Rethinking Monetary Policy – Cato’s 33rd Annual Monetary Conference

monetary policy, federal reserve, plosser, miron, selgin, sumner, john b. taylorMore than two hundred people gathered at the Cato Institute last Thursday for our 33rd Annual Monetary Conference.  Over the course of three addresses and four panel discussions, a distinguished cast of speakers — including St. Louis Fed president James Bullard, Richmond Fed president Jeffrey Lacker, and Stanford economist John Taylor — covered topics ranging from the rights and wrongs of monetary rules, to the ins and outs of the Fed’s long-awaited “exit strategy” from quantitative easing and near-zero interest rates.  If you didn’t make the event, here’s a synopsis.

Opening Keynote

Bullard kicked things off with the keynote address, noting that while he favors policy normalization — that is, a return to the kind of monetary policy (and Fed balance sheet) that prevailed between 1984 and 2007 — there is a risk that we’ll get stuck at “Permazero” if the economy fails to take off, or suffers new negative shocks.  He speculated that inflation would stay persistently below target in such a scenario, while monetary policy would lose its power to stimulate or stabilize.  Long-run growth would continue to be driven by real factors, but asset prices could become very volatile.  Bullard stressed that this was just one possible interpretation, and that it didn’t change his view that the Fed should begin raising rates and shrinking its balance sheet.  Nevertheless, he said, we should be prepared for the possibility that things do not go according to plan.

Panel 1: What Monetary Policy Can and Can’t Do

The day’s first panel, moderated by Wall Street Journal chief economics correspondent Jon Hilsenrath, focused on what monetary policy can and cannot do.  There was a broad consensus among the panelists — the Richmond Fed’s Jeffrey Lacker, the Bank of Mexico’s Manuel Sanchez, and George Tavlas of the Bank of Greece — that monetary policy should focus on price stability, while steering clear of objectives it is less suited to, like boosting growth, guaranteeing financial stability, or pricking asset bubbles.  Within that discussion, Tavlas made the case for monetary rules over “constrained discretion,” suggesting that Milton Friedman might be sympathetic to the Taylor rule if he were around today.

Panel 2: Inflation, Deflation, and Monetary Rules

Monetary rules were the focus of the next panel, which featured John Taylor (he of the eponymous rule), former Philadelphia Fed president Charles Plosser, the Mercatus Center’s Scott Sumner, and our very own George Selgin.  Although all four panelists favored a shift towards rule-based monetary policy, each took a different approach.

Plosser noted that the Fed already runs five different monetary rules through its model of the economy when preparing for Federal Open Market Committee meetings.  So why not release the results of that analysis, and use it to explain how policy decisions are made?  Sumner advocated a similarly incremental approach, suggesting the Fed could be “nudged” towards his favored paradigm — NGDP targeting — with requirements that it clearly define the “stance of monetary policy” in its communications, regularly review its past policy decisions, and set “guardrails” for the maximum permissible fluctuations in aggregate demand.  Selgin drew a distinction between rules and “pseudo-rules,” arguing that the former must be strictly enforced, hard to “innocently” break, and possible to stick to during a crisis.  Taylor, meanwhile, argued that capricious monetary policy was promoting massive capital flows between emerging and developed economies, stoking exchange rate volatility, and giving rise to widespread capital controls and currency manipulation.  Rule-based monetary policy, he suggested, is a necessary complement to open capital markets and floating exchange rates — and legislation in the U.S. would set a great example for the rest of the world.

Luncheon Address

Claudio Borio, the head of the monetary and economic department at the Bank for International Settlements (BIS), delivered the conference’s luncheon address, arguing that we need to reassess “three pillars” of received monetary policy wisdom — first, that the natural rate of interest is best defined in terms of output and inflation; second, that money is neutral; and third, that deflation is always and everywhere a disaster.  Borio rejected all three premises.  He preferred to think of the “natural rate” as one which is consistent with good, sustainable macroeconomic performance.  According to this view, financial imbalances (such as asset price bubbles) are the key signifier of disequilibrium.  Borio also questioned the idea of monetary neutrality, arguing that credit-induced resource misallocation is central to an accurate understanding of the economic cycle.  This means that easy money can’t always solve our problems; you need structural and balance sheet reform after a crisis.  Finally, on deflation, Borio highlighted BIS research suggesting that there is only a weak association between deflation and economic contraction.  What link there is derives largely from the Great Depression and is more aptly attributed, in that case, to a collapse in asset prices.  In reality, said Borio, garden-variety falls in the prices of goods and services do not always portend doom — and shouldn’t always spur offsetting policy actions.

Panel 3: Monetary Policy and the Knowledge Problem

The monetary conference’s third panel discussion focused on Hayek’s knowledge problem in the context of monetary policy.  Cato senior fellow Gerald O’Driscoll suggested that the knowledge problem explains why rule-based monetary policy is superior to central bank discretion — we don’t know enough to design an optimal monetary policy, so we’re better off using rules to create a monetary order and anchor expectations.  The American Enterprise Institute’s Alex Pollock took a similar approach, asking, “Does the Federal Reserve Know What It’s Doing?”  His answer was a resounding “no” — but it’s not their fault, said Pollock; it’s fundamental uncertainty, not incompetence, that dooms the Fed to recurring failure.  Speaking last, David Malpass of Encima Global LLC added his voice to calls for monetary policy normalization, arguing that the Fed’s zero-interest rate policy is actually weighing down economic growth.

Panel 4: The Fed’s Exit Strategy vs. Fundamental Reform

The prospect of monetary policy normalization provided the backdrop to the day’s final panel discussion: “The Fed’s Exit Strategy vs. Fundamental Reform.”  Alt-M contributor and George Mason University economics professor Larry White tackled the first half of that title.  He argued that quantitative easing (QE) wasn’t really a monetary policy at all: by deciding to pay interest on bank reserves held at the Fed, policymakers effectively “sterilized” QE, which meant it barely affected the broad-money (M2) aggregates.  What sterilized QE did do, however, was to preferentially allocate credit towards housing over other uses.  In this context, an “exit strategy” worthy of the name must put an end to this discretionary credit allocation — but, alas, there’s little indication that the Fed has any intention of doing that.  Jerry Jordan, former president of the Cleveland Fed, was similarly gloomy about the prospects for a meaningful exit strategy, arguing that monetary policy has lost its potency now that banks are no longer reserve-constrained, and questioning the Fed’s ability to normalize policy even if it wants to.  Kevin Dowd, an adjunct scholar at Cato’s Center for Monetary and Financial Alternatives, brought the session to a close by outlining a bold agenda for fundamental monetary and financial reform, eschewing incremental steps in favor of a re-commoditized dollar, an entirely new bank capital regime, radically reformed bank governance, and a thoroughgoing roll-back of government intervention in the United States’ monetary and financial system.

Closing Address

The closing address of the 33rd Annual Monetary Conference was delivered by Rep. Bill Huizenga (R-Mich.), who chairs the House Financial Services Subcommittee on Monetary Policy and Trade.  His remarks focused on the draft legislation he unveiled earlier this year, which would require the Fed to adopt an explicit policy rule, and grant greater auditing power to the Government Accountability Office, among other reforms.

If you missed the conference, video footage of all the sessions is available here, on Cato’s website.  The papers submitted to the conference will also be published in next year’s Spring/Summer issue of the Cato Journal.