Presidential Candidates and Fed Accountability

In an interview with Fortune, Donald Trump gave his views on  Federal Reserve Chair Janet Yellen, who will come up for reappointment in 2018. "I don’t want to comment on reappointment, but I would be more inclined to put other people in," he remarked, despite his opinion that Yellen "has done a serviceable job."

A change in the political party in power does not always result in a new Fed chair. Yellen's predecessor, Ben Bernanke, was first appointed by President George W. Bush and later reappointed by President Obama. Obama remarked, upon reappointing Bernanke in 2009, that "Ben approached a financial system on the verge of collapse with calm and wisdom; with bold action and out-of-the-box thinking that has helped put the brakes on our economic freefall."

Time reported in 2009 that "The Fed chairman is often described as the second most powerful U.S. official; the main check on him is the first most powerful official's power not to reappoint him. That power won't be used this year, and it's easy to see why. But someday, a President may have to use it..." I have written before that Fed accountability is a two-way street requiring diligence on the part of both the Fed and Congress. But the President also plays a role in checking the Fed's power. Just how far should a (prospective) President go?

Recently, Narayana Kocherlakota, who was President of the Federal Reserve Bank of Minneapolis from 2009 through 2015, has been urging Presidential candidates to address their views on the Fed. He proposes five questions we should ask the candidates, including whether they would seek a chair that would want to change the Fed's 2% inflation target, whether they would want the next chair to change the Fed's approach to its full employment mandate, whether they would want the chair to agree with using a Taylor-type rule for monetary policy, and whether they would want the chair to take an interventionist approach in a future crisis.

Good to see Mr. Trump talking about mon. pol. - more Pres. cands need to talk about this issue: https://t.co/1kMKThHmAS

— NRKocherlakota (@kocherlakota009) April 20, 2016

Kocherlakota tweeted, "Good to see Mr. Trump talking about mon. pol. - more Pres. cands need to talk about this issue." This was not Trump's first discussion of the Fed. Trump previously claimed that "Janet Yellen for political reasons is keeping interest rates so low that the next guy or person who takes over as president could have a real problem."

In Trump's Fortune interview, he continued to express some qualms with low interest rates, namely: "the problem with low interest rates is that it’s unfair that people who’ve saved every penny, paid off mortgages, and everything they were supposed to do and they were going to retire with their beautiful nest egg and now they’re getting one-eighth of 1%." However, he also pointed to an upside of low rates, noting that he would like to take advantage of low interest rates to refinance the debt and increase infrastructure and military spending.

Interestingly, neither of Trump's takes on the Fed's interest rate policy are directly related to the Fed's Congressional mandate. He does not evaluate the Fed's success in achieving either price stability or full employment. Rather, he is concerned with the distributional and fiscal implications of low interest rates--areas in which the Fed chair is traditionally reluctant to tread.

The other candidate who has said most about the Fed is Bernie Sanders, who wrote an op-ed about the Fed in the New York Times in December. Sanders' remarks focus mainly on Fed governance and financial regulation, though he also comments on the Fed's interest rate policy:

The recent decision by the Fed to raise interest rates is the latest example of the rigged economic system. Big bankers and their supporters in Congress have been telling us for years that runaway inflation is just around the corner. They have been dead wrong each time. Raising interest rates now is a disaster for small business owners who need loans to hire more workers and Americans who need more jobs and higher wages. As a rule, the Fed should not raise interest rates until unemployment is lower than 4 percent. Raising rates must be done only as a last resort — not to fight phantom inflation.

On Friday, I took my students in my Federal Reserve class at Haverford on a field trip to DC, where we got to meet with Ben Bernanke at the Brookings Institute. I asked Bernanke whether he thought that the presidential candidates should talk about monetary policy and the (re)appointment of the Fed Chair. He agreed with Kocherlakota that candidates should talk about what they would like to see in a Fed Chair, but said that he does not think it's a good idea to politicize individual interest rate decisions, emphasizing that the Fed does not have goal independence, but does have instrument independence. In other words, Congress has given the Fed a monetary policy mandate—full employment and price stability—but does not specify what the Fed needs to do to try to achieve those goals.

Anyone who wants to is welcome to evaluate the Fed on how successfully they are achieving that mandate. Anyone who wants to is also welcome to evaluate the merits of the mandate itself. Different people will come to different evaluations depending on their own beliefs and preferences. But neither of these two evaluations requires an audit of monetary policy by the Government Accountability Office, as both Sanders and Trump have advocated.

