Awhile back, I thought it might be interesting to create one of those island economy stories to demonstrate a problem with the Fed's policy framework. I finally got around to it over the past week, after reading an article on the same policy flaw.
My island story's relevance won't be clear right away, but stick with it if you're wondering what could go wrong with monetary policy (or if you like islands). I'll show how the Fed's inflation target can cause policymakers to do the exact opposite of what they should be doing. And then I'll come back to the excellent article I read last week.
Introducing Debtor and Creditor Isles
Imagine an island where basic necessities are free, thanks to an abundance of miracle plants that drop a never-ending supply of shoes, clothes, fruit, vegetables, Big Macs and more. The island has mostly two types of inhabitants - those who make Gadgets and those who build houses. Each Gadget maker produces a different type of Gadget and sells one unit per year for $100. Except for the housing sector, the economy is essentially a giant Gadget exchange.
Now imagine a second island whose inhabitants expend virtually all their efforts just to produce basic necessities. But they still save a substantial portion of their incomes. Their savings are used by the government to build a brand new city - Export City - with a factory that's equipped to produce Gadgets.
I'll call the first island Debtor Isle and the second Creditor Isle. Let's see what happens once Export City's factory is complete…
Tracking the island economies
Each year, one Creditor Isle inhabitant takes a new job at the factory and produces a perfect replica of a Gadget used on Debtor Isle. She exports the Gadget to Debtor Isle for $50 and then visits the People's Bank of Competitive Currency Controls (PBOC3) to exchange her dollars for local currency. The PBOC3 then loans the dollars back to the inhabitants of Debtor Isle.
Back on Debtor Isle, one domestic Gadget maker is priced out of the market each year by the new Creditor Isle producer. She's only unemployed for a short moment, though, because she designs a new Gadget. Her new Gadget is priced at $100 with an annual production run of one unit (just like the other Gadgets produced on Debtor Isle). In other words, Debtor Isle produces an unchanging number of Gadgets, but it imports and consumes one additional Gadget each year. As above, the imported Gadgets are priced at $50 apiece and buyers pay for them with loans from the PBOC3.
Debtor Isle inhabitants see three key trends in their economic indicators:
- The trade deficit grows by $50 per year.
- Household and external debt grow by increasing amounts - $50 of additional debt in year one, $100 in year two and so on.
- The consumer price index falls (Gadgets priced at $50 gradually replace those priced at $100).
Enter the planners
Now let's add the Far Reaching Bankers (FRB) of Debtor Isle to the story. The FRB are responsible for monetary policy and closely monitor the indicators above. In this instance, they ignore foreign trade and debt and adjust policy in response to inflation. They have an inflation target of sorts - a range of inflation rates that's deemed acceptable - and the Gadget deflation sets alarms ringing. They reduce interest rates to virtually nothing (say, 1%) to stimulate the economy and encourage inflation.
Debtor Isle inhabitants take advantage of this cheap money and double their annual increase in borrowing, using the additional funds to buy newer and bigger houses. The money pouring into the housing sector enriches homebuilders, who then loan funds back to Gadget makers to keep the boom alive. Here are the effects on economic indicators:
- The trade deficit and external debt continue to climb at the same rate, while household debt rises even faster than before.
- Home prices soar.
- Increasing home building costs push inflation above the FRB's target, while Gadget prices rise slowly because producers are wary of competition from Export City.
The Far Reaching Bankers see off the deflation "scare" and declare great success. They begin to raise interest rates toward levels more typical of a buoyant economy with inflation now above target. But they show little urgency and make only tiny, gradual changes. They aren't especially concerned about trade deficits or external and household debt. Nor are they concerned about house prices reversing their rapid climb. That could never happen according to a review of data extending back to, well, the time period immediately after the last instance of falling house prices.
The Far Reaching Bankers' backstory
More fundamentally (digression warning!), Far Reaching Bankers are drawn from a religious sect with core beliefs such as rational agents and a general equilibrium. In a nutshell, their religion holds that rational people always force the economy toward an ideal state of equilibrium, where it then remains. Like any other religion, their faith is guided by sacred objects. The FRB's sacred objects are abstract mathematical models, from which they take great comfort that their beliefs are valid.
Far Reaching Bankers also believe in stabilization policies, which suggest they can guide the economy even faster to its presumed equilibrium than natural forces allow. That's where the inflation targeting comes in. They declare that if they take care of the inflation targets, while rational agents take care of the rest, Debtor Isle inhabitants can enjoy a utopian world called a Great Moderation.
