The way you were, the way you were.
With your simple plans.
Take me back to the way you were.
-- Shayne Ward.
The annual monetary policy meeting at Jackson Hole has an uncanny way of picking the right topic at the right time. This year it was the mechanics of government policy-making. In other words: How should fiscal and monetary policy be organized?
Hanging out at Jackson Hole.
Now that the Crisis is truly over in the United States, it is a good time to think about that. And Chair Yellen advanced the right approach in the right way. I have often been surprised by the amazing coincidental propriety of the personalities of Fed Chairs to the circumstances into which they are appointed. Volcker, for example. A tough guy when a chorus of whining needed to be ignored and an entire country kicked in ….
The stand-out example was Chairman Bernanke.
- He had unquestionable credentials for fighting the Crisis. He was already a top expert on our worst crisis, The Depression.
- He proved capable of thinking outside the box when the problems of the nation's economy could never be solved by simply maintaining a policy rate of zero. Quantitative easing and forward guidance were desperate measures necessary at a desperate moment.
- He knew how to stay in his lane, staying out of policy decisions - like Lehman - that might have brought him down.
But that was then. This is a time for someone other than a screaming alpha male. As with many great figures, Bernanke underestimates his own stature. I realized this reading his summary of the Jackson Hole meeting. His article summarizes the meeting and argues not to change the policy innovations of his tenure as Chairman. As he indicates, Chair Yellen disagrees. His policies were right in a crisis; wrong in normal times.
The apparent consensus at Jackson Hole:
- Monetary policy carries too much of the responsibility for management of the US economy. Fiscal policy should bear an equal share of the burden, under the guidance of our responsible legislative branch, led by the Chief Executive. And the lion should lie down with the lamb.
- The Fed should institutionalize the major changes in monetary policy-setting instituted by the Bernanke Fed. This is the position Bernanke defends in his article.
Pre-Crisis Policy. Before the Crisis, the Fed had, through time, decided to limit communications of its policy intentions with the economy to changes in a single instrument, the fed funds rate, the price commercial banks that borrow pay lending commercial banks for funds borrowed overnight. This is one of a welter of closely related short-term rates, all of which would work as a policy instrument - the T-bill rate, and the overnight rate on Treasury-based repurchase agreements, for example, are alternatives. But without resurrecting the boring details, the Fed has tried alternatives, and found them flawed for one reason or another.
Post-Crisis Policy. During the Crisis, the Bernanke Fed realized that reducing the fed funds rate to zero did not produce stimulus sufficient to drive the US economy out of its accelerating slide toward a genuine Depression. Policymakers realized two actions were needed: one, quantitative; the other, atmospheric.
Quantitatively, an enormous overhang of mortgages and their containerized relatives, mortgage-backed securities, needed to be taken from the market to give that fundamental sector of the US economy a chance to recover from the disastrous excesses of pre-Crisis governmental housing policy, compounded by massive irresponsible behavior of financial institutions that had climbed upon the housing bandwagon.
Atmospherically, the Fed had to change, through its words and actions, global perception of viability of the financial system itself. The financial institutions of the globe required assurance that the Fed would throw the full weight of its power behind an effort to finance this major need, on a scale not seen since World War II. This was achieved through the introduction of "forward guidance," the Fed's commitment to maintain interest rates at zero, for as long as necessary. The Fed provided certainty that funds sufficient to finance a recovery would be provided.
Pre-election policy. If anything is clear about the upcoming election, it is that it would be best to focus upon the implications of this presidential choice on these things: immigration, social policy, trade policy, bank regulation, and foreign policy. It would be beneficial, therefore, not to distract the electorate through change in either monetary policy and its effects on the stock market as measured, for example, by the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), or the methods of monetary policy-making, until December.
Post-election policy procedures. This is the most important question considered at Jackson Hole. And it is the topic of Chairman Bernanke's article. His conclusion is that the changes wrought during the Bernanke era should be ratified. He notes that Chair Yellen differs, believing that it would be wiser to return to the policy procedures of the pre-Crisis Fed. Here I argue for Yellen's position.
