Federal Reserve documents 5 page

The FOMC had reacted quickly to the downturn. Through the course of 2001, it slashed its policy instrument—the target for the federal funds rate—from 6-1/2 percent to 1-3/4 percent, quite a rapid response by historical standards. The federal funds rate is a private-sector interest rate—specifically, the rate that banks charge each other for overnight loans. Although the federal funds rate is a private rate, the Federal Reserve was able to control it indirectly by affecting the supply of funds available to banks. More precisely, the Fed managed the funds rate by affecting the quantity of bank reserves.

Bank reserves are funds that commercial banks hold at the Fed, much like the checking accounts that individuals have at banks. A bank can use its reserve account at the Fed for making or receiving payments from other banks, as well as a place to hold extra cash. Banks are also legally required to hold a minimum level of reserves.

The Fed was able to affect the quantity of bank reserves in the system, and thereby the federal funds rate, by buying or selling securities. When the Fed sells securities, for example, it gets paid by deducting their price from the reserve account of the purchaser’s bank. The Fed’s securities sales consequently drain reserves from the banking system. With fewer reserves available, banks are more eager to borrow from other banks, which puts upward pressure on the federal funds rate, the interest rate that banks pay on those borrowings. Similarly, to push down the federal funds rate, the Fed would buy securities, thereby adding to reserves in the banking system and reducing the need of banks to borrow from each other.

At that time, moving the federal funds rate up or down was the FOMC’s principal means of influencing the economy, and the level of the funds rate was the primary indicator of policy. If the FOMC determined that economic activity needed a boost, it would cut the rate. A cut tended to push down other interest rates—from the rates on auto loans to mortgages to corporate bonds—and thus promoted borrowing and spending. As Keynesian theory predicts, so long as the economy had unused capacity, increased spending causes firms to raise production and hire more workers. If the economy had little or no unused capacity, however, increased demand might push prices and wages higher—that is, boost inflation. If the Committee believed that the economy was “running hot,” with output above sustainable levels, it could raise the federal funds rate, leading to increases in interest rates across the board and

slowing economic growth and inflation.

Raising rates wasn’t a serious option in August 2002. The rapid rate-cutting campaign of 2001 had no doubt contributed to the relative brevity of the recession. However, the recovery that followed had been tepid, with only moderate economic growth, and the pessimists around the table worried the economy might be faltering. Moreover, despite the growth in production, the economy was in a “jobless recovery.” The unemployment rate had actually risen since the end of the recession. And inflation had been exceptionally low—often a symptom of economic weakness, since firms are reluctant to raise prices when demand is soft. Stock prices remained depressed in the aftermath of corporate governance scandals at the telecommunications company WorldCom, the energy trader Enron, and the accounting firm Arthur Andersen.

As usual, Greenspan got the last word in the economic go-round. He proposed that we refrain from further cuts in our target for the federal funds rate, but state in our closely watched postmeeting statement that “the risks are weighted mainly toward conditions that may generate economic weakness.” In central bank speak, that would signal to the financial markets that we were worried about the slow pace of the recovery and thought that the next rate change was more likely to be down than up. Greenspan’s remarks were the transition to a second opportunity for each person to speak, the “policy go-round,” and effectively served as both the closing of the first round and the opening of the second round. Under Greenspan, this second round was usually brief and consisted of little more than participants stating their agreement with (or very occasionally their opposition to) his recommendation. This time, I concurred.

Unfortunately, the economy showed little sign of strengthening by the time of my second FOMC meeting, in September. Some participants noted that rising concern about a possible war with Iraq seemed to be making businesses and households extra cautious. We also discussed whether inflation was falling too low. People tend to think low inflation is a good thing, because it means that they can afford to buy more. But very low inflation—if sustained—also comes with slow growth in wages and incomes, negating any benefit of lower prices. In fact, inflation that is too low can be just as bad for the economy as inflation that is too high, as Japan’s experience starkly illustrated. The drag on the economy from very low inflation or deflation might be so great that even lowering short-term interest rates to zero may not provide enough stimulus to achieve full employment. When my turn came to speak, I acknowledged that easing rates might further heat up already hot sectors such as housing but said I leaned toward a rate cut as a preemptive strike against the risk of falling into deflation.

We also debated whether the “zero lower bound”—the fact that interest rates cannot be reduced below zero—meant we were “running out of ammunition.” Cutting the federal funds rate wasn’t the only conceivable tool for spurring growth, as staff research papers had been exploring for several years and as I had argued at Princeton. But Greenspan downplayed the zero-bound concern. He suggested that, if the federal funds rate did hit zero, the Committee would be able to find other ways to further ease monetary policy, though he did not at that point say exactly how.

