Questions—and Answers—for Janet Yellen

Janet Yellen

The Senate hearings to confirm Janet Yellen as Federal Reserve Board Chairwoman are likely to be held next week, according to news reports.

Here are some Questions that I hope the Senators will ask her, along with what I regard as the Wrong Answers and the Right Answers. I expect that her actual answers will lie somewhere in between these two extremes.

Q: One of the three goals that the Federal Reserve Act mandates for the Federal Reserve Board of Governors and the FOMC to “seek to promote effectively” is “stable prices.” What inflation rate do you view as most compatible with that mandate?

Wrong Answer: 2%, since this will enable employers to cut real wages by 2% per year without any labor unrest.

Right Answer: “Stable prices” means 0% inflation, appropriately measured.

Q: A second goal the FRA mandates for the Fed is to “seek to promote effectively… maximum employment.” Can or should the Fed attempt to maximize employment?

Wrong Answer: Yes, the Fed should always try to stimulate employment, even if this means a little more inflation than workers expect.

Right Answer: Since the 1970s, economists have generally agreed with Milton Friedman that monetary policy can only push unemployment below its “Natural Rate” by engineering an inflation that is higher than was expected. Trying to do this on a regular basis necessarily leads to inflation that increases without bound. This goal is therefore at odds with what should be the Fed’s primary goal, that of price stability. The best the Fed can do on this front is to refrain from destabilizing unemployment with start-stop policies. King Cnut is said to have tried to repeal the law of tidal motion, to no avail. Similarly, Congress can’t just repeal the laws of economics whenever it feels like it.

Q: What is the third goal the Federal Reserve Act mandates for the Fed, and how can it be achieved?

Wrong Answer: I dunno. The press always talks about a “dual mandate” for the Fed, not a “triple mandate.”

Right Answer: Congress’s third mandate for the Fed, according to The Federal Reserve System: Purposes and Functions, 9th edition, is “to promote effectively the [goal] of …moderate long-term interest rates.” Milton Friedman long ago pointed out that most of the fluctuations in long-term interest rates, including mortgage rates, come from changes in inflationary expectations rather than from changes in real interest rates. An effective way to keep long-term nominal interest rates low is therefore to keep long-run inflationary expectations low, by pursing price stability. These two goals are therefore consistent, so long as the Fed does not attempt to reduce long-term real interest rates by direct intervention in mortgage or long-term Treasury markets (as it has been doing since 2008).

Q: Should the Fed use a money growth rule, as long advocated by Milton Friedman, or an interest rate rule, such as that embodied in the “Taylor Rule” (named for Stanford economist John Taylor) to control inflation?

Wrong Answer: Monetary growth has no causal influence on inflation, since money merely grows with the demand for it, as determined in part by the price level. The Fed should therefore pay no attention to any of the monetary aggregates.

Right Answer: In principle, the Fed could use either a monetary aggregate or a “Taylor Rule” to control the price level. However, the first approach requires that the Fed know the demand for real money balances, while the second requires that it know the equilibrium real interest rate. Since the Fed doesn’t precisely know either, neither approach will be perfect. The Fed has been using a “Taylor Rule” approach for as long as two decades with only moderate inflation, so that policy will continue to be framed in these terms. However, the Fed should at the same time closely monitor the appropriate monetary aggregates.

Q: The “Taylor Rule” calls for the Fed to overreact to inflation by raising short-term interest rates more than one-for-one with inflation. If inflation were to pick up to, say, 5% or 10%, would you hesitate to raise the Fed Funds rate to the 8.5% or 16% level called for by the traditional Taylor Rule coefficients?

Wrong Answer: As long as the Fed announces a 2% inflation target, the public will continue to expect about 2% inflation, regardless of observed inflation. The Fed should therefore ignore actual inflation when implementing the Taylor Rule, but rather should base it on its target inflation rate.

Right Answer: The Fed should react aggressively to the best time-series forecast of inflation, as a proxy for the public’s inflationary expectations. The traditional coefficient of 1.5 (50% overreaction) is probably adequate, though there is evidence that the Volcker Fed was using a coefficient as high as 2.0 (100% overreaction) when it successfully brought inflation down in the 1980s.

Q: Since 2008, the Bernanke-Yellen Fed has acquired about $1.4 trillion of mortgage-backed securities, making it now as large a mortgage intermediary as Fannie Mae or Freddie Mac ever were. One economist has even called this new mortgage intermediation function of the Fed, “Feddie Sue.” It has financed this new position with zero-maturity interest-bearing excess reserve deposits that banks may withdraw on demand. When short-term rates inevitably return to normal levels, the Fed will either have to allow these deposits to flow out as currency, or else will have to pay banks a high enough rate on these deposits to keep them from withdrawing them. Which should it do?