The Bernanke proposal. Bernanke proposes status quo post Crisis. Although none of the Bernanke Fed actions to staunch the bleeding of the Crisis have yet become established Fed modus operandi, Bernanke proposes that this should be done. As Bernanke indicates, the essence of the Bernanke Fed's change is to modify the function of reserves. Excess reserves, as Bernanke explains, have grown to be something more than a weekly error made by banks.
In the status quo ante Crisis, the joint determination by banks and the Fed of the price (the federal funds rate (fed funds rate) and the quantity (total reserves) of the Fed's basic liability, bank reserves, fell primarily to the banks. The banking system minimized its reserve holdings in response to the Fed's daily repurchase agreements and other Treasury security-based transactions conducted to achieve their Fed funds targets. In other words, during the status quo ante, the Fed controlled the price of government money, leaving the banks to determine the amount.
In the status quo post, the Fed has basically changed the day-to-day decision-making process, implemented by the New York Fed, into an after-thought. The fed funds rate has become monetary policy's red-headed step child. The true indicator of the Fed's intentions for interest rates is now the interest the Fed pays on excess reserves (or IOER). The Fed has extended its reach as well to the money market funds, through what the Fed calls its reverse repurchase agreement program (RRP), where the Fed offers reserves to these funds at a discount to the IOER. The IOER rate now stands at 0.5%; RRPs are offered at 0.25%.
In short, monetary policy implementation, status quo post, is no longer market-involved. The FOMC votes a policy rate, the IOER, and changes the amount of reserves at will through repo transactions with its counterparties.
To summarize the differences:
- The FOMC both determines and implements policy ex post. Ex ante, the FOMC determined policy, to be implemented by the New York Fed.
- Ex post policy is implemented solely by government decisions. Ex ante it was implemented through the Fed's interaction with market forces in New York.
- Ex post policy controls two instruments, the quantity of total reserves and the interest rate, IOER. Ex ante policy controlled only one instrument, either the fed funds rate or its determinant, the daily amount of reserves supplied by the open market desk.
Policy ex post is both determined and implemented at the FOMC through two choices, the volume of reserves and their value to the banks, the interest paid on reserves, IOER. Policy ex ante was implemented by the open market desk at the New York Fed, using market transactions in an amount determined by bank demand for reserves, at a policy rate set by the FOMC.
While Bernanke's article describes the difference clearly, he does not mention two salient effects:
- A shift from interaction with the market to dictation to the market.
- The use of two policy instruments instead of one.
I consider both changes to be critical mistakes.
Dictation to the market eliminates an important source of the Fed's understanding of its policy impact historically, feedback from the market. Although, as most things governmental, Fed decision-making has drifted inexorably away from markets and toward the Washington bureaucracy, it is a trend to be resisted. The Bernanke recommendation is a step in the wrong direction, a result in part, of the fact that in recent years, the Fed has been dominated by academics such as Bernanke. A markets maven would have reconsidered.
Two instruments are one too many. As every student of high school algebra can tell you, if you increase the instruments under your control from one to two, you increase the outcomes you control from one to two. This increase in Fed power has been used to date to increase the ratio of government assets held by the banks to an amount substantially greater than they would choose, left to their own devices.
The effect of this new weapon, combined with others I oppose, such as Comprehensive Capital Analysis and Review (CCAR) and the really unacceptable requirement for Too Big to Fail Banks (TBTF) to periodically submit living wills, has put the banking system into a state of paralysis. Smaller banks are gradually disappearing; larger banks, performing poorly.
This, simply because the nation's government refuses to acknowledge the most fundamental reality of finance. If you reduce investors' risk to a level below the risk they will tolerate, you reduce the returns to their investments below a level they will accept. The banking system, as represented, for example, by Financial Select Sector SPDR Fund (NYSEARCA:XLF), has become one gigantic sell recommendation. A return to Chair Yellen's status quo ante would be a step in the right direction.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.