naked capitalism

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

Low rates have a more powerful effect on driving financial assets than on driving the economy.
-Jeremy Grantham, GM0 Quarterly Letter January 2010

There has been a long-standing debate among economists and policymakers over whether or not monetary policy should reflect concerns about financial stability. One side has argued that monetary policy and stability policy are inexorably intertwined and that at times monetary policy must reflect the goal of financial stability. The other side has argued that monetary policy should address price stability only while regulatory policy addresses any financial stability concerns. Recently, Olivier Blanchard, chief economist at the IMF and a proponent of inflation-only targeting, scored an “own goal” (scored a point against his own position), even though neither he nor other proponents of inflation-only targeting seem to have noticed.

The most salient points of the recent piece by Olivier Blanchard are presented here. The Blanchard position represents a significant shift in that it acknowledges trade-offs and interplay between monetary policy and financial stability policy. Subsequently, it will be shown that Blanchard scored something of an own goal by proposing a target for inflation that is inconsistent with price stability, which remains the primary rationale of Taylor Rule-driven monetary policy.

From Blanchard et al’s “Rethinking Monetary Policy”:

What we thought we knew
To caricature: we thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job. . And we thought of financial regulation as mostly outside the macroeconomic policy framework. ..

One target: Inflation

Stable and low inflation was presented as the primary, if not exclusive, mandate of central banks. This resulted from … the intellectual support for inflation targeting provided by the New Keynesian model. In the benchmark version of that model, constant inflation is indeed the optimal policy, delivering a zero output gap, which turns out to be the best possible outcome for activity given the imperfections present in the economy. …There was also consensus that inflation should be very low (most central banks targeted 2% inflation).

One instrument: The policy rate

Monetary policy focused on one instrument, the policy interest rate. Under the prevailing assumptions, one only needed to affect current and future expected short rates, and all other rates and prices would follow. The details of financial intermediation were seen as largely irrelevant. An exception was made for commercial banks, with an emphasis on the “credit channel.”…. Little attention was paid, however, to the rest of the financial system from a macro standpoint.

Financial regulation: Not a macroeconomic policy tool

Financial regulation and supervision focused on individual institutions and markets and largely ignored their macroeconomic implications. Financial regulation targeted the soundness of individual institutions and aimed at correcting market failures stemming from asymmetric information or limited liability. Given the enthusiasm for financial deregulation, the use of prudential regulation for cyclical purposes was considered improper mingling with the functioning of credit markets.

What we have learned from the crisis

• Macroeconomic fragilities may arise even when inflation is stable
Core inflation was stable in most advanced economies until the crisis started. Some have argued in retrospect that core inflation was not the right measure of inflation, … But no single index will do the trick. Or, as in the case of the pre-crisis 2000s, both inflation and the output gap may be stable, but the behaviour of some asset prices and credit aggregates, or the composition of output, may be undesirable.

• Low inflation limits the scope of monetary policy in deflationary recessions
When the crisis started in earnest in 2008, and aggregate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further. But the zero nominal interest rate bound prevented them from doing so. Had pre-crisis inflation (and consequently policy rates) been somewhat higher, the scope for reducing real interest rates would have been greater.

• Financial intermediation matters
Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when some investors withdraw (because of losses in other activities, cuts in access to funds, or internal agency issues) the effect on prices can be very large.

• Regulation is not macroeconomically neutral

Financial regulation contributed to the amplification that transformed the decrease in US housing prices into a major world economic crisis. The limited perimeter of regulation gave incentives for banks to create off-balance-sheet entities to avoid some prudential rules and increase leverage. Regulatory arbitrage allowed some financial institutions to play by different rules from other financial intermediaries. Once the crisis started, rules aimed at guaranteeing the soundness of individual institutions worked against the stability of the system. Mark-to-market rules, coupled with constant regulatory capital ratios, forced financial institutions into fire sales and deleveraging.

Implications for policy design

The bad news is that the crisis has shown that macroeconomic policy must have many targets; the good news is that it has also reminded us that we have many instruments, from “exotic” monetary policy to fiscal instruments, to regulatory instruments. … Stable and low inflation must remain a major goal of monetary policy.

The following are important questions for economists to work on.

Exactly how low should inflation targets be?

The crisis has shown that large adverse shocks do happen. Should policymakers aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? Are the net costs of inflation much higher at, say, 4% than at 2%, the current target range?….

How should monetary and regulatory policy be combined?