Anyone who is dissatisfied with the mandate itself can go through the usual channels of political change in a democracy and pressure Congress to change the mandate. Congress, by design, is susceptible to such pressure: they need votes. Presidential candidates are in a good position to draw public attention to the Fed's mandate and urge change if they believe it is necessary. Sanders, for example, could propose redefining the Fed's full employment mandate to mean unemployment below 4 percent. I'm not quite sure what kind of mandate Trump would support. It is also fair game for any member of the public to evaluate the Fed on how successfully they are achieving their mandate. But Congress does not (or at least, should not) tell the Fed how to set interest rates to achieve its mandate, and Presidential candidates shouldn't either.

Congressional Attention to Monetary Policy over Time

The Federal Reserve describes itself as "an independent government agency but also one that is ultimately accountable to the public and the Congress...Congress also structured the Federal Reserve to ensure that its monetary policy decisions focus on achieving these long-run goals and do not become subject to political pressures that could lead to undesirable outcomes."

The independence of the Fed is by no means fixed or guaranteed. Rather, the Fed continually attempts to defend its independence. As Dincer and Eichengreen (2014) note, the movement of central banks toward greater transparency can be understood in part as an effort to protect independence by demonstrating accountability outside of the electoral process. They explain that "calls to audit the Federal Reserve have intensified as the central bank has come to rely more extensively on unconventional policies and expanded the range of its interventions in securities markets. The FOMC’s decision to make more information publicly available can thus be understood as an effort to reconcile the increased complexity of its operations with the desire to maintain and defend its independence."

The Fed derives its authority from Congress, and Congress can alter the Fed's responsibilities (and decrease its independence) by statute. Since the financial crisis, congressional calls for more oversight of the Fed or for less discretion by monetary policymakers abound. In National Affairs, Steve Stein writes:

"The independence of the Federal Reserve may well be more threatened in the coming years than at any time in the 100-year history of America's central bank. That independence could prove impossible to protect as long as the Fed continues to exchange its role as a defender of monetary stability for a new role as the ultimate overseer of the financial system. That new role is an inherently political one, and the Fed cannot expect to be permitted to perform it without interference from the democratically elected institutions of our political system."

It is difficult to measure the level of "threat" to Federal Reserve independence, but some indicators of Congressional attention to monetary policy are available. The Comparative Agendas Project tracks data on policy agendas, including hearings and bills, across several countries. Congress may use monetary policy-related hearings or bills as a form of signal to the Fed--an indirect form of political pressure or warning.

The figure below shows the number of bills in the U.S. Congress related to interest rates or monetary policy over time. Unsurprisingly, the 1970s and early 80s saw the largest number of such bills. The 1973-74 Congress considered 101 bills about interest rates and 55 about monetary policy. But the 2009-10 and 2011-12 Congress considered just 15 and 22 bills about monetary policy, respectively, which is low by historical standards.

Created at http://www.comparativeagendas.net/

The next graph, below, shows the number of Congressional hearings on interest rates and monetary policy. These also peaked around the late 1970s. Since then, however, while hearings on interest rates have dwindled, hearings on monetary policy remain frequent--typically 10-20 per year. There is a mild upward trend from 2005 to 2012. Still, by neither metric of bills nor hearings is the Fed facing an unprecedented era of Congressional meddling.

Created at http://www.comparativeagendas.net/

A Financial-Fiscal Trilemma

Financial crises and sovereign debt crises are, of course, not a new phenomenon. But the strong connection between fiscal crises and financial crises is relatively recent, primarily developing since the Great Depression and especially since the 1980s. In a new and ambitious NBER working paper, Michael Bordo and Chris Meissner survey the literature on financial and fiscal crises and their interconnections, providing both a history of thought and a catalog of open questions.

The key to the growing link between fiscal and financial crises, they explain, is the increased use of government guarantees of financial institutions. This means that banking crises are often followed by a rise in the debt-to-GDP ratio that can be partially attributed to costs of reconstructing the financial sector. Based on a synthesis of the research in this area and some preliminary empirical analysis, Bordo and Meissner posit that countries face a “financial/fiscal trilemma.” As they explain:

This financial/fiscal trilemma suggests 43 that countries have two of the following three choices: a large financial sector, a large bailout package, and a strong discretionary reaction to the downturn associated with financial crises. The logic is as follows by way of an example. Assume a country with a large financial sector faces a banking crisis. If so, then the government can provide a bailout package of a size that is commensurate with the size of the financial sector. If so it uses up its fiscal space. Otherwise it could lower the size of the bailout and devote its fiscal space to discretionary fiscal policy. With a smaller financial sector, and the same amount of fiscal space, since the size of the bailout would by definition be smaller, the size of the rise in debt due to expansionary policy could rise (p. 42-43). 

