Archive for the ‘Monetary Policy’ Category

Does the Fed Have the Tools to Achieve its Dual Mandate?

Michael Stephens | September 25, 2013

Stephanie Kelton recently sat down with L. Randall Wray to discuss, among other things, the news that the Federal Reserve will refrain for the time being  from tapering its asset purchases (QE).

Wray took the occasion to elaborate on his view that quantitative easing is ineffective as economic stimulus and that — given the tools at its disposal — the Fed can’t actually carry out its dual mandate (on employment and price stability).

One interesting wrinkle here is that Wray makes this case not just with regard to asset purchases — which even some QE supporters have admitted don’t accomplish much in and of themselves — but also the “expectations channel” (forward guidance).

Kelton and Wray also touch on the latest debt ceiling showdown and the future of retirement security programs.

Download or listen to the podcast here.


Money as Effect

Greg Hannsgen | September 24, 2013

Regarding spurious policy arguments about “excessive growth of the money stock”: Ed Dolan posts helpfully to Economonitor on the more realistic approach suggested by the theory of endogenous money. In particular, I took note of the following passage, which brings up a point that I wrote about recently:

 “Formally, a model that includes a minimum reserve ratio or target plus unlimited access to borrowed reserves would not violate the multiplier model, in the sense that at any given time, the money stock would be equal to the multiplier times the sum of borrowed and non-borrowed reserves. However, the multiplier would have no functional effect, since the availability of reserves would no longer act as a constraint on the money supply. Economists describe such a situation as one of endogenous money, by which they mean that the quantity of money is determined from the inside by the behavior of banks and their customers, not from the outside by the central bank.”

In this simplified setting, the constant known as the “money multiplier” becomes the “credit divisor,” a concept defined in a short article I wrote recently for the forthcoming Elgar volume Encyclopedia of Central Banking.

Using the divisor D, instead of

bank reserves ×  M = money,

one can write

credit/D = bank reserves.

The equation reflects a theory in which causality runs from left to right, reflecting the endogeneity of reserves.

Indeed, the divisor is far more realistic as a model of the money-creation process than the money multiplier. The collapsing money multiplier in the figure in Dolan’s post corresponds to a rapidly rising credit divisor.

The post also points out that after loan demand, “the second constraint is bank capital.” The post notes that when this constraint is binding, the idea of a “reserve constraint” is still more irrelevant. Also, a profitable and solvent bank that wishes to expand its lending can usually increase its capital by retaining earnings or by other moves, as Marc Lavoie and others have pointed out in the academic literature. Moreover, Lavoie observes that a commercial bank having difficulty raising capital might be able get the central bank to purchase its shares in some countries.  Lavoie’s account can be found in his fairly comprehensive essay, “A Primer on Endogenous Money,” in Modern Theories of Money, edited by Louis-Philippe Rochon and Sergio Rossi, Edward Elgar, 2003.

From a policy perspective, a fast-growing stock of money is not generally a “cause” of inflation, though it can be an effect of rising prices or economic activity. (Of course, interest rates that were low enough long enough could cause inflation in a situation in which there was a lack of unused productive capacity.) Central banks cannot fix the growth rate of money to achieve a desired inflation rate, by setting the growth rate of bank reserves. For, as the concept of the credit divisor illustrates, the latter are also endogenous in a modern banking system.


Janet Yellen on Bubbles and Minsky Meltdowns

Michael Stephens | September 17, 2013

Back in 2009, Janet Yellen delivered a speech at the Levy Institute’s Minsky conference that explained how the financial crisis had changed her views about the role of central banks in handling financial instability. At the time she was the head of the San Francisco Fed.

The focus of her 2009 remarks was the question of how (or whether) central banks should try to counteract bubbles in asset markets. (Yellen also recalled the unfortunate topic of her 1996 conference speech: supposedly promising new innovations in the financial industry for better measurement and management of risk.) Bursting suspected bubbles has become the topic du jour in US monetary policy discussions, as it currently stands as the fashionable justification for tightening despite low inflation and high unemployment.

With the announcement that Larry Summers’ name has been withdrawn from consideration for the next Fed chair, the spotlight has turned to Yellen. Here (from the 2009 conference proceedings) is the text of her speech and a transcript of the brief Q&A that followed:


A Minsky Meltdown: Lessons for Central Bankers? (1)

It’s a great pleasure to speak to this distinguished group at a conference that’s named for Hyman Minsky. My last talk at the Levy Institute was 13 years ago, when I served on the Fed’s Board of Governors, and my topic then was “The New Science of Credit Risk Management at Financial Institutions.” I described innovations that I expected to improve the measurement and management of risk. My talk today is titled “A Minsky Meltdown: Lessons for Central Bankers?” and I won’t dwell on the irony of that. Suffice it to say that with the financial world in turmoil, Minsky’s work has become required reading. It is getting the recognition it richly deserves. The dramatic events of the past year and a half are a classic case of the kind of systemic breakdown that he—and relatively few others—envisioned.

