Harry Potter's Monetary Policy Wand?

The Federal Open Market Committee (FOMC) is reassuring us that, so long as we are patient, price stability will return without further pain. But its narrative seems less grounded in historical experience and more like something Harry Potter might have conjured at Hogwarts. By the end of 2024, the Committee expects trend inflation (measured by the price index of personal consumption expenditures excluding food and energy) to drop by more than 3 percentage points while economic growth remains above (and the unemployment rate below) its sustainable level. And, all this magic materializes with the real (inflation-adjusted) policy rate barely turning positive.

The principal means by which the Fed affects the inflation outlook is by influencing financial conditions. Yet, having telegraphed its policy shift for months, the FOMC’s most recent actions on March 16—initiating a series of rate hikes and suggesting that balance sheet tapering could begin soon—barely affected the ease with which firms and households obtain financing. And, while financial conditions are indeed a bit tighter than six months ago—when about one-half of FOMC participants anticipated no interest rate hikes in 2022—these conditions remain quite accommodative (see here).

Is the FOMC’s current policy path consistent with its longer-term price stability goals? In this post, we address this question by exploring policymakers’ newly published projections. Our conclusion is that bringing the inflation trend back to 2% will require a tightening of financial conditions significantly beyond what the Fed currently envisions….

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Russian Sanctions: Questions and Answers

This post is authored jointly with our friend and colleague, Professor Richard Berner, Co-Director of the NYU Stern Volatility and Risk Institute.

Russia’s invasion of Ukraine is altering global security and economic relationships. In this post, we focus on the financial and trade sanctions imposed on Russia. These sanctions are the most powerful and costly punishments imposed on a major economy at least since the Cold War. Their speed, breadth and coordinated global support appear unprecedented.

Not surprisingly, the impact is immediately visible. The damage to the Russian economy and financial system includes, but is not limited to, a plunge of the ruble (by about 40 percent versus the dollar over the past month amid heightened volatility); runs on domestic banks; a sharp hike in the central bank’s policy rate; imposition of capital controls; shutdown of the Russian stock market; collapse in the value of Russian companies traded on foreign stock exchanges; removal of Russian equities from global indexes; and the collapse of Russia’s sovereign credit rating to junk status.

The purpose of this post is to pose and provisionally answer a series of questions raised by this new sanctions regime.…

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Comments on Fed CBDC Paper

Last month, the Federal Reserve issued a long-awaited discussion paper on the possibility of introducing a central bank digital currency (CBDC) for retail use. The Fed paper calls for comments on the benefits and risk of introducing a U.S. CBDC, as well as on its optimal design. In this post, we respond to each of the 22 questions posed in the discussion paper. For the most part, these responses are based on our previous analyses of CBDC (here and here).

At the outset, we highlight our doubt that the benefits of a U.S. CBDC will exceed the risks. In our view, other, less risky, means are available to achieve all the key benefits that CBDC advocates anticipate. Moreover, we are not aware of sustainable design features that would reduce the risks of financial instability that many analysts agree will accompany the introduction of a digital U.S. dollar.

However, this overall judgment regarding a CBDC’s benefits and risks is sensitive to two considerations that appear in the Fed’s analysis either explicitly or implicitly. First, CBDC may be a less risky alternative to stablecoins, should regulation of the latter prove politically infeasible (see our earlier post). Second, if other highly trustworthy financial jurisdictions (with convertible currencies, credible property rights protections, and free cross-border flow of capital) offer their own CBDC, the case for a U.S. CBDC—as a device to sustain widespread use of the dollar—would become stronger.

Against this background, we applaud the Fed’s conservative approach. Most important, the U.S. authorities are not rushing to act. Instead, they are thinking carefully about the design elements, are actively engaged in public outreach, and have committed not to proceed without first securing broad public support….

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Fed Monetary Policy in Crisis

The Federal Open Market Committee (FOMC) is facing a crisis of its own making. The crisis has four elements. Policymakers failed to forecast the rise in inflation. They failed to appreciate how persistent inflation can be. They are failing to articulate a credible low inflation policy. And, so far, there is little sign that monetary policymakers recognize the need to react decisively.

Our fear is that matters have now progressed to the stage where the Fed’s credibility for delivering price stability is at serious risk. And, as experience teaches us, the less credible the central bank, the more painful it is to lower inflation to target.

