From President Trump lobbing invectives against Federal Reserve Chairman Jerome Powell on Twitter to progressives clamoring for the Federal Reserve to use monetary policy to finance social projects, our central bank’s independence looks increasingly tenuous. Recently, Chairman Powell called for an internal "strategic review" of how Fed policymakers "formulate, conduct, and communicate monetary policy."
At Cato’s 37th Annual Monetary Conference in November, organized by Jim Dorn, Cato’s Vice President for Monetary Studies, current and former Fed officials, economists, monetary scholars, and experts gathered to hold a "shadow review" in tandem with the Fed’s own. Below are summaries of the panels and addresses (click the section titles for videos of each presentation). The speakers' written remarks will be published in next year's spring/summer edition of the Cato Journal.
Keynote Address: Richard H. Clarida on the Federal Reserve's Review of its Monetary Policy Strategy, Tools, and Communication Practices
Richard H. Clarida set the tone of the conference in his keynote address, which outlined three questions that the Fed also needs to ask of itself. First: are the Fed’s existing policy strategies sufficient to help it achieve its dual mandate of promoting maximum employment and price stability? Clarida noted that the Fed’s current operating framework, which measures price stability according to a self-imposed 2 percent inflation rate target, treats inflation shortfalls or excesses as "bygones." If the annual rate of inflation rate falls below or above 2 percent, that is, nothing changes policy-wise. This has prompted several proposals for "make-up strategies"—policies that require the Fed to compensate for prior deficiencies or excesses in inflation. Clarida cautioned, however, that make-up strategies are only as effective as the public expects them to be. A successful make-up strategy depends on creating public confidence that "the make-up will be delivered when the time comes."
Second: can the Fed combat future crises more effectively by expanding its current operating framework, or by reverting to the comparably narrower powers it assigned itself in its precrisis system? Today, the Fed attempts to regulate the economy mainly through policies that it adopted in the aftermath of the recent financial crisis. While these policies significantly expanded the Fed’s asset portfolio (and its market footprint), some data suggest that its current framework may not be sufficient to mitigate subsequent economic shocks.
Finally: how can the Fed improve its communication strategies? In a market system where central bank policy is only as effective as it is transparent, communicating policies—and achieving them in line with consumers’ expectations—is paramount.
The first panel of the day, moderated by Chris Condon (Federal Reserve reporter for Bloomberg), concentrated on targets and mandates. The panel began with remarks from Peter Ireland (Murray and Monti Professor of Economics, Boston College) who emphasized the importance of central bank independence. Ireland’s presentation relied on evidence from economic models as well as real-world case studies (notably, the fiscally catastrophic “Great Inflation” of the 1970s, which Ireland attributed to the politicization of the Federal Reserve). Yet "independence" hardly means "free rein," Ireland reminded audiences. He proposed that, in order to restore its independence and enhance its accountability, the Fed adopt a single mandate that concentrates solely on stabilizing inflation. Absent this maneuver, Ireland warned, the Fed’s independence, already waning, is at risk of eroding entirely.
Next, Jeffrey M. Lacker (former President of the Federal Reserve Bank of Richmond and currently Distinguished Professor of Economics at Virginia Commonwealth University) analyzed the Fed’s 2012 Consensus Statement on Longer-Run Goals and Monetary Policy Strategy (often simply referred to as its Consensus Statement). The Consensus Statement both clarified and rendered official the Fed’s current dual mandate. Two key features of the Consensus Statement were the targets of Lacker’s critique. First, the Fed had attempted to project a sense of continuity in communicating its statement to the public by suggesting that the statement merely formalized preexisting policies. While the aim of this maneuver may have been to quell a negative market reaction, it may have backfired, Lacker said: "with such a rollout, it’s not clear that the statement had much of a chance of improving inflation expectations."
Second, the consensus statement deliberately neglected to specify an employment target, aiming only for "maximum employment." This, too, may have minimized the statement’s capacity to improve market behavior. Lacker concluded by considering whether the Fed’s dual mandate was sufficient to support a stronger operating framework. "I used to think so," he said. "I’m less sanguine right now after having conducted this review."
