Tuesday, June 7, 2016

The Fed's Monetary Policy Apocrypha

In a blog post simply titled "Curious", Tim Duy ponders why so many FOMC participants seem eager to raise rates despite failing to meet either of its official mandates (price stability and full employment). Duy has two theories: (a) the FOMC does not view the removal of QE as tightening, and therefore believes it has yet to remove accommodative policy, and (b) the FOMC views a much higher level of interest rates as "normal" and is eager to reach these higher rates.

I find the second argument more convincing (by which I mean, I find it convincing as explaining Fed policy. As I will try to argue, it is a problematic stance for the Fed to take, since giving too great a weight to "normalizing policy" makes it ever hard to reach those levels). The Fed's desire for "normalization" may also reflect some view of the "normal" size of its balance sheet. But really, this argument is a sub-set of a much broader argument - one which makes the Fed's action far less curious. Simply put, the Fed is trying to meet not two, but (at least) four mandates.

No doubt this is already raising the ire of hard money types in particular, who think central banks should be focused solely on price stability, and to whom a full employment mandate is already venturing into dangerous territory. Many of these folks are likely to lionize Paul Volcker for successfully driving inflation down, even at the expense of causing a recession. But here's the funny thing: if you listen to Volcker himself, he was focused on at least three mandates throughout his lauded career. Yes, price stability was incredibly important to him. No, he didn't think the full employment mandate was particularly helpful. But he was also focused on mandates no. 3 and 4, namely international considerations and financial stability. This is strongly apparent in an excellent two-part interview he recently gave the FT's Cardiff Garcia.

Broadly speaking, I would define the extra mandates as follows:

Mandate 3: The Fed seeks to implement monetary policy in a way that (a) harmonizes internal and external realities, and (b) recognizes its influence on global economic, monetary and financial conditions.

Mandate 4: The Fed seeks to implement monetary policy in a way that maintains financial stability, avoiding both unwarranted booms AND busts in asset prices.

These mandates are hidden from the public eye. The Greek phrase for "hidden things" is Apocrypha - a phrase most commonly used in reference to a group of non-canonical writings only included in some Christian Bibles. These books are called Apocrypha "because of the belief that the men who wrote them were not addressing their contemporaries but were writing for the benefit of future generations; the meaning of those books would be hidden until their interpretation would be disclosed at some future date by persons qualified to do so." In a similar vein, the Fed's monetary policy Apocrypha are implemented for the benefit of future generations, but are largely shielded from the eyes of current observers (presumably because they lie outside the Fed's official purview).

I mainly want to talk about Mandate 4 (financial stability), but let me make some brief comments on Mandate 3. Mandate 3a is something every central bank must grapple with, particularly if it has pegged its exchange rate. Mandate 3b, however, only applies to major central banks, like the Fed, the ECB, the PBoC, and the BoJ. David Beckworth coined this the "monetary superpower" phenomenon, which I covered in a prior post.

The hidden financial stability mandate appears to be the biggest source of controversy at this point, and I cover this in my next post.

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