In this post, we discuss the policy crisis and suggest how to respond. In our view, the FOMC needs a plan to raise rates quickly and substantially. For the FOMC to ensure inflation returns to its target of 2%, policymakers likely will need to bring the short-term real interest rate into significantly positive territory. Put slightly differently, we suspect that the policy rate needs to rise to at least one percent above expected inflation.

Won’t a sharp policy tightening trigger a huge recession? In our view, credibility is the key to how much pain disinflation will cause. Applying the painful lesson of the 1970s and early 1980s leads us to conclude that the FOMC now needs to show clear resolve. Inflation rose very quickly over the past year, so it may still be possible to bring it down sharply without a recession. The more decisively policymakers act, the lower the long-run costs are likely to be. Failure to restore price stability in a timely way would almost surely render this expansion disturbingly short compared to recent norms.

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SEC Money Market Fund Reform Proposals Fall Far Short, Again

As the principal regulator of U.S. money market mutual funds (MMMFs), the SEC has a duty to end the market distortions and moral hazard that repeated public rescues create. There have been two MMMF bailouts, so far. The first came at the height of the Great Financial Crisis of 2008, while the second followed in the March 2020 COVID crisis. While the Treasury provided guarantees only once, the Federal Reserve offered emergency liquidity assistance both times.

These repeated government interventions encourage MMMF managers to behave in ways that make future liquidity crises more likely. Moreover, there is no credible way for the Fed to promise not to intervene should a systemic disruption again loom in short-term funding markets. The only realistic means to end the subsidies created by the implicit promise of future bailouts is to force MMMFs to be far more resilient than they are today.

Against this background, the SEC’s December 2021 MMMF reform proposals are seriously disappointing. In this post, we start with basic facts about the scale and mix of MMMFs today. We then describe the SEC’s proposals, before focusing on their key shortcomings. We hope that the public comments that the SEC receives will motivate it, at the very least, to conduct a serious quantitative assessment of introducing capital requirements for the most vulnerable MMMFs, to re-assess the scale of additional liquid assets needed for MMMF resilience in the absence of a Fed backstop, and to propose ways to enhance the effectiveness and utility of MMMF stress tests….

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Same Function, Same Risks, Same Regulation

Technological progress always brings new challenges for financial regulators. While some innovations today seem revolutionary, in many cases they are not. What is new is the pace and breadth of innovation associated with fintech. Taking advantage of recent advances in information technology and communication, entrepreneurs and incumbent financial firms are creating a wide array of new intermediaries.

At a conceptual level, regulators’ approach to the risks created by these new entrants would seem to be straightforward: any provider of the same financial service, creating the same risks, should face the same regulation. Encourage innovation, but guard against any harm that it poses to the financial system.

How might we do this? Again, the answer is clear: focus on the financial activities, functions and services themselves (even though rule enforcement will almost surely proceed through the firms, entities or institutions that provide the services). Such activity-focused regulation requires an enormous shift of our approach. With our regulatory objectives in mind, we need to enumerate the financial activities and then create a framework that matches these two lists. In this post, we outline how regulators can begin to approach this task….

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From Inflation Targeting to Employment Targeting?

Last year, the Federal Open Market Committee (FOMC) modified its monetary policy framework to focus on average inflation targeting. They stated that “appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time” after “periods when inflation has been running persistently below 2%.” At the same time, the Committee scaled back efforts to preempt inflation, introducing an asymmetric “shortfall” strategy which responds to employment only when it falls below its estimated maximum. FOMC participants view these strategic changes as means to secure their legally mandated dual objectives of price stability and maximum employment (see our earlier posts here and here).

Prior to this week’s FOMC meeting, the Committee’s forward guidance explicitly balanced these two goals. However, in what we view as a remarkable shift, changes in the December 15 statement are difficult to square with any type of inflation targeting strategy. Despite the recent surge of inflation, the Committee’s new forward guidance removes any mention of price stability as a condition for keeping policy rates near zero. Instead, it focuses exclusively on reaching maximum employment.

