Tag: Monetary Policy

Ignoring Microeconomic Conditions in Monetary Policy Risks Perpetual Failure

Theodore A. Gebhard

In a Wall Street Journal op-ed today, Hoover Institution Senior Fellow John H. Cochrane expresses his concern over the fact that some of President Trump’s potential nominees to the Fed’s Board of Governors have shown sympathy for a monetary system grounded in a gold standard. (John H. Cochrane, “Forget the Gold Standard and Make the Dollar Stable Again,” 1/18/2019) He argues that historical evidence shows that the gold standard the U.S. once had did not live up to the claims that current proponents of a return to such a monetary system make. He says that the evidence is that the gold standard prevented neither inflation nor deflation. Because of this history, Mr. Cochrane proposes a “CPI standard” as a rules-based means to determine monetary policy. Under this standard, the Fed would keep the CPI closely in line with a particular (and constant) value. He asserts that such a standard would be an improvement over the Fed’s current no-rules discretionary decision-making.

In my view, however, even if there were an improvement, it would be at best marginal and could result in undesirable outcomes under certain circumstances. The reason is because Mr. Cochrane’s proposal suffers from the same flaw that characterizes the rest of macroeconomics, namely a focus on aggregates and averages.  Such a focus neglects the significance of the underlying microeconomic variables that determine the path and composition of economic activity, including actual prices in individual markets.  So, for example, should significant productivity gains owing to technological advances or capital improvements take place across all economic sectors, the general price level should fall.  Such price deflation is neither a consequence of slowing economic activity nor indicative of the need for a policy response.  Yet, under the CPI standard unnecessary price inflation would have to occur to maintain the stability of the index.  An even worse scenario would occur if productivity gains are not spread evenly but instead are specific to certain of the index’s components.  In this situation, policies to keep the index stable risk inflating prices to bubble levels in those sectors for which there has been little or no productivity improvement in underlying microeconomic markets.  Moreover, relative prices would likely be distorted to the detriment of economy-wide allocative efficiency.  Perhaps, as Mr. Cochrane argues, returning to some form of gold standard is not workable under 21st Century conditions, but replacing discretionary policy with a CPI standard would also have its problems. 

Why Not a Stable Dollar?

Theodore A. Gebhard

In a “Letter to the Editor” in today’s Wall Street Journal, Michael Bird comments on the Fed’s 2% inflation target and on the long term effects on the purchasing power of American’s income. Mr. Bird is correct in his observations. Adding two more points to those observations, however, I submitted the following to the Journal as a follow up letter. I would also recommend that the reader see my longer piece on the Fed’s “Inflation Tax” here.

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To letter-writer Michael Bird’s observations about the Fed’s Orwellian definition of stable prices as 2% inflation and its long term effects on the purchasing power of the dollar, I would add two points. (“Fed’s Sole Policy Should Be a Stable Dollar,” 3/18/2017)  First, there is nothing in economic theory that generates the 2% inflation number as opposed to, say, 0% or 1% or 3%.  It is purely an arbitrary choice based on the idea that it is good to have an inflation rate above zero to incentivize spending and discourage saving, a policy goal of  questionable merit.  Second, designed inflation operates as a tax on wealth as well as a revenue generator for the government insofar as pushes people into higher tax brackets and permits the repayment of bonds with debased dollars.  Yet, Article 1, Section 7 of the Constitution assigns the taxing power solely to Congress and further requires that all revenue bills originate in the House of Representatives, the chamber most accountable to the people.  Even if not legally cognizable as a revenue bill, an inflation tax imposed by unelected central bankers plainly violates the spirit of the Framers’ constitutional framework.

