Taylor Rule

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Our Do Nothing Fed

Ugh.

These guys are getting really annoying.

The Federal Reserve Board released the minutes of the latest Open Market Committee today. The message was one of caution, slightly less optimism, and inaction. They promise to do something, sometime, just not yet.

The Fed has a charter to protect full employment and price stability. The latter has become the main goal of central bank policy the world over and with the former being relegated to a distant second. Focusing on price stability, aka combating inflation, has been such a priority that poor old full employment must feel a truly ugly step child. You could get kicked out of central banker clubs for allowing inflation to edge up, but a few points on the unemployment rate was never an issue. Indeed it became a badge of courage for central bankers to impose harsh measures that pushed unemployment up, as long as they fought inflation bravely. The feeling of that puritan hair shirt on their backs was a constant reminder to these bankers of their civic duty to impose discipline at any cost. Their reward was in the worldly and knowing looks they received from their peers around the globe. After all someone has to do the dirty work.

The relationship between inflation and employment has been well known for a while in economics. It is enshrined in the old Phillips curve which showed that higher inflation was associated with lower unemployment and vice versa. The relationship is not as strong as was first thought, but central banks all are supposed to manage that relationship in one way or another. In its current incarnation the Phillips curve is now the Taylor rule, which is more informal and a rule of thumb than a tight relationship. Using that rule, the current rate of interest for Fed funds, the overnight rate of interest banks charge each other, should be about -5%. Since that’s not possible we are left to use unconventional policies like buying a pot load of Treasuries to get loosen monetary policy.

Given all the above we would be reasonable to expect the Fed to be a hive of activity bashing away at the unemployment rate. After all:

  1. Full employment is one of the Fed’s stated policy goals
  2. We are nowhere near full employment
  3. Interest rates are at zero, or near zero
  4. Stable prices are also a policy goal for the Fed
  5. Prices are not stable, but are beginning to fall

So the Fed is failing to meet either of its stated policy goals.

That should stimulate a bit more than:

“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period. The Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings.”

Which is exactly what the Fed has been doing for a while.

So, even though it now acknowledges prices are out of line with its goals, and that employment is nowhere near the right level, the Fed is staying in a “wait and see” mode.

Our leadership is sorely lacking.

Meanwhile I won’t even dignify the comments of Thomas Hoenig with a response – he was the single “no” vote at the meeting and apparently worries that growth is so rampant that inflation is about to rage. Suffice to say he is an anti-social idiot.

With a do nothing Fed, no wonder this recovery is slow and feels more like a recession every day.

Addendum:

With respect to my comment on Thomas Hoenig: I have praised him in the past for his stand against big banks. He has been an advocate for breaking them up, and I applaud that approach.

But.

With that battle lost we have to focus on the current problems, and it is on those matters I find his position appalling. To advocate raising rates at present is ridiculous and deserves to be called so. To argue that our issue is that rates have been too low and that until they are higher we cannot return to normalcy is a statement without content. We would all like to return to the days of higher Fed Funds rates. Those levels of interest rate are associated with a thriving economy. It’s how we get there that matters. To summarize:

First, to argue we need to raise rates in order to re-esatblish a normal economy seems to me to be getting the cause and effect backwards. That makes him an idiot. Second: raising rates with unemployment still at horribly high levels is plainly and wantonly anti-social.

Hence anti-social idiot.

Good on the banking problem though.

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Was It Interest Rates?

One of the enduring myths about the banking implosion is that the real estates bubble was facilitated in part, or in main, by the incredibly lax monetary policy started by Alan Greenspan and then continued by Ben Bernanke. This story goes like this: interest rates were keep much too low for much too long during the years after the 2001 recession, partly in response to the recession and partly in response to the bursting of the hi-tech bubble. These low rates flooded the markets with liquidity and encouraged steadily increasing risk taking. The end result being the burgeoning of the sub-prime mortgage business which, in the eyes of the analysts pressing this line of reasoning, became the cause of the crisis.

One piece of evidence often used in arguing this case is the so-called Taylor rule I have mentioned here before. The Taylor rule is a ‘rule of thumb’ calculation that correlates the goals of the Fed – managing inflation and unemployment – with an appropriate interest rate. For those of you who have read more about these things the Taylor rule recalls the relationships we all used to see in the ‘Phillips curve’ of yore. The Taylor rule suggested a level of rates a good 3% higher than those actually implemented by the Fed for long stretches from 2001 onwards. This gap between what the rule suggested and what rates actually were is the ‘smoking gun’ that purportedly damns the Fed.

