Tuesday, June 7, 2016

Four Goals Good, Five Goals Bad

In my last post, I argued that despite talk of the Fed's dual mandate, it is targeting at least four goals:

1) Price stability
2) Full employment
3) International stability, seeking to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes the Fed's influence on global economic, monetary and financial conditions
4) Financial stability, avoiding both unwarranted booms and busts in asset prices.

Tim Duy has two theories (again, see previous post) for why the Fed seems surprisingly keen on raising rates. I think the Fed's recent actions appear much more understandable in light of their unstated financial stability goal.

One narrative of the cause of the financial crisis is that the Fed was directly responsible for the financial crisis of 2007-2009 by keeping interest rates too low for too long. A more generous view is that, as Hyman Minsky warned, stability breeds instability, and the success of "the Great Moderation" unfortunately encouraged high leverage and complex financial instruments at fragile institutions. 

Despite the Fed's best efforts to insulate itself from political pressure, it's unthinkable that it can have remained impervious to the two views above. In this sense, "normalization" can be seen as an attempt to head off any reprise of the financial crisis. Two more concerns are extant:

1) The notion that market participants have somehow become "addicted" to monetary stimulus. (Side note: If there's one thing that automatically sets my teeth on edge, it's references to the economy or financial markets as an alcoholic or drug addict, and to the Fed as a shameless enabler.) The problem is that this bias leads observers to see the 2013 taper tantrum and the 2016 Jan/Feb sell-off as evidence that financial markets are relying on low rates indefinitely. 
2) The notion that Fed actions have pushed all asset markets to overvalued levels. 

Part of the financial stability goal is clearly aimed at keeping unbridled speculation at bay. In Paul Blustein's "The Chastening", he recounts how Larry Summers famously told his bailout negotiating team, "We want to keep markets calm and the Russians scared." The Fed is playing an even more difficult game where it wants to keep markets calm and the speculators scared. This is already attempting to thread the needle, but even more difficult given the Fed's other three goals. 

I've been endlessly critical of hard money types, but it's worth acknowledging that they're not the only ones who may find this expanded array of goals troubling. Those who advocate different types of rules-based monetary policy, such as nominal GDP level targeting, may also consider the monetary policy Apocrypha too hard to achieve. Their concerns are understandable. In its attempt to fulfil its Apocryphal financial stability mandate, the Fed is failing to meet its Canonical dual mandate. Furthermore, in doing so, as Narayana Kocherlakota points out, the Fed is jeopardizing its credibility to meet the Canonical Mandates. I was stunned to read the well-known economist (and former Fed vice-chair!) Alan Blinder lament the limits of monetary policy. "If there is a cyclical downturn in a year or in the next several months, there would be nothing in that shotgun," Blinder warns. If a former Fed vice-chair believes that the Fed is out of ammo (another image I don't care for), it's unlikely economic and financial markets fully believe the Fed can stabilize economy in future downturns.

As unwieldy as the quadruple mandate may be, it seems to be the right approach to central banking in the US. There's no doubt that it's incredibly challenging to manage these four goals, but I don't see any other way. If, for example, we're aware that our diet will affect our teeth, skin, weight and ability to build muscle, it's challenging to choose the right food - but we have no choice but to constantly manage the trade-offs between these effects. Why, you may argue, should the Fed restrict itself to four mandates? Why not five? Why not six? I don't have a great answer to that, and recognize the danger of over-reach: in fact, one of the problems here is that policy-makers do indeed seem to have taken on a fifth mandate, "Normalization", which is at odds with many of its more worthwhile goals.

One of my favourite books is John Kay's "Obliquity." In it, he writes, "Good decision making is pragmatic and eclectic. Oblique approaches rely on a tool kit of models and narratives rather than any simple or single account. To fit the world into a single model or narrative fails to acknowledge the universality of uncertainty and complexity." Yellen's Fed has presumably used a dashboard of indicators to guide its policy-making thus far. It would be a huge mistake to fixate on one or two of those, despite the political appeal and intellectual comfort of doing so. While financial stability is a perfectly valid goal for the Fed to consider, the balance of risks does not appear to require a hasty set of rate hikes. If anything, it is that new mandate, "Normalization", that should be abandoned in favour of the four mandates that have historically served the Fed. 

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