Tayloring a criticism of Fed policy

Adam Posen and John Taylor have exchanged posts on the Fed Oversight Reform and Modernization Act.  The AP criticism of the Act, in a nutshell, is that discretion is better than rules:  that the Act would constrain the Fed to follow policy procedures declared in advance, that might later prove inappropriate.

JT rebuts this by pointing out that the Act does not make any rule that the Fed declares binding on itself.  It simply forces the Fed to declare such a rule, and explain how it uses it and why it deviates from it.

However, JT’s rebuttal seems like pure legalism.

We know from his writings that he thinks Fed policy would have been better if it adhered to the prescriptions of a Taylor Rule, or something close to it.  JT views quantitative easing as a dangerous act of discretion.  It’s not clear what he makes of the international evidence that QE appeared to lower long rates on impact.  But at any rate he considers the uncertainty generated by embarking on QE to have had a negative effect on activity, once that must presumably have swamped any stimulus via long rates, (and be greater than any uncertainty generated by the private sector wondering what on earth was going to counter the enormous recessionary shock, if not monetary policy.)

We also know that he supports the Act because he thinks it will make policy less discretionary than it was in the past, and more Taylor-Rule- like.  A re-run of the recent financial crisis under the Act would tilt Fed policy towards what he would have preferred.

This is precisely what Posen [and Krugman, and myself for that matter] object to.  Whether literally binding or not, Taylor knows that the Act will increase the chance that future FOMCs feel constrained by their prior rule declarations.

If JT didn’t consider this the effect of the Act, what possible benefit could it have?  And if this is the effect the Act would have, then, if you think QE and credit easing policies, and the subsequent zero interest rate policies were stimulative and beneficial, then the criticism stands.

Taylor goes against the modern consensus that central banks should have goals given to them by Parliaments [ie have no goal independence], and be held to account for achieving those goals, but have instrument independence, and discretion to operate monetary policy as best as it sees fit to achieve those goals.

He leans on the theoretical literature which accords benefits to committing to rules for instruments.  But these benefits accrue mostly because of the assumption of rational expectations, and their confinement to a fairly narrow class of DSGE models.  `Even without discarding the unrealistic assumption of RE, the crisis has taught us, surely, that know much less about the other bits of the model than we thought when the commitment studies ruled.


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What’s good for 100s of fiscal plans is good for monetary policy too

Today we saw the Government release its plans for a multitude of spending and tax instruments, conditional on a forecast of the economy produced by the Office for Budget Responsibility.

Imagine, instead, that the Chancellor simply announced today’s values for all those instruments.  And, quizzed about what was going to happen in the future, said simply that he was going to face one ball at a time.  Or that the next move in spending was likely to be up.

Perhaps, when pressed, they might publish a forecast based on what market observers of government guessed they were going to do with those instruments, as a means of helping us out.  But then, subsequently, tiring of speculation about future fiscal plans, based on these forecasts, explained that one can’t actually infer what the government were going to do from them after all.

Imagine, too, that when pressed for information about these plans, the Chancellor simply said ‘Well, these are essentially decisions arrived at collectively.  It would be impossible for a collective to agree and communicate a set of forward plans for our fiscal tools.’

And think how we might react if, pressed further, they said ‘We do formulate these plans, of course, but you know more information can sometimes mean less understanding.  And we are not sure that the quality of discussion is high enough to get that whether things pan out as the plans say depends on how the economy evolves, and these are not hard and fast promises.’

This is how the Bank of England’s Monetary Policy Committee approach the problem of communicating about interest rates and asset purchases.  A decision over 2 instrument plans, not 100s.



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Monetary and financial stability tools: Why is the ‘first line of defence’ metaphor always the first line of defence?

In the Treasury Committee hearing today [this is a cross-party committee of the UK Parliament that monitors the Bank of England], BoE Monetary Policy Committee members several times made recourse to the ‘first line of defence’ metaphor.

For example, in discussing whether interest rates might be used not for monetary purposes, but for financial stability purposes, he noted that interest rates were not the ‘first line of defence’ for that problem.

The analogy isn’t great.

The implication is;  if there’s  financial stability problem, we do nothing about it with interest rates, until we have first tried our prudential tools.  If that later is seen to fail, then we try interest rates.

Looming over the conversation too was the question of whether macroprudential tools might be used for monetary policy purposes.  I didn’t hear it said, but doubtless MPC members would have used that language too.

