Yves here. This post is a devastating critique of current Fed policy. But Alford sets his stage carefully before delivering his conclusions, so don’t be deceived by the tone of the early sections.
By Richard Alford, a former New York Fed economist. 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
In the last two years, some economists and even current policymakers have acknowledged that interest rate policy and financial stability are connected. They’ve also admitted external factors can have have a significant impact on US economic performance. However, economic policy itself still ignores these issues. Today, US monetary policy is based on a very narrow interpretation of the Fed’s legal mandate. The central bank pursues price stability and full employment without considering possible negative feedback loops via the financial markets or from abroad.
Policymakers Admit Financial Stability Matters to Monetary Policy, but…
More and more economists recognize that monetary policy plays a role in financial fragility and crisis. Yet, most Fed officials have failed to acknowledge the contribution of US monetary policy to the financial crisis of 2007. They also deny the possibility that policy since the crisis could be stoking financial vulnerability in the US and/or abroad.
In a recent op-ed piece, Adair Turner, former Chairman of the UK’s Financial Services Authority, discussed how accelerated rates of credit creation affects economic growth and economic and financial stability:
In fact, much credit growth is not critical to economic growth, because it does not play a direct role in financing consumption or investment. Economics textbooks often describe how households deposit money in banks, which lend to businesses to finance capital investment…– this story is largely fictional, because such lending accounts for only a small share of the total.
Instead, a large part of bank lending finances the purchase of existing assets, particularly commercial or residential real estate, the prices of which primarily reflect the value of the underlying land. Such existing-asset finance does not directly stimulate investment or consumption. But it does drive up asset prices, causing lenders and borrowers to believe that even more credit growth is both safe and desirable.
Lending to finance existing assets, primarily in real-estate markets, can thus play an asymmetric role in the real economy. While it has little impact on demand, output, and prices during the boom, it results in debt overhang, deleveraging, and depressed demand in the post-crisis period.
These observations are consistent with both the idea that monetary policy affects financial stability and with US monetary policy having contributed to the financial crisis of 2007. They also suggest an unfavorable trade-off: growth accelerates in economic growth during a long-lived, credit-driven boom but suffers in the subsequent bust due to deleveraging and depressed demand.
Paul Tucker, former Deputy Governor for Financial Stability at the BOE and currently a Senior Fellow at both the Harvard Kennedy and Business Schools, recently gave a speech directed at least in part at US policymakers. While the subject of the speech was macroprudential policy, capital controls and the international monetary system since the crisis of 2007, he made a number of observations pertinent to the analysis of the role of US policy in the run-up to the crisis. He also highlighted the international dimension of both the crises and the policy response:
The 2007/08 financial and economic crisis prompted a large and obviously overdue overhaul of an international economic system that had proved fatally frail. The official sector set up two programmes. One, entrusted to the Financial Stability Board, was to overhaul the rules of the game for the financial system itself….
The other was to reform the International Monetary System (IMS) itself, whose flaws had led to unsustainable global macroeconomic imbalances…
In focusing on the shortcomings of the global policy response, Tucker went on to repeat the point made by then Secretary of State Schultz in 1972 that surplus countries are unwilling to adjust policies to reduce global imbalances:
The collective reforms of the financial system have made good progress, while the top-down efforts on the IMS got nowhere slowly. That is basically because G-20 officials got stuck on the inevitable issue of how to get to a world of more symmetric adjustment to cumulative current account deficits. Guess what, the surplus countries didn’t want to play ball.
While Tucker, highlighted the role of surplus countries in the trade imbalances and the resulting net capital flows prior to and post the crisis, this does not relieve the US of a share of the responsibility for the crisis, as it ran a policy mix, including stimulative monetary policy, that encouraged the growth of the global imbalances. Both the US and its trading surplus counterparties were willing partners in a dance that could not end well. Policymakers in all countries failed to address the imbalances.
