Cato's Annual Monetary Conference last November hosted a "shadow review" of the Federal Reserve's own self-review, dedicated to examining "whether the U.S. monetary policy framework can be improved to meet future challenges." The articles in the spring/summer 2020 issue of the Cato Journal, drawn from that conference, are now available online.
With inflation then consistent with the Fed's 2 percent target and unemployment at remarkable lows, the Fed likely didn't expect that the "future challenges" it planned to address would come so soon, or be so extreme. Today, thanks to the federal response to the Covid-19 pandemic shuttering businesses across the country, the Fed has once again reduced its policy rate almost to zero, while renewing its large-scale asset purchases and undertaking an unprecedented program of emergency lending that has all but erased the conventional boundary line separating monetary from fiscal policy. These developments make a reexamination of the Fed's policy framework seem even more important than they were last fall.
In his Editor's Note, Cato Vice President for Monetary Studies James A. Dorn writes that today, "central banks have… greater discretion and lending authority than ever before. Monetary policy has morphed into fiscal policy. The Fed is in uncharted waters and a review of policies aimed at the 2008 financial crisis is inadequate. A major assessment of central banking and alternative money regimes is overdue." Several participants in last fall's event have updated their articles to reflect these developments.
In the spirit of fostering dialogue and debate about what we can learn from past policy errors and how to apply those lessons going forward, the Cato Journal is proud to present the articles summarized below. (To access the full text of an article, click on its title.)
"The Federal Reserve's Review of Its Monetary Policy Strategy, Tools, and Communication Practices," Richard H. Clarida, Vice Chair of the Board of Governors of the Federal Reserve System
Since the 2008 crisis, the global economy has changed in two critical ways, Clarida says. First, the natural rate of interest has fallen, and remained, well below its precrisis baseline. That makes it harder for central bankers to conduct effective countercyclical policy (which often means lowering their policy interest rate) during economic recessions. With the Fed's primary policy strategy increasingly in doubt, the Board of Governors is considering new tools it can use at the zero lower bound.
Second, the short-run Phillips curve, measuring the relationship between inflation and unemployment, is flattening. In and of itself, that's not necessarily a bad thing—but it does mean that Fed policymakers should take exceptional care to keep inflation at their self-assigned, 2 percent target, which they work to maintain together with maximum employment.
Given these changes, Clarida outlines three questions that the Fed needs to address in its review. First, given its mandate to promote price stability and maximum employment, should the Fed reconsider its current practice of "forgiving" past inflation shortfalls or surpluses, without attempting to compensate for them? While it's possible for the Fed to adopt "makeup" strategies to correct for inflation inconsistencies, this can work only if the public trusts central bankers to stick to them, which may be asking a lot. Second, does the Fed need different tools to reliably fulfill its dual mandate? While Clarida does not say whether the Fed might retire any of its existing policy tools, he does say that Fed leaders are thinking about adding new ones. Finally, how can the Federal Open Market Committee (FOMC) improve the way it communicates with the public? While it does so more often, and in more ways, than it once did, Clarida suggests that there is still room for improvement.
"Independence and Accountability via Inflation Targeting," Peter N. Ireland, Murray and Monti Professor of Economics at Boston College and Member of the Shadow Open Market Committee
Holding central bankers accountable for their decisions is vital to insulating them from partisan pressures. Yet, according to Ireland, accountability has proven difficult to achieve in practice. He illustrates this using examples from the Fed's own history: in the 1970s, "despite the occasional appearance of a statistical Phillips curve relationship between inflation and unemployment… [political efforts] to exploit that Phillips curve led… not to lower unemployment at the cost of higher inflation but instead to the worst of both worlds." Only "by focusing first on keeping inflation low," and not on propping up employment numbers, did future Fed chairs restore the American economy and its labor force. "Unemployment fluctuates no matter what," Ireland explains, "but keeping inflation low and stable can promote the Fed's full employment objective."
Ireland recommends that the Federal Reserve replace its current mandate with "a new, streamlined mandate… to focus on stabilizing inflation around its own self-declared 2 percent target." A numeric inflation target remains a key "institutional safeguard" for keeping Fed policymakers accountable to the public—while insulating them from political pressures.