Carola Binder (Assistant Professor of Economics, Haverford College) argued that the time has come to switch from inflation and employment targeting to nominal GDP (NGDP) targeting. Now would be an opportune moment, not only because the economy is relatively stable, but because the Fed has achieved the hypothetical NGDP target that it considered adopting when the measure was first introduced. In other words, had the Fed opted to target NGDP when it was suggested several years ago, the effects of central bank policy in subsequent years would have been consistent with that target. As a result, if the Fed chooses to switch to NGDP targeting now, its decision to do so is likely to promote faith in both the central bank and the market. Indeed, part of what makes NGDP targeting so attractive is that it is a smoother metric than inflation or employment targeting. It’s also one that the public can more readily grasp: consumers find it easier to think in terms of nominal income than inflation, meaning that NGDP targeting alone can improve the transparency of the Fed’s policy statements. "The informational advantage of NGDP level targeting is very strong," Binder concluded, "especially considering the uncertainty surrounding [inflation and] unemployment targeting."
Finally, Eric R. Sims (Professor of Economics, University of Notre Dame) emphasized that interest rates are very likely to hit or fall below zero percent again (as they did during the last financial crisis), and to do so repeatedly. He discussed the need to develop policy strategies suited to our new world of low, and possibly sub-zero, interest rates. "We’re going to need to deal with the zero lower bound in the future," Sims impressed. "This is a reality that we have to contend with." Since monetary policy is partly a matter of keeping policy interest rates in line with the natural rate of interest, a zero percent natural interest rate jeopardizes a central bank’s ability to conduct monetary policy effectively. After all, there isn’t much room to lower interest rates if those rates are already at zero percent, unless the central bank elects to move its policy rate below zero. Sims considered the merits of negative interest rates, but concluded that negative rates aren’t particularly effective at stimulating the economy. Equally inadvisable, in Sims’ view, was the alternate strategy of transitioning to a higher policy rate regime. Sims suggested that instead of shifting policy rates, the Fed should continue to use two of its most powerful postcrisis tools—quantitative easing and forward guidance—to combat stagnation when rates hit their zero lower bound.
Participants in the second panel discussed the Federal Reserve’s controversial operating framework. Heather Long (economics correspondent for The Washington Post) moderated the conversation. Charles I. Plosser (former President and CEO, Federal Reserve Bank of Philadelphia) began by arguing that the Fed’s unconventional monetary policies (especially quantitative easing, or QE) have weakened its independence. Within the Fed’s current operating framework, the Fed’s balance sheet—and therefore the overall volume of reserves—has little, if any, bearing on monetary policy. This is because the Fed’s main policy instrument is now the amount of interest that it pays other banks to store their excess reserves at Fed branches. "In adopting a framework where large excess reserves become a standing feature of the Fed’s operating regime," Plosser explained, "there is no limit to how large the balance sheet can become." This, he warned, invites congressional meddling, with elected lawmakers coveting the central bank’s abundant reserves for their own purposes. And lawmakers have already succeeded in funneling Fed money toward their pet projects. The crisis-era bailouts, FAST Act, and (somewhat ironically) the Consumer Financial Protection Bureau were all funded by Congress exploiting the Fed’s “power” to detach its balance sheet from the total quantity of reserves. Plosser closed by admonishing the Federal Reserve to stop undermining its own independence from congressional whims.
Manhmohan Singh (Senior Financial Economist, International Monetary Fund) critiqued the effects of QE operations (whereby central banks purchase high-volume—and typically high-risk—securities from the market and reap the rate of return on those securities). Singh’s main concern was that QE removes duration risk from the market. Not only does this alter the availability of long-term bonds (the objects of QE purchases), it affects short-term interest rates as well. This is because financial institutions often use long-term bonds as collateral when conducting shorter-term transactions in securities, prime brokerage, and other lending markets. An abundance of collateral, in other words, "lubricates" the money markets. When a central bank buys up this long-term collateral and its market availability declines, short-term interest rates rise, and the money markets can dry up. Singh, therefore, urged central banks to let financial institutions use, and reuse, long-term bonds—rather than buy those bonds up to remove market risk.
