Some thoughts on policy normalization and the Fed

Federal Reserve

November is an interesting month in Washington, D.C. for Economists, Researchers, Policy Analysts and overall, for those interested in the world of ideas. For example, during the month of November, one can attend interesting academic events and listen to prominent scholars at the Annual Dinner of the National Economists Club, or attend several events at think thanks in the area. This year, Washington, DC had the exceptional experience of being the official site of the Southern Economic Association‘s Annual meetings as well as the Annual meeting of the Society for the development of Austrian Economics, where some of the most talented scholars and students gather to present and discuss relevant research on different fields within the science of economics.

One of my favorite conferences that occur in Washington, DC during the month of November and that I make an effort to attend every year, is the CATO Institute’s Annual Monetary Conference. This year’s conference’s theme was Central Banks and Financial Turmoil and it was sponsored by their impressive Center for Monetary and Financial Alternatives. A good summary of the conference can be found here. My remarks on this post will focus on this conference, which I was able to attend. Specifically I will focus on a particular question that I asked to FDIC’s Vice Chairman and Former President of the Kansas City Federal Reserve, Dr. Thomas Hoenig. Dr. Hoenig’s talk dealt with concerns about policy makers focusing and worrying too much about short term effects of monetary policy and not so much about the long run effects of such policies. It was an overall interesting exposition and one that I agreed very much; except for one particular yet very important point in my view. This point had to do with the notion of policy normalization, that is, the assumed notion that monetary policy needs to return to “normal” levels. That is, that the federal funds rate target has to return to it’s normal pre-crisis level.

The question that I addressed to Dr. Hoenig at the end of his exposition was for him to explain what exactly he meant by policy normalization. Unfortunately in my personal view his answer was not the most accurate, since his answer (and I am paraphrasing), was along this lines: “I don’t know exactly what the Federal Funds Rate Target should be, but I know that 8 years of interest rates at zero are not normal”. This answer got a cheer and applause from the crowd that attended the conference, but to me it showed that Fed critics ought to be more careful when it comes analyzing policy. Don’t get me wrong, I am in the camp of those who think that the Fed and Central Banking overall, do more harm than good, and I also believe that a free banking system with competitive note issue produces far better macroeconomic outcomes and financial stability than a centralized banking system with a monopoly over the money supply.  My criticism relies in that all too often Fed critics focus on the level of current interest rates rather in whether that target level is in accordance with conditions that would ensure that distortions in financial markets are minimized. In other words, criticism towards the Fed’s interest rate policies should focus on whether they divert from the natural rate of interest or not, rather on simply vague notions of interest rates being “too low or too high”.

FED FUNDS RATE

 

It is important to remember that the crux of the Mises-Hayek Theory of the Business Cycle relies in this very important notion of natural rate-market rate of interest divergence. If the natural rate of interest, or sometimes described as the equilibrium rate or Wicksellian rate in honor of the monetary teachings of the late Knut Wicksell, is not aligned with the market rate, then distortions occur that could lead to a boom-bust trade cycle or to a deflationary cycle in the economy. In essence if one is to make the case that rates are “too low” or “too high” one has to demonstrate and explain what is meant by that, what are the implications and what are the alternatives. Also, so called “market monetarists” such as Scott Sumner, have explained that simply because rates are low, does not mean that necessarily Fed policy is expansionary, and that it could well respond to deflationary conditions.

Further, there seems to be ample evidence that the current environment of short and long term interest rates being low respond to several factors that respond to historical long term trends. Former Federal Reserve Chairman Bernanke makes the case for why interest rates have been low in recent years in a series of thought provoking articles at Brookings. Dr. Bernanke uses the concepts of the natural rate of interest to explain why rates have been so low. He also explains the importance of remembering that the Fed can only influence the federal funds rate which is at best a short term policy instrument. Long term interest rates are “set” or determined by macro and financial conditions in the economy. Do I believe that former Chairman Bernanke is absolutely correct about Fed policy? Of course not. For example I sympathize and agree with the criticism formulated by John Taylor, who show that in the period prior to the sub prime crisis, the Fed indeed held interest rates to a distorting level, thereby fueling the housing bubble that was exacerbated by misguided federal and regulatory policies. I also agree with Dr. Lawrence White’s criticism of Fed policy post recession as being policies of credit allocation and of favoritism to particular financial institutions. The point I am trying to convene is that it is important to understand three things: How Fed policy actually works, how distortions via interest rates occur, and the difference between the natural rate and real market rate of interests.

Can Monetary Policy Rules become effective in minimizing interest rate divergence distortions?

The debate between discretion vs monetary rules for central banking has become a lively one recently among macroeconomists and financial analysts. I hold the position that indeed a clear and effective monetary policy rule is indeed a much better monetary regime than an unconstrained discretionary central bank, and that would allow to minimize distortions in the market. However, I believe that most proposed monetary rules do not tackle the crucial problem expressed in this post, mainly the distortions that occur when the natural rate of interest is not aligned with the market rate. Most monetary rules focus on an aggregate level targeting: inflation, money supply or nominal GDP. A much less studied and analyzed monetary rule that I think it would produce stable financial markets and macroeconomic conditions is the monetary rule proposed by Erwin Rosen & Adrian Ravier, The Natural Rate of Interest Rule. The authors suggest that central bankers should follow a monetary rule for their interest rate target decisions that mimic or follow closely the natural rate of interest. Now, it is true that the natural rate of interest is not directly observable, however, current models such as the one created by Laubach & Williams (2001) serve as an accurate proxy for determining such equilibrium rate. By following this rule, The Fed and other Central Bankers can actually focus on the true nature of distortions and boom-bust cycles, in the tradition of  Wicksell-Mises-Hayek and other economists who understand the importance of adequate market rates to natural rates in order to avoid boom bust cycles such as the most recent crash of 2007-2008 but also the great crash of 1929.

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