"A Look Back at the Consensus Statement," Jeffrey M. Lacker, former President of the Federal Reserve Bank of Richmond and Distinguished Professor of Economics at Virginia Commonwealth University
The Federal Reserve only formalized the terms of its dual mandate in 2012, with the release of its "Statement on Longer-Run Goals and Monetary Policy Strategy" (often abbreviated as its "consensus statement"). Lacker discusses two factors that may have limited the statement's efficacy. First, the FOMC advertised the consensus statement as a mere formalization of existing policy, meaning it produced only a minimal change in the public's inflation expectations. Second, it neglects to specify a numeric employment target—or even a concrete metric for its goal of "maximum employment."
Drawing from these lessons, Lacker makes recommendations for the Fed's current policy review. He commends the statement for beginning to rectify some of the more "problematic" elements of the Fed's dual mandate—namely, that "it injects distributional politics directly into monetary policy" by specifying a numeric inflation target. Yet the Fed must now decide whether, or how, to compensate when it misses that target. It must also resolve ongoing questions surrounding its employment mandate.
"NGDP Targeting and the Public," Carola Binder, Assistant Professor of Economics at Haverford College
When the Federal Open Market Committee (FOMC) first considered replacing its existing inflation-targeting regime with nominal gross domestic product (NGDP) targeting, the idea didn't get much of a hearing. Several years removed from that initial discussion, Binder gives NGDP level targeting a second look, arguing it compares favorably to inflation targeting when it comes to weathering new threats to central bank credibility and independence. The global trend toward populism does not bode well for central banks, which, being "unpopular by design," are frequently the lightning rods of populist discourse: Binder's data show that regimes classified as "populist" or "nationalist" put greater political pressure on central banks—and higher pressure is also correlated with higher rates of inflation.
The Fed's "twin deficits" of credibility and trust make it all the more vulnerable to political interference. Partly to blame is that the FOMC conducts monetary policy via inflation targeting, which it has a harder time explaining to the public. Switching to NGDP level targeting, Binder says, would make the Fed's actions "easier to communicate, more popular, and less prone to political interference than a flexible inflation target or dual mandate." It would also "allow the Fed to frame its policy decisions in terms of income rather than inflation"—something that households and politicians can see and feel directly, which makes it easier to grasp. Nor would the switch cause any major policy disruption: in fact, had the Fed switched to NGDP level targeting in 2012, it would seem all the more successful today, given the steady growth rate NGDP has maintained since the last recession. What's more, the low inflation and unemployment rates that we had seen from 2017 until quite recently would look like a policy victory, rather than an anomaly "casting existential doubt on the Fed's model of the economy" (which assumes that inflation and unemployment are inversely correlated).
The Fed can protect its independence and enhance its credibility by replacing its dual mandate with a "single, explicit, numerical" NGDP level target, Binder says. This will make it easier for the public to gauge the Federal Reserve's credibility, easier for Fed officials to explain their decisions, and harder for politicians to subject the Federal Reserve to partisan interference.
"Federal Reserve Policy in a World of Low Interest Rates," Eric R. Sims, Professor of Economics, University of Notre Dame and NBER Research Associate, and Jing Cynthia Wu, Associate Professor of Economics, University of Notre Dame and NBER Faculty Research Fellow
Since the last crisis, interest rates around the world have found a new normal: nearly zero percent. That's typical even for flourishing economies—and that might signal trouble for central bankers whose main monetary policy strategy is interest rate targeting. Because that strategy generally means keeping the central bank's policy interest rate in line with the natural market rate of interest, a natural rate of zero jeopardizes the central bank's ability to conduct accommodative monetary policy—which often means lowering their policy rate—in the event of a recession. Sims and Wu ask whether this new reality of near-zero interest rates requires a new policy framework to match—one that can better address the increased risk of natural rates hitting the zero lower bound.
While some suggest that the next recession might warrant sub-zero interest rates, Sims and Wu show that cutting rates below zero is not effective at stimulating recessed economies. Yet the converse strategy—gradually transitioning to a higher policy rate regime before the next recession hits—is equally fraught, and unlikely to do much good. Instead of shifting policy rates, they suggest that the Fed continue using two of its most powerful postcrisis tools, quantitative easing and forward guidance, to combat economic stagnation when natural interest rates broach their zero lower bound.
