The Fed's 'Improvisation' Phase
Via Morgan Stanley's Vincent Reinhart: Writing Prescriptions
Nine years ago while on a panel at the Federal Reserve Bank of Kansas City’s Jackson Hole Symposium, I quoted Franz Kafka. In “A Country Doctor,” he has his protagonist admit ruefully, “To write a prescription is easy, to understand people is hard.”
That sums up the problem at the Fed as they try to translate the advice from economic textbooks to the application of policy by the diverse group of people on the Federal Open Market Committee.
Individually, most Fed officials accept the chief recommendation of monetary theorists, such as Michael Woodford of Columbia University, about how to conduct policy when the nominal federal funds rate is stuck at its zero lower bound. Policy works best if the Fed links its instruments—how long it stays at the zero bound and how much it expands its balance sheet—in a predictable fashion to economic performance relative to its goals.
What are the advantages? The minutes of the September meeting explained the benefits of such an approach as:
“… including the potential for enhanced effectiveness of policy through greater clarity regarding the Committee's future behavior. That approach could also bolster the stimulus provided by the System's holdings of longer-term securities. It was noted that forward guidance along these lines would allow market expectations regarding the federal funds rate to adjust automatically in response to incoming data on the economy.”
Add to that the notion that once a rule is in place, the Fed does not have to respond data-point-by-data-point in resetting the monetary policy bar. Announcements following changed economic circumstances are a mixed bag, as they convey both the Federal Reserve’s willingness and need to act. Often, news on the latter—that the Fed has shifted its economic outlook lower—partly offsets the impetus associated with the former—that it will provide more support to activity. Lastly, an intelligently designed rule will be symmetric, thereby relating the triggers to provide more accommodation and those to remove that accommodation. Reassurance that the Fed has a built-in exit strategy might allow a more aggressive pursuit of its goals.
If a conditional policy rule works so well in theory, why has it not been put into practice? We have been emphasizing for some time that the fundamental design flaw of the Fed is its ambiguous mandate. The Congress instructs the Fed to foster maximum employment and price stability but gives no guidance on weighing deviations from those goals in the short run. The people making policy at the Fed do not agree on how to fill in the Congress’s silence on this issue. If they cannot agree on the weights, then they cannot agree on a rule. As a result, the Fed is living out a collective action problem, in that officials individually support a rule but collectively cannot agree to a single rule. You have but to admire the drafting delicacy of Fed staff preparing the minutes in their summary of the issue that “…reaching agreement on specific thresholds could be challenging given the diversity of participants' views…”
Despite media reports pressing the case that Chairman Bernanke is conducting a harmonious chorus, Fed officials are not on the same page of the hymnal. Consider the tabulation of views of “appropriate” monetary policy in the latest Summary of Economic Projections. Even though the Fed issued a commitment to keep the policy rate low until mid-2015, six participants responded that policy firming should begin before then. The Fed also promised open-ended balance-sheet expansion in its statement, but only eleven of the nineteen FOMC participants held that additional asset purchases were appropriate in the near future.
Fed officials are now in the improvisation phase of their monetary policy experiment. Policy makers have told us that they will do whatever it takes to get what they want. The problem is that they have not told us specifically what it takes or what they want.