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Paul A. McCulley
By Richard Clarida
Speech Delivered to the Boston Federal Reserve Bank Conference, October 15, 2010
Paul McCulley October 15, 2010
The way one answers these questions depends importantly on the conclusions one has drawn about the conduct of monetary policy in the last decade and the role of monetary policy, if any, in contributing to the crisis. The subtitle of this talk is not ‘I Told You So’ and for a good reason. I didn’t, and it wasn’t because I was shy. Rather, I, like the vast majority of economists and policymakers, suffered – in retrospect – from Warren Buffett’s ‘lifeguard at the beach’ problem: “you don’t know who is swimming naked until the tide goes out.” But that is getting ahead of the story. Let’s begin with the pre crisis consensus.
The Pre Crisis Consensus
An insightful recent paper by Charles Bean and colleagues at the Bank of England (2010) nicely summarizes what has been dubbed the Jackson Hole consensus on monetary policy that prevailed in the central banking community (and it is a community) in the years before the crisis. This consensus consisted of seven pillars.
Of course, while there was a pre-crisis consensus on inflation targeting monetary policy and the role that asset prices and volumes should play in guiding that policy, it was not unanimously shared. Researchers at the BIS and several prominent academics, including Benjamin Friedman (2006) had for some years leading up to the crisis offered critiques of the inflation targeting consensus and since the crisis, have called for major changes in that consensus.
The focus on price stability, combined with the fact that many central banks had limited or no supervisory role meant, according to this view, that they ignored or failed to incorporate into their rate setting decisions the very real, systemic threats arising from credit and asset price bubbles that had been building during the Great Moderation. By confining monetary policy to only setting a path for short term interest rates, many countries were unable to prevent both booms and busts in real economic activity and inflation resulting from excesses in financial markets.
A Great Moderation Yes, but Also a Great Leveraging Funded Through a Shadow Banking System
Although the Great Moderation got most of the attention at the time, it is startling to note in the U.S. the chasm that emerged during the Great Moderation between credit extended to the household and non-financial business sectors – much of it through the Shadow Banking System – compared to nominal GDP. This was the Great Leveraging that accompanied the Great Moderation (Chart 1).
For example, in 1984, $3.5 trillion of nominal GDP supported $3.5 trillion of private credit outstanding. By 2007, $14 trillion of nominal GDP supported – until it didn’t – $25 trillion of private, non financial credit outstanding. Of course, debt levels are supported not only by income – as measured by nominal GDP – but also by asset valuations themselves. Indeed, throughout the great credit boom, household net worth rose to record levels, hitting $64 trillion dollars in 2007 (up from a mere $12 trillion back in 1984). With household asset values rising faster than debt – and nominal GDP, debt appeared to be sustainable and, as a result, too few questions were asked for too long by too many (and I certainly don’t exempt myself) about the implications of this surge in non financial leverage which, at least in retrospect, was itself the source for much of this asset price appreciation. It was just presumed that with inflation tame and GDP growing reliably along its Great Moderation path, the widening chasm between private credit and nominal GDP could be ignored, much as the roughly coincident breakdown in the velocity of the monetary aggregates was at the same time ignored.
Financial history suggests “never again” eventually becomes “this time it is different” and as Rogoff and Reinhart (2009) remind us, throughout history “this time it is different” eventually sets the stage for the next financial crisis. This is especially true when, as emphasized by Minsky (1982), the “this time it is different” wisdom supports and encourages greater and greater use of leverage which in turn supports asset prices which in turn support more leverage.
In the case of the current crisis, it was supposed to be different because securitization and the expertise of the ratings agencies in assessing default risk correlations across various tranches of structured products was in theory supposed to make the financial system more stable and reduce systemic risk. And for those investors – including as it turned out systemically important bank holding companies – who were nervous about the credit quality of the structured products they purchased, well they could just buy credit default protection – from AIG among others! – who it was just assumed, had the internal risk controls necessary to limit exposure to a level that would not bring down the firm, let alone the global financial system. It was supposed to be the brave new world of originate and distribute financial intermediation and for twenty years it was – until in July 2007 when it was no longer.
Given what we know now, it is hard to escape the conclusion that the supervision and regulation of U.S. investment and commercial banks during the Great Moderation was based on an assumption about how the financial system was supposed to work, not upon sufficient knowledge about how the financial system actually worked. For those who doubt this conclusion, I refer you to an exhaustive, authoritative study recently published by the New York Fed, Staff Report Number 458 “Shadow Banking” (Pozsar et. al).