"Operating Regimes and Fed Independence," Charles I. Plosser, former President and CEO, Federal Reserve Bank of Philadelphia
The Fed's postcrisis operating regime makes it more vulnerable to partisan pressures, Plosser writes, by allowing the size of the Fed's balance sheet, and therefore the overall volume of reserves, to have little—if any—bearing on its monetary policy decisions. As long as large excess reserves remain a standing feature of the Fed's operating regime, there is no limit to how large its balance sheet can become. This makes Fed policy a prime target for congressional meddling, with elected lawmakers coveting the central bank's abundant reserves for their own purposes. Indeed, lawmakers have already succeeded in funneling Fed money toward their pet projects: the crisis era bailouts, FAST act, and the Consumer Financial Protection Bureau were all funded by Congress exploiting the Fed's "power" to detach its balance sheet from the stance of monetary policy. Plosser writes that it is imperative that the Fed revise its current operating regime in order to protect its independence from congressional whims.
"How QE Changed the Shape of the U.S. Yield Curve," Manmohan Singh, Senior Financial Economist, International Monetary Fund, and Rohit Goel, Financial Sector Expert, International Monetary Fund
Lending firms often re-use long-term securities as collateral for short-term loans, which they use to purchase additional long-term, interest-earning assets. Borrowing firms get that collateral back immediately upon repaying those loans—meaning that the same long-term securities can get "recycled" through short-term lending markets again and again. Re-using high-quality bonds as short-term collateral is a process "akin to the money creation that takes place when banks take deposits and make loans," Singh and Goel write; and it "change[s] the effective supply and demand dynamics at the long-end [of the yield curve], which then feeds back into short-term rates." Their article is the first to analyze how that relationship has changed since the 2008 crisis. Before 2008, short-term policy rates "drove" interest rate behavior at the right end of the yield curve, so that "market expectations about the future path of the overnight federal funds rate were reflected in 10-year yields and beyond." Postcrisis, however, transactions using long-term securities as short-term collateral are fewer, and the influence these transactions have on short-term market rates are weaker.
Quantitative easing (QE) may play a role in that. An abundance of high-quality collateral "lubricates" the money markets. When, during a round of QE, a central bank buys up this long-term collateral and transforms it into so many permanent, static holdings on its balance sheet, its market availability declines, money markets dry out, and short-term interest rates rise. New regulations compound these effects, especially leverage ratios limiting how much collateral banks can hold, relative to reserves, at any given time.
Post-pandemic, Singh and Goel write, central banks should reduce the size of their balance sheets, and by extension, their role in lending markets. Unwinding central bank balance sheets, while freeing up more space for the assets commercial banks can hold on theirs, "is likely to improve transmission to the short-end money market rates." Regulatory changes should also keep "central bank reserves and U.S. Treasuries… as equal as possible," granting dealer banks more freedom to exchange some of their leverage (in the form of reserves) for collateral (in the form of U.S. Treasuries). That, in turn, will bolster the velocity and money-creating power of that collateral. This is especially important now, since "Covid-19 related bailouts will keep central banks' footprint even larger for even longer, unless regulations are softened to allow dealer banks more balance sheet capacity."
"Monetary Policy Operating Frameworks: Are Reforms Heading in the Right Direction?" Andrew Filardo, Head of Monetary Policy, Bank for International Settlements and Visiting Fellow, Hoover Institution
Filardo examines the repeated, and unexpected, interest rate spikes that rattled financial markets during the final months of 2018 and September 2019. Many blamed these episodes on the Fed's gradual balance sheet unwind, which added risk to the market and subtracted reserves. Yet Filardo counters that these spikes were instead "symptoms of deeper pathologies." In particular, he attributes them to flaws in how "monetary policy operations have been adapted to the new financial regulatory environment."
Contrary to claims that the Fed's postcrisis, "floor-based" operating system offers the best chance of stabilizing the money markets, Filardo argues it actually weakens incentives for financial institutions to lend to, and monitor, one another. With the Fed pumping large quantities of reserves into the market whenever money becomes scarce, private institutions rely on one another less for overnight lending. That makes them less likely to monitor one another's risk-taking behavior. If the Fed increases its lending activities, it could further erode market trust and stability. Filardo recommends two reforms for returning responsibility to the hands of private financial institutions. First, the Fed should abandon its current floor system and return to its precrisis corridor system. Second, it should adopt Filardo's own "sequestered reserve rule," requiring financial institutions and regulators to negotiate an "appropriate preannounced level of reserves necessary to satisfy liquidity regulations." That ratio would curb institutions from hoarding excess reserves and encourage them to use reserves, alongside other high-quality liquid assets, in their day-to-day operations.