Central to Minsky’s view of how financial meltdowns occur, of course, are “asset price bubbles.” This evening I will revisit the ongoing debate over whether central banks should act to counter such bubbles, and discuss “lessons learned.” This issue seems especially compelling now that it’s evident that episodes of exuberance, like the ones that led to our bond and house price bubbles, can be time bombs that cause catastrophic damage to the economy when they explode. Indeed, in view of the financial mess we’re living through, I found it fascinating to read Minsky again and reexamine my own views about central bank responses to speculative financial booms. My thoughts on this have changed somewhat, as I will explain.(2) continue reading…


Barbera on the Case Against Mainstream Economics

Michael Stephens | September 6, 2013

Robert Barbera, a regular contributor to the Levy Institute’s Minsky conferences, has a great post at Johns Hopkins’ Center for Financial Economics on the cycle of amnesia and remembrance that seems to plague mainstream economic theorists. Here’s a key passage:

Perhaps the most indictable offense that mainstream economists committed, from 1988 through 2008, was to retrace, step by step, Keynes’s path of discovery from 1924 through 1936. Wholesale deregulation of finance and categorical confidence in a reductionist role for central banks came into being as the conventional wisdom embraced the 1924 view that free markets and stable prices alone gave us the best chance for economic stability. To add insult to injury, the conventional wisdom before the crisis was embedded in models called “new Keynesian” which were gutted of the insights of Keynes. This conventional wisdom gave license to a succession of asset market boom/bust cycles that defied the inflation/deflation model but were, nonetheless, ignored by central bankers and regulators alike. Quite predictably, in the aftermath of the grand asset market boom/bust cycle of 2008-2009, we are jettisoning Keynes, circa 1924, for the Keynes of 1936.

It’s worth reading the whole thing: “Exit Keynes, the Friedmanite, Enter Minsky’s Keynes.”


Modern Money Network

Michael Stephens | August 29, 2013

The Modern Money Network at Columbia University — heir to the “Modern Money and Public Purpose” seminar series — is starting up in September, with a pair of events that might be interesting to some of our readers:

1. Money as a Hierarchical System

Date: Thursday, September 12th, 6.15pm
Location: Room 104, Jerome Greene Hall, Columbia Law School

Moderator: Raúl Carrillo, J.D. Candidate (’15), Columbia Law School
Speaker 1: Christine Desan, Leo Gottlieb Professor of Law, Harvard Law School
Speaker 2: L. Randall Wray, Professor of Economics, University of Missouri-Kansas City
Speaker 3: Katharina Pistor, Michael I. Sovern Professor of Law, Columbia Law School & Director, Center on Global Legal Transformation
Speaker 4: Perry Mehrling, Professor of Economics, Barnard College & Director of Education Programs, Institute for New Economic Thinking

2. Central Banking in Theory and Practice

Date: Monday, September 23th, 6.15pm
Location: Room 103, Jerome Greene Hall, Columbia Law School

Moderator: Richard Clarida, C. Lowell Harriss Professor of Economics and International Affairs, Columbia University
Speaker 1: Lord Adair Turner, Senior Fellow, Institute for New Economic Thinking and former Director, U.K. Financial Services Authority
Speaker 2: James K. Galbraith, Lloyd M. Bentsen Jr. Chair in Government/Business Relations and Professor of Government, University of Texas at Austin
Speaker 3: Matias Vernengo, Associate Professor, Bucknell University & Senior Research Manager, Central Bank of Argentina

Livestreaming of these events will be hosted at the MMN website (seminar 1; seminar 2) — the site also links to background reading for each seminar.


What Do You Want in a New Fed Chair?

L. Randall Wray | August 26, 2013

I was recently asked by an interviewer who’s going to replace Chairman Bernanke. I declined to predict because I don’t do horseraces. You’d have to be inside the beltway to understand which way President Obama is leaning. There’s not much doubt that Wall Street is pulling for one of its own, Larry Summers, and Wall Street usually gets what it wants.

Let me turn to what we should want in a central banker, rather than trying to pick the winner of the contest. To understand the qualities desired, we need to know what central bankers should be able to do. There is a lot of misconception over the role played by the Fed in our economy.

The power of the central bank is substantially less than usually imagined, or at least what influence it has is not in the areas usually identified. It has little direct impact on inflation, unemployment, economic growth, or exchange rates. It does set the overnight interest rate, but there is no plausible theory nor evidence that this matters very much. The “interest rate channel” is weak — normally the Fed is raising rates in a boom, when everyone is enthusiastically borrowing and spending, so higher rates do not diminish optimism. In a slump, when the Fed normally lowers rates, it is too late — pessimism has already taken hold.

