The Fed Fails, Um, Does Irony

In a speech in 2002, Bernanke said that the Fed would prevent the US from experiencing a Japan-like outcome.

However, the US has experienced a pattern of economic and policy developments that parallels developments in Japan.

Japan experienced a financial bubble and crisis. The Japanese authorities took actions to support asset prices and prevent insolvent businesses from failing. The growth of the Japanese economy remains so anemic that almost two decades after their financial crisis, the authorities are still introducing new stimulative measures and packages.

The US has also experienced a financial bubble, a crisis, a recession and a very slow recovery. The Fed and the Treasury took unprecedented measures to support asset prices and have prevented or helped to prevent the failure of insolvent firms. Despite the Fed’s opportunity to learn from the Japanese experience and all Fed’s efforts to promote the growth, per capita growth in the US has been slower than in Japan.

In short the US economy has experienced exactly what Bernanke said the Fed could and would prevent, save outright deflation.

In the same speech, Bernanke also said that the Fed could call on other government agencies for help should a financial crisis occur.

Despite Bernanke’s statement that the Fed would be part of a multi-pronged, multi-agency, counter-cyclical response to a serious economic downturn, the Fed has been the only macroeconomic policy game in town. There was no sustained fiscal stimulus, and supporters of the use of fiscal stimulus have argued that the package that was adopted was too small to be effective. Fed-Treasury cooperation during the crisis was limited to the Fed financing the Treasury’s de facto nationalization of AIG. This allowed Treasury to avoid going to Congress for the funding and a debate about the appropriateness and terms of the take-over.

Recently, Bernanke said that monetary policy is no panacea. However, the Fed still insists that a recovery based on monetary stimulus alone is forthcoming.

Again, there is dramatic divergence between what the Fed says or expects on the one hand and actual outcomes on the other.

Before the crisis, the Fed denied the existence of a bubble in residential real estate.

Unfortunately, there was a massive bubble. When the bubble popped, it crippled the financial system and ushered a recession with a slow recovery, high unemployment, and the pain of foreclosures.
The Fed had bet on heads only to have tails come up.

The Fed asserted that a rules-based policy regime was better than one based on discretionary decision making.

However, the rule/discretionary dichotomy has proved to be a false one. Policy makers have exercised discretion when they chose the 1) type of rule, e.g., the Taylor rule versus a nominal GDP target; 2) the variant of the rule employed, e.g., the use of CPI (as favored by Taylor) or forecasts of the PCE deflator (as favored by the Fed); and 3) the sensitivity of policy to deviation of targeted variables from targeted levels.

A truly rules-based, no-discretion-allowed regime would also have rules for when and why the rule should be ignored, as well as a rule that would govern if, who and when the rule can be changed, e.g., from the Taylor rule to nominal GDP targeting. The current regime does have any such rules.

However, the Fed did set interest rate policy in accordance with a variant of the Taylor-Rule. The adoption of this rule-based policy was supposed to insure the continuance of the Great Moderation. Prior to the crisis, FOMC members frequently gave speeches in which they took credit for the Great Moderation. Post the crisis, all we heard from them in effect was: “It cannot be our fault. We were following the rule.” A framework that was supposed to impose discipline and to enhance accountability on policy makers became an alibi for a policy failure.

Again the actual outcomes were the opposite of the outcomes and the goals that the Fed set for itself.

Prior to the crisis, the Fed promoted the idea that a rule-based, inflation-focused policy would make policy design and implementation purely technical problems. This, in turn, would insulate the Fed and its policy from political pressures and insure its independence.

The Fed has not enhanced its independence from political meddling and interference far from it. There is an unusually large amount of political pressure and interference aimed at the Fed and its independence. There are efforts in Congress to 1) require audits of the policy design process, 2) impose a quota system on the Board of Governors of the Federal Reserve System requiring that a seat on the Board be allocated to a community banker, and 3) require the Fed to adhere to a Taylor Rule framework for policy design.

The Fed also opened the door to political meddling when it financed Treasury’s de facto nationalization of AIG and the bailout of AIG counterparties, as well as when it decided to engage in a massive re-distribution of wealth and income via ZIRP.

Once again, the outcome – increased politicalization – was opposite of the desired result.

Prior to the crisis, the Fed said it would not comment on or interfere in the design of fiscal policy in yet another attempt to stay above the partisan political fray.