The report argues persuasively that the rapid growth of the Shadow Banking System changed the “nature of financial intermediation in the United States profoundly… by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the Shadow Banking System thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.”
With the benefit of hindsight (excepting rare examples such as Rajan (2005) and McCulley (2007), two of very few to foresee the essential contours of the growing systemic instability being created by the Shadow Banking System) and authoritative, post-mortem research such as that in the Pozsar et. al., it seems clear – at least to this author – that the financial crisis and the credit and securitization bubble that preceded it resulted not only from spectacular failures in securities markets – to allocate capital and price default risk – but serious failures as well by policymakers to adequately understand, regulate, and supervise these markets.
Policymakers, academics, and market participants simply didn’t know what they didn’t know. They assumed that either it couldn’t happen (after all, AAA securities never default), or if it did, it would be systemically unimportant. Until the tide went out. But by then it was too late.
Interpreting Fed Policy 2000-2008
Although monetary policy even in normal times is the result of a complex process that must take into account numerous economic and financial factors, Fed policy 2000–2008 is straightforward to interpret using a version of a Taylor rule. A Taylor rule, first popularized by John Taylor (1993), is an equation for setting the federal funds rate that takes the form:
The r is the federal funds rate, rr is an estimate of the ‘neutral’ real interest rate, π* is the inflation target, E π is expected inflation, and ỹ is the output gap. In Taylor’s original formulation, rr is constant and equal to 2 as is π*, π is realized inflation over the previous four quarters, and the output gap is the difference between real GDP and de-trended real GDP. In Taylor’s original rule a = 1.5 and b = 0.5.
In my own work, I have found that a forward looking version of the Taylor rule (FLTR) does a good job of describing actual Fed policy during the last decade. I use data from the inflation linked bond market to estimate expected future inflation as well as the expected neutral real interest rate (this data is available contemporaneously at the time of each Fed decision). Also, given the Fed’s explicit dual mandate, I use an unemployment based measure of the output gap instead of detrended GDP. Finally, I find that actual Fed policy appears to place a greater weight on the output (unemployment) gap than can be explained by Taylor’s original rule so I make b = 1 (instead of 0.5) while a = 1.5 as in the original rule.
As can be seen from Chart 2, the real time forward-looking Taylor rule (FLTR) does a good job of describing the funds rate path of the Greenspan/Bernanke Fed between 2000 and 2008. During the first year or so of the crisis, the Fed eased right on its FLTR path as unemployment rose, expected inflation fell, and the neutral real interest rate declined. Between 2000 and 2007, the FLTR tracks Fed policy quite closely with the exception of the period between June 2003 and November 2005.
John Taylor (2007, 2008) has recently been critical of Fed policy during this period, and argues that this policy mistake by the Fed – keeping the funds rate at 1% for a “considerable” period and then, beginning in June 2004, hiking at a pre-announced ”measured pace,” was a significant contributing factor to the housing bubble. The counter factual path for the federal funds rate during this period suggested by Taylor in 2007 is shown on the chart. No doubt, the low short term interest rates that prevailed in 2003-2005 contributed to some extent to the housing bubble.
But in light of the explosive growth in the Shadow Banking System and the global saving glut that held down long term bond yields, I doubt whether or not any plausible alternative path for the Federal Funds rate in 2003-2005, including that implied by John Taylor’s original rule, would have prevented the credit bubble which extended to all corners of the securitization markets and the Shadow Banking System: credit cards, auto loans, students loans, home equity loans and leveraged loans.
September 2008 to the Present: The Zero Bound and Quantitative Easing
Amidst the financial turmoil that was the autumn of 2008, the Fed cut the funds rate aggressively to 25 basis points by the December 15, 2008 meeting. Figure 3 shows the yawning gap that opened between the actual federal funds rate and the rate suggested by a Taylor rule if the zero lower bound (ZLB) were not binding. A central bank, once it hits the ZLB, has three complementary strategies available to lower bond yields further and to boost asset prices.
First, the central bank can offer forward guidance promising to keep future policy rates low for an extended period (and lower than they would be if the central bank were solely targeting inflation). Second, the central bank can pursue quantitative easing by printing money to buy longer dated government bonds. Third, the central bank can pursue credit easing by printing money to buy select private sector debt obligations such as residential mortgages (the Fed), corporate bonds (the Bank of England), or covered bonds (the ECB). Both QE and CE can be characterized as large scale asset purchase (LSAP) programs.