In any case, Greenspan once again argued against an immediate cut, though he suggested one might be necessary before the next regularly scheduled meeting. I went along even though I had been leaning toward a rate cut. The Committee seemed headed in the direction of further cuts and I did not think the precise timing that important. But two other members of the Committee voted against Greenspan. Surprisingly, one was Ned Gramlich. Board members typically have a higher threshold for voting against the chairman than do Reserve Bank presidents, perhaps because the Washington-based governors have more opportunity to argue their case between meetings. The other dissenter was Bob McTeer of the Federal Reserve Bank of Dallas, who had earlier earned the nickname “The Lonesome Dove.”

WITH TWO FOMC MEETINGS under my belt, I felt ready to begin speaking in public. On October 15, 2002, in New York, I asked what monetary policy should do, if anything, about asset-price bubbles. The question was timely. A stock market boom and bust had helped trigger the 2001 recession, and we were seeing continuing increases in house prices.

Most people think they know what a bubble is, but economists have no exact definition. The term usually refers to a situation in which investors bid the price of a class of assets well above its “fundamental” value, expecting that they can resell at a still higher price later. I waded into the contentious debate over whether central banks should deliberately raise interest rates to try to deflate a bubble.

I raised two concerns about that strategy. First, identifying a bubble is difficult until it actually pops. Nobody ever knows for sure the fundamental value of an asset, which depends on many factors, including how the economy is likely to perform in the distant future. Indeed, if bubbles were easy to identify, investors wouldn’t get caught up in them in the first place.

Second was the problem the FOMC confronted in 2002: what to do when one sector, such as housing, is hot but the rest of the economy is not. Monetary policy cannot be directed at a single class of assets while leaving other financial markets and the broader economy untouched. I cited the stock market boom of the late 1920s. New York Fed president Benjamin Strong, the Fed’s de facto leader at the time, resisted increasing interest rates to squelch the stock market, on the grounds that the effects of higher rates could not be confined to stocks. He drew an analogy: Raising rates would be like spanking all his children just because one child—the stock market—had misbehaved. When Strong died in 1928, his successors abandoned his hands-off approach and raised rates. The ultimate results of this decision were not only the stock market crash of 1929 (in a tragic sense, the Fed succeeded in its effort to cool the market) but also a too-tight monetary policy that helped cause the Depression.

Do the problems with using monetary policy to pop bubbles mean that central banks should ignore bubbles as they are forming? No, I argued. First, sometimes bubbles will cause the overall economy to overheat—when higher stock prices encourage stockholders to increase their spending, for example— leading to unsustainable growth and higher inflation. In that case, monetary policy can lean against the

bubble and help stabilize the broader economy at the same time. Mark Gertler and I had made a similar argument in a paper we presented at the Fed’s Jackson Hole conference in 1999. Second, and critically, central banks and other agencies can fight bubbles by other means, such as regulation, bank supervision, and financial education. Or, as I put it in my speech, “Use the right tool for the job.”

In November—in a speech entitled “Deflation: Can ‘It’ Happen Here?”—I addressed the question that the FOMC had debated in September: Would the Fed run out of ammunition if inflation fell very low and interest rates were cut to zero? I said that central banks should do whatever they could to avoid deflation. For example, they can set a goal for inflation above zero to provide a buffer, or safety zone, against deflation. Advanced-economy central banks generally aimed for inflation of about 2 percent rather than zero, though in the Fed’s case the goal wasn’t stated explicitly. I also argued that it was important to get ahead of deflation by cutting rates preemptively if necessary.

But if deflation did arrive, what then? Even when short-term interest rates were close to zero, I said, central banks could do more. I suggested several methods to bring down longer-term interest rates, such as mortgage rates, thereby providing additional economic stimulus, even when short-term interest rates could not be cut further.

The deflation speech saddled me with the nickname “Helicopter Ben.” In a discussion of hypothetical possibilities for combating deflation, I mentioned an extreme tactic—a broad-based tax cut combined with money creation by the central bank to finance the cut. Milton Friedman had dubbed the approach a “helicopter drop” of money. Dave Skidmore, the media relations officer and former Associated Press journalist who edited my speeches when I was a Board member and later chairman, had advised me to delete the helicopter-drop metaphor. But I was unconvinced. I had, after all, referred to it in my writings as an academic. “It’s just not the sort of thing a central banker says,” he told me. I replied, “Everybody knows Milton Friedman said it.” As it turned out, many Wall Street bond traders had apparently not delved deeply into Milton’s oeuvre. They didn’t see my remarks as a hypothetical discussion by a professor; they took it as a policymaker’s signal that he was willing to push inflation too high, which would devalue their bonds.

