Month: February 2022

No Maestros: Further Thoughts

One of the things we see in the questions of monetary policy transmission discussed in my Barron’s piece is the real cost of an orthodox economics education. If your vision of the economy is shaped by mainstream theory, it is impossible to think about what central banks actually do.

The models taught in graduate economics classes feature an “interest rate” that is the price of goods today in terms of identical goods in the future. Agents in these models are assumed to be able to freely trade off consumption today against consumption at any point in the future, and to distribute income from any time in the future over their lifetime as they see fit, subject only to the “no Ponzi” condition that over infinite time their spending must equal their income. This is a world, in other words, of infinite liquidity. There are no credit markets as such, only real goods at different dates.1

Monetary policy in this framework is then thought of in terms of changing the terms at which goods today trade for goods tomorrow, with the goal of keeping it at some “natural” level. It’s not at all clear how the central bank is supposed to set the terms of all these different transactions, or what frictions cause the time premium to deviate from the natural level, or whether the existence of those frictions might have broader consequences. 2 But there’s no reason to get distracted by this imaginary world, because it has nothing at all to do with what real central banks do.

In the real world, there are not, in general, markets where goods today trade for identical goods at some future date. But there are credit markets, which is where the price we call “the interest rate” is found. The typical transaction in a credit market is a loan — for example, a mortgage. A mortgage does not involve any trading-off of future against present income. Rather, it is income-positive for both parties in every period.

The borrower is getting a flow of housing services and making a flow of mortgage payments, both of which are the same in every period. Presumably they are getting more/better housing services for their mortgage payment than they would for an equivalent rental payment in every period (otherwise, they wouldn’t be buying the house.) Far from getting present consumption at the expense of future consumption, the borrower probably expects to benefit more from owning the house in the future, when rents will be higher but the mortgage payment is the same.

The bank, meanwhile, is getting more income in every period from the mortgage loan than it is paying to the holder of the newly-created deposit. No one associated with the bank is giving up any present consumption — the loan just involves creating two offsetting entries on the bank’s books. Both parties to the transaction are getting higher income over the whole life of the mortgage.

So no one, in the mortgage transaction, is trading off the present against the future. The transaction will raise the income of both sides in every period. So why not make more mortgages to infinity? Because what both parties are giving up in exchange for the higher income is liquidity. For the homeowner, the mortgage payments yield more housing services than equivalent rent payments, but they are also harder to adjust if circumstances change. Renting gives you less housing for your buck, but it’s easier to move if it turns out you’d rather live somewhere else. For the bank, the mortgage loan (its asset) carries a higher interest rate than the deposit (its liability), but involves the risk that the borrower will not repay, and also the risk that, in a crisis, ownership of the mortgage cannot be turned into immediate cashflows while the deposit is payable on demand.

In short, the fundamental tradeoff in credit markets – what the interest rate is the price of – is not less now versus more later, but income versus liquidity and safety.3

Money and credit are hierarchical. Bank deposits are an asset for us – they are money – but are a liability for banks. They must settle their own transactions with a different asset, which is a liability for the higher level of the system. The Fed sits at the top of this hierarchy. That is what makes its actions effective. It’s not that it can magically change the terms of every transaction that involves things happening at different dates. It’s that, because its liabilities are what banks use to settle their obligations to each other, it can influence how easy or difficult they find it to settle those liabilities and hence, how willing they are to take on the risk of expanding their balance sheets.

So when we think about the transmission of monetary policy, we have to think about two fundamental questions. First, how much do central bank actions change liquidity conditions within the financial system? And second, how much does real activity depends on the terms on which credit is available?

We might gloss this as supply and demand for credit. The mortgage, however, is typical of credit transactions in another way: It involves a change in ownership of an existing asset rather than the current production of goods and services. This is by far the most common case. So some large part of monetary policy transmission is presumably via changes in prices of assets rather than directly via credit-financed current production. 4 There are only small parts of the economy where production is directly sensitive to credit conditions.

One area where current production does seem to be sensitive to interest rates is housing construction. This is, I suppose, because on the one hand developers are not large corporations that can finance investment spending internally, and on the other hand land and buildings are better collateral than other capital goods. My impression – tho I’m getting well outside my area of expertise here – is that some significant part of construction finance is shorter maturity loans, where rates will be more closely linked to the policy rate. And then of course the sale price of the buildings will be influenced by prevailing interest rates as well. As a first approximation you could argue that this is the channel by which Fed actions influence the real economy. Or as this older but still compelling article puts it, “Housing IS the business cycle.”

Of course there are other possible channels. For instance, it’s sometimes argued that during the middle third of the 20th century, when reserve requirements really bound, changes in the quantity of reserves had a direct quantitative effect on the overall volume of lending, without the interest rate playing a central role one way or the other. I’m not sure how true this is — it’s something I’d like to understand better — but in any case it’s not relevant to monetary policy today. Robert Triffin argued that inventories of raw materials and imported commodities were likely to be financed with short term debt, so higher interest rates would put downward pressure on their prices specifically. This also is probably only of historical interest.

The point is, deciding how much, how quickly and how reliably changes in the central bank’s policy rate will affect real activity (and then, perhaps, inflation) would seem to require a fairly fine-grained institutional knowledge about the financial system and the financing needs of real activity. The models taught in graduate macroeconomics are entirely useless for this purpose. Even for people not immersed in academic macro, the fixation on “the” interest rate as opposed to credit conditions broadly is a real problem.

