Helping the Federal Reserve Work Smarter

Leonard Jay Santow

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781315486116
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Few presidents have sparked as much interest in recent years as Ronald Reagan. This biography finds Reagan's personal career and ability to understand and communicate with the American people admirable, but finds the long-term effects of his presidency harmful.

1
Introduction

Many books and articles have been written about the Federal Reserve and monetary policy—the policy of influencing the economy through changes in the money supply and credit availability. Fed watchers churn out memoranda regarding monetary policy; and the media, especially those in the print business, routinely focus on the government bond markets, policy statements, and related statistics. But monetary policy is in no position to take on primary responsibility for rejuvenating the economy, although many politicians seem unable to comprehend this fact. The limitations of monetary policy, how they came about, and how they can be countered, are key elements of this book.

The Fed’s Monetary Policy Problems

Some of the restraints are due to forces outside the Fed's control. However, policy limitations are also due to the fact that current Fed powers, influence, techniques, and tools are out of date and inadequate to cope with deregulated markets and a deregulated economy. These shortcomings help explain why, in recent years, monetary policy has often not been in the right place at crucial times.

The Fed's policy problems are compounded by the reality that the economic recovery that began in 1991 is neither robust nor broadly based, and the situation is not likely to change significantly in the next several years. The Fed can now do little to help the economy because its positive impact on the recovery was primarily in place by the end of 1991. Many of the economy's problems—budget deficits at all levels of government; an employment situation that will continue to be aggravated by mergers, acquisitions, and failures; and consumer and business sectors that are still trying to get out from under mountains of debt—are not related to monetary policy. A major improvement in budgetary laws and policies is needed if a meaningful, widespread business recovery is to be sustained.

Any additional easing during this sluggish recovery will have limited benefits and considerable costs. In future policy decisions the central bank needs to realize that lowering short-term interest rates is a two-edged sword: it helps borrowers but hurts savers. Lower short-term rates are not much of an inducement to borrow if individuals and corporations are trying to rebuild liquidity. Moreover, inasmuch as banks have profit margins and capital requirements to worry about, cutting the federal funds rate has not reduced borrowing rates, especially on a real interest rate basis. Tax law changes have made borrowing less attractive for many individuals as interest costs have lost much of their tax deductibility. Finally, the Fed can provide the reserves, but depository institutions must be willing to lend. Despite prodding by the Fed, banks are much less aggressive in lending in this recovery compared with their practice in similar periods of other business cycles.

The Fed's influence over the amount borrowed from banks has diminished, but that is not true with respect to savings. A low federal funds target rate and unattractive deposit rates, especially when these are compared with inflation, are limiting savings growth. Many individuals rely heavily on interest income, and when the interest rates are reduced on savings-type accounts or money market funds, the rate reduction quickly impacts the funds held in most of those accounts.

The aging of the population also means interest income is of growing importance to economic activity. Declines in interest rates are quickly reflected in reduced spending by the large number of elderly who live off their savings. Until the Fed fully appreciates that lower rates give to some and take away from others, and that its policies can hurt savers more than they benefit borrowers, the likelihood is for a period of frustration for policy makers. Moreover, too much monetary ease will ultimately mean more inflation, a result which hits the elderly and retired especially hard.

Irrespective of the lack of benefits derived from more aggressive easing, monetary policy is the one game in town that officials can use quickly, easily, and visibly. A close relationship between an administration and the Fed induces such an approach. Easing of policy is only a few phone calls away. Congress and the legislative process do not have to be dealt with. Therefore, monetary policy is often, by default, the chosen vehicle to stimulate the economy. Whether monetary policy is the proper vehicle, solves economic problems, or is desirable on a longer-term basis is another matter.

A monetary policy that is excessively easy but then turns out to stimulate the economy less than expected is inappropriate. The only way that reasonable and sustainable economic growth can be attained without inflation being a recurring problem is for the Fed to base policy on what is best for the economy in the long run, not on what is best for a particular political group over the short run. The Fed's credibility will be questioned if policy is too easy, and excessive ease will not go unnoticed in the financial markets. Investors in long Treasury bonds want protection from inflation. The combination of a huge supply of government securities because of current deficits and the refunding of maturing obligations is a big enough problem. Add growing inflation concerns, and the result will be undesirably high long-term rates that limit economic growth.

The likelihood of a monetary policy rollercoaster ride is not a new concern. Huge swings in monetary policy have occurred in the past, and there is nothing to indicate that any innovative method or technique is currently being employed to prevent them from recurring. Moreover, the financial world is now less regulated, the Fed has less control over the banks, and banks are less important in U.S. financial flows. Monetary ease may have to be greater than in the past to achieve acceptable economic growth. Less bang for the buck risks the Fed easing too much for too long, with the subsequent firming being too little and too late. Under this scenario, there should be concern that the Fed will sow the seeds for a tightening of policy that will cause short and long rates to move to undesirably high levels, choking off whatever recovery might exist.