However, in pursuing ZIRP and QE, the Fed is actively engaged in fiscal policy. ZIRP and QE have lowered the Treasury’s cost of borrowing. The decline in interest rates paid by the Treasury directly affects its outlays and the fiscal deficit. Hence QE has a fiscal policy dimension. It may seem benign today, but when ZIRP and QE are ended the rates paid by the Treasury will rise. Other things equal the fiscal deficit will increase as a result of the policy stance and the Fed will be in a political hot seat.

The Fed is more deeply involved in fiscal policy than ever before. Yet again, the Fed has achieved the opposite of the goal it set out for itself.

The Fed promised to be more transparent than in the past.

In some cases, the Fed is no more and probably less transparent than in the past. The Fed releases numerous point estimates of economic variables, including the staff forecast, the forecasts of individual members of the FOMC, forecast ranges, and central tendencies. In short, a series of often inconsistent forecasts with no confidence limits attached, none of which caught the crisis or the recession and all of which have continuously over-estimated the strength of the recovery. On the other hand, the Fed does not divulge one set of numbers that it knows with certainty and that are of interest to the markets, i.e., the vote tallies at FOMC meetings. If transparency is a goal, why not report the exact vote tallies instead of characterizing the votes as “few, some, many”?

In some cases, the Fed is less transparent. The Fed has never released the rationales for targeted rates of asset purchase under the QEs, nor has it released the rationale behind the pace of tapering of the QE purchases. Policy now emerges from a black box. In addition, the Fed has not specified exactly what the expected goals of the ZIRP and the QE programs was/is. Hence the public has no way of evaluating the success of the programs.

Policy transparency is down and not up.

Prior to the crisis, the Fed attached very little if any importance to its regulatory function. As a result, it failed miserably as a financial regulator.

Despite 1) its failure as a regulator, 2) the fact that its chosen model of the economy (DSGE) does not even contain financial institutions or markets, 3) the policy rule that it employed prior to the crisis as well as the leading alternatives do not reflect financial market developments, and 4) the fact that it only pays lip service to financial stability when setting policy, its regulatory reach was expanded.

The Fed now acknowledges that regulation is important. This is precisely the opposite of what the Fed had assumed. The expansion of the Fed’s regulatory reach is the opposite of what the Fed would have argued was necessary, as well as the opposite of what the record suggests is appropriate. Alternatively, one could argue that after resisting changes the Fed has suffered a de facto loss of regulatory authority, even as its regulatory reach outside the banking sector has been expanded.

In its role as a financial regulator, the Fed presents itself as having expertise in risk management.

When ZIRP did not work to the Fed’s satisfaction, the Fed doubled down with QE1. When QE1 did not work to the Fed’s satisfaction, the Fed doubled down with QE2. And when QE2 didn’t work to the Fed’s satisfaction, it doubled down with QE3. This despite a running debate on exactly and to what extent QE has stimulated the real economy.

Furthermore, the Fed says that it should not lean against asset price bubbles because it can never be certain there is an asset price bubble. However, the Fed cannot know with certainty that there isn’t an asset price bubble either. Nonetheless, it sets policy as if an asset price bubble does not exist or are of no concern.

With a sustained satisfactory rate of growth still illusive, signs of excesses in the capital markets, no agreed upon plan to shrink the size of its balance sheet and with the Fed already in a political hot seat, society and the Fed have more on the table than they can afford to lose. The Fed has demonstrated all the risk management acumen and discipline of the London Whale.

The Fed asserts, based on its expertise and knowledge of the economy, that the markets, financial institutions and society as whole should base their behavior on its forecast for the economy, interest rates and inflation.

However, better-credentialed individuals (former full professors at prestigious universities with Nobel Prizes in economics to boot) running a fixed income portfolio at LTCM managed to make errors that threatened the US financial system in 1998. This occurred despite all the credentials and the fact that managing a fixed income portfolio is a trivial problem compared to setting and implementing macroeconomic policy.

Given that episode, the Fed’s failure to foresee the financial crisis, and the repeated incorrect calls for acceleration in growth a few quarters out, why does the Fed assume that economic agents will treat its forecast as gospel and alter their behavior beyond the impact of the interest rate stance?

The Fed employs models that assume rational expectations and efficient markets, but its assertion that current policy pronouncements can manipulate expectations implicitly assumes that economic agents do not remember or learn from the recent past.

The economic and financial systems are complex and dynamic. The fact that the Fed did not achieve all the goals that it set out for itself is not surprising. However, is more than just ironic that the Fed made decisions and pursued policies which resulted in it achieving the opposite of its stated goals and forecasted outcomes.


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