Andrew Filardo (Bank for International Settlements and Visiting Fellow, Hoover Institution) continued the conversation on money market instability. By "instability," Filardo referred to the recent increase in both the rate and the frequency of repo loans—funds that central banks lend to private banks who end their business days with fewer reserves than the law requires. (In theory, a central bank is only the "lender of last resort," and private banks should serve as one another’s primary lenders. This theory, however, has not borne out in recent practice.) The recent repo rate spike, Filardo continued, is just one of several recent indicators of higher market volatility. (Again, in theory, the volatility of the global money market should be decreasing, not increasing, the further out we are from the last financial crisis.) One hypothesis for this counterintuitive trend, Filardo said, is that "central bank intervention in the money markets is contributing to instability." He then presented data to support his more detailed conclusion: that the Federal Reserve’s new floor system has weakened incentives for financial institutions to lend to one another. Owing to the reduction in interbank lending, private financial institutions have less of a reason to monitor one another. In the past, if a bank could not maintain a stable network of market-based lenders, this was seen as a sign of financial distress. Now, however, financial institutions depend on the Fed to pump large quantities of reserves into the market when money becomes scarce, which reduces their need to rely on one another for overnight lending. Filardo pointed to two ways that the Fed could work to re-incentivize market dynamism: first, abandon its current floor system and return to its precrisis corridor system; second, adopt a new "sequestered reserve rule" (which Filardo had developed), which requires financial institutions to "negotiate… and preannounce the amount of reserves [they intend] to hold as high-quality liquid assets."
David Beckworth (Director, Monetary Policy Program, Mercatus Center at GMU) closed the panel by surveying some of the more critical macroeconomic lessons of the past decade. After reviewing case studies from countries that had experimented with various postcrisis strategies—interest rate policy adjustments, QE strategies, and monetary base expansion—Beckworth suggested two measures that would make our own central bank’s operating framework more robust. First, transition to NGDP level targeting; second, move toward a more expansionary monetary policy (known as "helicopter money") when—and only when—interest rates drop below their zero lower bound. This will allow the Federal Reserve "limited access to fiscal policy," Beckworth said, but added the caveat that, according to his proposal, such access will be "very rules-based," and limited in both duration and scope.
The Cato Institute was delighted to welcome Sir Paul Tucker, former Deputy Governor of the Bank of England, to deliver the day’s luncheon address. In a discussion entitled "Central Banks and the Rule of Law," Tucker reminded listeners of monetary policy’s philosophic roots. "This isn’t about economics," Tucker said, reflecting on the fundamental purpose of central bank policymaking. "This is about our deepest political values." He emphasized the need for central banks to hold themselves accountable to the standards of classical republican virtue, given that elected lawmakers are often all too willing to exploit central banks’ immense power. Elaborating on his thesis that central banks should never serve as the economy’s "lender of last resort," Tucker explained that since a lender of last resort cannot set policy independent of its own interests, central banks’ lending responsibilities must be rules-based, not discretionary. He then considered how monetary authorities could achieve their mandated policy goals without reverting to overly interventionist measures. A central bank "should monitor itself, using rules to measure its own compliance with its mandate," Tucker argued; and "should explain publicly when it departs from those rules." He added that central banks should keep their balance sheets as small as possible, as well as develop transparent contingency plans for would-be extraordinary circumstances, such as financial crises, in which they might need to intervene more strongly in the market. Tucker closed with the reminder that "each generation of Fed leaders carries the burden of ensuring that they apply their powers in ways compatible with their country’s deep values."
