Scott Sumner  

Is Stanley Fischer too complacent?

The Most Convincing Figure in ... When Orwell Met Aumann...

Stanley Fischer is one of the world's most thoughtful monetary economists. And now he is also vice chairman of the Federal Reserve Board. He recently gave a speech on monetary policy, which as you'd expect contained many wise observations. However I was also deeply troubled by some of his comments:

The Federal Reserve responded aggressively to the crisis.4 By the end of 2008, the Federal Open Market Committee (FOMC) had reduced the target federal funds rate from 5-1/4 percent to, effectively, zero. The Fed also acted forcefully as the lender of last resort--in its traditional role of providing short-term liquidity to depository institutions, and also by providing liquidity directly to borrowers and investors in key credit markets.5

In addition, the worldwide scope of the crisis called for concerted international action. Because of the global nature of dollar funding markets, the Fed authorized dollar liquidity swap lines with major central banks, beginning in December 2007. In October 2008, central bankers coordinated reductions in policy rates and the Group of Seven agreed to use all available tools to prevent the failure of systemically important financial institutions.6 The next month, the Group of Twenty announced a broad common strategy, including fiscal expansion.

These steps likely prevented a second Great Depression, but they were not sufficient to avoid a severe global contraction.

The Fed takes credit for good macroeconomic outcomes when aggregate demand grows at a smooth rate, producing low inflation and stable growth. So why shouldn't it be blamed for periods where AD is highly erratic? In the 1930s and the 1970s the Fed denied responsibility for highly unstable movements in AD. Today even the Fed admits it was to blame for those two episodes. But why does it take so long?

The key monetary policy mistakes were made in 2008, when we were not even at the zero bound. Why can't the Fed just admit that monetary policy was far too tight, and that this tight money policy greatly worsened the fall in AD? Why no soul-searching?

Going forward, there is every reason to believe we'll again hit the zero bound in the next recession. Is the Fed prepared? What does this sound like?

For over six years, the federal funds rate has, effectively, been zero. However it is widely expected that the rate will lift off before the end of this year, as the normalization of monetary policy gets underway.

The approach of liftoff reflects the significant progress we have made toward our objectives of maximum employment and price stability. The extraordinary monetary policy accommodation that the Federal Reserve has undertaken in response to the crisis has contributed importantly to the economic recovery, though the recovery has taken longer than we expected. The unemployment rate, at 5.5 percent in February, is nearing estimates of its natural rate, and we expect that inflation will gradually rise toward the Fed's target of 2 percent. Beginning the normalization of policy will be a significant step toward the restoration of the economy's normal dynamics, allowing monetary policy to respond to shocks without recourse to unconventional tools.

I see absolutely no justification for this optimistic scenario. The Fed's belief (hope?) that inflation will soon normalize is based on macro models that have repeatedly proven to be inadequate over the past 6 years. And there is no reason to assume that interest rates will rise to a level that allows monetary policy to respond to recessionary shocks "without recourse to unconventional tools." BTW, part of the problem here is that the Fed views printing money as "unconventional," whereas it is actually normal monetary policy. Control of the monetary base is what the Fed does. It's how they control AD.

There are a number of effective methods of controlling AD when rates are at zero:

1. NGDP targeting, level targeting.

2. Price level targeting.

3. "Whatever it takes" QE, enough to target the forecast.

4. Negative IOR

The Fed has adopted none of these techniques, and seems unaware that anything is wrong, that its "conventional" techniques simply won't work in the 21st century.

