Populism and the Future of the Fed

EDITOR’S PREFACE

The 2008 financial crisis and 2020 pandemic greatly expanded the Fed’s scope and power. Populism and the Future of the Fed features highly readable essays that avoid technical jargon and provide a broad perspective on core issues—including the populist challenge to Fed independence, fiscal dominance and the return of inflation, the limits of Fed power versus the expansion of its dual mandate, and the strange world of helicopter money and fiscal QE (i.e., using the Fed’s balance sheet to support off-budget spending).

One could argue that those who want the Fed to allocate credit, help fund a Green New Deal, engage in helicopter drops, and so on, are well intentioned. However, the real issue is whether such actions are consistent with long-run price stability and the rule of law.

Thus, several questions come to mind: (1) What are the limits to what the Fed can do and what it should do in a free society? (2) Where do we draw the line between fiscal and monetary policy? (3) Do we want an activist central bank with wide discretion or a limited central bank guided by a monetary rule? (4) What are the risks populism poses for the conduct of monetary policy, Fed independence, and central bank credibility? (5) Can the Fed control inflation if populism and fiscal QE become pervasive?

The distinguished contributors to this volume address those questions in a clear and compelling manner that will help improve both policymakers’ and the public’s understanding of the complex relationship between politics, policy, and the rule of law. Moreover, the authors provide different perspectives—legal, philosophical, historical, theoretical, and ethical—in reflecting on the role of the central bank in a democracy. We are reminded that the Fed is an agent of Congress bound by the rule of law with limited powers that are ultimately shaped by public opinion. This book will help shape that opinion.

All the essays in this volume (except for those by Charles Plosser and myself) were first presented at Cato’s 39th Annual Monetary Conference, held virtually on November 18, 2021. I thank the authors for their diligence in preparing their papers for publication. I also would like to thank the George Edward Durell Foundation and the Harold J. Bowen, Jr. and DuVal Bowen Family Foundation for supporting the conference and this book. Finally, my colleagues in Cato’s Center for Monetary and Financial Alternatives were instrumental in helping me organize the conference, especially George Selgin and Nick Anthony; Eleanor O’Connor, as always, oversaw the publication process with grace and wisdom; and Connie Moy (eagle eyes) did an outstanding job proofreading the final text.

—J. A. Dorn

PART 1

THE POPULIST CHALLENGE TO FED INDEPENDENCE

1

CENTRAL BANKING, POLITICAL PRESSURE, AND ITS UNINTENDED CONSEQUENCES

Raghuram Rajan

The proper role of central banks, the frameworks they use, and the range of tools they believe they can legitimately employ, have changed considerably over the last two decades. Interestingly, this has come after perhaps their greatest triumph, taming inflation. What led to this rethinking? And what are its consequences, some possibly unintended. What have been the effects on financial stability? These are the questions this chapter examines.

To preview my answers, central bankers escaped lightly from the Global Financial Crisis (GFC), getting little of the blame, but acquiring an aura of possessing extraordinary powers as they helped resolve the crisis. One consequence, however, may have been more pressure on central banks to deliver for Main Street. As they subsequently and continuously undershot their inflation target, the pressure on them to aid economic activity increased. Perhaps tinged somewhat with hubris, central banks did not reject these pressures and make the case that there are limits to what central banks can properly do. Instead, they embraced the challenge and embarked on a much broader set of interventions, including direct interventions in asset and credit markets that they eschewed in the past. Arguably, these interventions have not helped central banks measurably in achieving their inflation targets. Instead, they have left them poorly positioned for an environment where fiscal spending has ramped up and inflation, not disinflation, is the key problem. Furthermore, central banks have continued underemphasizing financial stability throughout this time, which also leaves the world poorly positioned for future shocks, including from the changing climate. In trying to do too much, central banks have not just compromised on their fundamental responsibility—monetary stability—they have added to financial instability. In sum, this chapter is a call for central banks to go back to the knitting and reassess both their goals as well as their use of tools.