Wrong Answer 1: The Fed can always print enough currency to cover any withdrawals of these excess reserve deposits. The global demand for US currency is unlimited, so this will never be a problem. The Fed should continue to expand its purchases of mortgages until housing prices are fully re-inflated to their 2007 bubble peaks.

Wrong Answer 2: The Fed should just pay banks whatever is necessary to keep them happy keeping these funds on deposit. Happy banks are profitable banks, and the Fed’s ultimate, if unspoken, mission is to keep banks happy and profitable. If banks and financial institutions had to finance these mortgages themselves, they would have had to fund these long-term assets with more expensive long-term debt and would have had a much smaller profit margin. The Fed should continue to expand its purchases of mortgages until housing prices exceed their 2007 bubble peaks.

Right Answer: The Fed should never have acquired these mortgage-backed securities and bonds in the first place. In doing so, it has acted like a 1960s’ Savings and Loan Association, and has exposed itself to interest rate risk comparable to that which destroyed the S&L industry when rates rose in the 1970s and ‘80s. These long-term assets should have been funded with long-term sources of funds like pension funds and retirement plans all along. Allowing the corresponding reserve deposits to flow out as currency would be massively inflationary, so the Fed must raise the rates it pays to prevent this. This will generate ruinous losses that are already locked in. Whoever got the Fed into this mess should be fired.

Q: In addition, since 2008, the Fed, through its “Quantitative Easing” programs, has acquired about $1.3 trillion in Treasury debt, mostly financed with additional zero-maturity interest-bearing excess reserve deposits. Since the Fed turns its excess profits over to the Treasury, this is equivalent to the Treasury’s having refinanced this portion of the national debt with 0-maturity call loans. What is the point of this?

Wrong Answer: If the Treasury itself were to finance a substantial portion of the National Debt with call money rather than locking in long-term rates as it borrows, that would be considered an irresponsibly reckless policy. But if the Fed does this for it instead, that will be considered sophisticated monetary policy, and financial institutions will profit by selling these securities at premium prices to the Fed. If the Fed later has to sell these securities at a loss to meet reserve deposit withdrawals, or crank up reserve deposit rates to prevent withdrawals, no one will lose but the taxpayers, through reduced (or negative) profits the Fed turns over to the Treasury.

Right Answer: It is reckless to finance long-term National Debt with call money, whether the Treasury does it itself or the Fed does it on its behalf. Whoever was responsible for this policy should be fired. In any event, the Treasury, not the Fed, should be making these debt management decisions.

Q: In terms of the peak unemployment rate, the “Great Recession” has been the second worst since the 1930s: Unemployment peaked at 10.0% in 2009, versus 10.8% in 1982. However, this has clearly been the very worst recovery from a recession since the 1930’s: 4 years after the unemployment peak, unemployment remains over 7%, and the average duration of unemployment has been about twice as high as in any previous post-War recession. What has made this Bernanke-Yellen recovery so much worse than any previous recovery?

Wrong Answer: Under my predecessor, the Fed quadrupled its balance sheet in response to the recession. This was a step in the right direction, but as we have seen, even that massive effort was not enough to restore full employment. If I am confirmed as Chairwoman, I will see to it that the Fed redoubles its balance sheet again, to at least $7 trillion.

Right Answer: It is not the Fed, but Congress and the Bush and Obama administrations who are to blame for the abysmal recovery from this recession. Starting in 2008, Congress raised the maximum duration of unemployment benefits to as high as 99 weeks by 2009, or about twice as high as in any previous recession. It is small wonder that the average and median duration of unemployment has been about twice as high as well. Unemployment benefits subsidize unemployment while they tax employment. The natural result is more unemployment and less employment. According to a new study by Hagedorn, Karahan, Manovskii and Mitman, “the persistent increase in unemployment during the Great Recession can be accounted for by the unprecedented extension of unemployment benefit eligibility.” This dismal recovery is not a market failure, but a policy success. But it is Congress and the White House, not the Fed, who deserves credit for it.

Already in the early 1990s, Larry Summers called attention to the effect of unemployment benefits on unemployment, and warned that monetary policy should not be used to try to undo the effects of high unemployment policy.

Q: The 1999 Gramm-Leach-Bliley Act effectively repealed the 1933 Glass-Steagall Act by allowing bank holding companies to control both FDIC-insured Commercial Banks and risky Investment Banks that underwrite new securities issues. Was this a good idea?

Wrong Answer: Yes, since it gives Investment Bankers who want to float new subprime Mortgage Backed Securities access to cheap, federally insured deposits. The Fed should aggressively bail out bank holding companies when they get in trouble, as it did in 2008, making no distinction between Commercial Banks and holding companies.