Victoria Guida (Financial Services Reporter, Politico) led the third panel in a conversation about the Federal Reserve’s communication strategies. Sarah Binder (Professor of Political Science at GWU and Senior Fellow at the Brookings Institution) and Mark Spindel (Founder and Chief Investment Officer, Potomac River Capital, LLC) began by discussing the political roots of the Fed’s transparency issues. Until quite recently, Binder reminded audiences, Federal Reserve transparency came second to its unofficial policy of "strategic ambiguity" (to quote Alan Greenspan). Under the chairmanship of Ben Bernanke, however, the Federal Reserve adopted a new philosophy: the FOMC’s monthly policy statement is the policy. As Bernanke once put it: "the ability to shape market expectations through public statements is one of the most powerful tools the Fed has." But the high premium we rightly place on Fed transparency comes at a cost. Often, the more the Fed discloses about its strategies, the more likely we are to blame the Fed when those strategies go awry. Preliminary data from Binder and Spindel suggest that U.S. Presidents are more liable to pressure the Federal Reserve during periods of greater financial distress. (When the Fed folds to such pressure, of course—as it routinely does—the economy often ends up worse for the wear.) Fear of inappropriate political pressure, the pair concluded, may make the Fed even more reluctant to adjust its communications practices: owing to importunate political jawboning, transparency can be a thankless enterprise.
Next, Andrew T. Levin (Professor of Economics, Dartmouth College) examined the efficacy of proposed "make-up strategies" through which the Fed could compensate for prior failures to achieve its policy goals. Levin cautioned that make-up strategies are inherently risky, for three key reasons. First, the public may not trust the Fed to carry through on a given make-up strategy, rendering the Fed’s policy changes impotent. Second, and relatedly, is the challenge of "imperfect credibility." The less credible a central bank is, the less capable it will be of influencing market behavior. Finally, Levin pointed to "model uncertainty." Any make-up strategy the Fed might adopt would rely to some degree on economic modeling. But models are not mirrors of reality, and can at best only estimate the results of policy decisions.
Charles W. Calomiris (Henry Kaufman Professor of Financial Institutions, Columbia Business School) began his presentation with what he called an "optimistic prediction”: that central bank transparency is likely to improve, rather than deteriorate, in the near future. Calomiris attributed his rosy outlook to the phenomenon of natural language processing (NLP) software, which can detect characteristic markers of obfuscation in one’s speech or writing. Using NLP techniques like Fleish-Kincaid and "prattle scores," Calomiris showed, we can now highlight vague, meaningless, or redundant language in Fed policy statements. He also explained that our lack of a systematic policy framework disincentivizes transparency, by making central bankers shy away from accountability. As a result, many of the Fed’s policy statements are reprisals of those prior, and contain language that can be interpreted to coincide with any outcome. NLP is likely to become more popular and advanced in the coming years, Calomiris predicted, especially in a monetary system like ours where "the policy statement is the policy."
The final panel of the day looked forward, with speakers considering the optimal monetary system for a free society. Bloomberg Businessweek’s economics editor Peter Coy engaged panelists in a conversation about banking regulation, monetary stability, and the path to a more efficient operating framework.
George Selgin (Director of Cato’s Center for Monetary and Financial Alternatives) began by asking: can markets handle money better than central banks can? "In one sense, definitely yes," said Selgin, but added the caveat: "when you let them." Historically, banking has been a highly regulated sector. Yet Selgin pointed to cases—such as the Scottish and Canadian free banking eras—where deregulation of the banking sector heightened monetary stability and improved trust in the markets. Selgin also noted that many of the deregulation "horror stories" touted out today fail to mention the outsized role that misguided regulations have played in creating, or prolonging, financial crises throughout history. In many cases, over- or improperly regulated banks have been and remain "the main source of banking instability. Certainly, that’s been true in the United States," he said. Selgin also discussed the role that our present fiat dollar should have under an ideal operating framework. While one school of thought insists that fiat currency should be eliminated outright, he cautioned that the free market does not have a particularly good track record when it comes to creating money from scratch. Instead, he suggested, the value of the dollar should be tied to a predetermined monetary rule. Tying its value to something like a gold standard would be more difficult than a quantity rule, he said. The latter at least has "the merit of being possible in an age where trust in convertibility contracts," and the banking system in general, continues to depreciate.