DEFLATION AND FRIEDMAN’S IDEAS were at the center of a third speech early in my tenure, at the University of Chicago. The occasion was a ceremony honoring Milton on his ninetieth birthday. I knew Milton when I taught at Stanford and he was at Stanford’s Hoover Institution. A tiny man, he always seemed to have a smile on his face. He loved to talk economics with anybody, even a young assistant professor like me. It was from his work with Anna Schwartz that I had learned that the Federal Reserve’s failure to keep the economy from sinking into deflation had been a major cause of the Depression. With that in mind, I reminded the audience that I was now at the Fed and ended by saying, “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

* The Reserve Banks today are in the same cities as they were when the Federal Reserve was created: Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. The Reserve Banks also have branches in twenty-four cities within their districts.

† The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created a second vice chair position, for supervision. As of early 2015, it had not been filled.

‡ Actually, the law specifies a third objective for monetary policy—low long-term interest rates. Because long-term interest rates tend to be low when inflation is low and expected to remain low, this third part of the mandate is seen as being subsumed by the goal of price stability and does not often figure in FOMC decisions.

CHAPTER 4

In the Maestro’s Orchestra

As a junior member of the Maestro’s orchestra, I found life during the waning years of the Greenspan Fed to be as quiet or as busy as I cared to make it. It was also at times strangely isolating, even for someone used to the solitude of academic research. I traveled reasonably often to give a speech, to visit a Reserve Bank, or to represent the Board in a meeting abroad. But most days I worked alone in my office. I arrived early, parking in a garage in the basement of the Eccles Building. Some days Don Kohn’s bicycle would occupy the parking space next to mine.

On a typical day, between meetings I read reports, followed economic and financial developments, and worked on speeches or on academic research left incomplete when I moved to Washington. The staff was more than happy to help with speeches or even to write them, but I preferred to draft my own and then revise based on staff comments. Several governors had CNBC on their TVs all day, but I found that distracting. Instead I periodically checked the Bloomberg screen in my office or read the staff market updates.

When I joined, the full Board met infrequently; much of the substantive work was done by committees. We did convene every other Monday morning for a staff briefing on economic, financial, and international developments. Governors asked questions after the staff presented. As a professor, I had been used to asking speculative or hypothetical questions at seminars, but at the Fed I quickly acquired more discipline. Once I asked an idle question at a briefing. By the end of the day, the staff had sent me a ten-page memo that answered the question under four different sets of assumptions and included a bibliography. After that I only asked questions when I really needed the answer.

At Princeton, I often dropped into a colleague’s office to try out a new idea or to chat. At the Fed,

outside of scheduled meetings, I did not see fellow Board members much—unless I made an appointment. Board members’ offices are arrayed at intervals along a long carpeted hallway with vaulted ceilings and the hushed ambience of a library. Each office has an outer office occupied by an administrative assistant. Rita Proctor, a confident and efficient Fed veteran, was assigned to work with me. She quickly took me in hand, educating me about “how things are done” at the Board. At Princeton I had shared an assistant with other faculty members. I demanded so little of Rita’s time that she volunteered to work for Mark Olson as well.

Another difference between academic life and life as a policymaker was the dress code. As a professor, I often wore jeans to work. I wasn’t used to wearing a suit every day, especially in the summer heat of Washington. Of course, I understood that formal dress was just a way of showing that you took the job seriously. But at a talk before the American Economic Association, I made the tongue-in-cheek proposal that Fed governors should be allowed to signal their commitment to public service by wearing Hawaiian shirts and Bermuda shorts.

Life outside the office was as quiet as life inside it. On weekends I was either at home in Princeton or on the road on Board business. Friends from academia dropped by. But on most weekday nights I returned to an empty apartment and phoned Anna to catch up on life in New Jersey. My apartment in Georgetown was close to a couple of Vietnamese restaurants that I frequented. When I didn’t go out, I would microwave a Hot Pockets sandwich and eat it in front of a Seinfeld rerun. Sometimes I’d stroll over to Blues Alley, a jazz club across the street, or to a three-story Barnes & Noble bookstore a few blocks away. During off-hours, I read fiction and nonfiction, all subjects—history, biology, math, rarely any economics. I couldn’t immediately indulge my primary extracurricular obsession—baseball—because it was not until 2005 that the Montreal Expos moved to Washington, changing their name to the Nationals.