In this post, we provide two reasons why such an unbalanced approach is concerning. First, a monetary policy strategy that ranks maximum employment well above price stability is unlikely to secure price stability over the long run. Second, FOMC participants’ projections for 2022-24 are a combination of strong economic growth, further labor market tightening and a policy rate well below long-run norms. This mix seems inconsistent with the large decline in trend inflation that participants anticipate. While policymakers certainly can and do revise their projections, persistent underestimates of inflation fuel the perception that price stability is a secondary, rather than equal, goal of policy….

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Stablecoin: The Regulation Debate

Last month, the President’s Working Group on Financial Markets (PWG) called for the introduction of a regulatory framework for “payment stablecoins”—private crypto-assets that (unlike the highly volatile Bitcoin) are pegged 1:1 to a national currency and “have the potential to be used as a widespread means of payment.” Most notably, to limit the risk of runs, the Report calls for legislation restricting stablecoin issuance to insured depositories.

In this post, we first document the rapid growth of stablecoin usage. We then highlight the features which make stablecoins subject to run risk that, in the absence of appropriate governmental controls, could destabilize the financial system. Next, we consider the three regulatory approaches that Gorton and Zhang (GZ) propose for making stablecoins resilient: the first, and the one favored by the PWG, is to limit stablecoin issuance to insured depositories; the second is to require 1:1 backing of stablecoins with sovereign securities (in the case of the United States and the U.S. dollar, these would be U.S. Treasury issues); and the third is to require 1:1 backing with central bank reserves. We conclude with a brief discussion of whether central bank digital currencies are an appropriate means to displace stablecoins.

To foreshadow our conclusions, we view the PWG proposal as the preferred alternative. However, absent near-term prospects for legislative action, we hope that the Financial Stability Oversight Council (FSOC) will consider—as GZ suggest—using its powers under the Dodd-Frank Act to designate the issuance of payments stablecoins as an activity that is “likely to become” systemically important. FSOC designation would authorize the Federal Reserve to promote uniform standards without waiting years for legislation that authorizes a new regulatory framework.

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Inflation Policy

“Headline” inflation is making painful headlines again. In October, consumer prices rose by 6.2 percent from a year ago—the most rapid gain in at least three decades. Measures of trend inflation also are showing unsettling increases, with the trimmed mean CPI up by 4%. And there are reasons to believe that inflation will stay well above policymakers’ 2% target for an extended period.

In this post, we briefly summarize how we got here and argue that the Federal Reserve needs to change course now. In our view, current monetary policy is far too accommodative. Moreover, the sooner the Fed acts, the more likely it is that policymakers will be able to restore price stability without undermining the post-COVID expansion.

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U.S. Gets a Start on Climate-related Financial Risk

Co-authored with Richard Berner, NYU Stern Clinical Professor of Finance and Co-Director, Volatility and Risk Institute.

Many sources of risk threaten the U.S. financial system. Pandemic risk and cyber risk are at or near the top of our list of nightmares. Yet, with the UN Climate Change conference (COP26) under way in Glasgow, attention is shifting to efforts aimed at limiting the economic and financial damage from climate change, including a timely new “Report on Climate-related Financial Risk” from the U.S. Financial Stability Oversight Council (FSOC).

As the Report makes clear, U.S. policymakers need a far better understanding of climate-related financial risk. Indeed, when President Biden issued an executive order in May instructing financial regulators to conduct a thorough risk assessment, the United States already was behind other advanced economies. As an initial response to the President’s directive, the Report catalogs the range of climate risk threats, describes actions individual U.S. regulators have begun taking to address them, and lists many things that still need to be done. By setting priorities, the FSOC is now putting climate change “squarely at the forefront of the agenda of its member agencies.”

In this post, we highlight three themes in the Report: (1) the ongoing rise of physical climate risk; (2) the conceptual challenges associated with measurement, as well as the data gaps; and (3) the benefits of scenario analysis as a tool for assessing the financial stability risks arising from climate change. The key lesson that we draw from scenario analysis is that a financial system resilient to a range of other shocks is more likely to be resilient against climate risk. Put differently, a less-resilient financial system is vulnerable to all types of shocks, including those arising from climate change.

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Stagflation: A Primer

The term stagflation came into common use in the mid-1970s, when many advanced economies experienced higher inflation and slower growth than they had in the 1960s. At the time, the joint behavior of inflation and economic growth confused many economists. Throughout the 1950s and 1960s, growth and inflation generally moved in the same direction. Most important, inflation tended to fall during recessions and to rise in booms. Stagflation meant that these two key summary measures of macroeconomic performance moved in opposite directions. What caused this dramatic, painful, and persistent shift?

