Policy Uncertainty Is Not Helping the US Economy
MEASURING UNCERTAINTY AND ITS EFFECTS
The adverse economic effects of increased uncertainty have been analyzed and documented by Nicholas Bloom and others. Increased uncertainty can have a negative effect on short-run investment and hiring, and it may have been responsible for one-third of the decrease in GDP during the Great Recession (Bloom). Empirical measures of uncertainty have been developed, and they are readily accessible at the website of the Booth School of Business at the University of Chicago. Uncertainty about future government economic policy is a major component of general uncertainty, and uncertainty about future fiscal policy has been discussed in a previous posting. This posting will concentrate on uncertainty about monetary policy, trade policy, and the regulation of financial markets. All of these policies have become more uncertain recently.
Recent Congressional action has reduced near term uncertainty about fiscal policy without taking any action about long-term fiscal and debt policy. A compromise originating in the joint House- Senate committee chaired by Paul Ryan and Patty Murray made minimal changes in spending and taxation that would avoid shutting down the government again on January 15th. The House approved the bill, and the Senate is expected to approve also. This compromise would be an improvement over the government shut-down experienced in October, but giving credit to the Congress for refraining from shutting down the government is a rather low standard for judging the quality of governance. The budget compromise would affect spending and taxation for the next two fiscal years without addressing any of the long-term budget and debt problems related to the effects of aging on Social Security, Medicare, and Medicaid. However, the modest agreement does increase the probability that someone can walk in the national parks or visit a war memorial without being arrested for trespassing.
Charles Plosser has recently pointed out that U.S. monetary policy has become increasingly discretionary and difficult to predict. As the President of the Federal Reserve Bank of Philadelphia and sometime member of the Federal Open Market Committee (FOMC) that produces monetary policy, he is in a good position to evaluate the strengths and weaknesses of Fed’s policymaking. The Fed’s dual mandate that obliges them to target both inflation and unemployment is one source of uncertainty. The public naturally wonders when the Fed’s future actions, including quantitative easing, will be influenced by the inflation target and when the unemployment target will dominate. There is also substantial uncertainty, as shown by polls of business economists, about when the Fed will begin to taper its quantitative easing of $85 billion per month. Fed officials have tried to reduce policy uncertainty by offering statements that they describe as “forward guidance “about monetary policy. However, statements about forward guidance lack credibility to many observers, including Stanley Fischer, a likely new member of the Fed’s Board of Governors. He has stated that the Fed cannot provide credible statements about future policy because Fed decision makers do not know today what they will do in the future. Ben Bernanke is about to be replaced by Janet Yellen, and membership on the Board of Governors and the FOMC changes regularly. In addition, the FOMC may change its policy in response to changes in economic developments.
Committing the Fed to an unemployment rate target by itself is problematical. Since Mr. Bernanke has mentioned both 6.5% and 7.0% (reached in November) in the past, which rate will influence monetary policy? Since monthly unemployment rates include considerable noise, will the unemployment rate relevant for monetary policy be the rate be for one month or some average unemployment rate over several months? Another problem with the unemployment rate is that it is affected by both the number of people actively seeking employment but not getting hired and by the number of people entering or leaving the work force. These two effects are not equivalent, and the November work force remained near its 35 year low.
Uncertainty about how the Fed will deal with these issues has renewed the traditional discussion of whether government policy is better served by “rules or discretion”. Plosser has warned that U.S. monetary policy has become one of the most discretionary and least predictable among major countries. Benn Steil and Dinah Walker of the Council on Foreign Relations have characterized U.S. monetary policy as “unfettered discretion”. Other countries are also affected by uncertain U.S. monetary policy, as demonstrated in May when interest rates, capital flows, and exchange rates of several countries responded to vague statements by Ben Bernanke that many people perceived to be an indication about tapering of quantitative easing.
The housing sector and housing finance were at the center of a “housing bubble” that resulted in the Great Recession. The voluminous Dodd-Frank bill was intended to deal with reform of housing finance, but it never addressed the future roles of Fannie Mae and Freddie Mac. The failure of these agencies imposed a large cost on taxpayers, and “At the time of their collapse, no financial institution posed anywhere near the systemic risk of Fannie and Freddie” (Acharya et al).
The future status of the agencies remains in limbo. Their “heads I win, tails you lose” business model has been judged a disaster (Acharya et al). They were expected to be liquidated, but recently prominent private speculators have been buying outstanding shares in the agencies in the expectation that shares will increase in value.