Looked at through the lens of the kinds of models MPC and FPC use in the BoE, a better way to describe what ought to go on is:  financial stability outcomes can’t be influenced much without great movements in interest rates that would otherwise be damaging for the monetary policy mandate;  and vice versa.  But though one tool is an inefficient device for achieving the other committee’s mandate, nonetheless it’s aways the case that each tool should be set with both mandates in mind.

So inaction with respect to the other committee’s concerns while their line of defence is tried first is not the right policy.

This becomes even clearer when we remember that the mandates for the two committees are not really ends in themselves.  They are imperfect ways to judge how technocrats wield a policy lever or levers in pursuit of our overall wellbeing.  They are more like intermediate performance indicators.

For sure, things might get very messy if the Treasury simply told the BoE:  here are several policy levers.  Use them to make us better off.  But we should not take the particular assignment of tools and objectives that the BoE’s committees have grasped too literally.  And nor, we must presume, do the Committees themselves.

Perhaps MPC members today meant what I am describing here, and it’s just that the ‘first line of defence’ metaphor was just a first line of defence.


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Central banks and their interest rate plans

Ben Broadbent’s speech on the Bank of England’s Inflation Forecasts, and the yield-curve based interest rate trajectories on which they are based, is as lucid account of the issues as you will find, compulsory reading for interested observers.

Currently, the MPC present forecasts conditioned on constant interest rates [and constant asset purchases], and interest rate expectations derived from the yield curve.  The custom has grown that one uses both to infer something about what will actually happen to interest rates.  For example if inflation were forecast to glide pleasingly back to target under rising interest rates, but surge above it under constant rates, the custom is to infer that this means that the rising trajectory is preferred to the constant one.

Responding to the bouts of criticism that Mark Carney in particular has faced, Ben’s speech makes the following points.

First, genuine market expectations about interest rates cannot be cleanly extracted from market prices.  [Perhaps this is particularly true now, with concerns about liquidity in short term sovereign securities.]  So if we see that an inflation forecast conditioned under these ‘expectations’ seems to satisfy the mandate, or, as Lars Svensson used to put it ‘looks good’, that doesn’t mean that the BoE is going to follow ‘market expectations’.  Markets may not expect what has been extracted by the Bank Staff from market prices.

This first point is a relatively minor quibble with the BoE-watching code of practice.  At the point where we are trying to figure out what the BoE is going to do from their forecasts, no-one really cares whether the trajectories are based on cleanly extracted measures of market expectations or not.  What matters is whether those numbers, contaminated with risk premia or not, look like interest rates that the BoE wants to set.

Ben’s second point – neatly exposited by simulations on the Bank’s forecasting model COMPASS – is that, measuring expectations aside, an inflation forecast trajectory that looks good can be achieved by many possible interest rate trajectories.  So there is no way to tell, precisely, from an attractive inflation forecast, what will happen to interest rates.

This is true.  Though there will, in fact, usually be ONE unique path that produces the best outcome for all the goal variables that the BoE cares about.  That’s not just inflation, but competing measures of resource allocation, nominal wages, the real and nominal exchange rate, and more.

Ben’s comment does raise the issue, though, of the utility of publishing these conditional projections, if the paths on which they are conditioned are such bad indicators of what the Bank will do.

One purpose they serve, even if the interest rate projections were wildly out, is to illustrate the multipliers in the Bank’s model, as currently adjusted, massaged and baby-sat by its policy-making customers.  If these multipliers were constant, there would be no need for constant reminders.  But perhaps views change, and these charts allow us to keep track of that.

An even better way to do that would be to release and support working versions of the BoE’s model and its database, together with the forecast adjustments that allow one to scrutinise the forecast from quarter to quarter.

All in all, this speech reinforces to me the case for the Bank actually telling us what they think they would do to interest rates, given the way the economy is seen at the moment.

Models like the Bank’s forecasting model tell us that it’s not possible to make a coherent decision about today’s rate unless you have in mind how that fits into a sequence of future rates, a plan stretching far out into the future to the point where the economy is returned back to its state of rest.

Since these plans are not revealed to us, there are several ways to interpret MPC behaviour, and its communication strategy right now.

  1.  MPC take a different view about how interest rates should be decided from the mass of work on monetary policy models, and DO ignore future rates when voting on current rates.  This would be very concerning indeed.  But perhaps they know something we don’t?
  2. MPC agree with this mass of work, and do formulate interest rate plans, but despite minuting many things in detail about their deliberations, they think it best to conceal these plans from us.

Going back to my time working with policymakers at the BoE, I can think of individuals who fell into both categories.

Those in category 1 tended to be those who did not have long-duration backgrounds in economics.  That does not necessarily mean they must have been wrong.  Who knows, our profession has been wrong about many things, so perhaps an exclusive focus on current rates can be justified.

