Can The Fed Kill Two Birds With One Stone?
Diaz-Bonilla, in his recent EconoMonitor post, reminds us that “policy intervention must point directly to the problem, because the further away and more indirect the policy intervention, the more likely that other distortions and unwanted effects will occur”, something that he calls the Bhagwati Rule. He then builds on it and suggests the Fed to go beyond buying Treasury and agency securities and explore other unconventional measures that could improve the access to credit for small business and facilitate infrastructure investment.
We agree that each further round of quantitative easing in form of buying Treasury debt and agency securities is likely to be less effective and could contribute to future inflation. However, we disagree with the broader conclusion that the Fed should consider becoming a developmental central bank. The more the Fed enters the domain of politicians, the more political pressure it will face. More political pressure will result in gradual loss of political independence. Loss of political independence, in turn, will make it more difficult for the Fed to deliver on one of its mandates – to maintain price stability, as historical experience shows. By pursuing such a path, the Fed would likely “win the battle, but lose the war”. The Fed’s latest announcement of QE3, which includes monthly purchases of mortgage backed securities, continues their movement toward “development central banking”.
Ben Bernanke has used the depressed state of the US economy to justify quantitative easing, but the same monetary expansion could have been achieved by purchasing government assets rather than buying mortgage backed securities. It is also a bit odd that a federal agency proposes to fine-tune the housing sector so soon after other Federal agencies contributed to the housing bubble that contributed to the Great Recession. Mian and Sufi and others have shown that Fannie Mae contributed to the bubble by subsidizing credit and lowering loan standards. Is there reason to believe that another venture into developing the housing sector will be more successful than the last one? If the economy recovers, and it is time for the Fed to reverse the monetary expansion, how anxious will the Fed be to sell mortgage-backed securities and slow housing expansion? In the US it has been far easier to add subsidies to housing than to withdraw them. Mortgage interest payments are tax deductible and their exemption is one of the largest loopholes in the federal tax code. The government is facing an immediate ”fiscal cliff” and a longer–run debt crisis, but neither political party is willing to offer to withdraw the mortgage interest housing subsidy.
The Fed has a dual mandate of maximum employment and price stability. A discussion of whether the single mandate of the ECB generally makes it more effective than the Fed is beyond the scope of this post. However, in case politicians fail to do their part of the job, a single mandate is less dangerous, because it enables the central bank to put more pressure on politicians. This has apparently been the case in the Eurozone where the ECB, referring to its single aim to maintain price stability, keeps putting pressure on politicians to carry out reforms. When Mario Draghi says the ECB will do whatever is necessary to save the Euro, he adds a qualification, as long as it is “within the mandate” of the bank. The ECB also requires that debtors seeking ECB help must first apply to the European Financial Stability Facility or the European Stability Mechanism and accept strict conditionality.
While the Eurozone problems are not resolved yet, the path in the US now looks increasingly as follows: more procrastination on fiscal policy and more urging by Congress and the President for Chairman Bernanke and the Fed to take drastic and unconventional actions intended to solve the nation’s macroeconomic problems. Moreover, down the road that might also mean higher inflation. Ironically, the fatal flaw of the dual mandate of the Fed might be that those designing it failed to take into account the possibility of a prolonged failure by the politicians to implement a fiscal policy that complements monetary policy. Diaz-Bonilla also reminds us of the Tinbergen Rule that a government cannot attain two objectives with one instrument. If fiscal policy fails to contribute to macroeconomic stabilization, monetary policy remains the only policy instrument to deal with two goals. Can the Fed kill two birds with one stone?
Diaz-Bonilla, Eugenio. 2012. „Déjà Vu, All Over Again: QE3 and Developmental Central Banking”, EconoMonitor. September 13, 2012.
Mian, Atif, and Amir Sufi. 2010. „The Great Recession: Lessons from Microeconomic Data”, American Economic Review. May 2010.