Right Answer: In 1999, we were promised “firewalls” that were supposed to separate the risky Investment Banking operations of these firms from the federally insured, deposit taking Commercial Banking operations. In practice, these “firewalls” never materialized, so that by 2008 it was next to impossible to disentangle the bank holding companies, like Citigroup and Bank of America Corp., from their lead commercial banks, like Citibank, NA and Bank of America, NA. (NA = National Association, i.e. National Bank) If banks want to operate without FDIC insurance, they should be free to do so, but all FDIC insured commercial banks should be made subject to Glass-Steagall.

Even without the restoration of Glass-Steagall, every effort should be made to allow bank holding companies to fail independently of their lead commercial banks. This will simply result in the commercial banks having new shareholders, while continuing their operations without interruption.

In 2008, most Commercial Banks were actually in better shape in terms of capital, than they were in 2002. It was primarily the big bank holding companies that were in trouble, and they should have been allowed to fail as necessary.

Q: The “Taylor Rule” calls for the Federal Funds rate target to be reduced if inflation is below target, but it can’t be reduced below 0%. What are the implications of this “Zero Lower Bound” (ZLB)?

Wrong Answer: Hitting the ZLB as we did in 2008 will result in a Deflationary Spiral of Doom in which the Fed is helpless to prevent cascading falling prices. The Fed should do everything it can to prevent a recurrence of this disaster, by disregarding its “stable prices” mandate and instead targeting a substantially positive inflation rate.

Right Answer: Short-term interest rates are mathematically a component of every long-term rate, alongside forward interest rates that reflect expectations of future short-term rates (plus a small term premium). Lowering short rates therefore makes current consumption and investment a little less expensive relative to future output. But current resources are relatively fixed, so that the increased demand drives prices up.

The Federal Funds rate by itself is a one-day interest rate that has almost no effect on the long rates that are relevant for consumption and investment. However, the FOMC only meets 8 times a year, or every 6 weeks or so, so that its Fed Funds rate target is effectively a 6-week interest rate. Reducing it by 100 basis points while leaving longer forward rates unchanged thus reduces the discount on future output by about 1/8%, a rather subtle effect.

However, if the Funds Rate target hits 0%, the Fed can continue to be more stimulative if it wishes, simply by moving into longer maturities. Thus, pushing rates to 0% out to 12 weeks in the secondary market for Treasury bills, while leaving longer forward rates unchanged, will be about twice as stimulative as a zero rate out to 6 weeks, and so on. The ZLB is therefore not a big problem, even with a zero target for long-run inflation.

Q: Currency in circulation has increased by 50.7% since 2007, while real GDP has only grown by 5.6% over the same 6 years. Isn’t this likely to cause well more than 2% inflation?

Wrong Answer: Monetary aggregates like currency are irrelevant to monetary policy. Currency is particularly irrelevant, since a large portion of US currency is held abroad, and the global demand for it is unbounded. Inflation is determined entirely by inflationary expectations, which in turn are driven by the Fed’s announced inflation target.

Right Answer: While it is true that perhaps half of all US currency is circulating abroad, making the real demand for it harder to predict than it otherwise would be, this demand is always finite, and the price level must equate the nominal supply to the real demand for each monetary component. Currency is particularly important, since it doesn’t pay interest, and therefore always has a clearcut Divisia opportunity cost. With this much currency growth, we are very lucky that inflation has been as low as it has been (only 1.2% over the last 12 months). This huge expansion of currency is therefore very dangerous, but even more dangerous is the fact that the banks’ massive excess reserve deposits are all convertible on demand into currency.

Q: “Divisia Opportunity Cost” went right over our heads. Thank you for your testimony, Dr. Yellen!

Update 11/22/13: A videocast of Dr. Yellen’s Nov. 14 testimony before the Senate Committee on Banking, Housing, and Urban Affairs is now available online. The actual hearing begins at about 18:21 into the video file.

Ms. Yellen’s nomination was approved on Nov. 21 by a 14-8 vote in the committee. The full Senate vote is likely to come in December, but the outcome will not be in doubt under the Senate’s new majority-vote rule for most presidential nominees. Ben Bernanke’s departure at the end of January (assuming he chooses to resign his seat when he steps down as chairman) will leave three empty seats on the 7-member Board of Governors that the administration will likely try to fill with Yellen sympathizers in the near future. See “Yellen’s Fed Leadership Is an Almost-Done Deal,” The New York Times Nov. 22, p. B1. The hearings for these appointments will create a new opportunity for senators to ask hard questions about monetary policy.

In today’s Wall St. Journal, former Senator Phil Gramm and economist Thomas Saving concur with me that unwinding the Bernanke-Yellen Fed’s acquisitions of mortgages and Treasuries without inflation or ruinous losses will be very difficult. See “Janet Yellen’s Greatest Challenge,” Nov. 22, p. A15.

Photograph by Andrew Harrer/Bloomberg

J. Huston McCulloch is Professor Emeritus of Economics and Finance at the Ohio State University, and Adjunct Professor of Economics, New York University.
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