A few rogue inhabitants suggest this story is all wrong. They warn of fallacies in the FRB's religion and dangerous imbalances in the economy. But they're branded as heretics and relegated to often derided professions such as "hedge fund manager" and "tin foil hat wearing blogger."
Story ending and thesis
The story ends with a mountain of bad debt leading to an implosion of the imbalances in Debtor Isle's housing and external sectors. (I'm sure the suspense was killing you.) And here's my thesis:
- The story is a rough but reasonable approximation to certain developments during the housing boom - from the Fed's concerns about falling core inflation in 2003 to its response of slashing the Fed Funds rate to 1% to its decision to normalize policy only gradually and well after the deflation "threat" receded.
- Inflation objectives were a big part of the problem, for both the Far Reaching Bankers of Debtor Isle and the Federal Reserve Board of real life. In either case, deflation that was imported from abroad in certain sectors was merely another window on imbalances (overconsumption funded by foreign creditors, for example) that should have led to monetary restraint, not stimulus. For the Fed, the doctrine that core inflation should be kept above 1% at the lowest (later increased to 1.5%) overrode concerns about these imbalances, which received lip service at best and outright dismissals in policymakers' worst moments.
In other words, I'm arguing that inflation targets are too narrow to play such a large policy role. What's more, they sometimes tell you to do the exact opposite of what you should actually be doing. Disinflation in the housing boom's early stages was closely connected to the growing external debt that helped trigger the crisis; it was like the calm that tells you to expect a storm. But thanks to their discomfort with low inflation, policymakers felt threatened by the calm and tried to stir up a breeze just as the storm was approaching.
If you agree with this thesis, then you might have been surprised when the Fed formalized an inflation target in 2012. I certainly was. But then I thought about the heuristics and biases that cloud our ability for rational decision-making. The best explanation for the Fed's decision to formalize inflation targeting, in my opinion, gets back to the religion analogy. Real events are no match for religious fervor. As we've learned from studies demonstrating confirmation bias, deeply held beliefs resist contradictory evidence. History can be written in an infinite number of ways, and people generally craft it around their pre-existing positions.
The Fed's direction since the financial crisis seems a prime example of confirmation bias. Fed researchers produced work that absolved its interest rate policies (and inflation targets) of any responsibility for the crisis. And so it is.
How else might the Debtor Isle and U.S. FRBs have viewed their housing booms?
In David Stockman's bestseller, The Great Deformation, he describes Fed Chairman William McChesney Martin's decision to reign in speculative excess only four months into the recovery from the 1957-58 recession. Martin increased both interest rates and stock market margin requirements. Here's an excerpt from Stockman:
Unlike the ineffectual baby-step hikes of 25 basis points that Alan Greenspan later favored, Martin raised the discount rate by a full percentage point on each of several occasions, and also further tightened stock market margin lending.
Moreover, these moves were decisive. In one of its post-meeting statements the Fed zeroed in directly on excessive bank lending. Unlike today's debt-besotted central bankers, the Martin-era Fed worried about too much credit growth, not too little, saying that it was "restraining inflationary credit growth in order to foster sustainable economic growth."
Martin's signature definition of a central banker's job - adjusting policy when "the party gets going" by "taking the punch bowl away"- belies the Fed's technocratic inflation targeting of today. There's little room anymore for a broad and old fashioned assessment of speculative excess, taking account of both credit and asset markets in addition to inflation.
And it can't be emphasized enough (I've emphasized it here, here and here) that there's a close link between the Fed's narrowing focus and the core, theoretical models that economists developed in the decades after World War II. These model builders naïvely ignored boom-bust cycles in credit and asset markets, just as the Fed disastrously eliminated the relevance of these cycles from its policy framework. Or, more precisely, policymakers reversed Martin's maxim, spiking the punch bowl when credit and asset markets weaken but dismissing the case for action when the "party gets going".
Short of conjuring up the old school policy approaches of the past, there are indicators that we can use to understand how the Fed's inflation target might trip us up next. And this brings me to the article I mentioned at the outset. Asset manager Jake Honeycutt recently suggested one such indicator - an alternative inflation measure. He replaces the artificial "owner-occupied rent" component of the consumer price index with direct estimates of house prices (the S&P Case/Shiller Home Price Index). He concludes that the Fed should begin tightening almost immediately, although not aggressively. Here's his article.
Also, I don't remember when I first thought that an island economy might be an interesting way to look at inflation targeting, but it may have been when I read this post on ZeroHedge. I saved it at the time and liked it just as much on the second read as on the first over a year ago.