ZIRP Has Failed; So More ZIRP

Theodore A. Gebhard

If the definition of insanity is repeating the same thing and expecting a different result, the Fed is becoming close to being properly labeled as insane. After some six years of the Fed’s zero interest rate policy (ZIRP), economic growth rates remain in the tank. Plainly ZIRP’s failure to bring about anything close to a robust recovery from the 2008 financial collapse argues for a re-evaluation of the policy. Yet, in a Wall Street Journal op-ed today, Narayana Kocherlakota, president and CEO of the Federal Reserve Bank of Minneapolis and a participant in the Federal Open Market Committee, argues for more of the same. (“Raising Rates Now Would Be a Mistake”)

When I first began reading Mr. Kocherlakota’s op-ed, I thought that it had to be a deliberate parody on the Keynesian groupthink that characterizes the world’s central bankers. Then I realized that Mr. Kocherlakota is dead serious about wanting the Fed to continue with its ZIRP notwithstanding the policy’s proven impotence. He says it is imperative to do so because raising rates now would impede the Fed’s ability to achieve two goals: (1) raise inflation to its 2% target rate, and (2) stimulate spending via credit expansion and bank lending.  He fails to explain, however, how either of these goals arises from sound economic thinking or if met would change the trajectory of the economy and bring about the illusive recovery.  Indeed, both of these goals are highly questionable attributes of a growing and productive economy.

Regarding the first goal, Mr. Kocherlakota merely asserts that 2% inflation is how the Fed defines price stability.  No reason is given as to why 2% is superior to any other number, let alone superior to what most people outside of the FOMC would define as stable prices — zero inflation.  In fact, a 2% inflation rate means that the purchasing power of a dollar declines by almost a third over 20 years.  Not only is financial prudence on the part of households punished, saving is discouraged and debt-taking encouraged.  Diminished saving and increased debt, however, have never been shown to lead to growth and sustained prosperity.

Mr. Kocherlakota’s second goal, increased spending, is similarly misguided.  A focus on spending neglects capital accumulation, which is essential to productivity gains and economic growth. Capital accumulation, moreover, requires saving to finance the new capital.  Hence, incentivized spending and debt-taking, buttressed by lower saving owing to an inflation tax, must result in a lower rate of capital accumulation and ultimately diminished growth prospects.

In the end, price controls never work, and interest rate manipulation will be no exception.  Eventually, the distortions in asset pricing created by ZIRP must be corrected.  When that time comes, the tools that the Fed has in its bag will have been seriously depleted, and the correction could be long and deep. After years of tepid recovery, it is past time to jettison the monetary policy groupthink that Mr. Kocherlakota represents, bury the ZIRP, and return to free market principles in which interest rates are freely determined in the marketplace by peoples’ time preferences and an honest monetary policy.

(See also my earlier related Post here.)

Central Banks Are the Problem, Not the Solution

Theodore A. Gebhard

In an op-ed in today’s Wall Street Journal entitled “Beware the Currency Wars of 2015”, Mike Newton, a former macro trader for Caxton Associates LLC and global head of emerging market FX strategy for HSBC, argues that global policy coordination among nations and central banks is called for to manage what otherwise will be all out currency wars later this year.  Absent such coordination, there will be a race to the bottom as nations devalue their currencies in order to stimulate exports and growth that years of artificially low interest rates have failed to bring about.  Indeed, to avoid a no-win situation, Mr. Newton goes so far as to suggest that “[t]he world may ultimately be heading toward a global managed exchange rate regime.”

Mr. Newton’s prescription, however, misses the root cause of the problem he describes and therefore his solution is misdirected. The solution is not to implement more coordination among the world’s central banks, but to curtail central bank interventions into domestic economies in their attempt to remedy market distortions, including global trade imbalances, that the central banks helped to create in the first place. The “ratchet effect,” an idea often attributed to economist Robert Higgs, states that the scope of government interventions continually ratchet up by dint of more interventions to address the unintended consequences of earlier interventions.  Regrettably, the idea is not limited to domestic fiscal and regulatory matters. The historical evidence continues to grow that the world’s central bankers, armed with their computer models and their money supply and interest rate manipulation tools, rarely succeed to achieve desired results (to their never-ending surprise) and even make matters worse by delaying recoveries and other needed domestic and global adjustments.  Rather than ratcheting up these failures with still more “coordinated” intervention that will have its own unintended consequences, it is long past time to concede that worldwide monetary central planning is fraught with human error and that what the world actually needs is a return to specie-backed sound money that resists manipulation and permits necessary global adjustments to take place undirected by monetary bureaucrats.