My issue with this is that it ignores so much else.

While I agree that the Fed kept rates too low for a long time and thus missed an opportunity to throttle the bubble before it collapsed on us, I am no longer sure we can simply point at the Fed and ignore everything else.

The banks, for instance, were surely complicit. There is nothing in the Fed keeping interest rates too low that forces a bank to throw caution to the wind and abandon sensible loan underwriting policies. Lax standards at the banks are a much more likely cause of the bubble than rates.

Then why didn’t the profit motive, that old ‘market magic’, prevent the banks from being stupid? After all Alan Greenspan’s extraordinary naivety was based upon a faith that the market would identify and compensate for any foolish or overly risky activities. Instead the entire market went over the cliff, lemming like, at the same time. Far from acting as a balancing and purging force the market accelerated and hyped up the failure. This was an epic example of a ‘market failure’ – something that free market exponents have always told us cannot happen.

And this is why we see the blame shifted to the Fed.

The free market advocates deny that markets could be so insane as to allow an asset bubble to occur. Indeed Eugene Fama of the University of Chicago, and the inventor of the Efficient Markets Hypothesis we find at the center of the failed risk management models the banks used, still denies that a bubble even existed. So such people have to look for an alternative cause and, being ideologically so predisposed, they point to the government.

They actually point to two government errors:

First is the low rate environment of the Fed. Second is the social tinkering in real estate and the obsessive desire of American governments to encourage home ownership. This second cause found, according to the likes of Fama, its manifestation in the over funding of Fannie Mae and Freddie Mac, and in the continuation of the tax break given to home owners who use debt to buy a home. To Fama, if the government had not tried to skew the market towards home ownership there would have been no crisis.

I agree. Well in part. Clearly the government’s continuous support of home owners at the expense of renters does produce an over investment in housing. This inflates home prices because it encourages people who might otherwise rent to buy a home – the government is subsidizing ownership and not renting. So the number of people buying homes is artificially inflated and prices are forced up by this ‘excess’ demand. Abolishing the tax credit for mortgage interest would not just help close the budget deficit – it is one of our most expensive welfare programs – but it would lower home prices.

But what about market efficiency?

Should markets not adjust for this?

The rational expectations hypothesis of Fama’s colleague Robert Lucas tells us that consumers are rational enough to realize, and adjust to, distortions they see the government introducing. This is why Lucas argues against any government intervention and is such an ardent opponent of Keynsian style stimulus. [Lucas won the Nobel prize for this work]

So what happened?

The free market crowd cannot have it both ways. They cannot argue, as Lucas and Fama do, that it was all the government’s fault, and then turn around and argue that stimulus won’t work because the market won’t be fooled by it. I have to ask: why was the market fooled at all? By those low rates for instance?

The problem is much less complicated if, like me, you are more skeptical about markets than Fama and Lucas are. I prefer Minsky’s interpretation of Keyne’s basic theory: markets can and often do wander away from a balance or equilibrium position. They are often inefficient and absorb information poorly. They are prone to excess and crisis. Bubbles are a frequent and natural result of this inefficiency.

Minsky’s ‘Financial Instability Hypothesis’ stands far more justified by recent events than Fama’s Efficient Markets Hypothesis. This is a resounding defeat for the Chicago school of thought, the legacy of Milton Friedman, in economics, and brings to an end a very divisive chapter in the history of economic theory. Keynes has been rehabilitated from the temporary victory won by Friedman and his ‘monetarist’ colleagues and the subsequent ‘New Classical’ theory developed mainly at Chicago.

The irony of this was summed up well by Greg Mankiw, a Harvard professor and sometime advisor to George Bush, who wrote in 2006 that most of economic theory developed since 1970 has proven to be useless at best and damaging to public policy at worst. Mankiw is a Keynsian of sorts and so probably delights in the travails of the Chicago school.

For the rest of us: we see the conflict over economic theory form the outside. It manifests itself in this discussion over the role of the Fed. If you are a New Classicist and believe in market magic then the Fed must be at fault since the market is always correct. If you are a Keynsian you can be more ecumenical and so can spread the blame around.

It wasn’t just the Fed. The private sector went insane as well. The market failed.