"Upgrading the Fed's Operating Framework," David Beckworth, Director of the Monetary Policy Program at the George Mason University Mercatus Center
Beckworth reviews some of the major macroeconomic lessons of the last decade, examining monetary policy strategy experiments from around the globe—ranging from interest rate policy adjustments, to quantitative easing cycles, to policies aimed at expanding the monetary base. Ultimately, his survey leads him to suggest three measures for making the Fed more resilient to future crises. Along with adapting its operating framework for both positive and negative interest rate scenarios, switching from interest rate targeting to NGDP level targeting will help the Fed "provide meaningful forward guidance." To enhance the credibility of the Fed's operating framework, Beckworth also recommends that the Fed set up a standing fiscal facility for making "helicopter money" drops—with the stipulation that this facility be used only when the natural rate of interest breaches the zero lower bound. While he concedes that such a facility would allow monetary policymakers to engage in fiscal policy operations, he adds that its terms should be clearly outlined to keep the Fed's ability to marry fiscal and monetary policy constrained, rules-based, and limited in both duration and scope.
"Central Banking and the Rule of Law," Paul Tucker, former Deputy Governor, Bank of England
How can central banks can restore their legitimacy and integrity when their incentives to compromise both are so high? Tucker approaches this question from the standpoint of political and constitutional theory, rather than economics, which lends a unique perspective to his analysis. "[M]ost discussions, and especially justifications, of central bank independence are expressed entirely in the language of economics," he says; and economics, "positing a benign sovereign, sets out to achieve a flourishing society in which well-being is maximized." Political theory, on the other hand, "alert to the possibility of a malign sovereign, aims to avoid tyranny."
In constitutional democracies, Tucker says, central banks should not be exempt from "the values of democracy, constitutionalism… and of the rule of law." To that end, central bankers should design a transparent, rules-based, "money-credit constitution" for measuring their compliance with policy mandates. They should also be required to explain publicly any departures that constitution's terms. Central bankers should also keep their balance sheets "as simple and small as possible"; avoid making drastic discretionary policy changes; resist lending to insolvent firms; and develop transparent contingency plans for would-be extraordinary circumstances that may require them to temporarily increase their financial-market footprints.
"How Natural Language Processing Will Improve Central Bank Accountability and Policy," Charles W. Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia Business School, and Harry Mamaysky, Director of the Program for Financial Studies, Columbia Business School
However else central banking may change, central bank transparency is likely to improve, rather than worsen, in the near future. That's thanks to innovations in natural language processing (NLP) software, which can detect speech and language patterns associated with obfuscation or manipulation. While Fed bankers have a tendency to withhold the truth from the public, it's rarely out of malice. Instead, by making central bankers shoulder so many responsibilities—and therefore expose themselves to more blame—during economic difficulties, discretionary and unsystematic policy frameworks encourages them to dissemble. What's more, the lack of a definitive set of goals and metrics by which the public can hold them to account makes it easier for central bankers to dodge questions or provide meaningless answers about their policy decisions.
NLP can begin to address these challenges—with techniques that highlight evasive, long-winded explanations, or technology that reveals vague, meaningless, or redundant language in Fed policy statements. Calomiris and Mamaysky identify three ways that they foresee NLP improving central bank communications. First, NLP can help measure "how nonsystematic and nontransparent policy is" or reveal when central bankers "are failing to disclose their true beliefs about a policy." Second, NLP acts as a "mind reader," clarifying "which economic phenomena central bank policies are actually responding to." It also works as an "information leveler," reducing "the information asymmetry between central bankers and the public about the state of the economy." The authors predict that as NLP technology becomes more advanced, Fed policy will become more transparent (and systematic) in turn, with central bankers facing new incentives "to recognize and address observable shortcomings."