To understand the Fed's problems, it is important to remember what happened in 1990, 1991, and early 1992. The Fed did not trigger the recession that began in July 1990 and ended in May 1991; that would have happened even if Fed policy had been consistently correct. After an unusually long (seven and a half years) recovery that followed the 1982 recession, the economy, burdened by excesses and imbalances, finally ran out of sectors to support the advance; a no-growth period or modest recession was inevitable. This would have been the outcome even if the Fed had followed an appropriate policy in 1990 and most of 1991—which it did not.

By 1990, policy was too tight and this situation persisted despite the fact that the Fed was bringing down short-term rates. Easing was too slow, too little, and too late. The situation in the autumn of 1990 was especially unfortunate. The central bank stayed with a policy that was too tight, and waited for meaningful budget legislation that neither Congress nor the administration ever had a chance of delivering. When a compromise package passed in late 1990, the Fed showed its appreciation by easing monetary policy. This budget package produced little fiscal frugality and the Fed's response—a one-quarter percent cut in the fed funds target—was a negligible easing move. The bottom line is that fiscal policy was too stimulative, monetary policy too restrictive, and the Fed fiddled while the economy stagnated.

The Fed's lack of sufficient stimulation during 1990 and much of 1991 resulted in an anemic business recovery in 1992. The improvement was doomed to be modest due to problem sectors in the economy and because easier money could not cure basic weaknesses. However, the recovery should not have been as weak as proved to be the case and the Fed put itself in the position of having to ease further in order to "catch up" to an appropriate policy stance.

When monetary policy is tighter than it should be, and the Fed is trying to eliminate the excess firmness, a good chance exists the central bank will overshoot the mark. The substantial easing of policy in December 1991, with a 1 percent cut in the discount rate and a one-half percent reduction in the fed funds target, closed most of the gap. In 1992, it was fully closed.

When policy moves to the firming side, the impact of the change will be constrained by important forces, some of them new. Reserve requirements have been substantially emasculated and the Fed has either abdicated some of its regulatory powers over the government securities market or it has been nudged aside by other regulatory bodies. A probable effect flowing from a reduced regulatory role is a less effective early-warning system as to what market participants and market rates are telling the Fed about policy and the economy. A central bank that cuts back on its policy tools and regulatory influence, combined with an economy that has become less responsive to monetary policy changes, is adding to the likelihood of policy mistakes. The current Federal Reserve Board seems unaware of the magnitude and importance of these shortcomings.

The decline of the Fed's power in both absolute and relative terms is not new. It began in the 1980s and accelerated in the early 1990s. The trend started with deregulation, continued with the reduced power of policy tools, and is currently taking place through reduced regulatory powers over banks and the government securities market. Reduced independence from the executive and legislative branches of government has the potential to limit the power of the Fed. Step by step, the Fed is being drawn into the government's decision-making process.

The loss of power and economic influence and the misuse of policy tools lead to a lack of policy success and considerable Fed frustration. Some officials even complain that participants in the long-bond market do not understand the true economic picture. The more such comments are made, the more nervous one should become about policy decisions. What these officials do not realize is that the short end of the government yield curve sends a message from the Fed as to where it would like to see rates, while the long end of the curve contains the market's own message. A sharp upslope to the yield curve indicates officials and market participants are not seeing eye to eye. Market players can be wrong in their expectations, but at least the yields are dominated by basic supply-demand factors. The same is not true for the short end of the curve. The Fed does not know whether it has chosen the proper federal funds target because basic supply-demand forces are not dominant. The Treasury market's message to the Fed, the administration, and Congress is that when a sharp upslope to the yield curve exists, it is due to a budget deficit that is excessive, a Fed policy that could become too easy and that will monetize more of the government debt than is desirable, and an inflation rate that has already passed its low point for the business cycle. Given this message, a decline in the Fed's funds rate target will not help the long-bond market.

Improving Monetary Policy through a Different Approach

Electronic systems, such as Knight-Ridder, Reuters, and Telerate, allow economists to analyze Fed operations almost as soon as they occur. The Fed itself publishes enormous amounts of data, semimonthly, monthly, quarterly, and annually. More may be known about the monetary authority and its actions than about any other government or quasi-government agency.

Still, understanding monetary policy requires the reader to have some technical background. The more the emphasis shifts from the general to the specific, and from the conceptual to the technical, the more useful a strong technical background becomes. Although this book was written primarily for experts, much of it should be understandable to those who want to know more about monetary policy and believe it is important that it be improved. With the following points I try to provide some background and an understanding of the technical side of policy:

• The Fed has important goals, such as a desirable and sustainable level of economic growth with a minimum of inflation. Savings and investment must be sufficient to support these goals. To attain these objectives, the central bank tries to set a proper combination of intermediate targets. It seeks to attain economic growth and inflation goals, although it knows monetary policy is only one factor that determines the outcome. The Fed can use intermediate target levels such as federal funds rates, discount window borrowings, and free reserves, which are generally under its control. It can also choose growth rates for total reserves, nonborrowed reserves, and the monetary aggregates. With conditions constantly changing, the Fed has to adjust targets for both the levels and growth rates.

