Time consistency

The Slippery Slope of a Higher Inflation Target

With inflation significantly above target in most advanced economies, there are renewed calls for central banks to raise their targets from 2% to 3% or 4%, in order to limit the prospective costs of disinflation. In this post, we review the benefits and costs of a higher inflation target.

Yet, regardless of the balance between the costs and benefits of raising the inflation target, our view is that central banks ought not be able to choose their inflation targets. The key problem with such discretion is the slippery slope. If households and firms come to expect that a central bank will opportunistically raise its inflation target to avoid the economic sacrifice associated with disinflation, inflation expectations will no longer be anchored at the target (whatever it is).

To limit the “inflation expectations ratchet”—avoiding perceptions of opportunistic central bank discretion— the Federal Reserve should follow an approach that it now employs regarding the possible introduction of a central bank digital currency: namely, the Fed should announce that it will not alter its inflation target without the explicit support of both the legislative and executive branches, ideally in the form of legislation….

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Just Vote NO

On Tuesday, July 21, the Senate Banking Committee will vote on whether to support Dr. Judy Shelton’s nomination to join the Board of Governors of the Federal Reserve System. Accordingly, we are re-posting our July 2019 commentary in which we outlined our strong opposition to Dr. Shelton’s candidacy.

In our view, over the past year, the case against Dr. Shelton has strengthened. The Federal Reserve’s speedy and decisive response to the COVID pandemic is a key reason that the U.S. financial system has steadied and the economy quickly began to recover from the worst shock since the 1930s. Had the United States been operating on a gold standard, as Dr. Shelton has long advocated, these Fed actions would not have been feasible.

Indeed, under a gold standard, instead of easing forcefully and committing to sustained accommodation, the central bank would have been obliged to tighten policy in an effort to resist the 19-percent rise of the gold price since the end of 2019. Just as it did in the Great Depression, this policy would have led us down a path of financial crisis and economic disaster (see our earlier posts here and here).

We hope that the Senate Banking Committee will vote down Dr. Shelton’s candidacy and send a determined message that unambiguously backs the Federal Reserve’s commitment to use every means at its disposal―zero interest rates, large-scale asset purchases, and broad lending programs―to restore economic prosperity and maintain price stability. Barring outright rejection, the Committee should at least move to hold an additional hearing on this nomination, as the Committee minority has proposed….

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Bank Runs and Panics: A Primer

A bank promises its clients immediate access to cash. Depositors can redeem their funds on demand at face value—first come, first served. Other short-term creditors can do the same, albeit at varying speeds, by not rolling over their loans. And, households and firms that pay a fee for a credit commitment can take down their loans at will.

For banks that hold illiquid assets, these promises of liquidity on demand are the key source of vulnerability. The same applies to other financial institutions (de facto or shadow banks) that perform bank-like services, using their balance sheets to transform illiquid, longer-maturity, risky assets into liquid, short-maturity, low-risk liabilities.

A bank run occurs when depositors wish to make a large volume of withdrawals all at once. A bank that cannot meet this sudden demand fails. Even solvent banks—those whose assets exceed the value of their liabilities—fail if they cannot convert their assets into cash rapidly enough (and with minimal loss) to satisfy their clients’ demands. A banking panic is the plural of a bank run: when clients run on multiple banks. We call the spread of runs from one bank to others contagion—the same term used to describe the spread of a biological pathogen.

In this primer, we characterize the sources of bank runs and panics, as well as the tools we use to prevent or mitigate them….

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Some Unpleasant Gold Bug Arithmetic

Most people care far more about the prices of things they purchase—food, housing, health care, and the like—than the price of gold. Not coincidentally, professional economists display a remarkably explicit consensus against forcing the central bank to adopt a policy that fixes the price of gold.

Yet, there are still powerful people who think that the United States would benefit if the central bank’s sole purpose were to restore a gold standard. With the nomination of gold standard advocate Judy Shelton to be a Governor of the Federal Reserve, we feel compelled to take these views seriously. So, here goes.

Several years ago, we emphasized that a gold standard is incredibly unstable. In this post, we address the mechanics of how the U.S. central bank would run the system. In our view, it is incumbent on any gold standard advocate to answer a series of practical questions: What gold price are they proposing? How much gold would the Federal Reserve have to acquire and hold to make the scheme credible? Will the Fed be able to lend to banks and operate as a lender of last resort?

Our answers highlight the operational challenges. Since the Fed initially would commit to holding a particular dollar value (that is, the product of price and quantity) of gold, we need to consider price and quantity together. With the smallest balance sheet we can imagine, our best guess is that the Fed initially would have to triple its gold holdings, driving the price of gold up by two thirds (to about $2,600 per ounce). Then, to maintain the gold standard, the Fed would still need to purchase one-third of world gold production each year. Without gold holdings over and above this minimum, the Fed would not be able to lend at all, much less without limit as it can under a pure fiat money standard….

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Protecting the Federal Reserve

Last week, President Trump tweeted his intention to nominate Dr. Judy Shelton to the Board of Governors of the Federal Reserve System. In our view, Dr. Shelton fails to meet the criteria that we previously articulated for membership on the Board. We hope that the Senate will block her nomination.

