the federal reserve – stabilizing and destabilizing influences on the u.s. economy john b. taylor...

The Federal Reserve Stabilizing and Destabilizing Influences on the U.S. Economy John B. Taylor May 4, 2015 A Lecture Sponsored by the UNR Economics Club and University of Nevada Foundation

4-quarter average 2 Inflation rate

Congressional Testimony of Arthur Burns Arthur Burns, Fed chair (1970-78) during the Great Inflation, increased money supply rapidly, raising inflation, despite telling Congress the Fed would not do it

Five years later, inflation is roaring, President goes to Congress with Whip Inflation Now buttons. President Ford speaks to joint session of Congress

4-quarter average Q1 1968 Fed funds rate = 4.8% Inflation Rate 5

Finally Sensible Monetary Policy

Q1 1997 Fed funds rate = 5.5% 4-quarter average Q1 1968 Fed funds rate = 4.8% Q2 1989 Fed funds rate = 9.7% Inflation Rate

Q1 1997 Fed funds rate = 5.5% Q3 2003 Fed funds rate = 1.0% 4-quarter average Q1 1968 Fed funds rate = 4.8% Q2 1989 Fed funds rate = 9.7% Inflation Rate

Percent Growth rate of real GDP

Not returning to growth path

as in past recoveries

Example from Bernanke (2004). (post-2006) C updated to post 2006

Q1 1997 Fed funds rate = 5.5% Q3 2003 Fed funds rate = 1.0% 4-quarter average Q1 1968 Fed funds rate = 4.8% Q2 1989 Fed funds rate = 9.7% The Role of Monetary Policy Inflation Rate

where r is the federal funds rate p is the inflation rate y is real GDP gap A more systematic way to look at policy

From Has the Fed Gotten Tougher on Inflation? The FRBSF Weekly Letter, March 31, 1995, by John P Judd and Bharat Trehan of the San Francisco Fed 1965-79 1965-1980: monetary policy not well described by good rules- based policy r = p +.5y +.5(p-2) +2

From Has the Fed Gotten Tougher on Inflation? The FRBSF Weekly Letter, March 31, 1995, by John P Judd and Bharat Trehan of the San Francisco Fed 1987-92 1993-94 1965-79 Monetary policy gets more rules- based

Illustrative monetary policy chart from St Louis Fed February 2007, Bill Poole (former president)

Chart from The Economist, October 18, 2007

Housing Investment versus Deviations from the Taylor Rule in Europe During 2001-6

Empirical Evaluation of QE Most favorable evidence comes from announcement effects But these miss the reversal period My research shows little effect of QE1 MBS once credit and prepayment risks were taken into account QE3: When started 10-year Treasury was 1.7%, it then rose Effects of QE on yield spreads 1-year vs 10-year US Treasury spread 2003-2008 non-QE period1.3%. 2009-2013 QE period2.4%

Forward guidance, in practice, has also been unpredictable Dec 2008: Exceptionally low levelsfor some time Mar 2009: for an extended period Aug 2011: at least through mid-2013 Jan 2012: late 2014 Sep 2012: through mid-2015 Dec 2012: at least as long as the unemployment rate remains above 6 percent Feb 2014: abandon unemployment threshold

Adverse effects of UMP Creates incentives for otherwise risk-averse investorsretirees, pension fundsto take on too much risk Excursion into fiscal policy and credit allocation raises questions about central bank independence Redistributive in an arbitrary way Distorts price discovery in markets Money markets do not function normally Uncertainty about unwinding creates 2-sided risk

RulesBased versus Discretionary Periods Statistical Classification: 1984-2002 Nikolsko-Rzhevskyy, Papell, and Prodan (2014) Historical Classification : 1985-2003 Meltzer (2009, 2011)

But Virtually No Change in De Jure Independence Small legal changes in 1977, 2000, 2010 Crowe and Meade (2007) Used standard indices of de jure central bank independence Found no change over time for the US. Federal Reserve de jure independence is far too uncritically accepted as a foundation for a stable financial and monetary environment. Cargill and ODriscoll (2013).

Changes in De Facto Independence Meltzer A Monetary History of the Federal Reserve 1970s e.g. Burns-Nixon 1980s-1990s e.g. Volcker (1983) We havegone a long way toward changing the trends of the past decade and more. 2000s Involved in fiscal policy, credit policy, housing policy, Can be driven by the executive branch or the central bank, or both Goodfriend (2012) Issing (2012) come to similar conclusions

International Effects Policy deviations spread to other countries OECD researchers found similar pattern for OECD Starting around 2003 policy rates too low BIS researchers found Global Great Deviation

Causes of Spillovers of Policy Deviations Central banks follow deviations with below policy rule rates because of concerns about Excessive and uncertain exchange rate appreciation Excessive risk-taking in foreign currency loans Groupthink about discretion versus rules Political pressures reducing de facto central bank independence

Currency Wars Fought with Monetary Instruments Conventional monetary policy Can be illustrated with a simple diagram. Unconventional monetary policy Seems to work much the same: Fed 2010 BOJ 2012 ECB 2014

i ifif 2 nd central bank Initial cut is 1% i = -2 i f = -2 1 st central bank

Source: Hyun Shin, BIS

Currency Wars Fought with Monetary Instruments Conventional monetary policy Can be illustrated with a simple diagram. Unconventional monetary policy Seems to work much the same: Fed 2010 BOJ 2012 ECB 2014

Global Consequences Forces discretionary macro-prudential policy Singapore, Switzerland, Hong Kong Provides excuses for more capital controls Creates increased intervention in currency markets Undermines inflation targeting principles had led to less intervention, more rules-based policy Infects other parts of economic policy The end of NICE (Non-Inflationary Consistently Expansionary) led to the end of another NICE (Nearly International Cooperative Equilibrium)

What to Do Return to more rules-based monetary policies similar to what worked during the 1980s, 1990s and until recently

Can anything be done to help it along? In the United States, legislation may be needed In fact, some legislation is underway. "Requirements for Policy Rules for the Fed" in bill recently passed by House Financial Services Committee Requires that the Fed report publicly its rule or strategy for the policy instruments The Fed, not Congress, would choose rule or strategy.

But what about other central banks in the globalized world economy? A clear commitment by the Fed would help whether aided by legislation or not An international understanding would help further. Major central banks have a common inflation target Converging views about response of policy instruments.

Would the approach be enough to provide stability in markets and economies? Research (Helene Rey) finds that large capital flows are induced by erratic swings in monetary policy; these would diminish Large capital flows due to fear of free falling exchange rates would be calmed too Research shows that adoption of rules-based inflation targeting has had that effect already

the federal reserve – stabilizing and destabilizing influences on the u.s. economy john b. taylor...

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