change?

Economists understand that prices are best determined by the market and that attempts to keep prices artificially low or high distorts the allocation of economic resources.

The interest rate is a price; it’s the price of credit. If interest rates are set too low, this reduces the financing costs of things that are typically purchased by borrowing: homes, cars, and consumer durables, such as TVs and refrigerators. Consequently, the production of these goods could go well beyond what can be sustained when interests return to normal.

Moreover, as we saw during the last financial crisis, some people will incur debt beyond a level that is justified by their income/wealth profile; beyond the level that they can sustain when interest rates return to normal or if they suffer an adverse shock, i.e., becoming unemployed or incapacitated, perhaps even for a short period.

Furthermore, artificially low interest rates hurt retirees and others on fixed incomes. They are forced to either live on a lower income or invest in more risky assets to restore their income level. It also hurts those who are saving for retirement and those managing retirement portfolios, such as pension funds. They too will be forced to invest in more risky investments.

Policymakers also keep interest rates artificially low in an attempt to stimulate spending indirectly by increasing asset prices, such as stock prices. They do solely on the belief that if people feel wealthier they will spend more, the so-called “wealth effect.”

While there is evidence that low interest rates raise asset prices, such as stock, home, and commodity prices, researchers have been unable to find evidence of wealth effects on spending.

In any event, even if it exists, the wealth effect would be ephemeral. It would vanish when interest rates normalize and asset prices return to the level consistent with economic fundamentals.

What is the alternative?

The alternative is to use basic economics and finance facts to guide the FOMC’s policies and its actions. Basic economics shows us that monetary policy cannot affect the economy’s long-run growth rate.

The FOMC’s interest rate policy only can offset temporary, i.e., cyclical weakness in spending. Moreover, controlling interest rates is fixing the price of credit. Both economic theory and experience shows periods of prolong price fixing distorts the allocation of resources in a way that is not sustainable when interest rates return to normal. The longer policymakers keep rates abnormally low or high, the larger the distortion and the larger the problem when rates return to normal.

Moreover, if effective, the FOMC’s low interest rate policy will work with a lag. For example, much of the spending on plant and equipment that businesses might commit to because borrowing costs are low will continue when the recession has ended. For all of these reasons, keeping interest rates low for too long is a bad idea.

There is no reason to believe policymakers are more informed about the appropriate level of interest rates than the market. Consequently, there is no reason the FOMC’s low interest rate policy should be maintained after the recession is over.

If the economy hasn’t responded to the Fed’s interest rate policy within about a year or so, the economy’s problem is likely to be structural rather than cyclical. Policymakers should abandon their low interest rate policy and allow the market to set interest rates.

However, there is a conundrum: If monetary policy is solely about interest rates, the short-run interest rate policy is ineffective and persisting with the same policy results in longer-run damaging effects, what is the alternative?

The alternative is to acknowledge the facts stated above and conduct monetary policy in accordance with them. Doing so would lead the FOMC to adopt what I call economic-reality-based monetary policy (ERMP), see Fixing a Bad System.

Economists have long sought ways to restrain discretionary monetary policy, which they feared would make the economy less, rather than, more stable. Milton Friedman suggested a money growth rate rule. But modern monetary policy is about interest rates not money, so that won’t work.

More recently, economists have urged the Fed to adopt an interest rate rule, such as the famous Taylor rule (here), which requires the Fed to adjust its federal funds rate target mechanically with changes in the inflation rate and the gap between actual output and the Fed’s estimate of potential output. Indeed, many prominent economists, including several Nobel Prize winners, have signed a letter urging Congress to make the FOMC implement monetary policy using a specific interest rate rule. I pointed on in Chapter 7 of The Oxford Handbook of The Economics of Central Banking, this won’t happen for a variety of reasons, not the least of which is, like Friedman’s rule, it allows little room for discretion.

Instead, ERMP only requires the FOMC to conduct its monetary policy within the limits imposed by basic economic and financial market realities such as the ones described in this essay.

This would impose limits on the actions the FOMC could take, while maintaining a reasonable amount of discretion. This would make it more difficult for the FOMC to bailout the mortgage market, corporations and municipal governments under the guise of monetary policy.

Importantly, the FOMC would find it more difficult, if not impossible, to maintain an aggressively easy monetary policy for a lengthy period after a recession had ended. ERMP would result in constrained discretion and avoid the excessively aggressive monetary policies that have characterized monetary policy since the late 1980s when the FOMC began using the federal funds rate as its policy instrument. 


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.