A Short History of the Recent Evolution of Central Banking Thought

The actions of the Federal Reserve, no doubt influenced by developments in academia and by the actions of other central banks, have broadly framed the consensus in central bank thinking. After all, it was Paul Volcker’s determination to push short-term nominal interest rates really high, and hold them there until inflation came down, that broke the back of U.S. inflation, raised the Fed’s credibility as an inflation fighter, and contributed to decades of falling nominal interest rates. Kydland and Prescott’s (1977) theory of time inconsistency of policy and the need for commitment, and Rogoff’s (1985) arguments on how to achieve that commitment through an independent, inflation-minded central bank made the case for central bank independence. The Bank of New Zealand, in turn, became the first central bank to formally adopt inflation targeting in 1990, and this spread across the world. Meanwhile, John Taylor (1993) described central bank behavior with a simple model that then became the standard for evaluating whether a central bank was ahead or behind the curve in its fight against inflation. Indeed, so remarkable was the worldwide fall in inflation that Rogoff (2004) suggested that it could not just be attributed to central bank independence and policy, and conjectured that global competition must also have helped.

Be that as it may, with inflation quiescent over long periods, central banks no longer had to raise interest rates periodically. As Borio (2012) notes, this allowed the financial cycle—the unholy correlated increases in asset prices and leverage—to play out over longer periods and with greater amplitude. In this chapter, I argue there are many channels through which more accommodative monetary policy can initiate and propagate such a cycle. For instance, as interest rates fall, long-term expectations of growth account for a larger and larger share in asset valuations. Given there is little to anchor such expectations, a wide distribution of valuations is possible. The more optimistic among potential buyers buy more long-dated assets financed with borrowing (see Geanakoplos 2010 for a related model). Their wealth is further enhanced by falling rates, allowing them to exercise more of an influence in setting asset prices. Sustained periods of low and falling inflation could thus be accompanied by optimistic asset prices, leverage, and risks to financial stability when prices and leverage correct.

In late 1996, Fed Chairman Alan Greenspan came as close as a central banker can to saying he thought stock prices were overvalued, and that the Fed would potentially take that into account in setting monetary policy (Greenspan 1996). Yet, his speech warning of irrational exuberance at the American Enterprise Institute on December 5 was shrugged off by markets—and markets were right. The Fed did not act, perhaps warned off by the vociferous political reaction to his speech. The Fed watched while stock prices continued rising during the internet boom, and even cut rates following the Russian debt default in 1998 and the collapse of hedge fund Long-Term Capital Management.

When the stock market eventually crashed in 2000, the Fed responded by cutting rates, ensuring the recession was mild even if subsequent job growth was tepid. In a 2002 speech at the Kansas City Fed’s Jackson Hole Conference, Greenspan argued that, while the Fed could not recognize or prevent asset price booms, it could mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion (Greenspan 2002). His speech seemed to be a post-facto rationalization of why he had not acted more forcefully on his prescient 1996 intuition. He was now saying the Fed should not intervene when it thought asset prices were too high, but that the Fed could recognize a bust when it happened and would pick up the pieces. Given that inflation was quiescent, the resulting monetary policy was asymmetrical. The recipe was to take little action, other than a normalization of interest rates, when the economy was booming; but to take increasingly aggressive actions to support the economy when activity (and, not coincidentally) asset prices were down. Effectively, the Fed offered traders and bankers a put option, whereby if they collectively gambled on similar things, the Fed would not limit the upside; but if their bets turned sour, the Fed would limit the downside.

Clearly, no central bank wants such asymmetric incentives, yet with one interest rate tool, central banks believed they could not simultaneously achieve both monetary and financial stability. Therefore, it was left to an often poorly defined set of macroprudential policies to curb risk taking. It was convenient for the powerful monetary policy-setting arms of central banks to delegate this messy task to someone else. It was also dangerous for the system. First, as Kohn and Kerr (2015) pointed out, even today the Fed has no central body with macroprudential responsibility. This is particularly problematic since macroprudential regulation has the politically difficult task of constraining risk taking just when the risktakers have tasted success and are more influential. When responsibility is diffused, it is all too easy to leave action to someone else. Second, as Stein (2013) points out, vast areas of the financial system are regulated lightly, if at all. Macroprudential regulation has little bite there. The value of monetary action is that it gets in all of the cracks.