"How Politics Shapes Federal Reserve Communications," Sarah Binder, Professor of Political Science, GWU and Senior Fellow, Brookings Institution, and Mark Spindel, Founder and Chief Investment Officer, Potomac River Capital, LLC
Binder and Spindel reflect on the political origins—and consequences—of the double bind the Fed faces in its communication strategy. While transparency is vital for stabilizing market expectations and keeping central bankers accountable, it also makes it easier for politicians to blame the Fed when the economy sours. Now, conflicting and often impossible demands from Congress and the President make it nearly impossible for Fed officials to communicate openly. The authors discuss how our increasingly polarized political climate harms Fed transparency and independence, especially when it comes to inflation targeting and balance sheet operations.
One of the most politically troubling economic trends facing the Fed is the weakening relationship between inflation and unemployment. The idea that inflation and unemployment are inversely correlated has been a bedrock of Fed policy for decades, and is even the basis of the Fed's dual mandate. Now, however, "setting market expectations of future policy" through forward guidance "is near impossible in light of the Fed's uncertainties." At the same time, the Fed faces aggressive political jawboning from President Trump. Between the President's "procyclical pressure for more dovish policy… compounded by already low rates and an enfeebled Phillips curve," the Fed has dispensed with most of its communications strategies and "limited itself to meeting-by-meeting policy choices."
Nor are these choices themselves free from political pressure. When it comes to managing inflation expectations, former Federal Reserve officials have refused to consider higher inflation targets, not for economic reasons as much as out of fear that Congress might object. Similarly, the Fed's balance sheet policies are at once a topic of congressional criticism and exploitation: though Republican and Democrat lawmakers have each questioned the Fed's paying interest on excess reserves, they have also both "tapped Federal Reserve profits (a partial by-product of large balance sheet policies) to help fund political priorities."
"Pitfalls of Makeup Strategies for Mitigating the Effective Lower Bound," Andrew T. Levin, Professor of Economics, Dartmouth College, and Arunima Sinha, Assistant Professor of Economics, Fordham University
Levin and Sihna discuss three factors that make "makeup strategies" prone to failure. First is the challenge of "expectations formation": the public may not trust the Fed to carry through on a given makeup strategy; and unless people expect the Fed to change its own policy, they are unlikely to change their own patterns of spending and saving. Second is "imperfect credibility": the less credible a central bank is, the less capable it will be of influencing market behavior. Even a well-functioning and trustworthy central bank is not entirely credible—throwing the outcome of even the soundest make-up strategy in doubt. Third is "model uncertainty": all economic policies rely, to some degree, on economic modeling; and make-up strategies are no exception. Yet models are not markets, and cannot mirror reality perfectly. At best, models can merely help policymakers form educated guesses about how their strategies will pan out.
"Envisioning Monetary Freedom," George Selgin, Director of the Cato Institute's Center for Monetary and Financial Alternatives
Selgin's contribution addresses the question: what might a free market monetary system of the not-too-distant future be like? He begins by noting that, "if monetary freedom means anything, it means that people are free to choose what sort of money they will keep on hand, or accept from others, in exchange for their labor, goods, or services. And enjoying such freedom… means that government regulations neither compel people to use any particular sort of currency nor prevent entrepreneurs making alternatives to the dollar." What sort of monetary arrangements would these conditions give rise to? Among the changes Selgin contemplates are the fate of the U.S. dollar, new incentives for borrowers and lenders, and currency competition and valuation. The dollar will likely prevail in the short-term, he writes, with either a "convertibility rule" or a "quantity rule" regulating the total amount in circulation.
As for regulatory incentives, Selgin imagines a world where "both explicit and implicit deposit insurance," are done away with, followed by "all bank regulations [aside from those that] enforce voluntary contracts" between borrowers and lenders. (That includes all government bailout guarantees.) Future financial transactions will be mostly digital and "made using convertible [cash] substitutes, supplied by banks or other companies," tracked and executed by "an intricate clearing and settlement system," he says. He also discusses "converting today's Federal Reserve banks into so many private clearing houses," and allowing commercial banks the option to transact with them or a variety of competing clearing house systems.
Just how dramatic the changes will be between today's monetary system and that of a future, freer society, Selgin says, will depend not only on what changes are made—but how we make them.