The way that raising rates actually can work is by causing insolvency of those already heavily indebted — by pushing payments on floating rate debt above what can be afforded. There is no smooth relation between borrowing and interest rates that can be exploited by policymakers. Rather, they can cause a financial crisis if they are willing to do a “Volcker”: push rates so high that defaults snowball through the economy.

Over the past three decades, where the Chairman’s influence has been significant has been in the area of regulation and supervision of the financial sector. Unfortunately, three successive Chairmen have failed to pursue the public interest preferring instead to promote Wall Street’s interest. This has been disastrous. continue reading…


Money Creation for Main Street: Staking Out a Progressive Fed Policy

Michael Stephens | August 2, 2013

When it comes to the Federal Reserve and Fed policy, the bulk of today’s progressives can be sorted into two broad groups. There are those who, in the face of congressional sabotage of fiscal policy, shrug their shoulders and conclude that we might as well get behind QE because it’s the only game in town — thus setting the “progressive” pole of the debate in such a way that Milton Friedman represents the leftward edge of the possible — and there are those who largely cede the battlefield on Fed policy, either for lack of interest or due to skepticism that the Fed can do much to affect growth and employment anyway.

There are, of course, some notable exceptions, but they are a minority — and this has the effect of narrowing the dialogue when it comes to central bank policy. Bill Greider, in two new policy notes drawn from his work at The Nation, shows us what it might look like to go beyond progressive indifference or hostility to the Fed and articulate a positive alternative agenda.

Both of Greider’s notes focus on how the Federal Reserve’s money-creation power, which was used to great effect in propping up the financial system, might be redirected to aiding the “real” economy:

The Federal Reserve’s most distinctive asset is money—its awesome and somewhat mysterious power to create money and inject it into the economy by buying financial assets of one kind or another. If that power is abused, it can destabilize society. In an economic crisis, however, the money-creation power can be harnessed to public purposes and used to restore order and justice. That is essentially what Bernanke’s Fed attempted during the recent crisis when it created those surplus trillions for banking. The fact that the strategy did not entirely succeed suggests that maybe this power should be applied in a different direction.

According to Greider, the Fed’s authority to engage in direct lending to the real economy, to enable debt relief for underwater mortgages and the roughly $1 trillion in student debt, or to backstop infrastructure projects stems in part from from Section 13(3) of the Federal Reserve Act. In fact, the central bank has done this sort of thing before:

During the Great Depression, the Federal Reserve was given open-ended legal authority to lend to practically anyone if its Board of Governors declared an economic emergency. This remains the law today. The central bank can lend to industrial corporations and small businesses, including partnerships, individuals, and other entities that are not commercial banks or even financial firms. The Fed made thousands of direct loans to private businesses during the New Deal, and the practice continued for 20 years. Only in more recent times has the reigning conservative doctrine insisted that this cannot be done.

The Fed carried out its bank rescues under the auspices of Section 13(3), and although Dodd-Frank placed new limits on the use of this provision, Greider argues that there is still sufficient scope for the Fed to harness its “money power” for broader public purposes.

Read “Debt Relief and the Fed’s Money-creation Power” and “‘Unusual and Exigent’: How the Fed Can Jump-start the Real Economy.”


An Exception to a Keynesian Rule?

Greg Hannsgen | July 2, 2013

Paul Krugman warns against “caricaturing” Keynesian economics, and in particular the General Theory (GT), Keynes’s best known work. One caricature heard from time to time is that the book is not mathematically tractable. The caricature also claims that no one has succeeded in fitting such a contradictory and confusing bunch of arguments into a clear, mathematically coherent model. Okay, in the spirit of a concession to these macro skeptics, what follows is a schematic caricature of sorts that seems okay to me as a broad summary of the first 18 chapters or so of the book, from a classic book by Pasinetti. So for those who insist that (1) they need a preview in a very concise form or (2) that they will never have time for the lengthy and complicated GT, below is the aforementioned schema. It is only meant to show that one can in fact simplify this oft-misinterpreted work quite a bit using mathematical symbols and keep the gist of the first part of the story.

equation 1image

where the variables are defined as follows:

L = liquidity preference (psychological factors affecting long-term interest rates, especially expected future rate changes)

M-overbar = policy-determined money supply

I = nominal interest rate

E = expected profitability of investment projects, given economic conditions

C = consumption

I = investment

Y = total output

All arrows (→) show directions of causality, so that A→B means that knowing A allows us to determine B.

Finally, f(), ψ(), and φ() signify functions endowed with properties that allow one to use math to analyze the model.