Tucker also devoted a healthy portion of the speech to the role of gross financial flows. While the net international capital flows offset trade deficits, the gross capital flows also reflected the financing and purchase/sale of financial assets, e.g., purchase of US MBS funded by the sale of short-term dollar- denominated securities by non-US based market participants. He presents the argument in terms of gross flows to EMEs as wells as to developed countries:
For anyone familiar with financial markets, a prevalent trading strategy and a key mechanism behind short-term price developments has long been the cross-border, cross-currency carry trade. But until recently, this was frequently met with disbelief in official circles — because how could anyone bet rationally against uncovered interest parity (sic) — and neglected amongst academic macroeconomists. That myopia impoverished debates about the IMS…
Reinforcing a point made by Borio and Disyatat in 2011, Tucker places the gross capital flows at the center of international financial disruption post-Lehman:
The common thread is a vulnerable, fragile liability structure in part of the national balance sheet…
The importance of the pattern of gross capital flows and of the structure of the national balance sheet should not get lost again…
Time and again policymakers have had to be reminded that gross capital flows matter as well as net flows. (Editor’s note: Could Tucker be gently chiding US policymakers who repeatedly cited the net flows arising from the Asian “savings glut”, but never cited gross capital flows when discussing interest rates and quality spreads in the US capital markets?) In the 1990s Asian crisis, the sectors under pressure varied according to who had borrowed short term in foreign currencies in external markets…. In the early stages of the current crisis, for example, Euro Area (EA) central banks borrowed dollars from the Fed to on-lend to needy local banks, even though the current account position of the currency-area as a whole was broadly balanced. The dollars were lent as the vulnerabilities in Europe would otherwise have flowed back violently to the US, just as the US subprime crisis had spilled over to Europe in the first place. The balance sheet weaknesses were intertwined…
US Policymakers Still Set Policy As If the US Were a Closed Economy
Federal Reserve Bank of New York President Dudley recently gave a speech in which he acknowledged that US economic policy, specifically monetary policy, can affect the financial markets and economies of other countries, especially emerging market economies:
“…Changes in Fed policy, and especially moves in the past to tighten monetary policy, have often created challenges for emerging market economies (EMEs)… given the role of the dollar as the global reserve currency, the Federal Reserve has a special responsibility to manage policy in a way that helps promote global financial stability.
…Like other central banks, our monetary policy mandate is domestic. But, our actions often have global implications that feed back into the U.S. economy, and we need to always keep this in mind. We also need to be careful not to underestimate the consequences of our actions… when all of the indirect channels of feedback are aggregated properly—which admittedly is difficult to do—the effects may be considerably larger. My point is that we tend to underestimate these feedback effects. “
We are mindful of the global effects of Fed policy. Promoting growth and stability in the U.S., I believe, is the most important contribution we can make to growth and stability worldwide.
… The fundamental issue is whether U.S. monetary policy has helped support our dual objectives of stable prices and maximum sustainable growth and whether this is consistent with a healthy global economy….
Federal Reserve Bank of Dallas President Richard Fisher gave a similar speech that was reported in the WSJ Blog, “Real Time Economics,” January 31, 2014. The blog provided some background and excerpts from Fisher’s speech:
The Fed’s decision came amid heavy turbulence in emerging markets. There, the reality of reduced Fed stimulus and an end to bond buying some time later this year, is causing severe market volatility. The stress has been great enough some market participants have argued the Fed should refrain from further cuts in stimulus so as to help calm these markets and reduce the chance their woes will inflect the U.S. financial system.
Mr. Fisher observed “some believe we are the central bank of the world and should conduct policy accordingly.” But that’s not true: “We are the central bank of America” and need to pursue actions that promote the mission Congress has charged the Fed with, he said.
Other nations have their own central banks that have “their own responsibilities,” the official said. Mr. Fisher added “we try to help each other” but “we are mandated to meet certain standards Congress gives us.” Other nations “have to figure out” how to deal with their own issues, he said.
These comments suggest that Fisher sees a dichotomy. Either the Fed sets policy as if US economic performance is entirely driven by domestic economic developments, or it violates its mandate. The dichotomy is a false one. As Dudley pointed out, the US is not a closed economy. Any US economic policy that does not reflect possible interactions and feedback loops between the US and the rest of the world is unlikely to deliver sustained price stability or full employment in the US.
However, the tone of Dudley’s speech and the absence of any objections from FOMC members to Fisher’s speech imply that the FOMC would see any Fed involvement in an internationally coordinated policy effort aimed at reducing the global imbalances as a violation of its mandate. (This assumes that the coordination would entail monetary policy that tolerated larger deviations from the inflation and employment target implied by a policy that focused exclusively on those targets.) In fact, Dudley’s and Fisher’s speeches can be viewed as a restatement of the view expressed by the FOMC in June of 2004 when, despite acknowledging the existence of an unsustainable current account deficit it said:
Monetary policy was not well equipped to promote the adjustment of external imbalances, but could best contribute to maintaining an environment of price stability that would foster maximum sustainable economic growth.
