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Sunday, June 2, 2019

The Ossification Of Monetary Policy

Markets are again in an unsettled state. Gyrations in trade policy in the United States are one culprit, although more speculative financing practices at the fringes of the system are also running into difficulties. Although I am writing a book on recessions, my argument is that recessions are inherently hard to forecast. As a matter of internal consistency, I am not putting forth any odds that this latest scare will morph into wider recession. However, it is clear that something has spooked market participants. What is interesting about this that we can expect this to have no effect on policy actions. That is, even though the belief that markets offer information is a key platform of neoliberal orthodoxy, policymakers do absolutely nothing useful with that information.*

The chart above shows the evolution of the inflation breakeven rate in the United States, both the spot 10-year (top panel), and the 5-year rate, 5-years forward (bottom panel). (The 10-year inflation breakeven rate is the 10-year nominal Treasury yield less the yield on 10-year TIPS - an inflation-linked bond. I have a primer on breakeven inflation here, and my latest book is an in-depth analysis of breakeven inflation.)

The recent movements in the inflation breakeven are not particularly alarming, but both spot and forward have dipped below the psychological level of 2%. Since forward inflation rates are somewhat insulated from oil price movements, this cannot be explained away by developments in energy markets. 

Although the cycle is well advanced, this is a sign that inflation market practitioners have no worries that inflation will be rising above the Fed's professed target. (Note that the Fed focuses on the Personal Consumption Expenditure (PCE) deflator, which tends to be lower than CPI inflation.) Based on past history, it is a safe bet that some analyst at the Fed is writing a report explaining away the recent movements as being the result of changing risk premia. Nevertheless, it is very hard to imagine an inflation scare getting much traction now.

This leads to an interesting observation about monetary policy: it is far more ossified than is typically asserted by many commentators (at least in the United States). Right now, if we look at behavioural norms that developed over the past few decades, there is zero chance of a rate cut, even though common sense suggests that this would be the most prudent course of action: there is no chance of the economy overheating, and there are clear risk factors. After all, the policy rate could just be raised back six weeks later, in theory. In practice, such a rapid reversal is not socially acceptable among policymakers.

The chart above shows the evolution of the target for the federal funds rate since 1984. (Note that the target rate was not officially announced before the 1990s, and the post-2008 series is the midpoint of a target band for the effective fed funds rate.) Behaviour has evolved into a stylised ritual movement: rapid cuts at the onset of recession, a long pause, then a steady rise in rates until it plateaus at the top of the cycle.

There were some reversals of direction in the 1980s (before the modern fad of New Keynesian theory took over), and some stutter-steps in the 1990s. The 1998 cuts were in response to a financial crisis; although the U.S. avoided recession, Asian economies had previously imploded.

Chart: Canadian Policy Rate and Recessions

To a certain extent, this ossification may reflect the institutional practices of the Federal Reserve. For example, the Bank of Canada is not afraid to zig-zag the policy rate (figure above).  Nevertheless, even in Canada, the movements in the policy rate are not particularly large in absolute terms: one needs to have an exaggerated view of the effect of interest rates to believe that the realised moves mattered that much. (Admittedly, given the perilous nature of the Canadian housing bubble, caution with respect to rate movements is warranted.)

Conversely, fiscal policy is constrained by politics, not New Keynesian social norms. Although I think the Old and New Keynesian dream that the economy can be forced to folly a socially optimal trajectory is a dangerous fantasy, one could imagine that a competent governing elite would be able to enact a small expansionary fiscal programme right now to help moderate recession risks. Although this would not be enough to abolish "boom and bust," it would be better than nothing -- which is pretty much what the Federal Reserve will most likely do.**

In summary, I do not claim to have enough information to argue that the United States faces a severe recession risk. That said, it is safe bet that nothing useful will be done in response to these perceived risks. I am skeptical that policymakers can stop recessions from happening, but it is clear that the safety net can be improved to shield workers better from the fallout. (This is a topic that I will return to in a later article that will be worked into my book.)


* To be fair, they do one thing with the information they get from fixed income markets: they obliterate it by pushing it through an affine term structure model.

** I am ignoring "expectations fairy" stories, such as the Market Monetarist belief that the central bank can achieve a 5% nominal GDP growth path by really, really believing that it can hit that target. There is a reason why DSGE modellers are vague about equilibrium formation within their models: there does not appear to be any mechanism for such an outcome to be achieved if the models have plausible restrictions on central bank behaviour.

(c) Brian Romanchuk 2019

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