Wednesday, March 15, 2017

The Real Fed Issues

The media are usually fixated on the angels on heads of pins question, will she or won't she raise rates 0.25%? As such Fed discussion misses many of the really important issues. Fed’s Challenge, After Raising Rates, May Be Existential by Eduardo Porter in the New York Times is an excellent counterexample and a nice primer on some of the really big issues facing the Federal Reserve -- and the nation -- going forward.

The pressing question for this era of populist policy making and popular anger is whether the Federal Reserve as we know it — arcane and academic, with the autonomy to set monetary policy as it sees fit — will survive the tension this time.
The Fed already lost powers it deployed to counter the recession spawned by the financial crisis a decade ago: The Dodd-Frank financial reform legislation stripped it of its authority to lend freely to nonbanks, which it used to keep money market funds, insurance companies and others that had bet on the wrong side of the housing bubble from imploding and taking the economy with them. [JC: The latter is an opinion not a fact, but let's press on.]
Though the article starts with monetary policy, and politician's desire for low interest rates, you can see we're quickly getting to, I think, bigger issues. The Fed was founded to be lender of last resort, not for monetary policy. But just who can it lend to, orchestrate bailouts, buy dodgy debts, is an entirely different issue, and one with a whole different set of arguments about independence vs. political accountability vs. political pressure, rules vs. discretion, and so forth.
Efforts that stalled in the last Congress — to subject the Fed’s funding to congressional approval, to reduce its discretion in setting monetary policy and to subject it to the oversight of Congress’s Government Accountability Office — have acquired a new lease on life, cheered from the right and the left. 
The funding question is a little more delicate. The Fed now earns interest on treasuries, and does not have to pay interest on about $1 trillion of cash. So it earns interest on about $1 trillion of treasuries and MBS directly, and earns the interest spread between long-term treasuries and MBS (its assets) and the interest it pays on reserves. It rebates much of that profit to the Treasury, and keeps the rest to fund its growing operations. Don't be fooled -- every cent of that comes from you and me in the end. Every dollar of interest the Treasury pays to the Fed comes from our taxes. But unlike other spending there is very little oversight (benign) or political influence (not so benign view) of this money.

If we're just hiring a few hundred PhD economists to run models to think about interest rates this is not such a big deal. But the Fed's primary function these days is bank regulation in general and big bank / financial / stop the next crisis regulation in particular. The argument that a regulator should be independent and not even subject to the accountability of, say, the EPA or the securities and exchage commission is tougher. So putting the Fed on budget really means, I think, treating its regulatory activities as we treat those of other agencies, and an ideal worth consideration -- and an idea that is coming.

From later:
Perhaps there is a discussion to be had over whether the Fed should keep its role as supervisor of financial institutions, or whether the job should be placed with another agency. Maybe financial supervision should be made more rule-based, less subject to regulators’ discretion.
Or, if not with another agency, whether that part of the Fed should be cleaved off and treated like other regulatory agencies.