To understand the sources of stagflation in the 1970s—and how we subsequently avoided a repeat of that episode (at least so far)—we start with the simple premise that there are two types of disturbances hitting the economy: demand and supply. The first, changes in demand, moves inflation and growth in the same direction. The broad array of things that shift demand include fluctuations in consumer or business confidence, shifts in government tax and expenditure policy, and variation in the appeal of imports to domestic residents or of exports to foreigners. When any of these goes up or down, inflation and output rise and fall together.

Supply disturbances—which alter the cost of production—are fundamentally different. These stagflationary shocks move growth and inflation in opposite directions. For example, an adverse supply shock that raises the cost of production at least temporarily drives inflation up and growth down.

Importantly, these cost shocks cannot be the whole story behind a decade-long surge of inflation. Whether the consequences of a cost shock are one-off adjustments in the price level or an increase of the trend of inflation depends on the monetary policy response. Put differently, monetary policy determines whether we experience stagflation over any longer interval….

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The Urgent Agenda for Financial Reform

Thanks to unprecedented interventions by central banks and fiscal authorities, the pandemic-induced financial strains of March-April 2020 are now well behind us. Unfortunately, as a consequence of the official actions necessary to stabilize the financial system, market participants now count on government backstops to insure them against the fallout from future disturbances.

Naturally, central banks should be prepared to combat extreme shocks that threaten financial stability. However, to limit excessive reliance on central banks, we need to ensure that financial institutions can continue to operate smoothly on their own even in bad times. This means redesigning parts of the financial architecture. While market participants have a major role to play, it is authorities who need to address externalities—spillover effects—and to improve incentives for the private sector to maintain the liquidity of markets and access to short-term funding in times of moderate stress.

With the pandemic-induced disruptions still fresh in memory, this is the perfect time to identify deficiencies and implement reforms aimed at improving the resilience of the financial system. Fortunately, the June 2021 Report of the Hutchins Center-Chicago Booth Task Force on Financial Stability (H-B) addresses all the key challenges, laying out a broad agenda for U.S. financial reform. In addition, we have the July 2021 G-30 Report that provides detailed proposals for reforming the U.S. Treasury market.

In this post, we discuss these reform proposals, highlighting areas where we strongly agree and believe that implementation is urgent. In particular, we emphasize the benefits that would come from changes in the Treasury market (cash and repo), in the central counterparties (CCPs) that have become the most critical links in the global financial system, and in open-end mutual funds holding illiquid assets. We also highlight the governance proposals in the H-B Report. In our view, full implementation of the agendas set out in the these reports would make the U.S. financial system far safer than it is today….

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Central Banks and Climate Policy

Avoiding a climate catastrophe requires an urgent global effort on the part of households, firms and governments to reduce our reliance on fossil fuels. Like many economists, we support a carbon tax. We also favor generous fiscal support for R&D to substitute for fossil fuels and remove carbon from the atmosphere.

What role should central banks play in this global effort? That is the prime focus of this post. We argue that central banks must preserve the independence needed for effective monetary policy. That implies only a modest role in addressing climate change.

Central banks are involved in both financial regulation and monetary policy. In each case, there are some things that central bankers can and should do to help counter the threat posed by climate change. As financial regulators, they should implement an improved disclosure regime and develop tools to ensure the financial system is resilient to climate risks.

In conducting monetary policy, central bankers should follow a simple, powerful principle: do not influence relative prices. To be sure, it is and should be standard practice to use interest rates to influence relative prices between consumption today and tomorrow. However, central banks ought not influence relative prices among contemporaneous activities. We will see that achieving this form of relative price neutrality may require central bankers to shift the composition of their assets and to alter the treatment of collateral in their lending operations….

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The ECB's New Strategy: Codifying Existing Practice . . . plus

When the ECB began operation in 1999, many observers focused on its differences from the Federal Reserve. Yet, since the start, the ECB was much like the Fed. And, over the past two decades, the ECB and the Fed have learned a great deal from each other, furthering convergence.