I received invitations to receptions at embassies and the like but I turned down most. I did enjoy attending several dinner parties at the home of Greenspan and his wife, Andrea Mitchell. The chairman displayed a sly and sometimes self-deprecating sense of humor that was rarely visible in public. He told us, for example, about his marriage proposal to Andrea, which was so riddled with Greenspanian ambiguity that she couldn’t figure out what he was asking. Andrea regaled us with stories of her adventures as an international correspondent for NBC News. Board alumni, including former senior staff as well as retired governors, formed an informal club that extended outside the institution’s walls. Mike Kelley, a former Board member who lived with his wife, Janet, in the nearby Watergate complex, threw a reception around Christmas each year that drew everybody in town with current or past Fed connections.

At work, I had relatively few one-on-one conversations with Chairman Greenspan. I occasionally asked to see him in his office, and he sometimes invited me to lunch in his personal dining room. Although we got along fine, I suspect that he saw me as too academic, and consequently naпve about the practical complexities of central banking. That opinion was not without merit. And doubtless in FOMC meetings and speeches I harped on the need for policy transparency too much for his taste.

I was awed by Greenspan’s reputation and record, but I also perceived shortcomings that a conventionally educated academic could be expected to see in someone who is largely self-taught. He had learned much of his economics on the job, as a consultant. After a master’s degree at New York University, he had enrolled in a PhD program at Columbia University under the mentorship of former Fed chairman Arthur Burns, a pioneer in the empirical analysis of recessions and recoveries. Greenspan dropped out of graduate school in the early 1950s after his consulting business took off. Much later, in 1977, he received a doctorate on the basis of a collection of past articles rather than a conventional dissertation. He was shrewd and knew a remarkable number of esoteric facts, but his thinking was idiosyncratic and less conceptual than I was used to. His famous libertarianism (he had been a disciple of novelist and philosopher Ayn Rand) would show in offhand remarks, but he tended toward the pragmatic in making monetary policy.

Despite differences in our worldviews, I liked and admired the chairman. He was invariably cordial, and he seemed eager to discuss any economic issue. Once I went to see him about twenty minutes before an FOMC meeting—I forget the precise reason. When I entered his office, Greenspan was sitting at his desk eating oatmeal, a napkin tied around his neck. We began to discuss my point, and in the midst of his animated response he realized that we were five minutes late for the meeting, a significant breach of protocol. He ripped off the napkin and hustled into the boardroom through the door from his office. I took the circuitous route through the hallway to the boardroom’s main entrance.

Many outsiders at the time viewed the FOMC as a rubber stamp for Greenspan. I learned quickly that this was not the case. If the chairman had particularly strong views, his recommendation would almost certainly become policy. His personal prestige and the Fed tradition of deferring to the chairman would usually be enough. That had been the case in the late 1990s, when he had argued against interest rate increases because of his conviction that rapid productivity gains, which gave the economy more room to grow, made raising rates premature. (That call, featured in a book by Bob Woodward, helped earn Greenspan the title of the Maestro.) But he always knew where the center of the Committee was, and he generally accommodated members’ views—if not completely, then through clever compromises or vague promises to act at some future meeting.

On substance, Greenspan and I agreed on many things. He was passionate, as was I, about maintaining the Fed’s independence from short-term political pressures. The chairman made policy decisions in an apolitical, nonpartisan way. Like me, he also believed that monetary policy is a powerful tool, and he was prepared to act forcefully when warranted. We agreed on the benefits of low and stable inflation, and we largely agreed that monetary policy could remain effective even if short-term interest rates reached zero. Greenspan also shared my views that monetary policymakers could not reliably identify asset-price bubbles or safely “pop” them by raising interest rates.

Our thinking diverged in several areas. I championed, and he distrusted, formal policy frameworks like inflation targeting, which were intended to improve the Fed’s transparency. He had even made jokes

about his own strained relationship with transparency. He told a Senate committee in 1987, “Since becoming a central banker, I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.” Also, he did not put much stock in the ability of bank regulation and supervision to keep banks out of trouble. He believed that, so long as banks had enough of their own money at stake, in the form of capital, market forces would deter them from unnecessarily risky lending. And, while I had argued that regulation and supervision should be the first line of defense against asset-price bubbles, he was more inclined to keep hands off and use after-the-fact interest rate cuts to cushion the economic consequences of a burst bubble.

THROUGHOUT MOST OF the 1990s the Fed presided over an economy with employment growing strongly and inflation slowly declining to low levels. The Fed was thus meeting both parts of its congressional dual mandate to pursue maximum employment and price stability. In contrast, when I arrived at the Fed, we saw risks to both sides of our mandate. On the employment side, we had the jobless recovery to contend with. On the price stability side, we faced a problem unseen in the United States since the Depression—the possibility that inflation would fall too low or even tip into deflation, a broad decline in wages and prices.