Next non-interest rate issue: The balance sheet.
Disgruntlement in Congress will only grow worse as the Fed gradually winds down the enormous stash of bonds it built over the last eight years 
As blog readers know, I didn't think the balance sheet did any stimulating on the upside, and don't think keeping a big balance sheet does any harm on the downside. I think the Fed is a bit victim of its own marketing. By saying a roughly symbolic measure saved the world with great stimulus, it's awfully hard to turn around and say it isn't doing anything. But that's another big, not-about-interest rates issue to watch.
Congressional action might not be the Fed’s biggest problem. Mr. Trump’s appointments to the Federal Reserve Board could prove as destabilizing: Two of the seven positions are vacant, and a third will come open with the retirement of Daniel K. Tarullo in April. By the middle of next year, Mr. Trump will also have the opportunity to replace Ms. Yellen as Fed chief and Stanley Fischer as her deputy.
A scenario that the economy stalls a bit, and the Trump administration views the Fed as undermining its efforts with "high" interest rates, views the academics at the Fed as out of touch pointy headed fools, and puts in bankers and business people who "understand the importance of low interest rates", is not far fetched.
The argument for central bank independence is as powerful as ever. Political influence over monetary policy would produce more destabilizing booms — as politicians pumped up growth to serve their electoral purposes — and inevitable busts.
Yes, but remember, the big point is about the structural issues -- balance sheet, bank regulation, systemic regulation, and so forth, not interest rates. The argument for monetary policy independence, and the arguments for discretion, do not necessarily apply, or at least in the same way.
The popular mistrust of central bankers should not be ignored. After all, central bankers failed to prevent the most devastating financial crisis in generations — looking on idly, at best, while financial institutions peddled shady bonds to fuel a housing bubble of gargantuan proportions.
And central banks have emerged, at least implicitly, with a bigger job than before, adding the preservation of financial stability to their duty to ensure low inflation and, in the Fed’s case, full employment. Some central banks — though not the Fed — have been given new tools for this new job.
Given this power, it is inevitable that the enormous discretion central bankers have in executing their mandate will inspire popular mistrust.
... Maybe the Fed needs extra tools — to impose limits on indebtedness, for instance, or to adjust monetary policy to serve measures of financial stability.  
This "financial stability" is the big new mandate at the Fed, has little to do with interest rates, and not obvious that the same discretion and independence are appropriate -- or that there is a consensus in Congress that it should be. The "financial stability" mandate, and how it should be approached is the big question, at least until inflation hits 5% or -5%.

I'm much more skeptical of "new tools," and Porter seems to be slipping in to the trap of assuming disinterested technocratic competence at the Fed; that all it needs is "more tools." What we're talking about here -- should the Fed, like other central banks, buy stocks and corporate bonds? Or, if it thinks a "bubble" is at hand, sell them? Should it direct bank lending directly, telling them to cool down "hot" markets or lend in to weak ones? Should it jigger capital and leverage constraints to boost or cool lending? You can see that all of these are much (even) more political than raising or lowering interest rates.
And yet the populist streak driving through American politics seems unlikely to yield such measured outcomes. The Federal Reserve was designed to be insulated from the full force of democracy in order to protect its mandate from political opportunism, to ensure that policy hewed to technical expertise. It was designed — precisely — to protect it from a moment like this. One can only hope that the protections hold.
In a democracy, the price of independence and discretion is sharply limited authority. If the Fed just sets short term interest rates, does not interfere in bond, stock, real estate, lending markets, it can have great independence. If it takes on these much more politically fraught areas, it will, and must, necessarily lose independence.

What about interest rates?

Real interest rates (interest rate minus expected inflation) must rise. Eventually, there are two immutable market forces behind real interest rates -- real interest rates are related to the profitability of investment (the marginal product of capital), and to the economic growth rate. As an economy grows better, there are more profitable opportunities, and people need to get the market signal to invest in those opportunities rather than spend now. (r = f'(k), and r = delta + gamma * expected consumption growth)

Higer real interest rates are, like high house prices, a sign of good times as well as a cause of bad times. Don't confuse the two sources. If growth and investment really are emerging, indeed the Fed should bend to market forces and allow rates to rise. Sometimes there is supply, not just demand, and that's where we are now.

In my somewhat eccentric view, it would be possible for the Fed to keep interest rates low, if everyone thought that would last basically forever, but then we would have to tolerate deflation like the late 1900s. If the Fed wants to keep inflation at 2%, then as long as the economy continues to expand, raising rates merely recognizes market forces.

But the expansion is long in the tooth. That doesn't argue for any change in policy, but I would like to hear a lot more stress testing from the Fed. If a recession emerges, here is what we will do. If China and then Italy blow up, here is what we will do. I presume they're doing all that quietly behind the scenes.


  1. Personally, I think that the Commercial Paper Funding Facility was a sensible program at the time. Would the world have ended without it - perhaps, perhaps not. It certainly seemed to be in line with Bagehot's famous prescription.

    On the other hand, I think the intervention in the housing market through QE3 went over the line. Congress had decided to bring in the sequester. It really was not the place or mandate of the Fed to try to pre-emptively save the country (and the politicians) from the natural consequences of that political bargain.