William Nelson (Executive Vice President and Chief Economist, Bank Policy Institute) outlined the steps necessary for returning to the Fed’s pre-2008 operating framework. Prior to the last financial crisis, our central bank regulated the money supply mainly through its purchases of U.S. Treasuries and short-term sales of government securities (repo agreements), buying those securities back the next day at a slightly higher price. Together, these tools allowed the Fed to raise and lower the money supply to adjust to changes in market demand. As a result, it didn’t engage in many day-to-day financial transactions with private banks, as it does now. Banks instead borrowed and lent among one another, with the Fed serving only as their lender of last resort. Nelson then outlined the consequences of the Fed’s crisis-era decision to house unlimited Treasury deposits at Federal Reserve banks—initially in an effort to raise interest rates—and to continue doing so well after those rates surpassed their zero lower bound. He also discussed the Fed’s misguided QE3 (or “QE Infinity”) program, which was unique in that it allowed for unlimited QE purchases—and which was unfortunately par for the course in that it extended long past its proposed duration. This, in turn, postponed the Fed’s plans to renormalize its balance sheet. It also altered those plans: rather than sell back the assets it had purchased from the market, the Fed has now opted to allow those assets to roll off naturally as they mature. Nelson ended with three steps that the Fed can take to return to its precrisis operating framework. First, discontinue its policy of allowing the Treasury to keep all of its deposits at Fed banks. In the medium and long term, he said, the majority of Treasury bills should be housed in private banks (where they will earn interest and reduce money market volatility). Second, undertake a "massive reeducation campaign" incentivizing private banks to return to conducting most of their borrowing and lending with one another, and not the Fed. Finally, the Fed should begin unwinding its asset portfolio immediately.
William J. Luther (Assistant Professor of Economics, Florida Atlantic University; Director, Sound Money Project, AIER) described the four characteristics of an optimal base money regime. First, a base money regime has a stable inflation rate—one close to zero, although economists continue to debate whether that rate should be slightly negative or slightly positive. Second, it is "demand-elastic"; that is, the quantity of base money either increases or decreases depending on market demand. Yet it should not adjust according to shocks in the real money supply, Luther said, since these generally affect only "a particular subset of markets," and not the economy as a whole. Third, an ideal base money regime is global. Luther explained the benefits of a common global currency: it promotes exchange in both direct and indirect ways; and it lowers "information costs, transaction costs, and riskiness of cross-border production plans." Finally, an ideal base money regime is "incentive-compatible," meaning that those who are charged with creating and maintaining it benefit from adhering to its rules. All the money regimes that currently exist are deficient in at least one of these attributes, Luther said; "but these four principles provide a useful starting point for [improving on] the available alternatives."
Closing the panel—and the day—was Steven H. Hanke, Professor of Applied Economics at Johns Hopkins University. In Hanke’s view, the greatest threat that monetary instability and financial crises pose to free societies isn’t the supply shock itself, but rather the fact that these shocks are “always followed by policy proposals that constrain liberties.” In his remarks, Hanke proposed three strategies for improving global monetary stability. First, there should be a formal linkage—albeit a loose one—between the U.S. dollar and the euro (Hanke recommended an exchange rate between $1.20 and $1.40). Second, we should "mothball at least 100 central banks" and establish currency boards in their stead. Currency boards, Hanke explained, have an "exchange rate policy, but no monetary policy." They also have a far better history of promoting financial stability than central banks have, and they are far more consistent in terms of producing lower inflation, lower debt, and higher rates of economic growth. Finally, Hanke insisted that central banks should "greenlight private currency board systems" like libra and other competitors. Central banks, of course, tend to regard independent currency boards as their own competitors—and therefore as threats to their power. Yet competition is a good thing, Hanke reminded audiences; and central banks’ opposition to independent currencies is perhaps the greatest argument in their favor.