“Fed Self-Evaluation: Marking Monetary Policy to Model”

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

It has been frequently charged that the Fed, under Alan Greenspan and Ben Bernanke, kept interest rates too low for too long, contributing to bubbles in the stock, credit and real estate markets. The Fed has repeatedly denied that this is the case. The arguments, while presented with conviction, remain unsatisfying.

For example in a recent blog posting, an official at one of the Reserve Banks joined the chorus in arguing that monetary policy was not to blame. He presented a chart of the actual Fed funds rate and an estimate path for the Fed funds rates based on measures of inflation, actual output relative to potential output, and the lagged Fed funds rate for the period 1988-2009.

The estimated and actual rates never diverge by very much. (The author explicitly disavows calling his formulation a “Taylor Rule”. Perhaps it is because John Taylor has stated that the Taylor Rule correctly formulated indicates that the Fed funds rate was too low too long.)

The author then draws the following conclusion:

..whatever the underlying structure of policy decisions, after the fact the FOMC appears to have behaved in an extraordinarily consistent way over the period extending from the late 1980s. This observation, in turn, suggests to me that there was nothing all that unusual about monetary policy in 2003 once you account for the state of the economy. Which leads me to my main point…: If you are of the opinion that interest rate policy was good through the late 1980s and 1990s, then there seems to be a good case the FOMC was just sticking with “proven” success as it set interest rates through the dawning of the new millennium.

In its bare bones form, the argument is simply:

1. this policy regime was appropriate in prior years (late 1980s and 1990s);
2. the policy regime was unchanged;
3. therefore the policy regime must have been appropriate during the period in question (2002-2007).

I suggest that the Fed official talk with the fellows from LTCM. They back-tested their models during periods that include the late 1980s and early to mid 1990s and they did well—for a while. I suggest that the policymaker talk to the financial engineers who structured mortgage backed securities and portfolios based on the historically accurate premise that house prices had not fallen on a national basis since the Great Depression (as opposed to just the late 1980s and 1990s). They also did well –for a while. The list goes on.

The author does acknowledge that macroeconomics and policy has not kept pace with changes in financial markets:

…prior to 2007 it was not at all clear that detailed descriptions of how funds moved from lenders to borrowers or how short-term interest rates are transmitted to longer-term interest rates and capital accumulation decisions were crucial to getting monetary policy right. Models without such detail tended to deliver policy decisions not far from the sort depicted above, and, as I noted, they seemed to be working quite well in terms of macroeconomic outcomes.

However, the underlying argument is unchanged. This policy regime was consistent with “getting monetary policy right” in the past. Hence it cannot be responsible for poor outcomes in the present. Given the nature and the pace of recent change in:

1. the US financial sector,
2. the US external position and trade competitiveness,
3. the role of imported disinflationary pressures, and
4. the savings behavior of households

choosing a policy regime because it “got” it right in the late 1980s and 1990s is/was like trying to drive a car by looking through a telescopic rear-view mirror.

Furthermore, by what measure did policy get it right during the period 1988-2002? From 1996 to 2001, we had an economy supported by an unsustainable bubble in stock prices, growing external imbalances and a decline in the household savings rate while measured inflation was held down by imported disinflation. Toss out the Tech bubble years and the author’s base period is down to 1988-1995, which includes one recession. For much of the time in the expanded time horizon (1988-2009), the US economy was either in recession (1990, 2001, 2007), experiencing asset bubbles (1996-2000 and 2002-2007) which eventually burst causing economic dislocation, or enjoying a jobless recovery.

Throughout the discussion of the merits of Fed policy, I get the sense that the Fed wants to be Marked-graded-to-Model (of its own choosing) as opposed to the actual economic outcome. The Fed does appear to have done a credible job when the chosen metric is how closely the actual Fed rates tracks an estimated Fed funds rate (based on one or another variant of the Taylor Rule). However, when the metric is one that includes concerns such as sustainability of growth, external balance, and financial stability, as well as the output gap and inflation, it does not.

The Fed was quick to take credit for the “Great Moderation” and the longest economic expansion in US history, but now the Fed portrays itself as an innocent victim of circumstance. It is almost as if the Fed sees itself as a comic book super hero, endowed with powers that can only be used for good.

