Crisis-Era Policy: Has the Fed Been Successful?

Federal Reserve

In two papers, two Federal Reserve Economists and Directors, William English and David Wilcox, teamed up with other economists to discuss monetary policy and central banking. The papers will be presented at the International Monetary Fund’s (or, IMF) annual research conference, to be held November 7-8. The theme this year is “Crises Yesterday and Today.” It is intended to present research and stimulate discussions among policymakers and researchers.

English, who is the Director of Monetary Affairs at the Fed, is one leg of a trio of authors on a paper evaluating the Fed’s framework for monetary policy. It begins by explaining that the ”nontraditional policy tools — specifically, forward guidance regarding the path of the federal funds rate and large-scale asset purchases” the Fed undertook as a result of the financial crisis necessitated a greater level of transparency. This introduced changes to operating procedures, including clearer communications about intentions and policy.

In the past decade, the report claims, the Federal Open Market Committee has improved communications by stating goals, including data-driven benchmarks, such as inflation and unemployment rates. With these changes in mind, the report then turns its attention to evaluating how the Fed has fared since the crisis with its policies.

One of the key parts is where the report analyzes the benefits of using a “threshold strategy” in policy implementations, such as the Fed stating they will not begin to taper until unemployment levels fall to 6.5 percent. It explains that this is a necessary policy because ”reducing the unemployment threshold improves measured economic performance until the unemployment threshold reaches 5.5 percent. A further reduction in the threshold to 5.0 percent, however, reduces welfare, as the control of inflation becomes notably less precise.” In other words, an aggressive policy to help lower the unemployment rate is a boon for the entire economy.

As a tool, “employing threshold-based forward guidance” the report says, “can significantly improve economic outcomes.” It does however, cage this by saying that if the public is skeptical, or confused about the goals, the credibility and results of the program can be undermined.

The next policy tackled by the report is a program like the Fed’s bond-buying scheme. Currently, the Fed is purchasing $85 billion worth of bond per month. This is referred to as large scale asset purchases in the paper.

In reference to this program, the report finds that there has been much less clarity than what a clear cut threshold program offers. Concluding that, “The mere announcement of promises of future funds rate actions might be insufficient to successfully obtain the benefits today of the planned policy.” It recommends “a visible action, like the expansion of the balance sheet,” because this “may help to convince the public that the Federal Reserve will carry through on its promised degree of policy accommodation.” The paper concludes by saying “central banks should remain flexible over time to ensure that their frameworks are changed appropriately in order to best support the success of their economies.” Flexibility is also key for Wilcox’s paper.

Wilcox is the Director of Research and Statistics at the Fed, and also collaborated with three authors for his IMF paper. It examines aggregate supply in the U.S. and the implications of recent developments on monetary policy. According to Wilcox, et. al. calculations, potential first-quarter 2013 GDP was 6 percent lower than pre-crisis trends. In the fourth-quarter, this is expected to grow to 6.75 percent.

“The largest contribution to the slowdown in potential output growth is from trend labor productivity,” according to the report, “reflecting both a sharp decline in the contribution to labor productivity from capital deepening (capital services per trend employee hour) and smaller increases in trend multifactor productivity since the financial crisis.”

Labor-market driven, supply-side damage plays a crucial role in the findings for the paper. Accordingly, the authors spend a great deal of time with calculations and simulations to provide credibility to their theory, and central bank policy guidelines. The paper makes the case that when an economy suffers serious supply-side damage, policy makers need to become more accommodating in their decisions and actions. Significant supply-side damage, like that witnessed as a result of the Great Recession, “provides an additional rationale for policymakers to take highly accommodative actions in response to sharp contractions in real activity.”

“Optimal” policy, they found, tends to be an aggressive one. However, this should not be blindly pursued, but rather it “ may appropriately be restrained” if the policymakers “fear the attendant risks to financial stability, or are concerned that inflation expectations may become unanchored.”

Joseph LaVorgna, chief U.S. economist for Deutsche Bank Securities Inc., told his clients in a note that the papers could be a way for the Fed to explain why it is keeping interest rates low after it eventually starts tapering. Bloomberg printed portions of the note, as well as one written by Chief economist of Goldman Sachs Group Inc., Jan Hatzius. The Hatzius note stated that, “Our initial assessment is that they considerably increase the probability that the FOMC will reduce its 6.5 percent unemployment threshold for the first hike in the federal funds rate.”

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