Rajan Plays Calvinball on Monetary Policy

Raghuram Rajan has a post on monetary policy and QE2 at Project Syndicate titled Money Magic (h/t Reihan Salam). A friend pointed out that post-crisis conservative economists talking about monetary policy in general, and QE2 specifically, is like watching a game of Calvinball – they appear to be making up the rules and the specifics of how to score points in the debate on the fly.

If I read this correctly, it’s an argument against monetary policy in general. Rajan:

Some Americans view Fed Chairman Ben Bernanke as a modern-day wizard, able to revive the economy through a swish of his monetary wand – first ultra-low interest rates, then quantitative easing, and perhaps eventually money-printing. If inflation is low, they want the Fed to use every spell it knows to revive the economy. Like the World War I generals who reacted to every slaughter of their men by sending even more over the top of their trenches in a vain attempt to overwhelm the enemy, “free money” types react with “More!” if their policy does not seem to be working.

More than any other policy action, monetary policy suffers from the sense that there is a free lunch to be had. Yet the interest rate is a price for the savings that are transferred to spenders. To the extent that the Fed manages to push this price down (and some economists will dispute its ability to push any meaningful interest rate down), it taxes the producers of savings and subsidizes the spenders of savings. Clearly, no government considers pushing down the price of any real good an effective way to stimulate the economy – any gain to consumers is a loss to producers, and the loss typically will outweigh the gain if the market price is a fair one. So why are savings different?…

A second view is that households are scared and saving too much – they need to be pushed into consuming by lowering the returns to savings. It is hard to imagine, though, that with the US household savings rate at about 5%, and with households severely indebted, they are saving too much. While it might be nice to get them to spend a little more now, and save more later, it is hard to engineer this easily….

Clearly, someone is paying a price for ultra-low interest rates: the patient and uncomplaining saver….

Here’s a thought exercise I encourage people to do when they dissect what people think about monetary policy at the zero bound, where we are now.  Imagine short-term interest rates were actually at 2% right now.  Somebody forgot to actually go ahead and push them down to zero. Whoops.  If you looked out at the economy, would you lower interest rates?  Given unemployment, inflation, off-trend GDP and all the other conditions of the economy, do you think the economy is heating up too fast or too slow?  If you would lower short-term interest rates at 2% now, which you probably should, why don’t you do it at zero, other than the fact that you can’t?

Rajan, who previously argued that there was something special about being at zero that made the market go sideways, apparently wouldn’t reduce the short-term rates given the state of the economy. Even worse, he’s gone from creating arguments that the zero-bound encourages too much speculation to a morality play.  There’s Ben Bernanke, a WWI general pushing soldiers over the trenches.  Inflation taxes producers and subsidizes spenders is the main result.  Would the phrase that inflation taxes hoarders, provides incentives to do transactions, relieves the debt burden of the past and balances the relationship between creditors and debtors (and debt and the entire economy) be equally acceptable?

There’s a reason people either look to employment and inflation or a level or inflation target to determine what is the best course of action in monetary policy.  It’s so that the goal of monetary policy is clear.  It’s not about rewarding the good people and punishing the wicked, it’s about stabilizing growth, prices and maximum employment without overheating the system or letting it choke to death from a lack of oxygen.  And it isn’t clear to me what rules or rough guidelines are motivating the argument here.  Hence, Calvinball.

We’ll have more on this next week, but as for severely indebted households, remember that QE kicked off a refinancing boom that was important for repairing balance sheets. As Joe Gagnon noted at the Roosevelt Institute’s Federal Reserve conference ”one of the biggest goals of QEI was to push down the mortgage rate to spark a refinancing boom to encourage households and enable households to reduce their expenditures and repair their balance sheets and be able to spend again. That worked not quite as well as we hoped because the administration’s program for getting underwater borrowers to borrow didn’t work and I think that’s a true disaster that has no excuse.” Getting the GSEs to allow refinancing of underwater homes on more favorable terms would constitute another wave of immediate stimulus.

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Monetary policy since 2000

I just returned from the annual conference of the

Society for Financial Econometrics
hosted by the University of Chicago. One of the many interesting papers described changes in Federal Reserve policy over time.

One formulation commonly used to summarize Fed policy is the

Taylor Rule ,
which calls for the Fed to choose a higher interest rate when inflation is high and a lower interest rate when there is a big gap between the level of GDP and estimate of what the economy could produce at full potential. The Taylor Principle suggests that in response to a 1 percentage point increase in inflation, the Fed needs to increase the short-term interest rate by more than 1 percentage point in order to keep the economy on a stable path. A paper by Li, Li, and Yu presented at the SoFiE conference proposed that perhaps the Fed has been using different coefficients for this rule at different points in time. They estimated a regime-switching model that allows for such shifts. They identified some periods in which the Taylor Principle was adhered to (with a 1% increase in inflation leading the Fed to increase the interest rate by 1.5%), and others in which it was not (with a 1% increase in inflation leading the Fed to increase the interest rate by only 0.86%). The graph below plots their inferred probability that the Fed was in the accommodative regime at different historical dates. Their conclusion is that the Fed was not adhering to the Taylor Principle in the 1960s and 1970s, and returned to that accommodative regime again over the last decade.

Inferred probability that the Fed was in the accommodative regime. Source: Li, Li, and Yu (2010).

It's interesting to look in detail at their description of the most recent decade. The red line in the graph below denotes the actual 3-month T-bill rate over 2000-2007. The blue line indicates the interest rate the Fed would have set if it were following the historical pro-active rule, and fuchsia indicates the predicted rate under the accommodative rule. The Fed seemed to start out the decade following the pro-active rule and then switched to an interest rate even below the accommodative rule.

Red: actual 3-month interest rate; blue: level implied by stable Taylor Rule; fuchsia: level implied by accommodative Taylor Rule; turquoise: level predicted by regime-switching model. Source: Li, Li, and Yu (2010).

This provides an interesting confirmation of the theme of a talk by Stanford Professor John Taylor also given at the conference. Taylor argued that a shift away from the policies followed in the 1990s was one factor contributing to the excessive housing boom and subsequent problems. My personal view is that Taylor overstates the contribution of low interest rates, and that poor regulation of the shadow banking system was a more important cause of the problem.

Nevertheless, I agree that the lax monetary policy of 2003-2005 was a mistake.

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