Which is why we need to set up new rules and boundaries to stop a repeat. This is the basis for the re-regulation argument. Since markets can and do go wrong, it is socially less expensive, and very wise, to limit the extent of the market by hemming in the players with institutional rules. We call those rules ‘regulation’. The people who are regulated see it all as unnecessary government tinkering and red tape. Taxpayers should see it as insurance to limit the cost of the next bail out.

And, yes, we will need another bail out. Markets go wrong. That means banks will need help. Regulations are designed to reduce the cost of that next bail out.

So it wasn’t just interest rates.

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Interest Rates … Time For A Raise?

No. No. No.

Not at all.

One of the oddest discussions now taking place in economic policy making circles is the one that concerns when, and how fast, interest rates should be raised. I find it odd simply because there is no analytical, theoretical, support anywhere for a raise. It is likely to stay that way for many months. So why is it that practically every day I see articles opining on the subject, and read of miscellaneous Federal officials – usually from the more obscure regions of the Federal Reserve System – making tough statements about how it mat be necessary for the fed to raise rates even if unemployment has not improved.

“Tighter money now would not just slow the recovery, it would eliminate it.”

Say what?

Frankly a raise in rates could not be more catastrophic. So what’s with all this talk?

Traders. That’s what.

The only people who could conceivably benefit from higher rates are within the trading community. Everyone else would lose. And lose big.

The whole discussion is simply an aspect of the ongoing war within the economics world about whether a stimulus was a good idea and whether the Fed has gone too far in pumping money into the economy.

I touched on some of this at the end of last week, but let’s review the facts anyway.

The Fed raises and lowers interest rates as its primary management tool as it tries to keep the economy growing at an even rate. The objective is to prevent surges in inflation and to balance the threat of inflation against the threat of unemployment. The recent bias has been to ‘manage’ inflation’ aggressively on the principle that a low and steady inflation rate provides a strong basis for a healthy economy.

There is a rule of thumb called the ‘Taylor Rule’ which provides an analytical background for policy as the Fed goes about this balancing act. Essentially the Taylor Rule – developed by John Taylor, a conservative economist from Stanford, is a regression analysis that provides a good fit with actual Fed policy over the last few decades. The Fed itself doesn’t openly say that it uses the taylor Rule, but it reports on where rates would be if it did. As I just noted for most of the last few years rates have tracked the rule well.

The problem we have now is that, given the gap between actual output and potential output in the economy, and given the very high unemployment we ore now experiencing, the Taylor Rule indicates that the Fed should be holding the Fed Funds rate – its primary weapon in rate management – at -5%. That’s right, minus 5%. Or maybe even closer to minus 6% depending on your view of the unemployment trend.

Since it is not possible to run negative nominal interest rates – imagine what would happen if the bank had to pay you interest when if borrowed from it – the Fed is stuck. It has hit what economists call the ‘zero bound’. So even though all the signs are that we need lower rates to get the economy moving, we cannot go there. This is why the Fed has had to resort to all sorts of unorthodox and never before seen methods to get cash into the economy. The result of these methods – collectively called ‘unconventional easing’ in the jargon of monetary economists – is that the banking system is awash with cash. Cash that is going nowhere because banks are refusing to lend while they are afraid of future loan losses.

This is where the interest rate ‘hawks’ – those who want to lift rates sooner rather than later – enter the discussion.

Generally speaking the hawks are folks who objected to the unconventional easing in the first place. They saw that sea of cash as an inevitable trigger of future inflation, and have lived in terror of it ever since. They are the ones using emotive phrases such as the ‘upcoming great inflation’ and urging a quick reversal of the easy money strategy currently dominating Fed policy. They are also the kind of analysts who see inflation as the only object of Fed policy – they argue that the Fed has no impact on unemployment except as a derivative of its primary function as regulator of tight money. Therefore targeting an unemployment rate, or even worrying too much about it, is irrelevant to the formation of sound Fed policy.

Needless to say most of these people are conservative politically and very oriented towards money market matters.

They are also nuts.

There is nothing in any theoretical tract that I am aware of that would argue for higher interest rates any time soon. Nothing. On the contrary, using that Taylor Rule and plugging in forecast activity in the economy, it seems that we should be continuing our current easy money policy regime until the unemployment rate has fallen to somewhere around 7% to 7.25%. No one that I know of thinks we will reach that happy point for a few quarters. Most think we won’t arrive at that level of unemployment until 2011 at the earliest. Raising rates before then would be seriously, and possibly fatally, damaging to the recovery.