Those in category 2 I think had four motivations.

One, not stated openly, so surmised by me only, was to avoid scrutiny and preserve maximum room for discretion and changing direction in a world where changes of direction would be interpreted by outsiders as incompetence.  To the extent that is part of today’s mindset – I have no idea – we can obviously not expect the BoE to become more transparent of its own volition, and it would be for its Treasury owners, or Treasury Select Committee observers to intervene.

Another was the firmly held belief that these forecasts would not be understood as forecasts, and would be taken to be promises.  Which, once broken, would, well, reveal the MPC to be promise-breakers.  Who would be capable of anything, like disregarding the inflation target, perhaps.  Or reveal them to be people who changed their plans, when the plan had not in fact changed, only the news about the economy.

A third motivation was the view that while the plans would be concealed, they could be promulgated in ways like those Ben today tells us they cannot.

A fourth motivation was that while, somehow, individually, MPC members could think about plans, it would all be ‘too difficult’ to arrive at one collectively.  I always found this baffling.  Committees in many walks of life have to agree multidimensional plans [plans for many things, like investment, prices, location, output, hiring….].  Surely MPC’s  difficulties were not insurmountable, and no harder than the task of agreeing a collective sense of what the economy will do for a given interest rate trajectory – something they do already in the Inflation Report.

Today’s MPC clearly wrestles with these same issues and finds itself unresolved.

Despite Ben’s scepticism about what can be read into the conditional forecasts, they continue to be published, and probably partly because not all share the view that they don’t at all serve the purpose for which he says they are not fit.

Despite the concerns about interest rate forecasts being interpreted as promises, MPC members continue to talk verbally about such forecasts, through hints, with accompanying [correct] mini-lectures about the conceptual pitfalls, sometimes pitched as a telling off, if they feel their earlier hints were misinterpreted.

Perhaps it’s time for the Treasury Committee to intervene, and ask for some exchange of views about why, if these plans are formulated, we can’t be told about them.  And, if they are not, why they are not.

The Bank might reasonably point out that the formulation and communication of its interest rate plans are an operational matter on which it should have independence.  Grounds for compelling the BoE to change its practices would be the fact that the issue affects the ability of those who are charged with holding the BoE to account to do this job well.

At the very least, the BoE could be asked to subject itself to an independent review on this issue, permitting a frank exchange of views without any compulsion (other than the fear of shame!).


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NK2 and whether it matters if his knowledge of NK macro<NK1.

Paul Krugman has been worrying about the appointment of Neel Kashkari to the FOMC as President of the Federal Reserve Bank of Minneapolis as replacement for Narayana Kocherlakota.

The Wall St Journal circulated a summary of NK2’s recent tweets on monetary policy.  This appointment was the third in a row of non-economists to the FOMC, but in the context of a lower frequency invasion of the FOMC by economists, according to a WSJ chart doing the rounds of Twitter, prompted by this debate.

The issue is what expertise is appropriate for setting monetary policy.  Deep understanding of monetary and financial economics, as extolled by the Universities, or experience in the University of business or political Life?  Leaders and managers, or Matlab and spreadsheet-loving nerds?

Here, the UK’s Monetary Policy Committee has an advantage.  Setting policy in a state that is not yet significantly federated, seats on the committee can be divided up into those allocated to the Bank of England’s executive team, who manage the Bank, and sit on its other policy and management committees, and those there solely to think about how they cast their interest rate vote.

By contrast, the US, hampered by the legacy of the geographic distribution of its banks at the time of the inception of the latest incarnation of the Federal Reserve, has to allocate many seats to those also charged with managing hefty local institutions, the regional Feds, on top of 7 seats to the Board of Governors, many of which will be genuine senior management jobs, not expert advisory jobs.

Things are worse still in the Euorozone.  All of whose who cast votes are member state central bank Governors or managers of large units within the ECB proper.  And in selecting these individuals, member polities and the ECB have to balance the attributes of leadership and economics within a single person.

This is one reason why I would be against any move towards a regional MPC in the UK, one of the ideas that seems to be on the table for Labour’s BoE mandate review conducted for John McDonnell.  It would reproduce the pressure to find rounded leader-experts.

This is not to denigrate leadership, where it’s needed, and suggest that nerds be made leaders of large institutions.  There are probably a fair few individuals nominally in senior management positions in central banks who would not consider leadership and management to be a comparative advantage.   They got there by dint of their economics and financial expertise, chosen as part of a pragmatic response to the problem I am drawing attention to – that too many seats on a decision making committee that requires expertise are nominally reserved for managers and leaders.