I was also concerned by this suggestion of mission creep:

As discussed in the FOMC's statement titled Policy Normalization Principles and Plans, which was published following the September 2014 FOMC meeting, we will use the rate of interest on excess reserves (IOER) as our primary tool to control the federal funds rate.16 We also plan to use an overnight reverse repurchase agreement (ON RRP) facility, as needed. In an ON RRP operation, counterparties may invest funds with the Fed at a given rate, possibly subject to a cap on the aggregate amount invested. Because ON RRP counterparties include many money market participants that are not eligible to receive IOER, the facility can be a powerful tool for controlling money market interest rates. Indeed, testing to date by the New York Fed suggests that ON RRP operations have generally established a soft floor for such rates.17

However, an ON RRP program also has certain risks. For example, a large and persistent program could have unanticipated and adverse effects on the structure of money markets. In addition, in times of stress, demand for the safety and liquidity of ON RRPs with the central bank might increase sharply, potentially exacerbating disruptive flight-to-quality flows.18 To mitigate these risks, the FOMC has agreed that it will use an ON RRP facility only to the extent necessary and will phase it out when it is no longer needed.

In addition, the Fed has been discussing and testing other supplementary tools, such as term reverse repurchase agreements and term deposits, and can use these tools as needed to help support money market rates.

The Fed does not need additional tools; they need to use their already adequate tools more effectively. They do not need to put more emphasis on controlling interest rates; they need to instead let the markets determine interest rates. The Fed's job is to stabilize the monetary system.

Many readers will inevitably view this post as being hopelessly naive. They'll say the Fed caters to special interest groups, and doesn't care what academics thinks. All I can say is that you are wrong. Back in 1980 you would have ridiculed academic suggestions that the Fed adopt inflation targeting. You would have said political pressure made that impossible, that the Fed was biased towards inflation to bail out this group or that, or perhaps to create jobs. And of course you would have been wrong. The Fed did decide to target inflation, and succeeded in bringing it down to an average of 2% since 1990. That doesn't happen by accident, it happens because the Fed takes the best ideas from the world of monetary research, and adopts them. It happened before and it WILL happen again. That's why I keep blogging.

HT: Jim Glass

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CATEGORIES: Monetary Policy

COMMENTS (13 to date)
alexander writes:

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Borrowed writes:

Fed seems eager to raise rates. Is this really justified by any metric? I'm curious about your take. It seems to me that they have yet to hit their inflation target, certainly wouldn't have hit a reasonable NGDP target, so how can they justify?

One reasonable policy they could adopt is to raise rates while simultaneously announcing a new policy to target over a longer period of time (say 5 year or 10 year inflation expectations), but I don't see the fed as likely to announce new tools (even though it might make sense) at a time like this.

What are your thoughts on the merits of the Feds projected actions?

Kenneth Duda writes:


> One reasonable policy they could adopt is to raise rates while
> simultaneously announcing a new policy to target over a longer period of
> time...

How is that even coherent, let alone reasonable? Are they targeting interest rates, or are they targeting a "new policy"? You can't drive your car to two places at the same time.

The only thing that makes sense for the Fed to do is to tell us what is trying to accomplish, try to accomplish that, and then tell us how they're doing in accomplishing it. Right now they can't even get that right. Maybe they're trying to get to 2% PCE inflation, or maybe not --- they say they are, but then they "taper" before they hit the target, and they never apologize for undershooting their target month after month after month. Maybe they're trying to do something like get to a certain unemployment rate or prevent a "bubble". Who knows?

What they are really doing, of course, is following the guts of 10 governors, some of whom have no clue about monetary economics. The miracle here is that things aren't much worse than they are. Yellen, (Stanley) Fischer, and Bernanke doubtlessly deserve some credit, but the fact we need them so badly exposes how broken the system is. If the Fed simply targeted the level of NGDP guided by a prediction market, a god-damned python script could run monetary policy and outperform the current Fed and all other central banks in the world in terms of providing monetary stability.


Kenneth Duda
Menlo Park, CA

Borrowed writes:

@Kenneth Duda
I just meant they could potentially try to do another "twist" try to raise short-term interest rates, but aggressively target average 5 year inflation expectations (maybe by doing simultaneous repos and reverse repos depending on duration?)

I don't want to make it sound like I think this is a good policy. I think it's crazy that they think they can raise rates. I never remember 2% being an upper bound for inflation before. Seems like they're really concerned they might accidentally do their job well.

Kenneth Duda writes:

> Seems like they're really concerned
> they might accidentally do their job well.

