Liftoff well into the future
Oct. 8, 2015
On October 2nd James Bullard, St. Louis Fed President, gave a speech to the Shadow Open Market Committee in New York, titled: Three Challenges to Central Bank Orthodoxy. In it he discusses what the current orthodox view of monetary policy is, what the three challenges to that view are, and how to think about monetary policy going forward. He puts forward a model of monetary policy that envisions a normalization of interest rates soon, beginning with a move to lift interest rates off the zero bound, and an eventual well into the future normalization of the Fed balance sheet. The speech is available at the St. Louis Fed website.
The speech summarizes well the current policy of the Federal Open Market Committee (FOMC), the economic modeling used to justify the policy, what the FOMC believes to be a realistic path to normalization of monetary policy, and the limited scope of challenges the FOMC considers to be facing such policies. It provides insight into the lack of understanding and concern the Fed has reference to the next crisis; one that likely has already started.
The speech starts out by acknowledging the very aggressive monetary policy strategy response to the 2007-2009 period. A strategy that he describes as having been successful in improving the labor market under and environment of moderate growth and inflation close to the FOMC target of 2%.
He then iterates the FOMC exit strategy. The first part of the exit strategy of ending the last round of quantitative easing (QE3) was accomplished in 2014. The next steps include the soon to be implemented liftoff of the short term Fed Funds rate, followed by a gradual shrinking of the Fed’s balance sheet via an end to reinvestments and eventually, reverse QE. The return of the balance sheet to pre-crisis levels and normalization of the short term rate, is to be accomplished sometime well in the future.
The “orthodox”, “classic”, or “traditional” U.S. monetary policy is deemed to be successful and largely having met its objectives.
Is the Committee achieving these objectives? The classic view emphasizes that indeed, these Committee objectives are close to being met…
The unemployment rate is currently 5.1 percent and has been on a downward trend. Given the large amount of uncertainty around the concept of a long-run or natural rate of unemployment, the current 5.1 percent value is statistically indistinguishable from the Committee's statement of the likely long-run level. In the last two expansions, unemployment fell well into the 4 percent range, and, barring a major recessionary shock, unemployment is likely to fall to similar levels in the quarters and years ahead. This is likely regardless of the date of liftoff, because monetary policy will remain exceptionally accommodative even after normalization begins. In short, the Committee has already hit its objective on this dimension. In addition, labor markets are likely to continue to improve going forward, barring a major negative shock…
The classic view, as I am outlining it here, would then say that unemployment of 5.1 percent and underlying inflation of 1.7 percent constitute values that are exceptionally close to the objectives of the Committee. This is so much so that based on a quadratic objective in deviations of unemployment and inflation from target, today's combination of labor market performance and inflation performance is about as good as it has ever been in the postwar era. While the metrics concerning Committee objectives are close to normal, the policy settings are not.
The three challenges
Bullard suggests that one of the challenges facing the current policies is the view that strict inflation targeting of inflation should be the target of FOMC strategy. Real output and employment statistics would be deemphasized in favor of a Taylor-type rule that would target an inflation rate of about 2%. The second challenge is the issue of the real low interest rates and whether a Taylor-type rule would imply that rates are too low; as policy objectives are close to being met. The conclusion is that low rates are fully rationalized as a Taylor-type rule might actually imply that monetary policy is not accommodative enough. The third challenge is the whether or not independent monetary policy by each countries’ central bank will increase instability in a global environment. The answer here is that each country should pursue the best stabilization policy for its own economy, and that this will also result in close to optimal conditions for the global equilibrium.
In sum, while the challenges to orthodoxy presented here are certainly tangible and interesting, I do not think they provide sufficiently robust arguments to guide U.S. monetary policy over the near and medium term. The U.S. economy will likely enjoy better outcomes if the monetary policy orthodoxy I have described is preserved as the guiding principle.
So there you have it. If we just stay the course of current monetary policy the economy is about to enjoy “better outcomes” as we move into lift-off. There is no mention of the risk of asset bubbles, or whether FOMC policy might actually be contributing to increased systemic risk.
The real “challenge” or risk to monetary policy is that the “major negative shock” as Bullard puts it, is endogenous within the model of monetary policy. The shock is not an exogenous variable. It is not a random unforeseen external factor that happens once in a great while as Gaussian distribution would indicate. The economic system is inherently unstable because of central bank policy. It is the originator of the self-similar pattern of boom bust cycles we have seen recently. By using increasingly aggressive monetary policy, all the Fed can do is create economic booms that are followed by increasingly deeper busts. They can keep this cycle going up to the point that the U.S. dollar remains relatively strong, and they avoid a currency crisis.
Murray Rothbard explains this process in his book America’s Great Depression.
In sum, businessmen were misled by bank credit inflation to invest too much in higher-order capital goods, which could only be prosperously sustained through lower time preferences and greater savings and investment; as soon as the inflation permeates to the mass of the people, the old consumption–investment proportion is reestablished, and business investments in the higher orders are seen to have been wasteful. Businessmen were led to this error by the credit expansion and its tampering with the free-market rate of interest.
The "boom," then, is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit's tampering with the free market. The "crisis" arrives when the consumers come to reestablish their desired proportions. The "depression" is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments.
There will be no lift-off because there was no real recovery; only malinvestments due to the Fed’s distortion of the economy. The next crash will be worse than the previous one as the Fed’s responses are non-linear and increasingly aggressive. We have seen a series of self-similar crashes going back to the October 1987 crash. All the Fed has done with monetary policy since then is increase the scale of each crash. Orthodox monetary policy will not provide the liftoff into economic growth as the Federal Reserve is predicting. It is the cause of the next crash, one that may have already started.
Comparing the two models
The next chart is what monetary policy might look like if we actually began the process of rate normalization and a gradual reduction of the Fed’s balance sheet.
The second chart is what monetary policy might look like if the Fed has to return back to a non-linear response consistent with the last two crashes. The data assumes the Fed Funds rate stays near zero. The monetary base is increased by $50 billion a month for 2016, $100 billion a month for 2017, and $200 billion a month thereafter.
The timing & size of QE4 are of course unknown. The assumption for this chart is that we yet get a crash in Q4 of 2015, and the Fed is forced to respond shortly thereafter with a return to QE3 level stimulus. This will have to be expanded at some point as the crisis deepens into to something worse than 2008-2009. $200 billion a month level expansion would be consistent with the non-linear nature of each successive response, and is not out of proportion with what Japan is already doing relative to GDP.
These charts are not predictions, but help illustrate the differences of the two schools of thought. The comparison helps explain how far off the Fed is when it comes predicting economic activity and what its relevant monetary policy will be. We shall see shortly if third time's a charm for the Fed.