    It would be ironic if the Republicans, after complaining for so long that the Fed was artificially suppressing rates, started complaining if the Fed lets rates rise. The Fed should be letting its holdings of longer dated, non Treasury, securities "roll-off". A roll-off would presumably steepen the yield curve while leaving short term rates near zero. A roll-off would change the composition of the Fed balance sheet but not its size. To reduce the size, there needs to be a withdrawal of the excess reserves.

    1. It's a balance sheet, excess reserves come off automatically as Treasury securities roll off

  2. "The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction,"

    I disagree with rolling over the agency debt and mortgage backed securities. If they want to tighten slightly the first thing to do would be to stop the rolling over.

  3. "Don't be fooled -- every cent of that comes from you and me in the end."
    A large chunk of it comes from MBSs. And many of us don't have mortgages. So that statement looks a bit fishy to me. Or am I missing something?
    -LK Beland

    1. The next sentence in his post answers your question. He's talking about the interest the Treasury pays the Fed.

  4. Ronald Reagan proposed making the Fed part of the U.S. Treasury.

    Reagan was echoing sentiments of Donald Regan, his Treasury Secy who also made such proposals. The Reaganauts were at war with Fed Chair Volcker (initially a Carter appointee) who they felt was too tight.

    I think placing the Fed under executive branch control makes sense.

    First, democracies should always err on KISS---keep it simple stupid.

    The voting population cannot be expected to dissect and extract why the economy is floundering, be it too tight monetary policy, or Trumponomics. There needs to be accountability.

    If inflation is too high or growth too low, the public needs a mechanism to register its sentiments.

    As it stands, this is a possible scenario: Trump actually does things right, and cuts corporate income taxes, say. His border tax is small enough to not matter much. The rest is a wash. So, for sale of argument, let's say Trump is a positive.

    But the Fed over-tightens, and we hit the skids.

    The public will blame Trump, may even conclude, "See? Tax cuts for the rich again, tickle-down blah, blah. Never again."

    I give the scenario about a 25% chance of happening.

    Secondly, does it make sense to have an insular body like the Fed conduct macroeconomic policy? The Fed has been staffing up through thick and thin. Hiring more and more economists. The Dallas Fed HQ is a country club, with sculpture gardens and a cafeteria regarded as the best in Texas. Superb pension and benefits. The other Fed campuses may be as nice, but that is the only one I know.

    Recently, Cochrane posited economic incentives drive people. Fed staffers do better in a deflationary economy than the population--after all, they are paid in step-grades, they keep their salaries, their campuses are comfy. Housing become cheaper and they can buy.

    A real estate developer, a restauranteur, any business guy might get gutted in a deflationary recession. Not Fed staffers. They gain.

    If we say economic incentives matters, how are Fed staffers incentivized?

    In the private sector, we try to incentivize management to align with shareholders.

    At the Fed, the opposite arrangement is in place. What if Fed staffer pay was closely tied to real GDP growth?

    I gather the establishment consensus is "We believe economic incentives matter except when they don't."

    Maybe the Fed should be abolished, and the Treasury given the reins on monetary policy.

    Reagan had a point.

    1. Benjamin, The evidence seems to support you: i.e. there does not seem to be much relationship between central bank independence and inflation. Scroll down to the first chart here:

      The obvious exceptions are Robert Mugabe and Weimar.

      But if there was a referendum on the subject, I think I'd still vote for central bank independence.

    2. Ralph:

      Well, as they say, democracy is crummy way to run a country, until you try the second-best way.

      Sovereign nations must have their own central banks, and those banks must be accountable to the voting public.

      The ECB is horrible. What say do the citizens of Greece have in their economic future? They should be printing drachmas to the moon.

      So, we trust a President with his finger on global nuclear war, but not with monetary policy?

      You know, inflation above 5% is worse than getting nuked. Just ask any central banker.

    3. Ben,

      "What say do the citizens of Greece have in their economic future?"

      They control their own fiscal policy and that is enough. Governments (all of them) have all fallen under the spell cast by central bankers telling them they must either borrow (sell bonds) to finance deficits or print money (as you seem to suggest).