There is a shortcoming inherent in the FOMC’s position both in 2004 and presumably today, given Dudley’s and Fisher’s remarks. The FOMC is correct in that monetary policy is an inappropriate tool to promote the adjustment of an external imbalance. However, if sustainable growth is a goal and an external imbalance is unsustainable, then it is also inappropriate to set monetary policy as if the external balance does not exist or is being addressed by some other policy.
The US domestic-only policy focus raises an additional hurdle for international policy cooperation. The focus gives license to countries with trade surpluses to refuse to alter their policy mix to reduce their surpluses. Why should they change their chosen policy mix and miss hitting their domestic targets at the request of the US (and other trade deficit countries) if the Fed and the US will not alter policy and sacrifice hitting their domestic targets?
The US and other trade deficit countries have long complained about the asymmetric burden of adjustment to correct global imbalances. However, Fisher’s position, and presumably the position of the majority of the FOMC, is extreme. His comments suggest that he would not be satisfied even if the asymmetry was removed. His statement indicates that in order to satisfy him, the asymmetry would have to be reversed with all the burden of adjustment falling entirely on the surplus countries. Given history, this position renders any effort at global cooperation a non-starter and suggests that there will be no policy on anyone’s part to address global economic imbalances.
Trade deficit countries also have reason to object to this position. Reserve currency status has often been referred to as the “exorbitant privilege,” as it confers a host of benefits, e.g., lower interest rates and a greater degree of freedom to pursue domestic policy objectives, as well as generally lower volatility in the exchange rate and inflation. Fisher’s positions suggest that the Fed and the US still look upon the reserve currency status of the Dollar as a “free lunch”, i.e., benefits with no attendant policy constraints or responsibilities. Other countries may have reasonably assumed that the reserve currency status implied some obligation on the part of the US to set policy in a manner that is consistent with US external balance and that does not undermine global financial stability.
The speeches and the FOMC’s comment in 2004, reveal exactly how far the Fed has come since 1967 when then Chairman Martin gave his “International Responsibilities of the Federal Reserve” speech at the Guildhall in London. Fisher’s comments, in particular suggest that the Fed, as the bank of issue of the world’s reserve and principle trade financing currency, bears no responsibility to consider global economic or financial stability in the setting of policy. The most disturbing aspect is that Mr. Fisher totally ignores Mr. Martin’s point: it is in the interest of the US to set policy consistent with global economic stability, not because of altruism, but because global economic stability is in the long-run self interest of the US.
Should the Fed now refrain from setting policy that reduces US and global financial riskiness because it causes dislocation in some markets? No. However, the Fed, the US and the global economy would not be in the position that they are in had the Fed not set policy prior to 2007 as if the US were a closed economy and had considered the implications of the announced low-for-long policy stance for domestic and global financial stability.
Given the closed economy mentality, it is not surprising that US policymakers have also failed to learn from the experiences of other countries. In 2002, Bernanke said the US would avoid a Japan-like crisis and lost decades with slow growth and elevated rates of unemployment. However, since 2006 the US has experienced a financial crisis, a severe recession and an unsatisfactorily slow recovery. While the US and Japanese economic policy responses have not been identical, they have been very similar.
After two decades of failed counter-cyclical stimulative monetary and fiscal policy, policymakers in Japan have called for a policy mix that has been dubbed the “three arrows,” i.e., stimulative monetary, expansionary fiscal policy, and a laundry list of growth supporting structural reforms (including an as yet failed effort to stimulate exports).
In contrast to the “three arrows’ approach in Japan and despite Bernanke’s statement in July of 2011 that monetary policy is no panacea, Fed policymakers are still acting as if monetary policy is a panacea. The Fed is still setting policy with an eye to promoting a satisfactory monetary policy induced sustained recovery even though there are no proposed structural reforms to speak of, e.g., no trade, Dollar or competitiveness policies, and with fiscal policy largely a captive of inherited levels of debt and political paralysis.
Policy and the Dual Mandate
The recent comments made by Dudley acknowledge that international considerations and financial stability concerns should enter the policy calculus. However, he and Fisher argue that a successful focus on the Fed’s dual mandate is the best contribution that the Fed can make to global economic and financial stability.