Our opposition arises from four observations. First, Dr. Shelton’s approach to monetary policy appears to be partisan and opportunistic, posing a threat to Fed independence. Second, for many years, Dr. Shelton argued for replacing the Federal Reserve’s inflation-targeting regime with a gold standard, along with a global fixed-exchange rate regime. In our view, this too would seriously undermine the welfare of nearly all Americans. Third, should Dr. Shelton become a member of the Board, there is a chance that she could become its Chair following Chairman Powell’s term: making her Chair would seriously undermine Fed independence. Finally, Dr. Shelton has proposed eliminating the Fed’s key tool (in a world of abundant reserves) for controlling interest rates—the payment of interest on reserves….

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Bad Precedent

Recent reports that President Trump wanted to fire Board Chairman Powell in response to Federal Reserve interest rate hikes are unprecedented. Denials from senior officials―Treasury Secretary Mnuchin and Council of Economic Advisers Chairman Hassett―have even less credibility than would a statement (or tweet) from the President himself. We find this entire discussion extremely disheartening and surely damaging to economic policy and the credibility of the Federal Reserve. As former Chair Yellen has stated, the risk is that people lose “confidence in the Fed, in the basis for its actions and its responsiveness to its mandate” (see here, time mark: 18:51).

To be sure, there is some debate over whether the President can fire the Fed Chair, other than “for cause.” We are not lawyers, but thoughtful people such as Peter Conti-Brown suggest that the answer is yes. Against this background, we view President Trump’s actions (and reported wishes) as the most serious threat to Fed independence since the Treasury-Fed accord of March 1951….

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Trump v. Fed

Last month, interrupting decades of presidential self-restraint, President Trump openly criticized the Federal Reserve. Given the President’s penchant for dismissing valuable institutions, it is hard to be surprised. Perhaps more surprising is the high quality of his appointments to the Board of Governors. Against that background, the limited financial market reaction to the President’s comments suggests that investors are reasonably focused on the selection of qualified academics and individuals with valuable policy and business experience, rather than a few early-morning words of reproof.

Nevertheless, the President’s comments are seriously disturbing and—were they to become routine—risk undermining the significant benefits that Federal Reserve independence brings. Importantly, the criticism occurred despite sustained strength in the economy and financial markets, and despite the stimulative monetary and fiscal policies in place….

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Making Unelected Power Legitimate

Through what administrative means should a democratic society in an advanced economy implement regulation? In practice, democratic governments opt for a variety of solutions to this challenge. Historically, these approaches earned their legitimacy by allocating power to elected officials who make the laws or directly oversee their agents.

Increasingly, however, governments have chosen to implement policy through agencies with varying degrees of independence from both the legislature and the executive. Under what circumstances does it make sense in a democracy to delegate powers to the unelected officials of independent agencies (IA) who are shielded from political influence? How should those powers be allocated to ensure both legitimacy and sustainability?

These are the critical issues that Paul Tucker addresses in his ambitious and broad-ranging book, Unelected Power. In addition to suggesting areas where delegation has gone too far, Tucker highlights others—such as the maintenance of financial resilience (FR)—where agencies may be insufficiently shielded from political influence to ensure effective governance. His analysis raises important questions about the regulatory framework in the United States.

In this post, we discuss Tucker’s principles for delegating authority to an IA. A key premise—that we share with Tucker—is that better governance can help substitute where simple policy rules are insufficient for optimal decisions….

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Understanding Bank Capital: A Primer

Over the past 40 years, U.S. capital markets have grown much faster than banks, so that banks’ share of credit to the private nonfinancial sector has dropped from 55% to 34% (see BIS statistics here).  Nevertheless, banks remain a critical part of the financial system. They operate the payments system, supply credit, and serve as agents and catalysts for a wide range of other financial transactions. As a result, their well-being remains a key concern. A resilient banking system is, above all, one that has sufficient capital to weather the loan defaults and declines in asset values that will inevitably come.

In this primer, we explain the nature of bank capital, highlighting its role as a form of self-insurance providing both a buffer against unforeseen losses and an incentive to manage risk-taking. We describe some of the challenges in measuring capital and briefly discuss a range of approaches for setting capital requirements. While we do not know the optimal level of capital that banks (or other intermediaries) should be required to hold, we suggest a practical approach for setting requirements that would promote the safety of the financial system without diminishing its efficiency....

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Time Consistency: A Primer

The problem of time consistency is one of the most profound in social science. With applications in areas ranging from economic policy to counterterrorism, it arises whenever the effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future.

For simplicity, we will define a time consistent policy as one where a future policymaker lacks the opportunity or the incentive to renege. Conversely, a policy lacks time consistency when a future policymaker has both the means and the motivation to break the commitment.

In this post, we describe the conceptual origins of time consistency. To emphasize its broad importance, we provide three economic examples—in monetary policy, prudential regulation, and tax policy—where the impact of the idea is especially notable....

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