• The thrust of this book is to get monetary policy right. Because budgetary policy is typically stimulative, and often overly so, the temptation is for the Fed to be too tight. Yet, two wrongs do not make a right. If budgetary policy and other measures are failing miserably, a proper combination of target levels and growth rates may be insufficient to enable the Fed to attain its broader goals. This situation creates a major problem for the Fed: does it optimize its role, or does it try to compensate for others' mistakes? The Fed was mistaken in the fall of 1990 when it delayed easing policy while Congress and the administration argued about the deficit reduction package. An accommodative policy should have been instituted, using several policy tools. An earlier move would have delayed the onset and limited the depth of the 1990–91 recession. Within the confines of monetary policy, as of late 1993 the tools were not being used to their best advantage, either separately or together. Moreover, no evidence exists that the Fed is trying to rectify the situation.

• Required reserves, federal funds rates, discount window borrowings, open market operations, capital requirements, and deposit insurance tools are all underutilized. They also are insufficiently coordinated. Yet little has been written, either inside or outside the Fed, about improving the practical application of these tools. With a properly designed strategy, any one of the policy tools can be used in either an aggressive or passive way. Circumstances should dictate which combination of tools is brought into play when a change in policy takes place.

The situation with respect to reserve requirements is perplexing: they have been neglected for many years. Requirements are an instrument that, under an improved set of regulations, could be an important policy tool, even when policy changes are moderate. In late 1990 an attempt to use required reserves was not handled well; change in the requirement was ill-coordinated with open market operations (a mechanism whereby the Fed adds or drains reserves from the banking system). Even more important, the change did not enhance reserve requirements as a policy tool. Quite the contrary: the reduction in requirements in 1990, and again in 1992, gradually did away with requirements as a policy tool.

Countering the Limitations of Fed Policy

Unfortunately, it is impossible to know whether any of the major recommendations in this book would have affected monetary policy history and substantially improved results. Unlike a scientific experiment, monetary policy implementation cannot employ practice rounds, or replicate conditions, or try different methods. The best that can be done is to select an extended period and review the history of policy changes and the tools used to accomplish the changes. Where policy changes appear to have been inappropriate, inadequate, or ill-timed, judgments can be made as to whether events were misread, the wrong tools were used, or the tools were used in the wrong combination or with the wrong emphasis and intensity.

A Map of the Book

The book is divided into eight chapters, of which this introduction is the first. The second chapter traces monetary policy, tools, and targets from 1964 to 1993, in terms of both absolute and relative performance. The cutting edge of monetary policy is examined in considerable detail. Graphics are used to clarify the flow of policy changes. A limited number of variables are charted (the federal funds rate, the discount rate, window borrowings, and M₁), and reasons given as to why they have been chosen. By using a wide selection of variables, the reader can examine the degree of ease or tightness over three decades. Typically, it is the degree of ease or tightness and the policy changes that receive most of the attention from analysts and the public.

The reasons for policy mistakes are less critically discussed. In this respect, one question of great importance is: when the Fed erred in judgment during key periods, was it due to a misreading of the economic outlook, the lack of proper determination of ease or tightness, or the methods of policy change?

Chapter 3 presents key policy tool recommendations, detailing new targeting techniques for federal funds and window borrowings, a policy package in case of an emergency, and a new reserve requirement approach. No attempt is made to estimate how much the recommendations might improve future policy results, whether implemented separately or in a combination.

Chapter 4 discusses reserve requirements since World War II. A brief history is followed by an analysis of the Fed's current approach and how circumstances in recent decades have limited the effectiveness of required reserves. In addition, reasons are presented for changing the current reserve requirement approach and sharpening the requirements as a policy tool. Important reserve requirement topics are discussed in the last part of this chapter. The topics are not new—many of them go back to the 1960s—but they are still worthy of additional analysis and commentary.

Chapter 5 discusses the Fed's relationship to the government securities market in terms of regulation and open market operations. In both cases the relationship needs to be changed. The 1991 scandal in the government securities market in which Salomon Brothers and others were implicated is explained and analyzed in some detail.

Chapter 6 presents a method to evaluate economic activity and Fed policy. This method looks back at central bank estimates of economic activity, and how accurate policy was in its activity estimates. An index rating system is used to indicate the appropriateness of monetary policy with respect to economic activity. Admittedly, the rating system is crude, but it serves a useful purpose; it indicates that the Fed's assessment of economic activity has been quite good, but i...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Contents
• List of Tables and Figures
• Preface
• Acknowledgments
• 1. Introduction
• 2. Tools and Techniques
• 3. Proposals for Helping the Fed Work Smarter
• 4. Experience with Reserve Requirements Since World War II
• 5. Helping the Fed Meet Its Treasury Market Responsibilities
• 6. Helping the Fed Evaluate Economic Activity and Policy: A Proposal
• 7. Helping Commercial Banks Work Smarter
• 8. How Fed Policy Proposals Would Have Helped in Difficult Times
• Glossary
• Index
• About the Author