LOL. Check out this great Kevin Erdmann rant:

Kevin points out that a low equity risk premium means that the economy is running well (good monetary stability), yet the Fed interprets it as a sign of failure! Up is down, you know. I especially like this line from Kevin's post:

> Mr. Dudley is poised to hit us sooner and harder if the Fed can manage
> to bumble into the range of optimal policy long enough for risk premiums
> to get back down to the long term average.

Can I nominate Kevin for Fed chairman?


foosion writes:

The Fed used to say it wants 2% inflation and that it is data driven.

Now it wants to feel some confidence that inflation expectations are moving towards 2%.

The TIPS spread, a good proxy for market expectations of inflation, is currently 1.2% at 2 years and 1.9% at 30 years. Accordingly, the Fed has moved from market data to surveys of inflation expectations. Survey data is even less reliable than, as Scott puts it "macro models that have repeatedly proven to be inadequate over the past 6 years".

In addition, 2% seems to have moved from a target to a ceiling.

Paraphrasing something he said in a recent post, the Fed wants to raises interest rates, because . . . well, just because. Or maybe the best explanation is

This is no way to manage monetary policy. What's worse, is the Fed is doing a better job than other major central banks.

Scott Sumner writes:

Borrowed, In fairness, they don't think it's time to raise rates right now. But if I had to guess, I'd guess that the Fed will end up raising rates a bit too early, but not as disastrously so as some of the previous episodes such as 1937, 2000, 2006, 2011, etc.

Foosion, Yes, and keep in mind that the TIPS spreads measure CPI expectations, while the Fed targets PCE inflation. The latter runs about 0.35% below CPI inflation.

Vaidas Urba writes:


I see no mission creep at all. RRP program optimizes the liability structure of the Fed. It is like optimizing the relative supply of 10 and 100 dollar bills.

"They do not need to put more emphasis on controlling interest rates; they need to instead let the markets determine interest rates."

The problem is the law that restricts the ability of some entities to hold Fed's liabilities. Where you see markets determining interest rates, I see markets measuring the size of the distortion. Let's abolish the distortion and make RRP unlimited.

Brian Donohue writes:

Interest rates are close to being 'normalized' already. Welcome to the New Normal.

Scott Sumner writes:


1. Even if you are right it's still mission creep.

2. I see gains and losses from the policy, with the losses being greater.

Brian, Good point.

Jose Romeu Robazzi writes:

Great post, Mr. Sumner, I have read other similar public remarks from famous economists (I remember Larry Summers, but certainly there were others) stating the "success" of the profession, in "saving" the world from another great depression, or something like that. Although I certaily recognize the FED has done a lot, their performance also certainly cannot be considered a "great success". I think that the failure to recognize that not all things were great is annoying, to say the least. Congratulations to Professor Sumner and others for repeatedly showing the public that things could have happened a lot better ...

Vaidas Urba writes:

Scott, this is not a mission creep but simply plumbing. I see no losses at all; the logic of gains is similar to the logic of abolition of trade barriers and price floors. The price floor is created by the law that prohibits paying IOR to GSEs, the trade barrier is the inability of some institutions to hold reserves at the Fed.

Borrowed writes:

Sorry, I know this thread is mostly dead, but I was just thinking about this over the weekend.

If the fed does try to raise rates in June, will they be successful? I know at some level this sounds stupid, but if we assume that the rates are currently stable and some countries have negative interest rates and still have stable markets for loans at those prices, will the fed have to take large action to get even a modest increase in rates?

Traditionally the mechanism for monetary policy has been repos and reverse repos, but the repo markets for government securities are at negative nominal rates. I guess this doesn't matter too much, but seems if there's relatively little supply of risk assets right now, adding treasury liquidity to the market and decreasing the nominal profits to long treasury holders might increase the demand (yet further) for other risk assets, but would probably decrease the supply of risk assets further.

I'm probably thinking about this upside-down in someway or arguing from a price change (although that hasn't happened yet so I don't think I could be doing it).

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