(I have altered some of Pasinetti’s notation slightly.)

As Pasinetti points out, this causal schema is different from Krugman’s favored IS-LM model, and it does leave out much that is important, including changes in the numéraire (chapter 19) and long-run dynamics, which the formal argument left up in the air. In a footnote, Pasinetti says that the model is only a first approximation to Keynes’s theory, and that care should be taken with attempts to do exercises involving shifts in the curves. But while Pasinetti’s schema, and the simple model it represents, certainly succeeds in simplifying the GT, it is really not a caricature. The original version of the schema can be found in Growth and Distribution, by Luigi Pasinetti, chapter II, Cambridge University Press, a 1974 collection of generally lucid essays (publisher’s book site).


Fed Tapering and Bullard’s Dissent

Michael Stephens | June 20, 2013


Here’s what’s new from yesterday’s FOMC statement and Bernanke’s press conference:  the Fed has indicated that asset purchases (QE) will end when unemployment hits 7 percent.  (Note that that’s different from the point at which the Fed will begin considering raising short-term interest rates — previously linked to a threshold of 6.5 percent unemployment.)

Commentators have pointed out that the Fed seems to be basing its expectations — that asset purchases will begin “tapering” this year and end by next year — on some fairly optimistic economic forecasts (this is a recurring issue).  There are also a lot of questions as to what’s motivating these signals of a less expansionary stance, given that inflation is too low by the Fed’s own measure.  “Frankly,” Yves Smith writes, “the real issue seems to be that the Fed has gotten itchy about ending QE.  Who knows why. It may be 1937 redux, that they’ve gotten impatient with the length of time they’ve been engaged in extraordinary measures.”

Somewhat related to this post on the Fed’s historic “reaction function,” here’s Tim Duy’s analysis:

Bernanke continued to deflect attention from the low inflation numbers, describing them as largely transitory, identifying the impact of the sequester on medical payments as a factor.  Here is what I think is going on:  Overall, the Fed has basically a Phillips Curve view of inflation.  Low inflation now is attributable to high unemployment.  Given that unemployment is forecast to fall, and the forecasts are improving such that it is falling faster than anticipated, they anticipate that disinflation will soon be halted.  In other words, right now policy is being driven by the unemployment rate.  The more quickly unemployment is moving to the Fed’s long run target, the more they will reduce accommodation despite low inflation.  At least, that is what it appears.

One interesting wrinkle is that James Bullard dissented from the near-unanimous decision.  According to the official FOMC statement, he “believed that the Committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings.”

Normally, you would think of Bullard as a “hawk” (this dove–hawk framework seems to have become less useful in the era of unconventional monetary policy).  In his April speech at the Minsky conference, Bullard warned against unemployment targeting and suggested the Fed ought to focus primarily on price stability (price-level targeting).  The cynic might dismiss this as just a convenient technical excuse for ignoring high unemployment, but Bullard’s dissent suggests that he takes the model quite seriously — which is to say, not just when inflation is above or near the target.  If you want more insight into what might be motivating his vote, here’s the full speech:

Update (6/21):  Bullard explains his dissent (copied below from St. Louis Fed).  Key line:  “to maintain credibility, the Committee must defend its inflation target when inflation is below target as well as when it is above target.” continue reading…


Why Is the Federal Reserve Talking about “Tapering”?

Michael Stephens | June 11, 2013

Ryan Avent wonders why, with unemployment too high and inflation too low — even by the Federal Reserve’s own previously articulated standards — there is so much talk of “tapering” coming from members of the Open Market Committee (talk of slowly drawing down the Fed’s asset purchases).

Avent mentions the possibility that considerations other than inflation and employment are guiding policymakers’ decisions:  in this case, the concern that the current monetary policy stance is generating financial instability (by blowing up asset bubbles, according to the theory).  Narayana Kocherlakota, head of the Minneapolis Fed, has occasionally been associated with this view, but if his April speech is any indication, his position has much more nuance to it.

For what it’s worth, a paper by James Galbraith, Olivier Giovannoni, and Ann Russo looked back at the Fed’s behavior from 1969 to 2003 to determine what really drives changes in Fed policy.  The paper made waves by revealing an apparent partisan bias in monetary policy during election years, but the main findings were, if anything, more disturbing.  In addition to Fed policy playing a causal role in increasing inequality, the authors found an important behavioral change after 1983:

… contrary to official claims, the Federal Reserve does not target inflation or react to “inflation signals.” Rather, the Fed reacts to the very “real” signal sent by unemployment, in a way that suggests that a baseless fear of full employment is a principal force behind monetary policy. … [A]fter 1983 the Federal Reserve largely ceased reacting to inflation or high unemployment, but continued to react when unemployment fell “too low.continue reading…