They use data from Laeven and Valencia (2012) on 19 systematic banking crises to estimate the equation:

Fiscal costs refer to the fiscal costs of bailouts in the three years following a crisis. Discretion is the change in debt not due to the fiscal costs of bailouts, also in the three years following a crisis. The estimation results, with standard errors in parentheses, are:

Notice that the estimated coefficients on the fiscal cost and discretion to GDP ratios sum to approximately 1, suggestive of a tradeoff. If the financial sector is smaller, or if the bailout package is smaller, then the change in fiscal costs to GDP ratio is likely to be smaller, which could allow a larger change in the discretion to GDP ratio, hence the "trilemma." The trilemma is illustrated by Figure 5, below. The discretion to GDP ratio is on the y-axis and the fiscal costs of bailout to GDP ratio is on the x-axis. For a given change in the debt to GDP ratio, the regression estimates imply an "iso-line" showing the fiscal costs of bailouts and discretion to GDP ratios that are possible.

Source: Bordo and Meissner (2015)

As further evidence of the trilemma, they present Figure 6, which illustrates that countries with a larger financial sector, as measured by the domestic credit to GDP ratio, tend to have a larger rise in the share of the debt to GDP ratio explained by bailouts.

Source: Bordo and Meissner (2015)

This evidence of a new "trilemma" certainly merits more rigorous empirical evaluation. As the authors note, however, empirical studies of financial and fiscal crises face the challenge of inconsistent classification and measurement. Alternative crisis chronologies lead to contradictory results. Bordo and Meissner thus propose the following:

If economists and policy makers truly believed that crises were an important phenomenon to understand and possibly avoid then it might be the case that an independent crisis dating committee could help set the standard in much the same way the NBER business cycle dating committee works. The advantage of following this model is that the NBER is a respected non-governmental, non-partisan organization. Other organizations such as the IMF are not sufficiently politically independent. If crises are becoming increasingly global and crisis fighting is a global public good, then the importance of such a reform should be obvious. 

Downside Inflation Risk

Earlier this month, New York Federal Reserve President William Dudley gave a speech on "The U.S. Economic Outlook and Implications for Monetary Policy." Like other Fed officials, Dudley expressed concern about falling inflation expectations:

With respect to the risks to the inflation outlook, the most concerning is the possibility that inflation expectations become unanchored to the downside. This would be problematic were it to occur because inflation expectations are an important driver of actual inflation. If inflation expectations become unanchored to the downside, it would become much more difficult to push inflation back up to the central bank’s objective.

Dudley, perhaps because of his New York Fed affiliation, pointed to the New York Fed’s Survey of Consumer Expectations as his preferred indicator of inflation expectations. He noted that on this survey, "The median of 3-year inflation expectations has declined over the past year, falling by 22 basis points to 2.8 percent. While the magnitude of this decline is small, I think it is noteworthy because the current reading is below where we have been during the survey history."

The 22 basis-points decline in 3-year inflation expectations that Dudley referred to is the median for all consumers. If you look at the table below, the decline is more than twice as large for consumers with income above $50,000 per year.

Source: Data from Survey of Consumer Expectations, © 2013-2015 Federal Reserve Bank of New York (FRBNY). Calculations by Carola Binder.

This might be important since high-income consumers' expectations appear to be a stronger driver of actual inflation dynamics than the median consumer's expectations, probably because they are a better proxy for price-setters' expectations. These higher-income consumers' inflation expectations were at or above 3% from the start of the survey in 2013 through mid-2014, and are now at their lowest recorded level. Lower-income consumers' expectations have risen slightly from a low of 2.72% in September 2015. We need a few more months of data to separate trend from noise, but if anything this should strengthen Dudley's concern about downside risks to inflation.

Long-Run Monetary Policy and Inequality

The following is a draft of my remarks from my meeting this afternoon with Philadelphia Federal Reserve President Patrick Harker and a group from Action United.

