The Letter and the Spirit of Monetary Policy

If there was one major disappointment with Bernanke’s speech at the AEA meetings last weekend it was his choice to fight insular battles will equally insular arguments.

Part of the reason was tactics of course. Inane criticisms arguably deserve a commensurate response. So when you have somebody like (Stanford economist) John Taylor on a self-appointed mission to prove that his own Taylor rule can explain absolutely anything—from the Great Inflation, to the Greenspan put, to (coming soon!) life on other planets—, using the “enemy’s” own weapon to neutralize him is a cunning strategy.

But it’s also a big letdown for an audience that longed for much more substance than the difference between the consumer price index and its PCE counterpart. Indeed, the very fact that different inflation metrics often send divergent signals about the “right” path for interest rates highlights the weakness of a monetary policy framework narrowly fixated with product price inflation and/or output gaps—a fixation the Fed still seems to possess.

The second big letdown was the sly arguments Ben offered to absolve the Fed from causing the house bubble. Here they are:

1) “The rise in house prices [fell] well outside the predictions of [a VAR] model” based on the historic inter-relation between the fed funds rate, house prices and other macroeconomic variables such as economic growth, inflation, unemployment and residential investment.” Yes, maybe—though this also silences those Greenspanesque die-hards who claim you can’t spot a bubble before it bursts!

2) “The overall relationship between house prices and monetary policy [based on international evidence] is statistically insignificant and economically weak; moreover, monetary policy differences explain only about 5 percent of the variability in house price appreciation across countries.” Yes, maybe too… though it’s baffling that one would choose to provide “evidence” based on a framework (the Taylor rule) he just trashed only a few minutes earlier.

3) “[C]ountries in which current accounts worsened and capital inflows rose had greater house price appreciation over this period. [T]he relationship is highly significant, both statistically and economically, and about 31percent of the variability in house price appreciation across countries is explained. This simple relationship requires more interpretation before any strong conclusions about causality can be drawn [..].”

Now that’s something… Ben’s “savings glut” is back with a vengeance! Global savings glut –> wider US current account deficit –> house bubble!

Gets better… monetary policy apparently had little to do with the widening of the US current account deficit.

There is some truth to this latter point… but only some! One contributor to the rise in absorption (and the current account deficit) during Q1 2002-Q3 2006 was the dissaving by a government that saw it wise to both cut taxes and go to war in the same breath. Another—smaller—part was a decline in private savings, which cannot however be attributed to the fed funds rate alone, since this was only the tail end of a secular decline in savings that began in the early 1990s (and even before then) and went on even when real rates were considerably higher than during 2002-06.

But here is where it gets tricky: The third (and meaningful) contributor to the widening of the deficit was an increase in private investment—residential investment. So the only way to absolve monetary policy from contributing to the house bubble is by postulating that, well, monetary policy did not contribute to the house bubble (and the associated boom in residential investment)!

This criticism may sound pedantic, so let me bring out the bigger point here: Ben’s focus on the house bubble is misplaced, if not narrow-minded. There was a giant credit/asset bubble underway, which struck not only housing but also the credit-card industry, auto loans, stock prices, credit spreads, commodities, what-have-you. Qualitative explanations abound and include the bout of financial innovation that seemed to permit a structural, economy-wide increase in debt(/leverage) “risk free.”

Against this backdrop, gauging the role of monetary policy in all this will have to rest on more than distinctly macro arguments like the ones above. Indeed, a key question emerging in the aftermath of the crisis is whether developments at the “micro” level (i.e. in financial institutions, shadow banks, etc) have transformed the transmission mechanism as we know it, and hence the appropriateness of the current framework guiding monetary policy. The fact that none of this budding research was mentioned, even as a hint, leaves one wonder how long before our monetary authorities start adhering to the spirit, rather than the letter, of macroeconomic stability.

But there is a ray of hope, offered at the very end of Ben’s speech:

“[I]f adequate [regulatory] reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks [..]. Clearly, we still have much to learn about how best to make monetary policy and to meet threats to financial stability in this new era.”

I’ll leave it at that… though, Mr. Chairman, let me say that’s not the kind of statement you throw out just like that, without more detail. So we’re waiting anxsiously for the follow-up!

Originally published at Models & Agents and reproduced here with the author’s permission.