Be that as it may, the Global Financial Crisis of 2007–2009 was evidence that the system of fractured responsibilities did not work. No doubt, bank regulation has increased considerably since then, and banks are much better supervised, capitalized, and incentivized than before the GFC. Yet the nonbank periphery of the financial system, also termed the shadow financial system continues to have considerably less oversight or regulation, and risks tend to migrate there, periodically coming back to ensnare the banking system—as evidenced by recent blowups such as Archegos or Greensill. With the rise of cryptocurrencies, stablecoins, and decentralized finance, the size and complexity of the unregulated shadow system has only grown.

Further offsetting the post-GFC increased bank regulation is the fact that, post-GFC, central banks have not been achieving their inflation targets, and therefore have come under greater pressure to be aggressively accommodative on monetary policy. For instance, in the United States, personal consumption expenditure (PCE) inflation, the Fed’s preferred measure, averaged about 1.4 percent from 2012 to 2020, below the 2 percent target. That policy interest rates were at the zero lower bound seemed to be no defense. From the political side, pressure on the central bank mounted in a time of low growth. If the central bank is not meeting its target, there must be some stimulus it is not delivering, or so the thinking went. Pressure on central banks also came from a potentially appreciating exchange rate, as the European Central Bank (ECB) realized over 2010–2013, as other central banks found new, innovative, ways of easing financing conditions. But central bankers did not also reject their own responsibility for excessively low inflation, perhaps because they were worried about losing credibility if they claimed they had done all they could. They always seemed to suggest they had more tools to push inflation up, even after repeated failures. Indeed one can discern a hint of smugness in their lament that fiscal policy and reforms were not working, and monetary policy was the only game in town. But while Volcker had taught central banks how to bring down inflation, there was no obvious playbook for reflating an economy, especially when nominal rates were already at zero and fiscal policy limited.

How Did Monetary Policy Change after the GFC?

Following the Global Financial Crisis, with interest rates at zero, further unconventional monetary interventions took three broad forms: repairing markets, altering asset prices, and directing credit. At the core of all these was a greater willingness of the central bank to intervene in markets.

Repairing Markets

A number of financial markets had broken down during the GFC. Some of this was due to lack of confidence, some to lack of liquidity, and some because key players were undercapitalized. Of course, there was also a possibility that some of the financial claims being traded were worthless because the issuers were insolvent. Nevertheless, central banks attempted to alter perceptions and engender a virtuous circle by intervening. The hope was that the restoration of public confidence through the central bank’s support of financial markets, coupled with the liquidity injected through purchases, would recapitalize market players, increase their participation, and restore values and volume to asset markets. In its first round of quantitative easing (QE1), the Fed invested in the disrupted mortgage-backed securities (MBS) market while the ECB, through its misleadingly named ordinary monetary transactions (OMT) policy, backed sovereign bonds of periphery governments.¹ Whether the central bank changed perceptions of market fundamentals or whether it merely made explicit put options that it had written for these markets is hard to tell. Regardless, the interventions seem to have restored transaction volumes and prices to more normal levels, ensuring their place in future toolkits.

Altering Asset Prices

Monetary policy works, in part, by signaling the path of short-term interest rates, and therefore affecting long-term interest rates. With policy rates at zero, and with little room to cut them further, central banks looked for other ways to affect long-term rates more directly. One way was to expand central bank balance sheets through an announced program of buying long-term government bonds, with the intent of depressing long-term interest rates. Whether this worked by taking long-term assets out of private hands and forcing private portfolios to rebalance by buying more long-term assets (Tobin 1969), or by committing that policy rates would not be raised so long as the central bank is buying long-term assets (see Krishnamurthy and Vissing-Jorgensen 2011), is unclear. Indeed, whether it had much sustained effect on long rates (Cochrane 2018; Greenlaw et al. 2018) is also a matter of debate. Other central banks such as the Bank of Japan practiced yield curve control where they sought to keep the yield of a specific bond such as the 10-year bond at a targeted level through direct central bank purchases or sales of the bond. While the effects of such interventions on long-term rates were much clearer, there was little compelling evidence that those efforts helped enhance real investment or economic activity.