It is not as if we have no history to guide us. The Fed made exactly this mistake in the late 1930’s. It raise rates too soon and choked off what appeared to be a healthy recovery sending the economy lurching straight back into depression. A depression that only the wartime build up of the early 1940’s ended.

So why are the hawks so aggressive in trying to force rates up?

Because they are money market people and are fearful of the reaction of the bond market to continued easy money as the recovery begins to take hold. The bond market is very sensitive to inflation, it builds inflation ‘expectations’ into its interest rate requirements. This is very rational behavior. After all a bond can have a very long life – up to 30 years – so an investor is exposed, theoretically, to a variety of risks not least of which is having the value of their investment depreciated by high and prolonged inflation. Conversely, a borrower such as the US government is quite happy to see high inflation since the money that they eventually have to pay back will be expressed in currency considerably diminished in value by that inflation.

It is because the hawks and the bond markets are suspicious that the government would like to encourage a higher rate of inflation – so as to reduce the impact of the deficit on future generations – that they want to see the breaks slammed on early. Inflicting a little bit of good old Puritanical pain on the unemployed is of no consequence to the hawks as long as the dollar remains strong. Maintaining that strength, for them, is paramount, and can only be accomplished by running rate up as soon as the recovery begins. That means raising rates early next year at the latest.

So that is the debate. Those in favor of an early rate hike have no theory to support them, they simply are biased towards a tight money policy so as to maintain bond values. They see all that cash sloshing around on bank balance sheets as the most dangerous aspect of the current economic situation. they want those bank reserves drained as soon as possible. Even if that slows the recovery.

They apparently forget the 1930’s lesson.

Tighter money now would not just slow the recovery, it would eliminate it.

Nothing could be worse.

Having a bond market bias is not necessarily a good credential for a central banker. In fact it is, currently at least, the acme of a disqualification criterion.

However, there seems to be a ton of those hawks about so I expect this discussion to run on through the winter. Which is too bad, since it distracts us from managing our way through the transition from our current stimulus supported recovery towards a self sustained one.

A sustainable recovery with more jobs should be our goal. Frankly a little inflation, to help ease debt burdens, would help us get there. No wonder the bond market is getting antsy.

Meanwhile: let’s vote no on any rate increases.

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Muddle Over The Fed [Or How John Taylor Can’t Think Straight]

Today’s Financial Times has a couple of articles in it concerning the Federal Reserve Board and Ben Bernanke. The general thrust of each is to diffuse criticism of the Fed and to advocate it’s independence and the overall record of Bernanke himself. One piece is an editorial favoring Bernanke’s re-appointment as Fed chairman. The other is an op-ed by the well known economist John Taylor – he of the ‘Taylor Rule’ – arguing against expanding the Fed’s role as a regulator, and defending it’s role as ‘independent’ overseer of monetary policy.

It is this second piece that I want to address.

I was originally going to entitle this post something like: ‘John Taylor’s an Idiot’, but thought better of itbothout of deference to him, he has that rule named after him, and he teaches at Stanford, and because I didn’t think anyone reading my blog would know who he was.

Should you all care?

Yes: he is influential, and his views are a good reflection of the muddle that neo-classical economists can get themselves into when they want to defend their rotten theories from attack and, at the same time, deflect blame for the economic crisis away from those theories. Taylor often pops up with a right wing viewpoint, so he’s worth listening to in order to understand why our economic elite has so little to offer as we fumble our way out of the crisis.

So let’s get to his article.

He begins with a very ordinary argument against expanding the Fed’s powers as a regulator. I find myself in agreement with Taylor that the Fed should be highly limited. But when he slips into his patronizing justification that the government department’s are best forced to focus on limited objectives he let’s his orthodox slip show a tad too much. I get the feeling he’s thinking that those government employees are just too dumb to handle several tasks at once, unlike the heroes over at Citigroup, for instance. Hmmm. A bit of bias creeping in there Professor Taylor?

Then he goes on to argue for the Fed to be limited because extending its oversight remit would raise the risk – gasp – of political interference. And in neo-classical ideology nothing – and I mean nothing – can be worse than political interference. this is because we all absolutely ‘know’ that the government is always inefficient when compared with the smooth operation of the free market – right Professor Taylor?

So we want to remove politics from the Fed so as to sanitize it from the taint of government. That way it can take those hard decisions raise interest rates and prevent bubbles without having to worry about what the politicians think, or what would happen to those big banks it regulates.