These are not new debates, of course. I’ve linked before to Juan Acosta’s fascinating article about the 1950s debates between Paul Samuelson and various economists associated with the Fed.5 The lines of debate then were a bit different from now, with the academic economists more skeptical of monetary policy’s ability to influence real economic outcomes. What Fed economist Robert Roosa seems to have eventually convinced Samuelson of, is that monetary policy works not so much through the interest rate — which then as now didn’t seem to have big effect on investment decision. It works rather by changing the willingness of banks to lend — what was then known as “the availability doctrine.” This is reflected in later editions of his textbook, which added an explanation of monetary policy in terms of credit rationing.

Even if a lender should make little or no change in the rate of interest that he advertises to his customers, there may probably still be the following important effect of “easy money.” …  the lender will now be rationing out credit much more liberally than would be the case if the money market were very tight and interest rates were tending to rise. … Whenever in what follows I speak of a lowering of interest rates, I shall also have in mind the equally important relaxation of the rationing of credit and general increase in the availability of equity and loan capital to business.

The idea that “the interest rate” is a metaphor or synecdoche for a broader easing of credit conditions is important step toward realism. But as so often happens, the nuance has gotten lost and the metaphor gets taken literally.

At Barron’s: There Are No Maestros

(A week ago, I had an opinion piece in Barron’s, which I am belatedly posting here. I talk a bit more about this topic in the following post.)

In today’s often acrimonious economic debates, one of the few common grounds is reverence for the Fed. Consider Jay Powell: First nominated to the Fed’s board of governors by President Obama, he was elevated to FOMC chair by Trump and renominated by Biden His predecessors Bernanke, Greenspan and Volcker were similarly first appointed by a president from one party, then reappointed by a president from the other. Politics stops at Maiden Lane.

There are disagreements about what the Fed should be doing — tightening policy to rein in inflation, or holding back to allow for a faster recovery. But few doubt that it’s the Fed’s job to make the choice, and that once they do, they can carry it out.

Perhaps, though, we should take a step back and ask if the Fed is really all-powerful. You might like to see inflation come down; I’d like to see stronger labor markets. But can the Fed give either of us what we want?

During the so-called Great Moderation, it was easy to have faith in the Fed. In the US, as in most rich countries, governments had largely turned over the job of macroeconomic management to independent central banks, and were enjoying an era of stable growth with low inflation. Magazine covers could, without irony, feature the Fed chair as  “Pope Greenspan and His College of Cardinals,” or (when the waters got choppier) the central figure in the “committee to save the world.”

Respectable opinion of the 1990s and 2000s was captured in a speech by Christina Romer (soon to be Obama’s chief economist), declaring that “the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years. …The story of stabilization policy of the last quarter century is one of amazing success.”

Romer delivered those words in late 2007. At almost exactly that moment, the US was entering its then-deepest recession since World War II.

The housing bubble and financial crisis raised some doubts about whether that success had been so amazing after all. The subsequent decade of slow growth and high unemployment, in the face of a Fed Funds rate of zero and multiple rounds of QE, should have raised more. Evidently the old medicine was no longer working – or perhaps had never worked as well as we thought.

In truth, there were always reasons for doubt.

One is that, as Milton Friedman famously observed, monetary policy acts with long and variable lags. A common  estimate is that the peak impact of monetary policy changes comes 18 to 24 months later, which is cripplingly slow for managing business cycles. Many people – including at the Fed – believe that today’s inflation is the transitory result of the pandemic. When the main effects of today’s tightening are felt two years from now, how confident are we that inflation will still be too high?

More fundamentally, there’s the question of what links monetary policy to inflation in the first place. Prices are, after all, set by private businesses; if they think it makes sense to raise prices, the Fed has no mind-control ray to convince them otherwise.

In the textbook story, changes in the Federal funds rate are passed through to other interest rates. A higher cost of borrowing discourages investment spending, reducing demand, employment and wages, which in turn puts downward pressure on prices. This was always a bit roundabout; today, it’s not clear that critical links in the chain function at all.

Business investment is financed with long-term debt; the average maturity of a corporate bond is about 13 years. But long rates don’t seem particularly responsive to the Federal funds rate. Between Fall 2015 and Spring 2019, for example, the Fed raised its policy rate by 2.5 points. Over this same period, the 10-year Treasury rate was essentially unchanged, and corporate bond yields actually fell. Earlier episodes show a similar non-response of long rates to Fed actions.

Nor is it obvious that business investment is particularly sensitive to interest rates, even long ones. One recent survey of the literature by Fed economists finds that hurdle rates for new investment “exhibit no apparent relation to market interest rates.”

Former Fed chair Ben Bernanke puzzled over “the black box” of monetary policy transmission. If it doesn’t move interest rates on the long-term debt that businesses mostly issue, and if even longer rates have no detectable effect on investment, how exactly is monetary policy affecting demand and inflation? It was a good question, to which no one has offered a very good answer.

To be sure, no one would claim that the Fed is powerless. Raise rates enough, and borrowers unable to roll over their loans will face default; as asset values fall and balance sheets weaken, households will have no choice but to drastically curtail consumption.

But being able to sink a ship is not the same as being able to steer it. The fact that the Fed can, if it tries hard enough, trigger a recession, does not mean that it can maintain steady growth. Perhaps it’s time to admit that there are no central banking “maestros” who know the secret of maintaining full employment and price stability. Balancing these critical social objectives requires a variety of tools, not just a single interest rate. And it is, for better or worse, the responsibility of our elected governments.