Housing is an important sector of the economy that has been traditionally given special treatment by the government. In addition to the implicit housing subsidies coming from Fannie Mae and Freddy Mac, the Fed has given special treatment to housing by altering its traditional policy of buying only government bonds in favor of also purchasing mortgage-backed securities. This allocation of credit to a specific sector has also been criticized by Plosser as an improper use of monetary policy that would be better served by fiscal policy.
The Dodd-Frank bill continues to be a major source of regulatory uncertainty. It was passed in 2010, but near the end of 2013 many crucial rules still have not been written. The bill itself took 1000 pages, and the latest version of one of its components, the Volcker Rule, is approximately another 1000 pages. The complexity of the rule is expected to create a cottage industry for lawyers and consultants. Since implementation (among five regulatory agencies) is expected to occur in 2015, financial market participants face substantial uncertainty.
In addition to uncertainty about financial regulation, the large sector of the economy devoted to health insurance and the delivery of medical services faces enormous uncertainty about implementation of the Affordable Care Act. Deadlines about timing and interpretation of the law have already changed many times, and millions of households and employers are trying to understand the law and adapt to it.
TRADE POLICY UNCERTAINTY
Most presidents and foreign negotiators have found “fast track authority” to be useful in completing trade agreements. Fast track requires that the Congress vote up or down on trade treaties without amending them, which implies that the treaty version voted on by the Congress is the same one approved by foreign officials. However, the Obama administration has been negotiating two treaties (Trans-Pacific Partnership, and an agreement with the European Union) even though fast track authority expired in 2007, and has not yet been renewed. U.S. Trade Representative, Michael Froman, has requested renewal of fast track authority, but the normal sequence of first obtaining Congressional approval and then negotiating with other countries has been reversed. This reversal allows opponents of trade in both parties to impose conditions on agreements, such as prohibiting “currency manipulation” that would not have been included otherwise. This awkward approach to trade negotiation increases uncertainty, and reduces the likelihood of a successful agreement.
Some degree of uncertainty in the world is unavoidable. The timing of innovations, resource discoveries, and natural disasters is inherently uncertain. The outcomes of elections and occurrences of wars and military coups are also uncertain. However, uncertainty about certain aspects of government policy is avoidable, and it can be reduced by relying more on rule-based policies rather than discretionary acts of government officials. In the United States, government policies were more certain in the past, but they have recently moved toward an extraordinarily high degree of uncertainty. Fiscal, monetary, trade, and regulatory policies have all become more uncertain, and this may be contributing to the slow recovery from the Great Recession, including slow growth in investment and hiring.
Acharya, Viral, Matthew Richardson, Stijn Van Nieuwburgh, and Lawrence J. White. 2013. “Guaranteed to Fail: Fannie Mae and Freddie Mac and What to Do About Them”. Economists’ Voice. June.
Bloom, Nicholas. 2013 ”Fluctuations in Uncertainty”. National Bureau of Economic Research Working Paper 19714, December.
Plosser, Charles. 2013. “A Limited Central Bank”. Cato Institute’s 31st Annual Monetary Conference. www.philadelphiafed.org/publications/speeches/plosser
Steil, Benn and Dinah Walker. 2013. “How Fed Policy Roils Emerging Markets” .Wall Street Journal December 10.
Wall Street Journal.2013. “Congress is Close to Fast Track Deal for Trade Accords”. December 6.
3 Responses to “Policy Uncertainty Is Not Helping the US Economy”
You write: The Fed’s dual mandate that obliges them to target both inflation and unemployment is one source of uncertainty. The public naturally wonders when the Fed’s future actions, including quantitative easing, will be influenced by the inflation target and when the unemployment target will dominate.
I agree. One solution would be to follow the advice of market monetarists, who advocate a singe target in the form of the level of NGDP. That would mean targeting the product of the price level and real GDP. Given the strong correlation between real GDP and unemployment, NGDP level targeting would strike a fairly predictable balance between the two parts of the current dual mandate.
A single target of nominal GDP might be better than the dual mandate, but of all single targets, why wouldn't an inflation target dominate NGDP? Central banks have demonstrated their ability to satisfy inflation targets, but they have much less control over unemployment or growth in real GDP. For example, the European Central Bank has been within one percentage point of its inflation target of 2% since the Bank opened in 1999. For the EMU, the United States, and nearly all other countries, unemployment and real GDP have been much more volatile. Furthermore, high inflation and low real growth is not equivalent to high real growth and low inflation even if growth in nominal GDP is equal in the two cases.
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