The limits of monetary policy, part 1
Editor’s note: This is the first of a two-part post on monetary policy. Part two can now be read here.
On Thursday, Philadelphia Federal Reserve President Charles Plosser gave a speech called “A Limited Central Bank” that I highly recommend. The underlying theme of Plosser’s speech was that central banks should have a limited role but that they are being called on to do ever more. Below I want to expand on this theme in view of comments from Larry Summers on central banks and secular stagnation.
I had this post teed up to write on Friday before I had even heard about Larry Summers’ comments on secular stagnation and monetary policy. But his comments give this topic extra importance because it demonstrates that – contrary to what I write here – policy makers see monetary policy as the only effective game in town. As a result, I expect monetary to remain loose for an extended period with large unintended consequences, some of which I will delineate below. This is a large topic so I will split this post up into two parts to give the subject a fuller treatment. This one is outside the paywall.
Before I start in with Plosser or Summers, let me give you my view, as I have espoused it over the years at Credit Writedowns.
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”
-The Federal Reserve Act, as amended in 1977 by the U.S. Congress
Despite the Fed’s mandate to concentrate on the “economy’s long run potential”, the truth is that most policy makers in the U.S. and elsewhere are concerned with maintaining the right levels of inflation, growth and employment only over the medium-run, say one to two years. I believe this focus on the short- to medium-term is what has caused a large build-up in credit aggregates in developed economies relative to GDP as well as repeated financial and economic crises, including the present one. Given the policy response to this crisis and the noises policy makers like Summers are making, I expect the concern with the short- to medium-term to continue.
Two examples of this kind of thinking that comes to mind immediately are the two papers released by Federal Reserve economists which will be used to give intellectual cover for continued policy accommodation by the Fed. The first paper by David Wilcox (pdf here) makes a hysteresis argument, meaning that it argues that things that happen now and in the medium-term will have long-lasting consequences. So Fed policy should be aggressive in trying to help eliminate those short-to medium-term problems. Wilcox argues specifically that elevated cyclical (short- to medium-term) unemployment is turning into a structural (long-term) problem. And so the Fed should be more accommodative to stop this. I think this concept that structural unemployment has increased due to the severity of this downturn has merit. But it is not clear to me that accommodative monetary policy is a proper tool to counteract this phenomenon. However, I do note the emphasis on the shorter-run over the longer run because I see this as an outgrowth of shorter-term thinking, shorter-term capture, if you will.
In the second paper (pdf here), William English argues that the Fed should keep an official threshold for its accommodative stance until unemployment reaches 5.5% instead of the present 6.5% threshold. While English’s argument is less overtly predicated on stressing the short-to medium term, his argument is basically that longer-term relationships between macro-economic variables have broken down so we need to be extra loose now in the short- to medium-term in order to counteract this. Again, I see this type of argument as an outgrowth shorter-term capture borne of frustration with the Federal Reserve’s inability to have a measurable impact on the real economy at the zero lower bound.
The asset-based economy
At the same time, for mostly ideological reasons, policy makers are leery of using fiscal policy in the same activist way that they use monetary policy. For example, traditional monetary policy sees the central bank increasing interest rates as an economy overheats and then reducing them again once the overheating phase has passed. Monetary policy then is an activist tool in the way it is generally used, with policy rates planned by a central agent, the central bank, which then lowers or raises that policy rate based on its judgment of the economy’s health. Fiscal policy – via changes in taxation and spending – would never be used so actively to steer the economy.
But, of course, monetary policy is all about credit and financial sector channels into the economy. Therefore, the over-reliance on monetary policy as a cyclical policy tool has resulted in an asset-based economic model of the economy. It works like this: the economy starts to flag or has lapsed into recession. So the central bank lowers interest rates to stimulate credit growth. As a result, financial institutions deem a greater number of projects and requests for credit profitable given the risks to capital; they extend more credit. Eventually, the extension of credit becomes excessive. The central bank, worrying about the excess growth in credit leading to inflation, tightens monetary policy by raising rates. And so the economy flags again. And the cycle is then repeated.
This cycle is only indirectly linked to the real economy via the investment and employment growth that emanates from the projects funded by credit. The direct impact of rate hikes and cuts is on asset prices and the value of financial assets like stocks and bonds. Therefore, monetary policy’s transmission channels are more geared to asset prices than to the real economy. This is why I call the over-reliance on monetary policy the asset-based economic model.
I have looked at how the credit cycle has functioned in the U.S. in the last 50-60 years and what I have noticed is a clear trend toward increased leverage across business cycles. For example, in 2009, I took a brief look at the asset-based economy at economic turns and what I saw as I documented in charts was a U.S. economy that relied on increases in debt to fuel recoveries. And this debt was never worked down relative to the size of the economy as the recovery ensued. Instead, debt loads increased relative to the size of the economy until the central bank raised interest rates and the economy turned down, ushering in a deleveraging. But the deleveraging during recessions never unwound the releveraging from the prior recovery such that across business cycles debt increased dramatically.
Clearly this trend of increasing debt and leverage is only sustainable as long as debt service costs remain low because it is the inability to service debt en masse that causes mass defaults and a liquidity crisis. During the last thirty years, interest rates have declined dramatically as inflation has remained subdued in developed economies. And this has kept debt service costs low, permitting economies to increase aggregate debt levels without a concomitant increase in aggregate debt service costs.