Although under certain conditions forward guidance alone can be sufficient to prevent an economy from falling into deflation and a liquidity trap, these conditions are unlikely to prevail in practice. Simply put, forward guidance is not time consistent: once the economy is lucky enough to emerge from disinflation and recession, the central bank will have every incentive to renege on its prior promises (perhaps by a predecessor) and instead, to prevent inflation from rising above target as it (or its predecessor) previously promised. The advocates of forward guidance acknowledge this problem, but their theoretical models just assume it away. Although forward guidance is sometimes called a “just do it” strategy, the problem is that, absent a commitment technology, the public and the markets know it won’t get done!
The Fed, thankfully, knows this and in the fall of 2008, having exhausted its options under Plan A after hitting the zero lower bound, put in place Plan B (balance sheet), announcing in November 2008 an explicit, massive LSAP campaign to purchase mortgage-backed securities (MBS) of “up to” $600 billion. In March 2009, the FOMC decided to substantially expand its purchases of agency-related securities and, as well, to purchase longer-dated Treasury securities, with total asset purchases of up to $1.75 trillion.
Gagnon et. al. (2010) provide an excellent overview of the LSAP program and find that by reducing the net supply of assets with long duration, LSAP programs have been successful in reducing the term premium somewhere between 30 and 100 basis points. To me, these results make sense and appear, if anything, to understate the impact these programs had on MBS yields. The program was seen by many market participants as implicitly targeting a ceiling on mortgage rates, specifically the par coupon that applies to recently issued mortgages. Those who had that expectation were not disappointed.
Lots of Questions, Not Enough Answers: or, what we know and don’t know about monetary policy in the low inflation environment in which we find ourselves in October 2010.
How Well Anchored Are Inflation Expectations?
Forward (if not near-term) inflation expectations appear to have declined little since the onset of the crisis in 2007. It is tempting to conclude that such evidence confirms that two decades of successful monetary policy have anchored inflation expectations and that these well-anchored expectations serve as a bulwark against the U.S. falling into a Japanese-style deflation.
But do we know that inflation expectations are well anchored? No. All we know is that measures of inflation expectations are adjusting sluggishly to a serious recession and a material decline in core inflation. There are two competing explanations: backward/nervous and forward/optimistic. According to the optimistic view, expectations of inflation are largely if not entirely forward looking. Thus the fact that expected inflation has adjusted only modestly lower during this cycle is the result of the Fed’s credibility in being able to promise that inflation in future years will return to 2% or above.
By contrast, according to the nervous view, expectations of inflation appear to have a significant inertial component. Thus, the fact that expected inflation has thus far adjusted only modestly lower during this cycle may be the result not of Fed credibility to generate inflation in the future but rather instead may be the result of the fact that the Fed in the past has delivered 2% inflation. Under this view, if inflation were to fall much below current levels, and certainly were it to turn and stay negative for some time, expectations of disinflation or even deflation could become entrenched as they did in Japan and be very difficult, given inflation inertia, to reverse.
In my judgment, this is no time for the Fed to “assume a can opener,” that is to assume that it has the ability to make a time inconsistent promise generate sufficient future inflation so as to anchor current inflation expectations in the face of a large, and potentially, widening output gap. Because I judge the Fed to be sufficiently nervous about the cost of this low probability outcome, I am cautiously optimistic the U.S. will avoid it. But it is a closer call than I would have imagined several years ago.
What is the Appropriate Role for Asset Quantities and Prices in Informing Monetary Policy?
Although the attention for much of the pre-crisis discussion was on the appropriate role that information about asset prices should play in informing monetary policy, it is really leverage and the adequacy of capital at banks as well as Shadow Banks that central banks should and likely will be focusing on going forward. Leverage ratios and loss-absorbing capital are key variables in the monetary transmission mechanism that need to be modeled to assess the impact of different policy paths on the economy as well as the scope and scale of fluctuations in inflation and the output gap from shocks to the financial sector, including shocks to credit spreads.
