In 2000, Bank of England Deputy Governor Mervyn King delivered a speech on monetary policy often quoted by central bankers around the world (“Balancing the economic swing», April 14, 2000). He said:
[O]Our ambition at the Bank of England is to be boring. No, I hasten to add, at events like this. But in our management of the economy where our belief is that boredom is best. Macroeconomic policy has, for most of our lifetime, been rather too exciting for comfort. … Our goal is to maintain economic stability. The reputation of being boring is an advantage – the credibility of the political framework helps to slow down the seesaw. If love never has to apologize, then stability never has to be exciting.
King’s reference to the “seesaw” emphasizes that monetary policy involves movements between looser and tighter monetary policy. Such a move is inevitable. But of course, the goal is to ensure that the macroeconomic policy swing involves small adjustments, rather than large swings. King argued that central banks should be willing to take small steps sooner, because otherwise they will likely have to take bigger steps later. He said:
The longer the correction, the more precise the adjustment required. The higher one end of the swing, the greater the subsequent yaw will be. … In one of the most influential contributions to post-war monetary policy, Milton Friedman wrote that the hallmark of most central banks was that “too late and too much has been the general practice”.
The often-heard recent complaint about the Federal Reserve and inflation was that it waited too long after inflation started in 2021 and then had to act more aggressively to raise interest rates from 2022 than would otherwise be necessary. The current monetary policy concern is that the Fed may have already taken sufficient steps to reduce inflation, but it takes some time for past interest rate hikes to trickle down to the macro economy. By not waiting to see what happens to its past actions, the Fed runs the risk of overreacting. The best description of this phenomenon that I know of comes from Alan Blinder, who was Vice Chairman of the Fed in the mid-1990s. He wrote in a 1997 article in the Journal of Economic Perspectives:
[H]Human beings struggle to do what homo economicus does so easily: patiently wait for the lagged effects of past actions to be felt. I have often illustrated this problem with the parabola of the thermostat. The following has probably happened to each of you; this has certainly happened to me. You check into a hotel where you don’t know the room thermostat. The room is way too hot, so you turn down the thermostat and take a shower. Coming out 15 minutes later, you find the room still too hot. So you turn the thermostat down a notch, take off the woolen blanket and go to sleep. Around 3 a.m., you wake up shivering in a freezing room…”
But putting aside questions of whether the Fed waited too long to act (I think it did) or whether it is currently in danger of overreacting (I think it is not yet the cases), perhaps the biggest complaint is that, when looking back over the last 20 years or more of monetary policy, what Mervyn King has called the policy “seesaw” has shown dramatic changes. It’s not just the raising and lowering of the federal funds interest rate – the Fed’s target key interest rate.
These are also the policies of quantitative easing, whereby the Fed now holds about $8 trillion in Treasuries and mortgage-backed securities. It is the evolution towards the use of “forward guidance,” in which the Fed seeks to alter interest rates and financial conditions in the present by making announcements about the likely course of future Fed policy.
It’s the fact that the Fed has fundamentally changed its monetary policy tools. Two generations of economics students have learned the three tools of monetary policy: open market operations, reserve requirements and the discount rate. But the Fed abolished reserve requirements in 2020, and open market operations only worked because banks wanted to avoid not holding enough reserves. Instead of discount rates, the Fed now creates funds for short-term liquidity, which pop up during the Great Recession or pandemic recession to reassure markets, then disappear again. The Fed now seeks to control the federal funds interest rate by paying interest on bank reserves held at the Fed, which only started in 2008and using overnight reverse repurchase agreements, which only started in 2013.
Add to this some of the recent debates about whether the policy objectives of the Federal Reserve should go beyond the standard swing of balancing the risks of unemployment and inflation, and also try to take consider the possible effects of monetary and banking regulatory policy on issues such as inequality and climate change.
Of course, the most recent example of the Fed’s policy shift is the Silicon Valley Bank collapse and its aftermath. Apparently, neither the monetary policy arm of the Federal Reserve nor its banking regulatory arm has failed to notice the basic fact that a monetary policy decision to raise interest rates would affect the value of fixed rate bonds held. by the banks (as well as the value of similar assets held by the Fed itself). As a result, the Fed ended up taking the rather sudden decision to guarantee all bank deposits, even those above the previous limit of $250,000, with certain “strategic” banks – a guarantee which, in practice, seems likely to be stale. apply to almost all banks in the country. worry.
This remains true in 2023, as Mervyn King said in 2000: “Macroeconomic policy has, for most of our lifetime, been rather too exciting for comfort.” I have a pretty good understanding of the reasons and justifications for the various Fed policy changes over the past 20 years. But it’s also worth remembering King’s other ambition: the Federal Reserve, along with other central banks around the world, needs to be more boring.