Against this background, it is unsurprising that the broad monetary policy strategies in the United States and the euro area converged as well. On July 8, the ECB published the culmination of the strategy review that began in early 2020, the first since 2003. The implementation of the new strategy comes nearly one year after the Fed revised its longer-run goals in August 2020 (see our earlier posts here and here).

If past is prologue, observers will exaggerate the differences. Perhaps most obvious, unlike the Fed, the ECB’s strategic update did not introduce an averaging framework in which they would “make up” for past errors. Nevertheless, we suspect that it will be difficult to distinguish most Fed and ECB policy actions based on the modest differences in their strategic frameworks. For the most part, both revised strategies codify existing practice, as they permit extensive discretion in how they employ their growing set of policy tools.

In this post, we summarize the motivations for the ECB’s new strategy and describe three notable changes: target 2% inflation, symmetrically and unambiguously; integrate climate change into the framework; and outline a plan to introduce owner-occupied housing into the price index they target (the euro area harmonised index of consumer prices). While the new strategy can help the ECB achieve its price stability mandate, in our view the overall impact of the revisions is likely to be modest….

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The QE Ratchet

When it comes to quantitative easing (QE), where you stand definitely depends on where you sit. That is among the conclusions of the important new report of the Economic Affairs Committee of the UK House of Lords.

The report provides an excellent survey of how it is that central banks now use their balance sheets. Its key conclusions are the following. First, central bankers should clearly communicate the rationale for their balance sheet actions, stating what they are doing and why. Second, policymakers should provide more detail on their estimates (and uncertainties) of the effectiveness of their various actions, especially QE. Third, they should be aware that the relationship between central bank balance sheet policy and government debt management policy poses a risk to independence. Finally, and most importantly, central bankers need an exit plan for how they will return to a long-run sustainable level for their balance sheet.

We discussed several of these points in prior posts. On communication, we argued that central bankers should be clear about their reaction function for both interest rate and balance sheet policies (see here). On the justification for policymakers’ actions, we emphasized the need for clear, simple explanations tied to policymakers’ objectives, distinguishing carefully between the intended purposes (such as monetary policy, lender/market maker of last resort, or emergency government finance; see here). And, on the relationship between QE and fiscal finance, we noted how the ballooning of the U.S. Treasury’s balance at the Fed in the early stages of the pandemic looked like monetary finance, putting independence at risk (see here).

In this post, we turn to the challenge that Lord King highlights in the opening quote: the need to ensure that central banks do not see bond purchases as a cure-all for every ill that befalls the economy and the financial system, causing their balance sheets repeatedly to ratchet upward….

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Talking about Tapering

In May, we argued that the FOMC needed to communicate its contingency plans for what they would do should the recent inflation pickup prove more stubborn than its members expect. Such transparency makes it more likely that financial markets will respond to incoming data rather than to policymakers’ actions. By clearly laying out their reaction function, central bankers can avoid disruptions like market taper tantrums.

In June, the FOMC began to remove the self-imposed communication shackles designed to encourage “lower for longer” interest rate expectations and address inflation risks more openly. Indeed, as the above citation from Chairman Powell indicates, at their June meeting, policymakers began to lay the groundwork for scaling back their large-scale asset purchases (LSAPs).

In this post, we start by highlighting how recent Fed communication (which reveals appropriate humility about inflation projections) has helped avoid a market tantrum so far. Along the way, we discuss the various means that FOMC participants have used to express their changing views about the timing of interest rate increases (“liftoff”), even as they make clear that tapering their asset purchases will come first….

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Central Bank Digital Currency: The Battle for the Soul of the Financial System

While the conflict is largely quiet and out of public view, we are in the midst of an epic battle for the soul of the financial system. Central banks are thinking about whether they should substitute publicly issued digital currency for the bank-issued digital money that people use every day. How this plays out can profoundly reshape the financial system and make it less stable.

The forces driving government decisions are unusual because there is a widespread fear of losing an emerging arms race. No one wants to face plunging demand for their currency or surging outflows from their financial institutions should another central bank introduce an attractive new means of exchange. But that pressure to prepare for the financial version of military mobilization can lead to a very unstable global system that thwarts monetary control.