Part of the debate about monetary policy, even before the crisis, was whether the interest rate rule, implicit or explicit, should be extended to deal with asset prices. The crisis has added a number of candidates to the list, from leverage to measures of systemic risk. This seems like the wrong way of approaching the problem. The policy rate is a poor tool to deal with excess leverage, risk taking, or apparent deviations of asset prices from fundamentals. A higher policy rate also implies a larger output gap….

it follows that the traditional regulatory and prudential frameworks need to acquire a macroeconomic dimension. This raises the issue of how coordination is achieved between the monetary and the regulatory authorities. The increasing trend toward separation of the two may well have to be reversed. Central banks are an obvious candidate as macroprudential regulators.

Blanchard’s blog post reveals how much the financial crisis of 2007 and its aftermath have changed the thinking about monetary and financial stability policy. Monetary policy and financial stability policy are now seen to be intertwined even by those who would continue to adhere to a Taylor-type rule to set official rates. Monetary policy is now seen as operating through a complex system of potentially fragile financial markets and consequently having implications for financial stability. Regulatory and supervisory systems are viewed as having macroeconomic dimensions.

This economist/policymaker mea culpa, however, quickly went off the tracks. The proposed revised monetary policy regime is the same as the initial regime he caricatured (as “that we thought we knew” one target, one tool) save for the 200 bps increase in the target rate of inflation. Blanchard calls for a combination and coordination of monetary and regulatory policies. However, Blanchard knows the details, down to the last basis point, of how monetary policy should be recast while the complementary changes in the regulatory regime are still very much up in the air.

Blanchard: “The crisis has shown that large adverse shocks do happen. Should policymakers aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks?” Silly me. I thought that the US economy and financial system got where they are today because of large, unsustainable economic imbalances and a complex/overleveraged/interconnected fragile financial system that had built up over time and collapsed when the housing market rolled over, but not because a large adverse shock.

Does Blanchard think that an additional 200 basis points of ease could insulate the financial system and the real economy from the unwinding of unsustainable economic imbalances of the same magnitude in the future? Blanchard is incapable of generalizing the lesson of the current crisis, i.e., it is better to lean against large imbalances and unsustainabilities then to clean up after them. He would still have central banks ignore everything but inflation and the output gap until the imbalances and unsustainabilities correct.

Blanchard has not combined monetary and regulatory policy. He just altered the central bank mandate, ending the requirement that it pursue stability

Blanchard asserted that the central banks pre-2007 inflation targets were too low (“most banks targeted 2 %”) to allow for sufficient room to ease. Too low relative to what?

Blanchard has put the cart before the horse. A 2% inflation target is not too low relative to the real goal of policy — price stability — which has always been defined as a rate of change in prices slow enough to leave economic behavior unaffected. On the other hand, a 4% inflation target is clearly too high to be consistent with price stability. At a 4% inflation rate, prices double about every 18 years. As a result, and given life expectancies, US baby boomers would on average live long enough after retirement (65) to see the price level more than double. Inflation of 4% will most certainly affect the way a wide variety of economic agents behave.

Preserving an elegant Taylor rule is evidently more important to Blanchard than is achieving price stability. If adopted, the Blanchard proposal will reveal the policy regime to be bi-polar and dysfunctional. Prior to 2007, monetary policy was designed and executed solely to produce price stability with not so much as an episodic deviation to backstop the regulatory system or address any other concern. Now Blanchard proposes that monetary policy pursue something significantly less than price stability in order to allow it more room to episodically respond after the fact to large adverse shocks. However, the monetary authorities were always free to respond after crises hit and output gaps opened up and 200 bps is unlikely to insulate the real economy from structural imbalances. In 2007, the Fed started cutting from 5.75%. The BOJ started its 1990 ease cycle from 8.75%. Hence the only real change under the Blanchard proposal would be the acceptance of higher inflation.

The primary goals of monetary policy should remain price stability and economic growth. However, given that regulatory reform will be the result of a lobbyist-dominated political process and the history of regulatory systems is littered with failures, relying on regulation alone would be mistake. A regulation-only approach to financial stability will only succeed until circumstances that again allow financial institutions to game the system. Alternatively, it is possible that a central bank — actually concerned with economic imbalances and financial stability — could episodically alter interest rate policy to take the wind out of the sails of credit-driven asset price bubbles that pose systemic risks. It could buy regulators time to catch up with regulation-avoiding market innovations that threaten the stability of the financial system. Would it be a perfect tool? There are no perfect tools.