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  1. fresno dan

    1st, I agree.
    But, as much as i love to bash the Fed, one has to see that we all enjoyed the drinking with no thought to the hangover.
    I read something the other day that was just heart wrenching – a 65 year old woman working a couple of jobs so that she wouldn’t lose her home. She had refinanced. What for wasn’t stated, but I assume that if she has more than one job she must be pretty healthy.
    But somewhere along the line, being prudent, doing without, living within your means, went out of style.
    We’re gonna get poorer, because much of our “wealth” was debt (homeOWNER??? No, mortgage payer), and our income borrowing. Our assets were a chimera, inflated by easy money.
    My only fear is that trying to keep the BMW, granite countertop, hamster wheel going is that it will make the readjustment take longer, and be even more painful.

    1. DownSouth

      fresno dan,

      You say “we all enjoyed the drinking with no thought to the hangover.”

      When you say “we,” you must be talking about the top 10% of earners, and especially the top .001%.

      Other than those at the top, pretty much everyone else seems to have come up sucking hind teat over the last 30 years.

      Sure, the bottom 90% were allowed to substitute household income with borrowing, household wealth with debt. But this was a cruel sleight of hand that merely replaced reality with illusion.

  2. jake chase

    Now, if the Fed can just maintain a stock market bubble without generating real economy profits or a viable housing market, consumers can use their equity profits to repair their credit and resume buying Chinese drek. Perhaps cheap money can keep things humming for another five or ten years without manufacturing anything in America except fraudulent statistics?

  3. ndk

    Perhaps it is because John Taylor has stated that the Taylor Rule correctly formulated indicates that the Fed funds rate was too low too long.

    So far as the economic mainstream is concerned, Taylor is as daft as Laffer, and their names are applied to general concepts rather than specific formulae. Though you’re likely right in this instance, I suspect the general reticence to acknowledge the use of the rule is a desire to preserve flexibility and autonomy rather than any direct issue with the rule or Taylor.

    Furthermore, by what measure did policy get it right during the period 1988-2002?

    The one that balances their dual mandate: lowering inflation as measured by CPI/PPI, and keeping employment high. Asset pricing was never part of their mandate. I’m gratified to see many other central banks around the world recognizing the importance of asset pricing for economic stability and consistent growth after watching Alan, Benny, and Mo here in America. I think there will be deep meditation on the Fed’s own mandate domestically following this latest adventure, but we’ll see.

    Separately, I’m obsessed with the decline in the equilibrium real interest rate that occurred over the same period in America. Krugman has observed that a neutral FFR by the Taylor rule is now -6%. This decline is even roughly visible in your graph of nominal rates.

    I don’t think imported disinflation is enough to explain away all the decline in neutral rates, given the small size of America’s import/export sectors, and it does little to explain away the decline in neutral real rates. Our CA deficits are shrinking and mostly oil at this point.

    It’s my contention that repeated use of monetary policy to “cure” recessions causes this decline in equilibrium real interest rate, a more insidious effect of chain recession fighting.

    By encouraging (or preserving) investment and consumption that would not have occurred in a less managed rates environment, aggregate demand is artificially managed upward.

    Savings contracts. As a result of the increased/preserved investment and increased apparent demand, supply increases as well to match a demand level that is unsupported by underlying incomes.

    This encouragement of excess investment and consumption and preservation of bad debts that would have defaulted in recession also leads to an increased total debt load, e.g. financial deepening. Excess financial depth relative to GDP is pretty clearly dangerous beyond a certain point, not to mention the risk-taking the “Greenspan Put” inspires.

    Done enough times in a row, we might expect to end up with an economy very similar to the ’05-’07 period. Or now.

    As demand attempts to revert to equilibrium levels in the face of increased supply, or actors try to return to equilibrium savings, the equilibrium real interest rate tends to fall. Until you go below zero. Then things get tough. I think we’re pretty clearly there, and I expect to be there for awhile.

    I don’t deny the power of recession fighting through monetary policy. It’s clearly very effective. I do question its wisdom when applied lovingly, tenderly, and asymmetrically as Greenspan and Bernanke have done. Not just for the asset bubbles, but much more for the artificially increased demand, supply, huge debt loads, and depressed equilibrium real interest rates it creates.

  4. joebhed

    The Fed’s MAJOR role is to prevent financial instability.
    It is also charged with promoting econmic stability and full employment.
    In the economy, as we know it.
    How’re they doing?

    Given that the M-3 (equivalent ShadowStats) has grown about 13 percent annually since they stopped keeping track, and given that ALL money has equivalent “cache” ultimately, what the frig difference does it make what the Fed Funds rate was?

    In the meantime, the shadow-banking community was running up enormous IOUs (more than the commercial banks) that are eventually bills to the US taxpayer and the US economy.

    Please, Yves, don’t pay too much attention to that middle shell.
    It’s the money SYSTEM that is breaking down – not the commercial banking sector.

    The Money System Common.

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