Taylor is right: a Fed that has big ‘systemically important’ banks as it regulatory target might be more inclined to do things to help those banks avoid trouble – after all it will know what kind of mess they are in and it wouldn’t want to be blamed if one went belly up.

But this raises a conundrum for Taylor and all ideologues like him:

If the Fed is independent of government and thus making decisions based upon purely economic grounds – informed by standard economic theory no less – how do we all account for its recent performance?

Taylor does this by eliding straight into an attack on government.

The second part of his article talks about how the current crisis stems from a failure of government. He puts it succinctly::

“The financial crisis was caused in large part by government actions such as monetary authority that aggravated the housing boom.”

Let’s think this through rigorously rather than sloppily.

The housing boom was, according to Professor Taylor, abetted by lax government actions. Ergo to avoid future recurrences we need to slap government into shape rather tan extend its role by giving the Fed more oversight.

But Professor: is the Fed not independent of the government? Is it not your fear that the Fed might lose that independence? Have you not just spent half an article arguing that extending the Fed’s role would jeopardize that independence?

I think the Professor has his proverbials in a twist.

He has run plumb into the neo-classicists ideological trap.

Yes the Fed is proudly independent. Yes it would lose that independence were it to take on more regulatory responsibility. That is why I want to strip it of all regulatory responsibility.

But that’s the point Professor: it is and was independent. It has been since 1951, when as the Financial Times editorial points out the heavy hand of Treasury [i.e. government] meddling was cut away.

So: it was not ‘government actions’ that contributed to the financial crisis, was it? No not at all. It was the independent Fed under the leadership of Alan Greenspan and Ben Bernanke.

There you have it.

Taylor is playing the usual right-wing bait and switch game.

He is saying the Fed should remain independent because that suits his anti-government bias. But then he turns around and blames the government for the financial crisis. And the government agency he pins the blame on is the same Fed whose independence he lauded but two sentences previously.

Now the Professor is academically very rigorous no doubt – tainted by his ideology, but so are most academic economists – but he allows himself to be extraordinarily sloppy in this article. He surely wouldn’t give himself a very good grade.

So why does he commit his error?

Because there is something even more sinister than government interference in his mind: criticism of orthodox economic theory.

It turns out that the independent Fed executed flawlessly along the lines expected by textbook theory. And thereby contributed mightily to the crisis.

So the good Professor is trapped into defending the Fed as independent when it works well, and then contradicting himself and labeling it as a government agency when it screws up.

How rigorous!

How non-scientific!

How totally political!

How ideological!

That’s textbook economics for you.

No wonder economists are the subject of ridicule.

A true scientist -something Taylor evidently is not – would look at the evidence and reformulate his hypothesis in the light of revealed facts. Not those neo-classicists! No. They reformulate the facts in order to preserve their hallowed theories.

Elsewhere in the FT another columnist – Tony Jackson – calls out the neo-classicists. He relates the story of Robert Schiller – a renegade in economics – getting a cold reception at an economics seminar when he used the word ‘bubble’. Schiller says that word was received like talk of zodiac signs at a meeting of astronomers. For those of you who don’t realize it: there can be no bubbles in a neo-classical world. The market is always correct in its valuations no matter how erratic or absurd.

It is that level of denial that allows Taylor to double talk in his article.

Back on planet earth, and away from the world Taylor and his ilk inhabit, it is the neo-classicists who are the astrologers.

Ben Bernanke as palm reader-in-chief. Now that has a ring to it.

Addendum:

More bad news for the Professor. Here’s a quote from the Wikipedia entry that describes the ‘Taylor Rule’ – a piece of economic thinking that the Professor is no doubt proud of:

“Although the Fed does not explicitly follow the rule, many analyses show that the rule does a fairly accurate job of describing how US monetary policy actually was conducted earlier under Alan Greenspan“

Hmmmm.

The Fed clearly followed the Taylor Rule during the Greenspan era. Right when the Professor claims that the Fed, qua government agency, was contributing to the financial crisis.

Now we’ve got him.

Apparently it was the Taylor Rule that contributed to the financial crisis.

Ouch!

That’s got to hurt.

No wonder he’s muddled about the Fed. They use his rule, and drive the ship onto the rocks. Oops. No wonder he’s angry at them.

Maybe it’s a different Taylor?

Nope. Sorry Professor: you’re part of the problem.