I would argue this dichotomy between debt aggregates and debt service costs is dangerous because it leads policy makers concentrating on economic flows within a business cycle to disregard macroeconomic stock variables like debt that build up across cycles. After the panic phase of financial crisis ended in 2009, it was clear to me that the potential for a multi-year recovery existed if policy makers were able to reflate the economy using the traditional asset-based means. But I worried and still worry about the large debt stocks and wrote a piece in 2010 suggesting the origins of the next crisis would come from a simultaneous public and private sector deleveraging that lay ahead. We have seen this crisis play out in Europe but so far policy makers have done just enough to keep the eurozone intact despite the economic depression still ongoing in the periphery.
Given how precarious the situation is and given the zero rates in America and Europe, one would think policy makers would look beyond monetary policy for answers to the problem in the real economy of secular stagnation. However, if the latest intervention from Larry Summers is any indication, policy makers are sticking with monetary policy as the only game in town. Here’s how Gavyn Davies describes what Summers wrote:
So what do the secular stagnationists add to these debates?
Implications of Secular Stagnation
The first implication, if they are right, is that the problem of under-performance of GDP will last for a very long time, and will not solve itself through flexibility in prices and interest rates, which is what happens in classical economic models (rapidly), and in new Keynesian models (more slowly). The reason for this is presumably that the zero lower bound prevents nominal interest rates from falling, and also prevents prices and wages from adjusting downwards. Therefore none of the normal forces for restoring equilibrium apply.
A second implication is that the normal route through which monetary policy works, by bringing forward consumption from the future into the present, is unlikely to be successful . If the secular stagnationists are right, there will still be a shortage of demand when the future comes around, so there will be a need for ever-greater injections of monetary stimulus (presumably through quantitative easing) in order to avoid an ever-worsening recession.
Sir Mervyn King pointed this out shortly before he retired from the BoE, but few people paid much attention. Sooner or later, central bankers are bound to become concerned about asset bubbles (rightly), or the risk of losses on their bond holdings, and give up this path. The consequences for asset prices could be very painful when this happens, not because the asset purchases themselves are crucial, but because the markets might decide that there is no other means of keeping growth going.
A third implication is that calls for fiscal action are bound to intensify. Following the Summers speech, Ben Bernanke commented that secular stagnation was unlikely to occur, because there would always be capital projects with a positive rate of return that would be undertaken by the public sector. These projects could be financed by raising public debt at zero or negative real rates of interest, so the debt would be sustainable and the net worth of the government would actually improve. Therefore, in a rational world, public investment would always be used to end the secular stagnation.
This, apparently, had first been pointed out by Paul Samuelson in the debates which followed the 1930s Depression, and the conclusion about public investment now seems to be supported by most shades of professional economic opinion, including Ken Rogoff at the IMF conference. Yet there is little sign of it happening on any significant scale.
The way I interpret this is that economist are increasingly coming to the view that we are seeing a secular stagnation that they find worrying. While calls for fiscal solutions to the stagnation are not going to be heeded as yet, calls for more monetary solutions are increasingly heeded. For example, the papers by Wilcox and English show you where the discussion is headed in the U.S. And the comments by ECB chief economist Peter Praet espousing QE and negative interest rates shows you that easier monetary policy is also actively being discussed in Europe.
I therefore expect monetary policy to not only remain accommodative for an extended period but to become even more accommodative unless asset bubbles become so acute that the central bank can no longer look the other way. This is bullish for asset prices, by the way.
On the other hand, The Fed’s Charles Plosser is uneasy with all of this and believes monetary policy has gone too far. Here are key comments from his Thursday speech:
Central banks have been around for a long time, but they have clearly evolved as economies and governments have changed. Most countries today operate under a fiat money regime, in which a nation’s currency has value because the government says it does… The ability to buy and sell assets gives the Fed considerable power to intervene in financial markets not only through the quantity of its transactions but also through the types of assets it can buy and sell. Thus, it is entirely appropriate that governments establish their central banks with limits that constrain the actions of the central bank to one degree or another.
Yet, in recent years, we have seen many of the explicit and implicit limits stretched. The Fed and many other central banks have taken extraordinary steps to address a global financial crisis and the ensuing recession. These steps have challenged the accepted boundaries of central banking and have been both applauded and denounced… Regardless of the rationale for these actions, one needs to consider the long-term repercussions that such actions may have on the central bank as an institution.
As we contemplate what the Fed of the future should look like, I will discuss whether constraints on its goals might help limit the range of objectives it could use to justify its actions. I will also consider restrictions on the types of assets it can purchase to limit its interference with market allocations of scarce capital and generally to avoid engaging in actions that are best left to the fiscal authorities or the markets. I will also touch on governance and accountability of our institution and ways to implement policies that limit discretion and improve outcomes and accountability.
Plosser goes on to outline limits that he would set on monetary policy that he believes are appropriate constraints despite crisis conditions and secular stagnation. Plosser does not talk about fiscal policy except to raise his worry that today’s monetary policy has strayed too far into fiscal policy and that he believes monetary policy must therefore be more limited.
Here we have two opposing views on what monetary policy should do in today’s post-financial crisis world. The conundrum for policy makers at this point has mostly to do with the real constraint to fiscal policy in the eurozone and the ideological aversion to large deficits elsewhere. If we are in a period of secular stagnation and fiscal policy is off the table, what are policy makers to do? The answer policy makers have given at this point seems to be to make monetary policy ultra-easy, unintended consequences be damned.