As has been widely reported, the Trump administration and the Republican Congress are making a run at unwinding many of the financial market regulations put in place after the last financial crisis. While Dodd-Frank is imperfect, its general thrust remains essential if we want to get out of the economic “shampoo cycle” — bubble, bust, repeat — that has repeatedly led to recessions and bailouts that end up being much more costly to Main Street than Wall Street.
I’ll have more to say about these deregulatory efforts in later posts — this Washington Post editorial presents a useful overview — but there’s an important piece of this that I haven’t seen covered: the Republican attack on the political independence and analytic flexibility of the Federal Reserve, a.k.a Title X of the Choice Act — “Fed Oversight Reform and Modernization.”
For central banks to be most effective in carrying out their mandates, they must be politically independent. Of course, the Federal Reserve must meet the broad mandates Congress legitimately sets for it, which in the U.S. case is full employment at stable inflation. But any micromanaging of how the Fed meets its mandates by those who hold political office raises the specter of politicizing the bank’s actions. As Fed Chair Janet L. Yellen recently wrote in a sharp critique of the proposal, the “framework” wherein central banks independently pursue their statutory goals “is now recognized as a fundamental principle of central banking around the world.”
One of the most objectionable aspects of Title X is its strict adherence to a formula that the Fed’s interest-rate-setting committee must use to set the federal funds rate (FFR), the benchmark interest rate they control. The text even spells out a specific formula, called the “reference policy rule,” which corresponds to economist John Taylor’s 1993 eponymous “rule:”
FFR = inflation + 0.5 * (output gap) + 0.5 * (inflation — 2 percent) + 2 percent
“Output gap” is specified as the percent deviation between actual and potential GDP, and inflation is the year-over-year rate of price growth. The first 2 percent is the Fed’s inflation target; the second is the variable that is these days called r* (“r-star”): the real, equilibrium interest rate at full employment that is neither expansionary nor contractionary.
This is a sensible and intuitive formula. It essentially says that when inflation is above the Fed’s target the FFR should go up, and when output is below potential, the FFR should come down. When inflation is on target and output is at potential, the formula says r* (FFR – inflation) should be 2 percent. Its simplicity, along with the fact that certain versions of the rule generally track the actual movements in the FFR, make the “Taylor rule” a standard tool for monetary policymakers. “Where is the FFR relative to the Taylor rule?” is always a good question. But it is definitely not the only question.
For one, to say that the rule describes the past does not ensure that past rates were optimal, nor that the rule’s output is appropriate for current or future conditions, a limit Taylor himself recognized in his seminal 1993 paper where he noted that “there will be episodes where monetary policy will need to be adjusted to deal with special factors.” One such factor — the zero lower bound on the FFR — is particularly germane in this context.
Advocates of Title X maintain that the Choice Act provides such flexibility, but as I read the text of the bill, any time the Fed’s interest-rate-setting committee (the FOMC) strays from the “reference formula,” their rule change would be subjected to five pages of required approvals. This process can occur post hoc, but such burdensome reporting requirements impose damaging constraints on the Fed’s discretion.
For example, within 48 hours of an FOMC policy meeting, the Fed chair must “describe the strategy or rule of the Federal Open Market Committee for the systematic quantitative adjustment of the Policy Instrument Target to respond to a change in the Intermediate Policy Inputs.” She must “include a function that comprehensively models the interactive relationship between the Intermediate Policy Inputs” (the variables in the rule). She must “include the coefficients of the Directive Policy Rule that generate the current Policy Instrument Target and a range of predicted future values for the Policy Instrument Target [the FFR] if changes occur in any Intermediate Policy Input.” Those are just three of the nine requirements in this section.
It is an astounding read from a Congress that claims to be invested in reducing red tape and complex, needless regulation, and it creates a strong bias toward a solely rule-based approach that is increasingly unrealistic.
