Thursday, June 10, 2010

The Mankiw Rule with Quantitative Easing: Why is the Fed So Tight?

In my last post, I suggested that the Fed – at least if it behaves in a reasonable manner consistent with its past practices – is not likely to raise its federal funds rate target any time soon. I argued that the Mankiw Rule (a.k.a. Greg Mankiw’s version of the Taylor Rule) has done a good job of tracking Fed policy in the Greenspan-Bernanke era and that it has now fallen well into negative territory, out of which it will take some time to climb. Some commenters pointed out that, while the Fed obviously can’t make interest rates go negative, it did continue to loosen during the period of zero interest rates, by means of “quantitative easing” or “credit easing” – attempting to pull down the level of riskier or higher maturity interest rates by acquiring unconventional assets. I don’t think this observation really affects the main point of my previous post, but it it’s interesting to take a closer look.

So I tried to come up with a simple measure of monetary policy stance that incorporates both the federal funds rate and quantitative easing. My first thought was to look at the growth of unconventional assets on the Fed’s balance sheet, but as it turns out, it’s not really necessary to specify “unconventional” assets, since the Fed had already reduced holdings of its conventional asset – Treasury bills – to near zero by the time Lehman Brothers failed. We can therefore measure the subsequent quantitative easing as an unusually rapid growth in the Fed’s total assets – or equivalently total liabilities, which is to say, the monetary base. To get a composite measure, we need to somehow graft a measure of this monetary base growth onto the federal funds rate. The simplest way is to subtract the monetary base growth rate from the federal funds rate. Here I have chosen to use the average monthly growth rate over 12 months, because it was a simple specification that gave vaguely reasonable results. Those results are summarized in the chart below.

If you take this chart at face value, it looks like the Fed initially far overshot the level of easing prescribed by the Mankiw Rule, but remember that my choice of equivalence between interest rate percentage points and monthly growth rate percentage points was arbitrary. I could have used a weekly growth rate, and the picture would look quite different. Moreover, I could have used a 3-month or 6-month average instead of 12 months, though I think such choices would only have made the picture look even more strange. The one conclusion that is robust to reasonable changes in specification is that the composite measure is now moving close to zero again, even as the Mankiw Rule interest rate remains well below negative 3 percent. (It will likely rise slightly above negative 4 percent based on the May data, but I’m waiting for the CPI report before I update.) Quantitative easing is over, but the economic conditions that justified it are still with us – at least if we measure retrospectively.

Basically, once we recognize that quantitative easing is an option – and one that is no longer being pursued – we can draw the conclusion that the Fed is much tighter today than what the Mankiw Rule would suggest. Indeed, relative to the Mankiw Rule, the Fed is much tighter than at any time during the Greenspan-Bernanke years. Since 1957, when the core CPI data series begins, there have only been two times when the Fed was as tight as it is today relative to the Mankiw Rule. One was in 1973, when the effect of Nixon’s price controls was artificially reducing the retrospective inflation rate used in the Mankiw Rule. The other was during the early 1980’s, when the Fed was targeting monetary aggregates rather than interest rates and attempting (with great success) to reduce the inflation rate dramatically.

So why is the Fed so tight? Here are some possibilities:

  1. Fed policy is better described by a rule that is non-linear in unemployment. With the unemployment rate so tremendously high, perhaps marginal increases in the unemployment rate affect the Fed less than they would if the rate were closer to normal. But given the Fed’s mandate to pursue high employment, wouldn’t the need for more aggressive monetary policy in response to higher unemployment rates be even more acute when the employment situation is already so obviously out of whack? And wouldn’t the unusually high unemployment rate, in and of itself, tend to eliminate the risk of pushing the unemployment rate too low and thereby free the Fed to pursue more aggressive policies than it otherwise would?

  2. The Fed is anticipating dramatic declines in the unemployment rate and/or increases in the inflation rate. Except that we don’t see those in the Fed’s forecasts.

  3. The Fed is correcting for its earlier overshoot, for being too loose in 2009. Except we’re not seeing much evidence that the overshoot (if there was one) needs to be corrected. There is no economic boom. The inflation rate has continued to fall. If the Fed did overshoot on the ease side, recent economic data suggest that, in retrospect, the overshoot was a good idea and not one that should be corrected by a reversal in subsequent policy.

  4. The Fed is passing the buck to fiscal policy. But fiscal policy is tightening too now, in relative terms. It doesn’t seem likely that the Fed is irresponsible enough to base its policy on hypothetical fiscal policies that aren’t actually happening.

  5. The Fed has “abandoned the Mankiw rule” and is now setting its policy stance according to very different criteria than it has used over the past 23 years. But is there any evidence that Ben Bernanke has had some sort of conversion experience? And is there any reason why the Fed would be interpreting its mandate differently than it has in the past?

  6. The Fed has dramatically altered the parameters of its “Taylor Rule.” But why?

  7. The Fed is uncomfortable with quantitative easing and would like to minimize its use and reverse it as soon as possible, irrespective of Taylor Rule considerations. I think we have a winner. The long term effects of quantitative easing are uncertain and could be seen as potentially dangerous. (What will happen if, at some point in the future, the Fed has to choose between liquidating its unconventional assets at a loss, exacerbating an inflationary environment, or raising interest rates high enough to risk a fiscal crisis?) So there is arguably reason for the Fed to be uncomfortable with it. But the implications are disturbing, if you believe in a Philips curve or anything like it. Faced with an excessively high unemployment rate and an excessively low inflation rate, the Fed is choosing to risk exacerbating the situation (i.e., to take the intermediate-term risk of deflation) rather than to risk a very different type of difficult situation in the distant future. Maybe it’s the right decision, but it’s an awfully scary one.

Here’s one way to think about the situation. Fed policy typically affects output and employment with a lag of less than a year. Over the past year, the Fed has tightened dramatically. The super-duper-easy aggressive quantitative easing policy of 2009 (especially early 2009) has given the US economy enough monetary fuel to get it almost to an employment growth rate (exclusive of the Census) that could stabilize, but not significantly reduce, the unemployment rate. That policy is gone. In order to believe that the economy is going to strengthen from here, you have to believe either (1) that the lag associated with monetary policy is longer than usual or (2) that the underlying strength of the economy, holding monetary policy constant, has improved dramatically. Maybe one (or both) of those things is true. Or maybe not.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.


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