I appreciate and admire the Fed staff and officials who have done an excellent job in the very difficult economic environment of the past decade. I do not consider myself a highly political person, and as an academic, I am much more interested in trying to contribute to a better objective understanding of monetary policy than in involving myself in monetary politics. The idea of a politically independent Fed is so comforting to economists like me, within and outside of the Fed, who idealize technocratic merit and objective policymaking. But monetary policy has inescapable distributional implications, some real and some perceived, many of which are not fully understood in theory or empirically. And because monetary policy affects distribution, there are always going to be interest groups with a stake in the conduct of policy. The Fed cannot and need not hope to please every person all the time, but the democratic legitimacy of the institution requires that it make a real effort to understand the disparate impacts of its policies on different groups and to communicate with all segments of the public about the issues that concern them most.

So how does monetary policy affect inequality and the lives of low- to middle-income households? Since the employment, hours, and wages of low-to-middle-income workers are most sensitive to business cycle conditions, I think it is generally accepted that lower interest rates and higher employment reduce inequality in the short run.[1] Of course, monetary policy cannot be permanently expansionary; we can’t arrive at and stay permanently above full employment just by allowing slightly higher inflation. Economists who understand this distinction between the short-run and long-run Phillips Curve might then conclude that monetary policy has only cyclical effects on inequality.[2]

In the long-run, as John Taylor noted in 1979,[3] there is no long-run tradeoff between the level of output and the level of inflation, but, there is a tradeoff between output stability and inflation stability. If you think of the long-run monetary policy tradeoff as a production possibilities frontier showing different combinations of output and inflation stability that are possible, then the two big issues are (1) choosing which point on the frontier we want, in other words what relative value to place on output stability versus inflation stability, and (2) achieving a point on the frontier, rather than inside of it. These are the issues I use to frame my thinking on monetary policy and inequality, and I would like to talk about each of these issues for the next few minutes.

Regarding the first issue, Stephen G. Cecchetti and Michael Ehrmann show that since the rise of inflation targeting around the world in the 1990s, policymakers’ aversion to inflation volatility has risen in both inflation targeting and non-inflation targeting countries, with a resultant increase in output volatility.[4] In evaluating the relative emphasis to place on output stability versus inflation stability, it is worth trying to understand how this long-run tradeoff affects workers across the income distribution. If the relative harm of output volatility vs. inflation volatility is greater for low than for high-income households, than monetary policy could have lasting effects on inequality. This seems likely, given differences in savings and credit constraints that make it more difficult for lower-income households to smooth fluctuations in income. Output volatility could be especially harmful in the presence of scarring effects of unemployment, which mean that the harmful effects of downward fluctuations are not fully offset in upturns.

The long-run monetary policy tradeoff between output stability and inflation stability, may not only affect inequality, but also be affected by it. High inequality can impact the Federal Reserve’s ability to conduct monetary policy, for example through differences in interest rate sensitivity across the income distribution. This can worsen the sacrifice ratio, effectively moving the frontier inward.

Regarding the second issue, achieving some point on the frontier of output stability and inflation stability requires good credibility and also requires that monetary policy fully offset aggregate demand shocks, avoiding short-run errors.[5] Otherwise, both output volatility and inflation volatility will be unnecessarily high. Financial crises and the zero lower bound impede the ability to offset negative demand shocks, so preserving financial stability through regulatory and supervisory policy is especially important.

Offsetting fluctuations in aggregate demand is easier said than done, especially because monetary policy works with lags and because there are so many indicators to consider. Currently, the labor market shows signs that it is beginning to tighten. Even though inflation is below target, the FOMC chose to raise the federal funds rate, presumably to fend off any inflationary pressures that might begin to build. In considering the pace of future rate hikes, the Fed should keep in mind that the positive effects of a tighter labor market for reducing inequality are just beginning to appear. The unemployment rate for white men fell from 4.4 %to 4.2%.over the past year, and for black men fell from 11% to 8.7%,[6] so you can see the tighter labor market beginning to benefit African Americans, with plenty of room for further improvement.

Hourly pay grew 2.5% in 2015, compared to 1.8% in 2014. That is definitely an improvement, but it will take continued and stronger nominal wage growth to see the labor share of income regain lost ground and to get a real rise in living standards for the majority of households. Even as wages begin to rise more rapidly, I do not think that there should be too much concern that this will lead to strong inflationary pressures. Research by Federal Reserve Board economists Ekaterina Peneva and Jeremy Rudd, for example, points to a much weakened transmission from labor costs to price inflation.[7]

There are also several indications that labor markets still have room to tighten further. The number of persons employed part time for economic reasons hovers at 6 million, and the U-6 unemployment rate was unchanged at 9.9% in the latest jobs report. Labor force participation, at 62.6%, also has room to grow. Overall, to me it appears wise, given uncertainty about the global economy and inflation dynamics, to act cautiously, erring on the slow side for raising rates.[8]

[1] See, for example, Coibion, Olivier, Yuriy Gorodnichenko, Lorenz Kueng, and John Silvia. 2012. “Innocent Bystanders? Monetary Policy and Inequality in the U.S.” IMF Working Paper 199.