Of course, there were parallels between various forms of QE and the discredited past direct financing of governments by their captive central banks. Monetary economists frowned on this practice because the central bank essentially gave the government a soft budget constraint, which proved to be inflationary. Central bank independence required them to stop financing governments directly. What distinguished the new central bank asset purchase programs from the discredited programs of the past was a fig leaf and circumstances. The fig leaf was that the central bank typically purchased in the secondary market, not directly from the government, though once the program was announced, markets anticipated such purchases, and this was a distinction without a difference. However, after the GFC, the circumstances were different from the typical situation where central bank financing of government debt is problematic. Interest rates were at the zero lower bound and developed country governments were typically not strapped for cash, so central bank financing was not critical for their budgets.

I say typically because European periphery countries were indeed strapped. With the onset of the pandemic, this has become the case with more governments, and central banks have become key players in bridging government financing gaps.

Directed Credit Programs

Another element in the new toolkit was central bank participation in providing cheap refinancing for any bank credit that met specific conditions—loans to small and medium firms, households, or sometimes even any loan expansion at all. Once again, this cheap refinancing for bank credit revived old practices abandoned by central banks, who had argued that directed credit distorted the working of the capital markets and could lead to political rather than market allocation of resources. Worries about distortions and politicization seemed minor when set against the enormity of the post-GFC economic downturn. Once again, directed credit programs were revived and expanded following the onset of Covid-19, in March 2020.

Did These Policies Work?

At a narrow level, some of these unconventional policies seemed to work in that some of the stated intent was met. For instance, the MBS market recovered. Di Maggio, Kermani, and Palmer (2016) show that Fed MBS purchases in QE1 led to an increase in refinancing, a reduction in mortgage payments, and an associated increase in consumption. Once again, whether the MBS market recovered because the central bank restored confidence (good), or because it offered the market a long-term put option (less good), is less clear.

Central bank actions did not always work as intended. Acharya et al. (2019) show that banks that held more European periphery sovereign bonds when Draghi boosted their value by announcing OMT lent more. The effective recapitalization they obtained seemed to release constraints on lending. However, Acharya et al. argue that a number of the additional loans went to economically unviable zombie firms, whose continued financing and survival may have held back the recovery of industry. Central bank activism also worked at second or third remove, even when support was targeted. For instance, Grosse-Rueschkamp, Steffen, and Streitz (2019) show that ECB purchases of corporate bonds reduced yields for eligible firms, allowing them to repay bank debt with bond issuances—enabling banks to lend to riskier firms.

Of course, there is also evidence that central bank actions worked as intended. Foley-Fisher, Ramcharan, and Yu (2016), for example, offer evidence that the Fed’s maturity extension program (also known as Operation Twist) allowed firms dependent on long-term debt to issue more of it, expanding employment and investment.

Despite such positive microevidence, the broader macroimpacts, including on real activity, of these new central bank tools are harder to discern. Fabo et al. (2021) examine 54 studies on the effects of QE on output and inflation in the United States, United Kingdom, and the euro area. While the papers by central bankers typically report a statistically significant QE effect on output, only half the academic papers do. Interestingly, studies by the Bundesbank, a rare central bank opposed to QE, finds even less effects of QE on output than the academic papers. While it is inappropriate to conclude that central bank research is necessarily biased, the fact that specific assumptions can drive conclusions suggests that the evidence is fairly noisy—that is, the new tools do not offer overwhelming evidence of effectiveness.

Why then did central banks embrace them? The nature of the tools suggests that post-GFC central banks had much less faith in the effective working of markets. Perhaps irrational exuberance was followed by irrational pessimism, with asset values significantly below true fundamentals. If so, central banks could put their balance sheets to work to correct misperceptions. Of course, there was always a danger that valuations would be altered not because the market recognized true fundamentals, but because the central bank intervention altered fundamentals. If true fundamentals eventually converged to central bank-altered-fundamentals, the central bank might indeed be providing a valuable service. But if they did not converge, we would realize this only too late—when central banks have little room to expand their balance sheets to deliver on their contingent guarantees. Put differently, a key question today is have central banks induced market dependence with their new tools, and consequently tied their own actions to market performance?