8 Responses to “Can The Fed Kill Two Birds With One Stone?”
Could not agree with you more! This is usual failure path in Europe and you see the huge trainwreck. Europeans just love state sponsored capitalism creating huge market distortions. The US path with Bernanke has become terribly political.
Misplaced credit allocation and artificially low interest rates cannot lead to any happy ending here any more than drug addicts with their heroin doses.
Historically many governments have used the power of government agencies to encourage purchases of government bonds (financial repression). The resulting lower interest rates reduce the immediate costs of government borrowing and the current government debt to GDP ratio. However, when interest rates are eventually allowed to rise
(perhaps due to inflation), there will be a jump in government borrowing costs and the debt/GDP ratio. The net effect over time may be to increase the variance of interest rates and destabilize financial markets. It will be interesting to see the effects of holding short-term interest rates to near zero by 2015.
Dear Thomas and Andris. Thank you for your commentary. Your hypothesis of the Fed moving towards "developmental central banking" begs questions like could you be a bit more specific in your definition of developmental central banking (do you see the Fed acting in a manner similar to what Argentina's central bank is doing?) and what is actually being "developed" ? Fed says their actions are to stimulate growth in the real economy. Critics say their actions simply maintain or stimulate "financial" asset prices held by the private banks in their networks, the shadow banking system and investors with other knock off effects on items like upward pressure on commodity prices and lowering the costs of leveraging.
We deliberately use the terminology, "developmental central banking" used by Diaz-Bonilla. In the current situation it refers to the US housing sector and the attempt by the Fed to influence it by monthly purchases of housing-related financial assets (mortgage-backed looans). The Fed has not done this yet, but there has been discsussion of buying
financial assets based on student loans. Since the U.S. government currently owns 25% of General Motors, they could also buy GM bonds.
"The fatal flaw of the dual mandate of the Fed might be that those designing it failed to take into account the possibility of a prolonged failure by the politicians to implement a fiscal policy that complements monetary policy. Diaz-Bonilla also reminds us of the Tinbergen Rule that a government cannot attain two objectives with one instrument."
More goals than policy instruments are definitely a problem, but which goals are the troublesome ones? Right now, it looks like the Fed is attempting to pursue four policy goals–the two in its dual mandate (an inflation goal and an unemployment/real output goal), plus trying to flatten the yield curve and trying to boost housing.
I don 't see the first two, the dual mandate part, as the most troublesome fatal flaw. The Fed could meet the Tinbergen rule within the spirit of its dual mandate by rolling the inflation and real output goals into one, NGDP. It would openly declare that it doesn't care about the composition of NGDP growth. It is already implying that it will allow inflation to exceed 2 percent temporarily until unemployment falls, which is getting very close.
Arguably the goal of flattening the yield curve involves a different instrument. It pursues the NGDP goal by changing the size of its balance sheet and the flattening goal by changing its maturity distribution for a given size. Whether that works very well is another question.
It is the developmental goal of boosting housing that is the most worrisome, as Tom and Andris point out. It is a goal that strays too far toward fiscal policy and an instrument that seems inadequate to the goal.
Yes, one could combine inflation and output goals into a nominal GDP goal, which got some support from Michael Woodford at the recent Jackson Hole Federal Reserve Conference. However, aggregating things that are different from each other results in a loss of information. 4% real growth and zero inflation are fundamentally different from zero real growth and 4% inflation, even though both result in 4% nominal GDP growth.
On the dual mandate, notice that James Bullard, President of the St. Louis Fed, has come out in favor of a single mandate with inflation as the goal. He is not a current voting member on the Federal Open Market Committee, but he will be in the future.
What is actually being "developed" ? Fed says their actions are to stimulate growth in the real economy. Critics say their actions simply maintain or stimulate "financial" asset prices held by the private banks in their networks, the shadow banking system and investors with other knock off effects on items like upward pressure on commodity prices and lowering the costs of. http://www.nonfaithbased-drugrehab.org/contact-us…
We agree that each further round of quantitative easing in form of buying Treasury debt and agency securities is likely to be less effective and could contribute to future inflation.