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The Real Fed Issues

The media are usually fixated on the angels on heads of pins question, will she or won't she raise rates 0.25%? As such Fed discussion misses many of the really important issues. Fed’s Challenge, After Raising Rates, May Be Existential by Eduardo Porter in the New York Times is an excellent counterexample and a nice primer ...

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The media are usually fixated on the angels on heads of pins question, will she or won't she raise rates 0.25%? As such Fed discussion misses many of the really important issues. Fed’s Challenge, After Raising Rates, May Be Existential by Eduardo Porter in the New York Times is an excellent counterexample and a nice primer on some of the really big issues facing the Federal Reserve -- and the nation -- going forward.

The pressing question for this era of populist policy making and popular anger is whether the Federal Reserve as we know it — arcane and academic, with the autonomy to set monetary policy as it sees fit — will survive the tension this time.
The Fed already lost powers it deployed to counter the recession spawned by the financial crisis a decade ago: The Dodd-Frank financial reform legislation stripped it of its authority to lend freely to nonbanks, which it used to keep money market funds, insurance companies and others that had bet on the wrong side of the housing bubble from imploding and taking the economy with them. [JC: The latter is an opinion not a fact, but let's press on
Though the article starts with monetary policy, and politician's desire for low interest rates, you can see we're quickly getting to, I think, bigger issues. The Fed was founded to be lender of last resort, not for monetary policy. But just who can it lend to, orchestrate bailouts, buy dodgy debts, is an entirely different issue, and one with a whole different set of arguments about independence vs. political accountability vs. political pressure, rules vs. discretion, and so forth.
Efforts that stalled in the last Congress — to subject the Fed’s funding to congressional approval, to reduce its discretion in setting monetary policy and to subject it to the oversight of Congress’s Government Accountability Office — have acquired a new lease on life, cheered from the right and the left. 
The funding question is a little more delicate. The Fed now earns interest on treasuries, and does not have to pay interest on about $1 trillion of cash. So it earns interest on about $1 trillion of treasuries and MBS directly, and earns the interest spread between long-term treasuries and MBS (its assets) and the interest it pays on reserves. It rebates much of that profit to the Treasury, and keeps the rest to fund its growing operations. Don't be fooled -- every cent of that comes from you and me in the end. Every dollar of interest the Treasury pays to the Fed comes from our taxes. But unlike other spending there is very little oversight (benign) or political influence (not so benign view) of this money.

If we're just hiring a few hundred PhD economists to run models to think about interest rates this is not such a big deal. But the Fed's primary function these days is bank regulation in general and big bank / financial / stop the next crisis regulation in particular. The argument that a regulator should be independent and not even subject to the accountability of, say, the EPA or the securities and exchage commission is tougher. So putting the Fed on budget really means, I think, treating its regulatory activities as we treat those of other agencies, and an ideal worth consideration -- and an idea that is coming.

From later:
Perhaps there is a discussion to be had over whether the Fed should keep its role as supervisor of financial institutions, or whether the job should be placed with another agency. Maybe financial supervision should be made more rule-based, less subject to regulators’ discretion.
Or, if not with another agency, whether that part of the Fed should be cleaved off and treated like other regulatory agencies.