"The Fed's Precrisis Monetary Framework is Well-Suited for a Free Society," Bill Nelson, Executive Vice President and Chief Economist, Bank Policy Institute
Before the 2007–09 financial crisis, the Fed's primary means of regulating the money supply were purchasing U.S. Treasuries and conducting short-term sales of government securities. These limited functions meant it seldom intervened in day-to-day market transactions. Banks borrowed and lent among one another, and the Fed served only as their lender of last resort. Postcrisis, the Fed has augmented its earlier operating framework dramatically. Nelson discusses the consequences of these changes and makes recommendations for reform. He addresses the Fed's decision to house unlimited Treasury deposits at Federal Reserve banks as well as the Fed's QE3 (or "QE Infinity" program), which continued well past its promised conclusion date. Extending QE postponed, and then altered, the Fed's earlier plans to renormalize its balance sheet. Rather than sell back the assets it had purchased from market dealers, as it first intended, the Fed opted instead to allow those assets to roll off as they mature.
Nelson argues that returning to the Fed's pre-2008 operating framework will help the economy run far more smoothly going forward. He outlines the steps the Fed should take to shrink its balance sheet and reinstate its "scarce reserves" regime. First, it should tame fluctuations in its own reserve balance (which shifts wildly owing to ups and downs in the Treasury General Account, or TGA) by relying on frequent repo operations in the short run, and by shifting more of the TGA's reserves to the private sector in the long run. Second, it should dispel the popular misconception that TGA deposits are counted among the Fed's own assets. It should also enact policies that encourage banks to rely on collateralized daylight overdrafts and use the Fed's discount window judiciously—not as a first recourse for borrowing. It should also unwind its own asset portfolio as soon as possible.
"Four Principles for a Base Money Regime," William J. Luther, Assistant Professor of Economics, Florida Atlantic University and Director, AIER Sound Money Project
Four properties define the optimal base money regime, writes Luther. The first is a stable inflation rate. While economists continue to debate whether the optimal inflation rate is slightly negative or slightly positive, it is certainly close to zero, Luther says—likely somewhere "between –4 percent and 4 percent." The second is demand-elasticity: changes in the total quantity of base money should depend, not on central bankers' discretion, but rather market demand. Luther adds the caveat that a "demand-elastic" regime does not mean adjusting the base money supply upon every shock in the real supply, "since real shocks tend to be concentrated on a particular subset of markets." The third is a uniform global currency. Not only does a uniform currency facilitate exchange in myriad direct and indirect ways; it also increases the benefits of exchange. "A common currency area prevents a regionally specific money-supply mechanism," Luther writes. "However, the financial system routes funds to those demanding them and remaining differences in regional price levels are relative-price differences. Taken together, this implies that the optimal currency area is the maximum currency area"—which is to say, global. The fourth is incentive-compatibility: those charged with creating and maintaining the monetary regime must not only be legally required, but incentive-bound, to uphold the rules by which it operates. While Luther notes that no monetary regime anywhere in the world possesses all four of these attributes, he says that taken together, they can serve as a guidepost for comparing, and improving upon, the ones in existence today.
"Money, Stability, and Free Societies," Steve H. Hanke, Professor of Applied Economics, Johns Hopkins University
The greatest threat that financial crises pose to free societies, Hanke writes, is not the supply shock that comes with it, but the civil liberty constraints that come after it. He outlines three strategies for improving global monetary stability overall, and in turn reducing the immediate and long-term threats financial crises pose to our prosperity. The first is to formalize a loose, yet official, exchange rate between the U.S. dollar and the euro. Hanke recommends that this rate be somewhere between $1.20 and $1.40 per euro. The second is to replace at least 100 central banks around the world with currency boards, which Hanke considers more stable, since unlike a central bank, a currency board is entirely non-discretionary and "cannot engage in the fiduciary issue of money." Its sole function is rather "to exchange the domestic currency it issues for an anchor currency at a fixed rate," meaning that "the quantity of domestic currency in circulation is determined by market forces." Because currency boards have "a [fixed] exchange rate policy… but no monetary policy," their economies consistently perform better than central banks' in areas like financial stability, lower inflation, debt reduction, and market productivity. Hanke's third recommendation is that governments greenlight private currency board systems, including digital currency boards like Libra. Like most businesses, central banks tend to regard these competitors as threats to their own market primacy. Unlike most businesses, however, central banks can effectively bar their competitors from entry via institutional strictures. Hanke argues against this: "The competitive forces that will be unleashed by the private alternatives would be a great stabilizer and enhance economic freedom and free societies."