[2] . As Romer and Romer (1998) explain, “Because of the short-run cyclicality of poverty, some authors have concluded that compassionate monetary policy is loose or expansionary policy…[T]his view misses the crucial fact that the cyclical effects of monetary policy on unemployment are inherently temporary. Monetary policy can generate a temporary boom, and hence a temporary reduction in poverty. But, as unemployment returns to the natural rate, poverty rises again.”

[3] Taylor, John. 1979. “Estimation and Control of a Macroeconomic Model with Rational Expectations.” Econometrica 47(5): 1267-1286.

[4] Cecchetti, S. G. and Ehrmann, M. 2002. “Does Inflation Targeting Increase Output Volatility? An International Comparison of Policymakers' Preferences and Outcomes,” in N. Loayza and K. Schmidt-Hebbel (eds), Monetary Policy: Rules and Transmission Mechanisms, Proceedings of the 4th Annual Conference of the Central Bank of Chile, Santiago, Central Bank of Chile, pp. 247-274.

[5] See Cecchetti, Stephen. 1998. “Policy Rules and Targets: Framing the Central Banker’s Problem.” Economic Policy Review. Federal Reserve Bank of New York.

[6] BLS January 8, 2016 Employment Situation Summary

[7]Peneva, Ekaterina and Jeremy B. Rudd. 2015. "The Passthrough of Labor Costs to Price Inflation."

[8] See Brainard 1967 "Uncertainty and the Effectiveness of Policy," American Economic Review Papers and Proceedings 57(2); and Blinder, Alan. 1999. "Critical Issues for Modern Major Central Bankers."

Household Inflation Uncertainty Update

In my job market paper last year, I constructed a new measure of households' inflation uncertainty based on people's tendency to use round numbers when they report their inflation expectations on the Michigan Survey of Consumers. The monthly consumer inflation uncertainty index is available at a short horizon (one-year-ahead) and a long horizon (five-to-ten-years ahead). I explain the construction of the indices in more detail, and update them periodically, at the Inflation Uncertainty website, where you can also download the indices.

I recently updated the indices through November 2015. As the figure below shows, short-horizon inflation uncertainty reached a historical maximum in February 2009, but has since fallen and remained relatively steady in the last two years. Consumers are less uncertain about longer-run than shorter- run inflation since around 1990. This makes sense if at least some consumers have anchored expectations, i.e. they are fairly certain about what will happen with inflation over the longer run, even if they expect it to fluctuate in the shorter run.



In my paper, I interpreted the decline of long-run consumer inflation uncertainty over the 1980s as a result of improved anchoring during and following the Volcker disinflation, but noted the apparent lack of improvement since the mid-90s, despite the Fed's efforts to improve its communication strategy and better anchor expectations. With an extra year of data, it looks like long-run inflation uncertainty may have actually declined, if only slightly, in the last few years. Still, that doesn't mean that consumers' expectations are strongly anchored, as I show in another working paper (which Kumar et al. follow up for New Zealand with similar results).

Did Main Street Expect the Rate Hike?

Over a year ago, I looked at data from the Michigan Survey of Consumers to see whether most households were expecting interest rates to rise. I saw that, as of May 2014, about 63% of consumers expected interest rates to rise within the year (i.e. by May 2015). This was considerably higher than the approximately 40% of consumers who expected rates to rise within the year in 2012.

Of course, the Federal Reserve did not end up raising rates until December 2015. Did a greater fraction of consumers anticipate a rise in rates leading up to the hike? Based on the updated Michigan Survey data, it appears not. As Figure 1 below shows, the share of consumers expecting higher rates actually dropped slightly, to just above half, in late 2014 and early 2015. By the most recent available survey date, November 2015, 61% expected rates to rise within the year.

Figure 1: Data from Michigan Survey of Consumers. Analysis by Binder.

Figure 2 zooms in on just the last three years. You can see that there does not appear to be any real resolution in uncertainty leading up to the rate hike. Consistently between half and two thirds of consumers have expected rates to rise within the year every month since late 2013.

Figure 2: Data from Michigan Survey of Consumers. Analysis by Binder.