Next non-interest rate issue: The balance sheet.
Disgruntlement in Congress will only grow worse as the Fed gradually winds down the enormous stash of bonds it built over the last eight years 
As blog readers know, I didn't think the balance sheet did any stimulating on the upside, and don't think keeping a big balance sheet does any harm on the downside. I think the Fed is a bit victim of its own marketing. By saying a roughly symbolic measure saved the world with great stimulus, it's awfully hard to turn around and say it isn't doing anything. But that's another big, not-about-interest rates issue to watch.
Congressional action might not be the Fed’s biggest problem. Mr. Trump’s appointments to the Federal Reserve Board could prove as destabilizing: Two of the seven positions are vacant, and a third will come open with the retirement of Daniel K. Tarullo in April. By the middle of next year, Mr. Trump will also have the opportunity to replace Ms. Yellen as Fed chief and Stanley Fischer as her deputy.
A scenario that the economy stalls a bit, and the Trump administration views the Fed as undermining its efforts with "high" interest rates, views the academics at the Fed as out of touch pointy headed fools, and puts in bankers and business people who "understand the importance of low interest rates", is not far fetched.
The argument for central bank independence is as powerful as ever. Political influence over monetary policy would produce more destabilizing booms — as politicians pumped up growth to serve their electoral purposes — and inevitable busts.
Yes, but remember, the big point is about the structural issues -- balance sheet, bank regulation, systemic regulation, and so forth, not interest rates. The argument for monetary policy independence, and the arguments for discretion, do not necessarily apply, or at least in the same way.
The popular mistrust of central bankers should not be ignored. After all, central bankers failed to prevent the most devastating financial crisis in generations — looking on idly, at best, while financial institutions peddled shady bonds to fuel a housing bubble of gargantuan proportions.
And central banks have emerged, at least implicitly, with a bigger job than before, adding the preservation of financial stability to their duty to ensure low inflation and, in the Fed’s case, full employment. Some central banks — though not the Fed — have been given new tools for this new job.
Given this power, it is inevitable that the enormous discretion central bankers have in executing their mandate will inspire popular mistrust.
... Maybe the Fed needs extra tools — to impose limits on indebtedness, for instance, or to adjust monetary policy to serve measures of financial stability.  
This "financial stability" is the big new mandate at the Fed, has little to do with interest rates, and not obvious that the same discretion and independence are appropriate -- or that there is a consensus in Congress that it should be. The "financial stability" mandate, and how it should be approached is the big question, at least until inflation hits 5% or -5%.

I'm much more skeptical of "new tools," and Porter seems to be slipping in to the trap of assuming disinterested technocratic competence at the Fed; that all it needs is "more tools." What we're talking about here -- should the Fed, like other central banks, buy stocks and corporate bonds? Or, if it thinks a "bubble" is at hand, sell them? Should it direct bank lending directly, telling them to cool down "hot" markets or lend in to weak ones? Should it jigger capital and leverage constraints to boost or cool lending? You can see that all of these are much (even) more political than raising or lowering interest rates.
And yet the populist streak driving through American politics seems unlikely to yield such measured outcomes. The Federal Reserve was designed to be insulated from the full force of democracy in order to protect its mandate from political opportunism, to ensure that policy hewed to technical expertise. It was designed — precisely — to protect it from a moment like this. One can only hope that the protections hold.
In a democracy, the price of independence and discretion is sharply limited authority. If the Fed just sets short term interest rates, does not interfere in bond, stock, real estate, lending markets, it can have great independence. If it takes on these much more politically fraught areas, it will, and must, necessarily lose independence.

What about interest rates?

Real interest rates (interest rate minus expected inflation) must rise. Eventually, there are two immutable market forces behind real interest rates -- real interest rates are related to the profitability of investment (the marginal product of capital), and to the economic growth rate. As an economy grows better, there are more profitable opportunities, and people need to get the market signal to invest in those opportunities rather than spend now. (r = f'(k), and r = delta + gamma * expected consumption growth)

Higer real interest rates are, like high house prices, a sign of good times as well as a cause of bad times. Don't confuse the two sources. If growth and investment really are emerging, indeed the Fed should bend to market forces and allow rates to rise. Sometimes there is supply, not just demand, and that's where we are now.

In my somewhat eccentric view, it would be possible for the Fed to keep interest rates low, if everyone thought that would last basically forever, but then we would have to tolerate deflation like the late 1900s. If the Fed wants to keep inflation at 2%, then as long as the economy continues to expand, raising rates merely recognizes market forces.

But the expansion is long in the tooth. That doesn't argue for any change in policy, but I would like to hear a lot more stress testing from the Fed. If a recession emerges, here is what we will do. If China and then Italy blow up, here is what we will do. I presume they're doing all that quietly behind the scenes.

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John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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