Tilting the balance too far in favour of economics expetise by shoehorning expert nerds into these jobs creates other problems.  Shadow management jobs and structures around them grow to take up the management slack left by the expert figure-head.  The power to deliver runs through lines different from those on the organagram.  And this can strain lines of responsibilty and accountability.

In short, the FOMC and ECB Governing Council would probably be better if there was a neater divide between manager decision makers, and nerds, along UK-MPC lines.  Reforming either institution along these lines is likely to be politically infeasible.

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Commitment and risk management motives for inflation target overshooting

Yesterday I posted following the BoE Inflation Report press conference, agitated by the repeated emphasis on avoiding an overshoot of the inflation target.  A private response to the post made it clear that I should write again and disentangle two separate motivations that exist for overshooting.

The first motive, Michael Woodford’s reasoning for urging that central bankers attempt to engineer a deliberate inflation target overshoot at the zero bound, is as follows.  Unable to loosen the current policy instrument, the current undershoot of the inflation target and the output gap can be limited by creating the expectation of lower spot central bank rates and of higher future inflation.  The inflation overshoot later on is more than compensated for by reducing the size of the undershoot now.

My private correspondent pointed out that some policy makers don’t like this advice because they fear that creating an overshoot would not be time-consistent.  Later on, once the benefits of the lower interest rate expectations in terms of a higher output gap and closer to target inflation have been pocketed, it’s best to re-adjust and not follow through with lower rates.  Knowing this ahead of time, observers won’t believe the announced overshooting strategy.

It’s true that this strategy may not be believed.  There’s nothing to tie the central bankers’ hands. And a history of them saying they take each month’s policy meeting as it comes [reinforced somewhat by Mark Carney’s remarks to that effect in the Press Conference].

On the other hand, it may be believed, and there’s no harm in trying.  Even if it isn’t, following through anyway will help bolster the overshoot strategy as a tool for escaping the zero bound the next time around.  With low equilibrium real rates for the foreseeable future, we might expect that the next time will come around pretty soon.

All this said, there is a separate motive for overshooting which does not rely on expectations management, and applies even if policymakers resign themselves to behaving in a purely discretionary fashion, (a nihilist position many central bankers might find odd if it’s put to them in such stark terms).

Overshooting is justified on risk management grounds alone.  Consider [as did Charles Evans and coauthors] uncertainty about future shocks hitting the economy that would perturb inflation and output away from the central bank’s central forecast.

A shock that depresses the economy and requires further loosening can’t be easily responded to at the zero bound.  One that boosts inflation and output above the expected path can be dealt with easily with higher rates.  Although in expectation we don’t expect any shock [that’s what our forecast is], it’s better to behave as though we think there will be a small depressing shock, as the costs of our forecast turning out too optimistic outweigh the costs of us being too pessimistic.

So, bringing this all together, we can rationalise the MPC’s desire not to overshoot as deriving from one of three sources.  First, it may be because they think they have not got a hope of convincing anyone of a commitment strategy they might announce.  Second, it may be that they are confident that the size of negative shocks hitting the UK will be very small, and thus won’t require much loosening to combat.  Third, it may be because QE is considered a perfect substitute for interest rate policy, and there are no constraints on its use.  None of these seem wholly convincing to me.

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Inflation overshooting should not be a major concern.

Mark Carney was at pains to stress several times that the BoE’s Monetary Policy Committee did not want loose policy to produce an inflation overshoot.

It’s puzzling why this concern is stressed so much.

If we were well away from the zero bound, or if we were not but QE was thought to be a perfectly adequate substitute for interest rates as a device for stimulus, the desire to prioritise avoiding an overshoot would be understandable.

However, since we are close to the zero bound, and there is good reason to doubt that QE would be an adequate instrument to loosen, the overriding priority is to generate a recovery of sufficient strength to allow interest rates to decisively escape the zero bound, and for this to be seen to be done as soon as practicable.

Inflation expectations have remained anchored, thus far.  But will they continue to be?  There is almost no risk that people would loose confidence in the ability of the central bank to tighten policy.  It has two instruments to do it with, and the government is sure to be glad to give them a helping hand with fiscal policy if was required to.  However, it’s quite likely that many will lose confidence in our ability to generate inflation and escape the liquidity trap.

Within a range of a percentage point or two, overshooting would in fact be a positively good thing, in my view, on account of it helping, should such an overshoot be believed in advance, to bring about the escape from the zero bound which we all want.

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