DETROIT (MNI) – The following is the second section of the remarks
of Chicago Federal Reserve Bank President Charles Evans Monday, prepared
for the Michigan Council on Economic Education on the topic of “Mandate
Responsibilities: Maintaining Credibility during a Time of Immense
Economic Challenges:”
Where does credibility come into play in all of this?
Since no policymaking process can be perfect, some errors will
naturally arise. At the forecasting stage, no one has a perfect crystal
ball. Forecast errors will be made, and these errors could have an
impact on credibility. It seems natural to believe that greater losses
would occur if there were repeated mistakes in economic projections of a
one-sided nature. An example would be repeated extreme optimism or
extreme pessimism in the face of reasonable evidence to the contrary.
Such bouts could be due to mistakes about cyclical factors or a
misunderstanding of the changing structure of the economy.
At the policymaking level, a continuing pattern of not taking
appropriate policy actions in the face of a changing economic outlook or
structure would presumably lead to poor outcomes against medium-term
goals. Now, caution in policymaking can be a virtue.
But at some point, when the weight of the evidence is large,
continued delays in action could erode credibility.
In general, although a policymaker’s credibility account is
credited and debited on a regular basis, the most substantial
credibility losses come in two varieties: 1) really large and systematic
deviations of outcomes from ex ante chosen policy objectives; and 2) a
substantial misunderstanding of policy objectives. Monetary economists
often point to the poor economic experiences of the 1970s and 1930s as
times when the Federal Reserve’s credibility account was debited
substantially because of both of these factors. I believe the current
liquidity trap environment following the 2008 financial crisis is
similarly challenging today’s policymakers. So far, I believe we have
done the right thing. Since the recession’s end in 2009, more than once
the FOMC’s projections have proved too optimistic, and the U.S. economy
has been unable to achieve escape velocity for returning to stronger,
self-sustaining growth. But instead of doing nothing, the FOMC took
further policy actions to support stronger growth in the context of
continued price stability. These actions have provided a credible
counterweight to the forecast errors and maintained steadfastness with
our medium-term policy objectives. I’m not so sure how well we will do
going forward. My recent speech in London on dual mandate arithmetic was
meant to clarify the challenges we face in describing the Federal
Reserve’s policy objectives. The upshot I take from that analysis is
this: If we sit on our hands as the economy withers relative to our
mandate, then we could take a huge hit to our credibility, akin to what
happened to our credibility following the devastating mistakes of the
1930s.
Two Examples of Enormous Credibility Hits to Monetary Policy: The
1970s and 1930s
The Federal Reserve’s policy actions during the 1970s and 1930s
stand out as two exemplary cases of poor monetary policymaking. In the
post-war era, most critics of expansionary monetary policy cite the
1970s Fed Chairmen, Arthur Burns and William Miller, as writing the
playbook for high inflationary outcomes. By most accounts, the
BurnsMiller Fed failed to understand that growth in the productive
capabilities of the U.S. economy had slowed. In addition, changes in
labor markets made it harder to allocate workers to new jobs in quick
order. As a consequence of these structural shifts in the functioning of
the economy, the Fed policymakers failed to realize that output was
higher than they thought relative to its potential. As a result,
additional monetary stimulus couldn’t bring about stronger growth and
lower unemployment, but only exacerbated inflation, higher inflationary
expectations and an accelerating wage-price spiral. In fact, inflation
rose to double digits, wages chased these prices higher in order to
minimize reductions in living standards, and unemployment remained high.
The Burns-Miller Fed failed, but where was the failure greatest?
With regard to my earlier description of the policymaking process, the
Burns-Miller Fed did not properly understand the changing evolution of
the U.S. economy in the 1970s, nor how monetary policy interacted with
the new structure. To be fair, the Burns-Miller Fed was not alone —
other experts at that time made the same mistakes. These common
misunderstandings meant that the credibility loss over being slow to
understand the changing environment probably was not large.
Far more damaging to the Burns-Miller Fed’s credibility was the
failure to adjust policy when it later saw rising and high inflation and
inflation expectations. Surely, those developments were major evidence
of a change in the structure of the economy, and the Burns-Miller Fed’s
failure to adjust its thinking and policy in light of them had huge
implications for credibility. I take such credibility risks
extraordinarily seriously.
The 1930s were an episode of even worse Fed policymaking. This was
a period of far greater economic dislocation and hardship. When thinking
about the 1930s, I find it useful to turn to the wisdom of Milton
Friedman and Anna Schwartz from their book titled A Monetary History of
the United States, 18671960. Friedman and Schwartz discuss how monetary
policy in the early 1930s actually contributed to the contraction,
despite the fact that bank reserves increased significantly over that
period. Broad monetary aggregates contracted, even though bank reserves
were higher, because 1) banking panics and the weak real economy led the
public to hoard cash and 2) banks wanted to increase reserve ratios as
insurance against liquidity shortages and runs. As a result, the amount
of lending supported by a given level of reserves fell dramatically, and
the U.S. economy experienced a period of deflation. However, the Fed
failed to see that it was running a restrictive monetary policy. One
reason was they were striving to stay on the gold standard, which
dictated policies to counter gold outflows. In addition, the Fed
interpreted the excess reserves on banks books and the associated low
level of money market interest rates as signs of an accommodative
financial environment and so did not aggressively loosen monetary
policy. But, as Friedman and Schwartz note, this interpretation was
misguidedthe excess reserves were attempts by banks to maintain a
larger buffer stock against liquidity shortages, and low interest rates
reflected heightened demands for low-risk assets that the Fed should
have further accommodated.
I bring up the 1970s and 1930s Fed policymaking examples because
they are relevant for the critiques of monetary policy that we are
hearing today. It’s safe to say that the aggressive moves the Federal
Reserve has made to provide monetary accommodation have not been
universally applauded. Critics point to the large expansion of bank
reserves and low levels of interest rates throughout the Treasury yield
curve and surmise that the Fed is sowing the seeds of future inflation,
as in the 1970s. They believe we should be taking back accommodation —
some say now, some say soon — as the recovery gains some more steam or
inflation creeps up a few more tenths.
I don’t see it that way. Rather than fighting the inflation ghosts
of the 1970s, I am more worried about repeating the mistakes of the
1930s. As in the 1930s, today we see a lack of demand for loans and a
resistance of lenders to take on risk factors that mean the high level
of bank reserves is not finding its way into broader money measures. As
in the 1930s, today’s low Treasury interest rates in good part reflect
elevated demand for low-risk assets — we see investors run to U.S.
Treasury markets every time they hear any bad economic news from
anywhere in the world. Consider another metric for interest rates, the
well-known Taylor Rule, which captures how monetary policy typically
adjusts to output gaps and deviations in inflation from target. Its
prescriptions would call for the federal funds rates to be something
like 3.6 percent now, well below the zero lower bound the funds rate is
currently stuck at. Our large-scale asset purchases have provided
additional stimulus, but by most estimates not enough to bring us down
to the Taylor Rule prescriptions. Also, I should note that in 1998,
Friedman gave a similar recommendation to the Japanese, advocating that
the Bank of Japan undertake more accommodation by buying government
bonds on the open market.
-more- (2 of 4)
** Market News International **
[TOPICS: M$U$$$,MMUFE$,MGU$$$,MFU$$$]