So Much Trouble For So Little Yield at the Fed
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Before even getting to the details, it begs the question, why go to all this trouble? So much effort for so little yield, figuratively and literally. For policymakers at the Fed, their job really should be simple, robotic, even. Supply enough money to the economy, then let the economy sort out the details.

But it’s the total lack of details about money which causes what is, in effect, a Rube Goldberg-esque mechanism for interpretation. Rather than go straight to the root, policymakers are forced to come at it backwards with predictable results.

In 1993, Economist John Taylor proposed a “rule” for guiding the Federal Reserve or any central bank similarly blinded. It sounded simple enough: compare the measured inflation rate against the current policy target, taking account of any potential shortfalls or excesses in economic output, resulting in a crude yet effective (so it has been claimed) quantitative means to evaluate non-money monetary policy.

Should inflation be too high or the economy too “hot” (negative output gap), Taylor’s regime (originally a simple formula that has been tweaked several times over the decades) demands the policy interest rate target move up to manage these problems.

Not just diagnostic, at the same time offering the solution.

Former Federal Reserve Chairman Ben Bernanke was and probably is today no fan of John Taylor’s regime. Among the former’s first missives produced at his post-retirement perch over at Brookings, Mr. Bernanke in April 2015 wrote:

“As a policymaker I often referred to various policy rules, including variants of the Taylor rule. However, it seemed to me self-evident that such rules could not incorporate all the relevant considerations for making policy in a complex, dynamic economy.”

Yes, but that’s the point in all this. The economy is too complex to direct from the top, and any effort trying to manage this way will be as it has always been doomed to fail. This is why the entire purpose of any central bank was narrow in scope, once constrained to Walter Bagehot’s ancient dictum.

Focus on the money, let the real economy undertake the real work. Being unable to do the first part leaves these pseudo-central bankers grasping at their own analysis of the details – such as divining inflation rates and output gaps. 

It was really this reality which had so irked Mr. Bernanke, especially when John Taylor used his most updated formula (why did it need so many variations?) to criticize Bernanke’s Fed for the lack of recovery following that “financial” crisis in 2008 (while remaining silent on the, you know, financial crisis itself).

Handling non-money monetary policy in real-time was, the Chairman complained, not an easy nor straightforward task. If it was, if there was really just the money question, then there’d be no need for Taylor at all. Or Bernanke.

“Monetary policy should be systematic, not automatic. The simplicity of the Taylor rule disguises the complexity of the underlying judgments that FOMC members must continually make if they are to make good policy decisions.”

He then closed by writing, “I don’t think we’ll be replacing the FOMC with robots anytime soon.” Blockchain enthusiasts are busy working to prove him wrong, but that’s a topic for a separate yet related discussion.

At issue was whether Bernanke’s policies were effective for recovery to take place. He obviously thought they had been; first offering a litany of excuses for why there was any question (the “scars” left by the crisis, without addressing why they’d been there; “tight fiscal policy from 2010”; etc.) before moving the goalposts:

“Compared to other industrial countries, the US has enjoyed a relatively strong recovery from the Great Recession.”

“We lost the least” isn’t a strong closing argument, but really that’s all he had. It was so pitiful, the only way in which the calculated output gap had been closed was as various econometric models drastically wrote down economic potential for nearly a decade. The more the economy failed to actually recover, the more those models had to presume it couldn’t.

This, after all, is both what the output gap seeks to measure (actual output vs. potential) as well as one huge downfall of the Taylor Rule (one Bernanke deftly exploited in his counterargument).

What is economic potential?

If it was unbroken from the pre-crisis era, what that would have meant – should have meant – in the context of the Taylor Rule was damning. A huge and persistent output gap along with consumer price increases well below the policy target for a sustained period, all of it pointed the finger of blame at the Federal Reserve.

That’s not really the problem, though, merely offering a place to start. What Taylor’s formula then does is assume the cure can be found in the overly simplistic quasi-central bank toolkit. Equally presumed, all one needs to fix the huge output gap and disinflation is a more robust interest rate target.

Naturally, Bernanke objected on the grounds he was limited by the nominal zero lower bound – technically true. And, as he and many mainstream Economists have asserted, the only way around it was via inflation expectations. The goal of QE wasn’t “printing money”, largely because none was, rather it was to fool enough people into thinking this had been done.

And it didn’t work, therefore Taylor. If it had, the output gap would’ve closed, inflation would have behaved, and no one would even be talking about any of these things.

Do you see the real issue here? Inflation, economic potential, output, nowhere is anyone asking about money supply. Even what has been said about it, QE’s bank reserves, isn’t even intended as money at all, merely an influence upon expectations.

They’ve taken something that should be relatively simple and straightforward, turning it into a morass of argument, ambiguity, and utter dependence on self-referential calculation of abstractions. Bring on the Fed robots which could easily replicate the results.