In the past, the end of a recession had typically been followed by an improving jobs market. But during the two years after the recession that ended in November 2001, the U.S. economy actually lost 700,000 jobs, and unemployment edged up from 5.5 percent to 5.8 percent even as output grew. Many economists and pundits asked whether globalization and automation had somehow permanently damaged the U.S. economy’s ability to create jobs. At the same time, inflation had been low and, with the economy sputtering, Fed economists warned that it could fall to 1/2 percent or below in 2003. Actual deflation could not be ruled out.

Worrying about possible deflation was a new experience for FOMC participants. Ever since the end of the Depression, the main risk to price stability had always been excessive inflation. Inflation spiraled up during the 1970s. Paul Volcker’s Fed ended it, but at a steep cost. Within a few months of Volcker’s becoming chairman in 1979, the Fed dramatically tightened monetary policy, and interest rates soared. By late 1981, the federal funds rate hit 20 percent and the interest rate on thirty-year fixed-rate mortgages topped 18 percent. As a consequence, housing, autos, and other credit-dependent industries screeched to a halt. A brief recession in 1980 was followed by a deep downturn in 1981–82. Unemployment crested above 10 percent, a rate last seen in the late 1930s.

After succeeding Volcker in 1987, Alan Greenspan continued the fight against inflation, although he was able to do so much more gradually and with fewer nasty side effects. By the late 1990s, the battle against high inflation appeared to be over. Inflation had fallen to about 2 percent per year, which seemed consistent with Greenspan’s informal definition of price stability: an inflation rate low enough that households and businesses did not take it into account when making economic decisions.

The Great Inflation of the 1970s had left a powerful impression on the minds of monetary policymakers. Michael Moskow, the president of the Federal Reserve Bank of Chicago when I joined the FOMC, had served as an economist on the body that administered the infamous—and abjectly unsuccessful—Nixon wage-price controls, which had attempted to outlaw price increases. (Predictably, many suppliers managed to evade the controls, and, where they couldn’t, some goods simply became unavailable when suppliers couldn’t earn a profit selling at the mandated prices.) Don Kohn had been a Board staff economist in the 1970s under Fed chairman Arthur Burns, on whose watch inflation had surged. Greenspan himself had served as the chairman of President Ford’s Council of Economic Advisers and no doubt shuddered to remember the Ford administration’s ineffectual Whip Inflation Now campaign, which encouraged people to wear buttons signifying their commitment to taming the rising cost of living. With Fed policymakers conditioned to worry about too-high inflation, it was disorienting to consider that inflation might be too low. But it was a possibility that we would soon have to take seriously.

The federal funds rate, after the rapid cuts in 2001, had been left unchanged at 1-3/4 percent for most of 2002. But by the November 2002 FOMC meeting, my third since joining the Fed, the case for another rate cut was gaining strength. After a brief upturn during the summer, job creation was stalling again. I agreed that we needed to cut interest rates to support job growth. Additionally, I said, a rate cut would help avoid further declines in the already low inflation rate. Greenspan had come to the same conclusion. “We are dealing with what basically is a latent deflationary type of economy,” he told us. “It’s a pretty scary prospect, and one that we certainly want to avoid.” Greenspan proposed, and the Committee supported, a significant half-percentage point cut in the federal funds rate target, to 1-1/4 percent. Our postmeeting statement indicated that, with the rate cut, the “risks are balanced,” meaning that future rate changes were about equally likely to be up or down.

The economy seemed to pick up for a few months, but by the time of our March 2003 meeting the recovery again seemed stalled. Shockingly, the Labor Department reported private payrolls had contracted by 308,000 jobs in February. “With recoveries like this, who needs recessions!” said Dallas Fed president Bob McTeer.

U.S. forces had invaded Iraq a few days before the meeting. Businesses and households were reluctant to invest or borrow until they saw how the invasion would play out. My colleagues and I also were uncertain about the economic consequences of the war, especially its effect on energy prices. At Greenspan’s urging, we decided to wait before considering further action. In our postmeeting statement, we said uncertainty was so high that we couldn’t usefully characterize the near-term course of the economy or monetary policy. That unprecedented assertion probably added to the public’s angst about the economy.

I HARBORED THE HOPE that aspects of my academic work would contribute to our debate. In particular, because accurate communication about policy becomes especially important as short-term interest rates

Date: 2016-04-22; view: 909