Central bank digital currency (CBDC) can take many forms. While some may be benign, the most radical version—one that is universally available, elastically supplied, and interest bearing—has the potential to trigger destabilizing financial shifts, weaken the supply of credit, and undermine privacy….

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Understanding How Central Banks Use Their Balance Sheets: A Critical Categorization

This comment is jointly authored by Stephen G. Cecchetti and Sir Paul M.W. Tucker.

Central banks have been reinvented over the past decade, first in response to the financial crisis, and then as a consequence of Covid-19. While trying to maintain monetary stability and promote economic recovery, their balance sheets have ballooned. In 2007, the central banks in the United States, euro area, United Kingdom, and Japan had total assets from 6% to 20% of nominal GDP. By the end of 2020, the Fed’s balance sheet was 34% of GDP, the ECB’s 59%, the Bank of England’s 40%, and the Bank of Japan’s 127%.

Before it is possible to consider how well this worked, it is necessary to be clear about what policymakers’ various operations were trying to achieve. Headline declarations of aiming at “price stability” or “financial stability” are unsatisfactory as they jump to end goals without attending to the motivations for specific operations and facilities. The case of the Fed is illustrative. Among other things, they bought U.S. Treasury bonds, offered to purchase commercial paper, corporate and municipal bonds, and set up facilities to lend directly to real-economy businesses as well as to securities dealers. These cannot be assessed solely on whether, alone or together, each materially improved the outlook for economic activity and inflation.

Without a sense of the intended purpose of each central bank action, it is difficult for political overseers or interested members of the public to hold central banks accountable. Precisely because central banks are independent (rightly in our view), that accountability takes the form of public scrutiny and debate. But we argue that it is also hard for central bankers themselves to do their jobs unless they distinguish carefully—in internal deliberations, and external communication—the rationale for different interventions….

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Climate Finance

Climate change is the topic of the day. The World Meteorological Organization tells us that the 2011-20 decade was the warmest on record. Earlier this year, the U.S. government re-joined the Paris Accord, and is proposing a range of new programs to mitigate the long-run impact of climate change. Now that a warming planet has made the Arctic increasingly navigable, national security specialists are concerned about geopolitical risks there. Thousands of economists have endorsed a carbon tax. Even central banks have joined together to form the Network for the Greening of the Financial System—a forum to discuss how to take account of climate change in assessing financial stability.

Against that background, last month, NYU Stern’s Volatility and Risk Institute (VRI) held a conference on finance and climate change. Speakers addressed issues ranging from the modeling and measurement of climate risk in finance to assessing its impact on the resilience of the financial system. In this post, we primarily focus on one of the central challenges facing policymakers and practitioners: what is the appropriate discount rate for evaluating the relative costs and benefits of investments in climate change mitigation that will not pay off for decades? We also comment briefly on several other issues in the rapidly growing field of climate finance research.

Past responses to the discount-rate question vary widely. Some observers call for a discount rate matching the high expected return on long-lived, risky assets—a number as high as 7%. This would imply a very low present value of benefits from investments to mitigate climate change, consistent with only modest current expenditures. Others postulate that climate change could lead to the extinction of humanity. For plausible discount rates, the specter of a nearly infinite loss means that virtually any level of mitigation investment is warranted (see, for example, Holt).

Recent climate finance research that we summarize here comes to the conclusion that over any reasonable horizon, the appropriate discount rate for computing the net present value of investments in climate change mitigation should be relatively low….

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Inflation: Don't Worry, Be Prepared

Everyone seems to be worried about inflation (see here and here). People also are concerned that the rising media salience of inflation could raise inflation expectations, leading to a sustained rise in inflation itself.

April price readings certainly boosted these worries: the conventional measure of core inflation—the CPI excluding food and energy—rose by nearly 3% from a year ago, the biggest gain since 1995. Fed Vice Chair Richard Clarida summed up the nearly universal reaction when he said: “I was surprised. This number was well above what I and outside forecasters expected.”

The experience of the high-inflation 1970s makes people prone to worrying about such things. Our reaction is different. After all, worry alone is not going to prevent a sustained pickup of inflation. Only credible anti-inflationary monetary policy can do that. To ensure that inflation expectations remain low, it is up to the central bank to make sure everyone understands how policy will respond if the latest elevated inflation readings prove to be more than temporary. As we have written before, the key is effective communications, not premature action….

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