      When they (Greece) figures out that deficits can be financed with the sale of equity claims against future tax revenue, they will regain their economic future.

    4. Ben,

      There is a distinct difference between having a central bank to begin with, and letting that central bank dictate fiscal policy.

      Reagan (and Regan) fell victim to their own prejudices / misunderstandings of both finance and Constitutional law. In spite of a government deficit, the Congress is under no Constitutional obligation to either borrow or print money. The U. S. Constitution lists borrowing and coining money as plenary powers that can only be exercised by the Congress not must be exercised by the Congress.

  5. "After all, central bankers failed to prevent the most devastating financial crisis in generations— looking on idly, at best, while financial institutions peddled shady bonds to fuel a housing bubble of gargantuan proportions." This is perverse. The Fed fail was AFTER the crisis broke. They failed to vigorously prevent a massive increase in unemployment even as they allowed the price level to drift farther and farther off target, validating expectation s that they would not 'do what it takes" to keep inflation on track.

    1. So the Fed played no part in the build-up to the crisis? I think that idea is perverse. Between interest rate policy and numerous statements that there was no bubble/ any issue would be contained they absolutely failed.

  6. the real question is whether "The Fed" is there to protect the "economy" or the "crony banks". My vote is they are there to enrich a select few mega banks....who are reckless! Why are rates at zero when banks have record profits? Why are there still CEO there at banks that would surely have failed but for the gratis of unlimited FREE MONEY!

  7. Raising or lowering in increments of 0.25% adds more volatility to the economy than the Fed could possibly remove through market timing.

    If the Fed were serious about reducing volatility, they would adjust their target every day, in increments of single basis points or smaller. Just like big-boy asset managers do.

  8. Dr. Cochrane,

    I do not disagree with the majority of your blog but there is one section I do not agree with.
    You wrote:"I didn't think the balance sheet did any stimulating on the upside, and don't think keeping a big balance sheet does any harm on the downside. I think the Fed is a bit victim of its own marketing. By saying a roughly symbolic measure saved the world with great stimulus, it's awfully hard to turn around and say it isn't doing anything. But that's another big, not-about-interest rates issue to watch."

    Tthe Federal Reserve Bank (FRB) vastly increase the supply of narrow money / monetary base (M0). Between September 2008 and September 2014 the supply of M0 quadrupled from 950 BUSD to 4,084 BUSD [4] through the Large Scale Asset Purchase (LSAP) programme. This increase in narrow money created intense inflationary pressures. This was important as monetary velocity was decreasing quite rapidly at the time [1] as was Nominal Gross Domestic Product[2]. These were indicators of intense deflationary pressures [3]. However, by creating these inflationary pressures through the LSAP the FRB were able to counter-balance the deflationary pressures. While inflation remained tepid at best, there was little outright deflation.
    While one might argue that this was not an outright monetary stimulus it did provide an important amount of support to economic growth.


    1. Isn't it more likely that 'velocity' 'went down' because of (and/or, in tandem with) the increase in reserve balances associated with the LSAPs? It's a measured/inferred quantity whose denominator was increased dramatically.

    2. Anonymous,

      Ah...the trouble with statistics...correlation is not sufficient to establish causality.

  9. I gather the Fisher effect revived lately by Williamson is what is being referred to by JC's "eccentric view [hat] it would be possible for the Fed to keep interest rates low, if everyone thought that would last basically forever, but then we would have to tolerate deflation"

    I suppose that is true, eventually. But to get from here to that low-rate-of-nominal-return, deflationary equilibrium, what has to happen? Prices must rise (especially equity and house prices, so they are "overvalued" enough that people expext prices to go down, down, down). But goods prices, too. In other words, low rates will result in INFLATION NOW if they are to cause deflation (much much later).

  10. Given some of your comments here, I thought the last 2 charts in this link are relevant. The US corporate sector seems to be coming out of its own recession. Y/Y profits are now on the plus side after 5 quarters of minus y/y numbers and cap ex has (for 1 qtr) gone positive in a big way. Hope the Fed doesn't nip this in the bud....


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.