We’ve ignored the Federal Reserve Board for weeks now and with good reason. We’ve been bored with the board.
There have been no taper tantrums. There’s been no pontificating about macroprudential supervision, quantitative easing or even forward guidance. No one is talking about negative interest rates anymore.
Neel Kashkari
How boring is the board? The Fed has even issued the same policy statements after each meeting with only a few word changes. And the original policy statement was not too exciting, either.
In fact, the Fed has done next to nothing in the three years since Janet Yellen was appointed to chair it. What’s happened over that period? The Fed has increased interest rates twice, by a total of 0.5% to 0.75%.
The latest yawner was in December, when the Fed raised rates by a whole 0.25%. Even the economists and experts predicted that one. Heck, even The New York Times predicted it correctly.
Financial journalists who have the misfortune of covering the Fed attempted to make it a big event. Google “taper tantrum” and you’ll find that virtually every journalist who wrote about the rate increase compared it to the May 2013 “taper tantrum,” which was when then-Fed Chair Ben Bernanke caused the stock market to tank by indicating that the Fed would end quantitative easing … someday.
A typical headline: “Mortgage rates surge past 4% as taper tantrum fears rekindle.” At one point, when the world was far more rational, a 4% mortgage rate would have been unimaginable low. Today, it’s a financial disaster.
Like the aforementioned financial journalists, we’ve been guilty of writing frequently about the nothing-happening Yellen-led Fed. Somehow, we managed to write 30 blog posts about the woman, but it’s been a challenge. Even out of office, predecessor Ben Bernanke has been more fun, having, for example, written the book, How the Fed Saved the World … which would have been titled How Ben Bernanke Saved the World if he weren’t so modest.
Kashkari vs. Taylor
So why, then, is the Fed no longer boring?
Because of newbie board member Neel Kashkari and John Taylor, a Stanford professor who served as a Treasury undersecretary. They made the Fed interesting again, relatively speaking, by airing their differences of opinion on The Wall Street Journal’s op-ed pages.
Kashkari started by claiming that a computer can’t do the Fed’s job. Given recent history, it might be fair to claim that a reasonably intelligent monkey could to the Fed’s job, but Kashkari seems to think that human interaction is necessary to keep the economy from imploding.
He called out the Taylor rule, created by the Stanford professor more than 20 years ago, which “calculates a desired level for the federal-funds rate based on measures of inflation and economic output.”
Kashkari claimed that following rules would “unduly limit the Fed’s policy tools and ultimately harm the economy and in turn employment.”
His staff at the Minneapolis Fed estimated that if the Federal Open Market Committee had followed the Taylor rule during the past five years, 2.5 million more Americans would be unemployed today. Kashkari doesn’t reveal how that wonderfully round number was arrived at, but we can guess that his staff knew the answer their boss wanted.
“Over the past 25 years the world has seen extraordinary technological innovations,” Kashkari wrote, “the rise of China, the creation and strains of the eurozone, the financial crisis and U.S. inflation falling from around 4% to less than 2%. No simple algebraic formula can take into account such a dynamic global economy. Google Maps is a brilliant application. Every once in a while it recommends driving into the middle of a lake.”
Man vs. Machine
It could be argued, though, that it was human intervention that put us in the middle of a lake. Many believe that former Fed Chair Alan Greenspan caused the 2007 housing bubble and the financial crisis that followed.
In an op-ed that ran two days after Kashkari’s, Taylor makes that point: “To understand why reform is needed, recall that the Fed moved away from a rules-based policy in 2003-05 when it held the federal-funds rate well below what was indicated by the favorable experience of the previous two decades. The results were not good. The excessively low rates brought on a risk-taking search for yield and excesses in the housing market. Along with a breakdown in the regulatory process, these actions were a key factor in the financial crisis and the Great Recession.”
He suggests that 1. No one is advocating that computers run the Fed and 2. Humans aren’t cutting it in their management of monetary policy. While he believes the Fed “did a good job” in fall 2008 by providing liquidity and cutting the fed-funds rate, he criticizes the Fed’s longer term quantitative easing program.
“These policies were ineffective,” Taylor wrote. “Economic growth came in consistently below what the Fed forecast and much weaker than in earlier recoveries from deep recessions. Such policies discourage lending by squeezing margins, widen disparities in income distribution, adversely affect savers and increase the volatility of the dollar. Experienced market participants have expressed concerns about bubbles, imbalances and distortions.”
Because of the Fed’s incompetence (my word, not his) and the potential for political influence, Taylor and other economists, including Nobel Prize winners, former Fed officials and other monetary experts, have signed a statement advocating for legislation mandating rules reform at the Fed.
“The legislation does not chain the Fed to any rule, and certainly not to a mechanical rule,” the statement says. “The Fed could change its strategy or deviate from it if circumstances called for a change, in which case the Fed would have to explain why.”
It adds that, “In no way would the legislation compromise the Fed’s independence. On the contrary, publically reporting a strategy helps prevent policy makers from bending under pressure and sacrificing independence. It strengthens independence by reducing or removing pressures from markets and governments to finance budget deficits or deviate from policies that enhance economic stability.”
Taylor wrote that his rule, which has been used worldwide, “calls for central banks to increase interest rates by a certain amount when price inflation rises and to decrease interest rates by a certain amount when the economy goes into a recession.”
Contrary to analysis by Kashkari’s staff, Taylor wrote that during periods when the Fed has used the Taylor rule, the U.S. unemployment rate was an average of 1.4% lower than during periods when it wasn’t used.
While Taylor’s conclusions seem reasonable to us, Kashkari did make a point that we agree with wholeheartedly.
“We need an economy that is growing strongly on its own,” he wrote, “driven by real, productivity-enhancing investments, rather than support of the central bank. … A high-growth, investment-driven economy will automatically put monetary policy on the back burner, where it should be.”
Indeed, it should.