Why unrealistic? Because every single parameter in this equation is fraught with uncertainty:
—What is the best inflation gauge? Taylor recommended the GDP deflator, but many contemporary applications of the rule use the PCE deflator, often the core version (excluding food and energy prices), as the Fed believes core PCE inflation to be the best predictor of future price growth.
—Should the coefficients be 0.5? Former Fed chair Ben Bernanke, in a recent piece that explores these very questions, argues that the coefficient on the output gap should be 1, not 0.5, as this formula more closely tracks the path of the FFR over the past few decades. Under Title X, any such changes in these coefficients would have to be justified to their regulator.
—How big is the output gap? Economists cannot accurately measure “potential” GDP and the lowest unemployment rate consistent with stable prices. One recent analysis estimates the current “natural” rate of unemployment is between a range that goes from 0 to 6 percent.
—Is 2 percent the right inflation target? There is increasing dissent on this point, with some people arguing that the Fed should raise its inflation target due to the increased risk of the FFR getting stuck at the zero lower bound. Just last week, Yellen recognized this possibility, pointing out “ … that the economy has the potential where policy could be constrained by the zero lower bound more frequently than at the time when we adopted our 2 percent objective.”
—There’s even greater disagreement about r*, the “neutral” real FFR, which is 2 percent in Taylor’s formula. Recent estimates of r*, such as those in the figure below, show it to vary considerably over time, with recent results near zero.
The rule is highly sensitive to these choices. In the depths of the last recession, the “reference rule” would have recommended an FFR of -1.8 (using real time data from 2009Q4). But upweighting the output gap coefficient and taking account of the fall in r* returns an FFR of almost -7 percent.
The differences in these results have huge policy implications. The Bernanke/Yellen Feds used their discretion to upweight slack concerns and the fall in r*. Given the zero-lower-bound on the FFR, such discretion led them to look for different ways to lower longer-term interest rates. Today, the reference formula returns an FFR of over 3 percent, way above the current FFR (1 percent), suggesting the Fed is way “behind the curve.” However, plugging in a lower r* and weighting slack more heavily produces FFR’s close to the Fed’s current path.
It thus seems obvious that the Fed should not have to jump through regulator hoops to decide how to calculate or even use the formula. Consider today’s economy, where the job market is tight, but wage growth is not rising quickly and inflation has been decelerating. Though the standard rule would call for rapid removal of monetary accommodation, doing so would needlessly hurt low- and middle-wage workers.
But there’s an even stronger objection to Title X: The combination of the portentous choices just noted and politics is a highly toxic mix, which is precisely why we do not want Congress micromanaging the Fed. The Fed is a highly functional institution without an explicit political agenda. Congress, conversely, is explicitly political and, to put it mildly, a far less smoothly functioning institution. It is easy to imagine partisans pressuring the Fed and their newly empowered regulators to upweight inflation or down-weight slack, while other partisans fight for the opposite weighting scheme.
It should not be controversial to observe that the Fed’s political independence affords it an ability to go about its work in a much more analytical and less fractious political environment than that of today’s Congress. This, in turn, allows the bank to do its job in a way that is systematic, timely, and generally predictable, the latter of which is important to markets. Contrast that with decisions and actions for which Congress is responsible, such as meeting budget deadlines. It would be an act of willful denial to not consider the problem of relative functionality — the Fed vs. the Congress — when considering reducing the Fed’s independence and increasing Congress’s authority over their actions.
The Choice Act will need 60 votes to pass the Senate, and it’s a good bet that it won’t clear that bar in its current incarnation. Even so, we must not ignore Title X, as it threatens to undermine the Fed in ways that will exacerbate inequality, wage stagnation, and the bubble-bust cycle, while lessening our ability to get to and maintain full employment.
To be clear, none of this is to imply that the Fed is perfect, doesn’t make costly mistakes, or should be immune to scrutiny and criticism, of which I have recently offered a heavy dose. But that’s a far cry from giving Congress the power to mess with their independence and effectiveness.