The problem with that position should be obvious. The Fed succeeded in achieving price stability and full employment in the years just prior to the financial crisis of 2007, but policy also encouraged unsustainabilities and fragilities, including:
• the growth of the unsustainably large trade deficit,
• the dependence of growth on housing price appreciation to drive consumption and residential real estate investment,
• the growth of debt relative to GDP,
• the increased and use of leverage and maturity mismatches by financial institutions and households, and
• the reaching for yield by investors
that in turn brought on the crisis and recession.
If post 2000, the Fed had interpreted its mandate to require it to set policy based on:
1. The premise that the US is an open economy and that large external imbalances are inconsistent with sustainable growth (The US trade deficit in 2006 was 5.5% of GDP);
2. A goal of promoting a sustainable pattern of demand i.e. final sale to domestic purchasers equal to estimated potential output (with trade and Dollar policy responsible for external balance – hence the equating of aggregate demand with final sales to domestic purchasers); and
3. The recognition that interest rate policy has implications for financial stability,
1. Other US policymakers would have had greater incentive to address the global trade imbalances via trade, competitiveness and exchange rate adjustments;
2. Both the trade deficit and the net capital flows would have been smaller;
3. The higher short-term Dollar interest rates would have reduced investors’ willingness to reach for yield by investing in lower-quality assets classes;
4. The interest rate stance would have reduced the incentive for US financial institutions (regulated and non-regulated) to leverage up and run maturity mismatches;
5. The interest rate stance would have reduced the incentive for non-US financial institutions to run maturity mismatches in Dollar markets;
6. The interest rate stance would have reduced the incentive for financial institutions to use short-dated Dollar borrowings to fund longer-dated position in non-Dollar asset markets.
As a result, the real global economic imbalances, as well as the net and gross capital flows would have been smaller. Financial fragility would have been less. There would have been costs. Unemployment would have been higher in the US and growth would have been slower during the expansion, but, at a minimum, the crisis and recession would not have been nearly as deep or as intractable, if not avoided entirely.
The crisis and recession of 2007 is not the only example of financial crises and recessions that followed periods of price stability and low inflation rates. The “lost decades” in Japan followed a period of stable growth with low inflation and unemployment. The Great Depression in the US followed a period of strong growth and low inflation.
History aside, the continued adherence to the narrow interpretation of the Fed’s dual mandate is not without risks. The current policy mix is again promoting the same unsustainable pattern of demand as existed prior to the crisis of 2007, i.e., 1) high levels of consumption relative to income (a low savings rate), and 2) investment in the housing sector, while real non-residential investment remains subdued, as well as 3)the reaching for yield by investors.
Furthermore, the trade deficit, while a smaller fraction of GDP than in 2006, is still unsustainable and at a minimum is a significant fraction of estimates of the US output gap. According to the BEA, the trade deficit in 2013 was 3.0% of GDP. In a brief piece published in February of 2014, Weidner and Williams updated the results of their 2009 piece: “How Big Is the Output Gap?” It presented seven estimates of the output gap, all of which employ different methodologies and data sources. The update reflects new and revised estimates. The estimates of the output gaps (as a % of GDP) for 2013Q4 are:
CBO output-based -3.8
Capacity utilization -2.1
CBO unemployment–based -2.5
Job market perceptions -3.0
Business survey -1.3
Job vacancies -1.0
Hence, the trade deficit, as reported by the BEA, is in most cases larger than the output gap (ignoring the negative signs) and at least 75% of the estimated output gaps as reported by Weidner and Williams. Even if one assumes a larger output gap, the trade deficit will remain a substantial fraction of it. Yet any effort to correct the trade deficit is conspicuous in its absence.
The FOMC is setting monetary policy as if the output gap were solely a reflection of a deficiency in domestic animal spirits. Policy remains focused on promoting demand, i.e., offsetting the unsustainable trade deficit by further encouraging the growth of consumption relative to GDP. This is despite the fact that consumption is already well above historical norms as a fraction of GDP. Furthermore, the almost exclusive reliance on monetary policy implies that asset prices, quality spreads, and the use of leverage are approaching levels last seen just before the crisis of 2007.
Policy has not evolved in light of the crisis of 2007 and the recession. Fed policymakers continue to adhere to a narrow and myopic interpretation of the dual mandate. This interpretation allows policy to 1) encourage domestic and global financial instability, and 2) to promote unsustainable patterns of demand and growth.
Policy did not solve a problem during the Great Moderation, but rather traded a then-current problem for a future problem. There is a risk that it is doing it again. In the absence of effective regulatory, Dollar and competitiveness policies, the US will experience crises in the future if, Fed policy only reflects international considerations and financial stability concerns at times of crisis.