You probably wouldn’t be shocked to learn how officials’ characterization of monetary policies during the Great Collapse of the early thirties sounds exactly the same. In the Federal Reserve Board’s 1932 Annual Report, for example, the text recounts how “during the year [1932] 1,456 banks with deposits of $716,000,000 suspended operations, compared with 2,294 banks having deposits of $1,691,000,000 in 1931,” as if this represented some commendable level of progress.

Quite blatantly, officials tried (repeatedly) to claim how despite so much obvious monetary destruction, monetary policies were, seriously, accommodative the whole time.

“During 1932 the Federal Reserve System continued to pursue the policy of monetary ease which it had followed since the beginning of the depression.”

The difference then to now, and the reason I’m bringing this up, hardly anyone believed such clear and utter bull. People may not have known exactly what went wrong (until Friedman and Schwartz), but they knew what went wrong had to do directly with what the Federal Reserve was supposed to do.

Even the corrupt, unwise politicians in DC could see through this blatant PR, using several banking reform laws to effectively sideline these Fed bureaucrats for a generation (but not before they were allowed to screw up again in 1937, if only to prove once and for all their destructive ineptitude).

Ben Bernanke obviously hadn’t written that passage or any from the 1932 Fed Annual Report, though it sure sounds like he had. How many times have we heard “policy of monetary easing” in the context of modern QEs whether or not there had been any sign of easing anywhere?

They claim easing when none can be found, even by Taylor. And they’ll claim restraint regardless of evidence, too. Performance left up to those doing the performing will always be characterized accordingly, which only raises this key question, why can’t people today see it?

We piece together our answer beginning from the Taylor Rule. Just as the latter intends, evaluating “monetary” policies has been similarly separated from monetary circumstances; focused on downstream economic symptoms instead of the monetary cause. The Fed looks to its list of macroeconomic variables which only begin with the unemployment rate or GDP levels to try to figure out if its programs have been successful.

When they’re not, they’ll tread so many gray areas in between to claim victory even if “compared to other industrial countries…”

The public has been led to do the same, and in doing so has been made to believe the answer is convoluted and ambiguous when it isn’t.

So now when we find ourselves facing what seem to be the opposite circumstances, confusion reigns. Just this week St. Louis Fed President James Bullard invoked John Taylor’s work when claiming the current form of non-money monetary policy still has a ways to go in order to become enough of a “restraint” to get back control over what he and the rest of the FOMC says are legit inflationary pressures.

Is there too much money? No one even asks the question nowadays, or even notices its absence!

Instead, like some ancient mystics examining tree rings and cloud patterns they scour dubious tabulations of economic potential and modeled forward inflation expectations if only to compare these with reformulated “real” rates and whatnot to divine, as Bullard said, “the policy rate is not yet in a zone that may be considered sufficiently restrictive.”

Sure, but what message did you get from the entrails?

Not everyone agrees. In fact, the whole monetary system is increasingly certain this is all wrong. Even Mr. Bullard acknowledged that part, saying, “Thus far, the change in the monetary policy stance appears to have had only limited effects on observed inflation, but market pricing suggests disinflation is expected in 2023.”

It’s actually quite a bit more extreme than Bullard is letting on here. The world’s major money and bond curves (plural) have moved recently to truly exceptional levels. The Treasury yield curve hasn’t been this inverted (2s10s) in four decades, and in other calendar spreads is even more extreme. Eurodollar futures are nearing 200 bps upside down. Germany’s bund curve has experienced one unprecedented inversion after another.

Individually, these already indicate a whole lot more than “disinflation is expected in 2023.” When combined and strung together with so many others (swaps spreads, currency derivatives, collateral), markets are consistently and thoroughly signifying that while policy rates aren’t in policymakers’ desired zone, the monetary system surely must be beyond just threatening another round of undesired results.

The idea behind Taylor’s guideline is essentially the problem, keeping the cart before the horse in arithmetic and public discourse alike. Non-money monetary policies attempt to influence the monetary system, and then we have to wait to see if such psychology can produce the preferred outcomes by digging through incomplete, backward-looking macro aggregates to make rough and thoroughly subjective approximations.

Why not let the monetary system itself tell us what’s going on in it so that we can prepare ahead of time for what the macro aggregates will later on confirm?

Whatever happens, you can absolutely count on one thing: whichever central banker will claim it all a qualified success no matter what. In fact, this is so predictable wouldn’t it be easier and more efficient if we just replaced everyone at the Fed with a computer program designed to do the same thing?

Sorry, Mr. Bernanke, but robots can just as easily be encoded to make then qualify unnecessary complex miscalculations.

Jeff Snider is Chief Strategist for Atlas Financial and co-host of the popular Eurodollar University podcast. 

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