Mechanically appending credit supply variables to a Taylor rule is not, however, likely to produce a robustly better policy in the face of a wide range of shocks. It seems clear that there is no substitute for understanding the source and persistence of shocks hitting the economy as well as the way the financial institutions – including the Shadow Banks that survive – intermediate credit, allocate risk and accumulate explicit or implicit put options against systemically important institutions and/or the Fed or Treasury. The problem with the pre-crisis consensus for the conduct of inflation targeting monetary policy was fundamentally the failure to understand the systemic implications of the financial frictions presented by the Shadow Banking System.
Do We Have Sufficient Confidence in Our Alternative Monetary Policy Tools to Stabilize the Economy at the Zero Lower Bound?
According to monetary theory, central banks have at least two powerful – and complementary – tools to reflate a depressed economy: printing money and supporting the nominal price of public and private debt. As Bernanke (2002) himself argues, a determined central bank can deploy both tools for as long as it wants regardless of 1) how credible its commitment is and 2) how expectations are formed or 3) how term or default premia are determined. There are two fundamental questions. First, can these tools, aggressively deployed, eventually generate sufficient expectations of inflation so that they lower real interest rates? Forward looking models generally predict that the answer is yes. However, the interplay between monetary policy and the yield curve can become complex when central banks are at the zero lower bound (Bhansali et. al. 2009) and central banks seek to provide a “deflation put.”
Also, as discussed above, given the prominent role that inflation expectations play in inflation dynamics, inflation inertia is the enemy of reflation once deflation sets in. A second question relates to the monetary transmission mechanism itself. In a neoclassical world that abstracts from financial frictions, a sufficiently low, potentially negative real interest rate can trigger a large enough inter-temporal shift in consumption and investment to close even a large output gap. But in a world where financial intermediation is essential, an impairment in intermediation – a credit crunch – can dilute or even negate the impact of real interest rates on aggregate demand. In the limiting case of a true liquidity trap, no level of the real interest rate is sufficient in and of itself to close the output gap and reflate the economy. Credit markets in the U.S. appear at this writing to be bifurcated.
Credit spreads on corporate bonds are at low levels and gross issuance is at high volumes, while bank lending, much of it to small and medium sized enterprises, has collapsed to an extent unprecedented in previous business cycles and continues to decline more than a year into recovery. While this does not in itself indicate the U.S. is in a liquidity trap, it does suggest that deleveraging and the collapse of the Shadow Banking System that intermediated so much credit before the crisis continue to represent a significant headwind that presents a challenge to policy effectiveness.
References:Bean, C., M. Paustian, A. Penalver, and T. Taylor, “Monetary Policy after the Fall,”Federal Reserve Bank of Kansas City Annual Conference, Jackson Hole, Wyoming, 28 August 2010
Friedman, B., “Why the Federal Reserve Should Not Adopt Inflation Targeting,” International Finance 7:1, 2004: pp. 129–136.
Pozsar, z., T. Adrian. A. Ashcraft, H. Boesky, “Shadow Banking” Federal Reserve Bank of New York Staff Report no. 458, July 2010
Rogoff, K., and C. Reinhart, This Time Is Different, Princeton: Princeton University Press, 2009
Minsky, H., Stabilizing the Unstable Economy, McGraw Hill, New York: 2002.
Taylor, John B. “Discretion versus Policy Rules in Practice.” Carnegie-Rochester Conference Series on Public Policy, December 1993, 39(1), pp. 195-214.
Taylor, John B. (2007). “Housing and Monetary Policy” in Housing, Housing Finance and Monetary Policy, 463-476. Federal Reserve Bank of Kansas City: Kansas City.
Taylor, John B. (2008). “The Costs and Benefits of Deviating from the Systematic Component of Monetary Policy”. Keynote Address at the Federal Reserve Bank of SanFrancisco Conference on Monetary Policy and Asset Markets, February 22, 2008.
Gagnon, Joseph, Matthew Raskin, Julie Remache, and Brian Sack (2010). “Large-scale Asset Purchases by the Federal Reserve: Did They Work?” Federal Reserve Bank of New York, Staff Report No.441.
Bernanke, Ben. 2002. “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Remarks before the National Economists Club, November 21
Bhansali, V., et al., Asymmetric Monetary Policy and the Yield Curve, Journal of International Money and Finance (2009).
Rajan, Raghuram G. (2005). “Has Financial Development Made the World Riskier?”, in The Greenspan Era: Lessons for the Future, 313-370. Federal Reserve Bank of Kansas City: Kansas City.
McCulley, Paul (2007): “Teton Reflections,” PIMCO Global Central Bank Focus, September 2007.
This article contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission.
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