Altering Frameworks

The Fed did more in the post-GFC low inflation environment than just adopt unconventional tools. It also set about changing its framework so as to alter public expectations. Essentially, by committing to be more tolerant of inflation in the medium term, the Fed would have greater credibility in signaling that interest rates would stay lower for longer even in the face of higher inflation. It would thus allow inflationary expectations to move higher. Put differently, the Fed had to erode some of its hard-won credibility for fighting high inflation in order to combat low inflation.

A key element of the Fed’s new framework (see Levy and Plosser 2020; Plosser 2021) is that it will no longer be preemptive in heading off inflation. Instead, it will be measured and reactive. The old Fed mantra, that if you are staring inflation in the eyeballs it is already too late, has been put to bed. Instead, the Fed will watch inflation rise until it has made up any shortfalls in past inflation, so that average inflation is around the target. Of course, since the period over which the average is taken is undefined, the Fed can allow higher inflation for a while and not be criticized for falling behind the curve. Monetary policy can be more discretionary and can be used to meet a broader employment mandate, where unemployment should not only be low but employment broad based and inclusive. Since minorities unfortunately are last to be hired, this means the Fed will potentially tolerate a tighter labor market than in the past. Finally, the Fed’s employment mandate has become more asymmetric: rather than minimize deviations from maximum employment, it worries only about shortfalls now, leaving it to the now-more-accommodative inflation mandate to react to an overly tight labor market.

Isn’t discretion good, especially for a professional apolitical organization? Possibly, but perhaps not when the environment changes in a way that was not envisaged by the framework and becomes vastly more politically charged.

What Changed?

Central banks were only partly responsible for the low inflation environment over the last few decades. Part of the responsibility also lay with deeper structural forces affecting demand and supply, such as globalization, population aging, and rising income inequality within developed countries. But these also were changing.

One important prepandemic development was growing impediments placed on global trade and investment. Earlier, the rise of emerging markets, which were moving more workers from low-productivity agriculture into industry and service jobs, created a truly global goods and labor market. Greater competition reduced goods prices and wages, but a longer-lasting effect (which is what matters for inflation over the medium term) was, as Rogoff (2004) argues, that greater competition reduced central bank incentives to raise inflation to boost growth. However, with growing protectionism, trade disruption, and investment disputes between the two biggest economies in the world, borders are no longer as seamless as they once were. So even before the pandemic, the conditions holding down inflation were turning.

The pandemic further altered those conditions. Apart from the tragic and widespread loss of lives and livelihoods, the pandemic has disrupted the market for goods, services, and labor. The short-run disruptions will fade, and whether they will have lasting effects on the public’s inflationary expectations is hard to tell. However, there are a number of channels through which the pandemic may have longer-lasting influences. The pandemic certainly seems to have led to a change in personal and public attitudes toward low-paying, low-benefit, precarious jobs. Such jobs have typically been on the pandemic front line, involving high contact with people, long hours, and little job flexibility. Not only are workers reluctant to return to such jobs, the public is also more supportive of higher pay and benefits for such work. More generally, wage demands are more likely to be accommodated in the postpandemic environment.

The pandemic has also increased the public’s perception of the likelihood of tail events, increasing the political will behind combating climate change. This will imply higher costs of new investments, fully pricing emissions, and compliance with stricter regulations. Of course, these measures are needed. But if firms pass through the higher costs, which will likely come as a steady stream rather than as a one-off, they will also contribute to inflationary impulses.

Perhaps the biggest change in the pandemic response, relative to the response to the GFC, has been on the fiscal side. There are many possible explanations for the dramatic opening of fiscal taps across the world. These include: the imperative for policymakers to act quickly; the need to obtain consensus in a sharply divided polity by spreading the benefits around; and the political pressure to exploit the change in attitudes toward fiscal deficits—driven perhaps by respectable economists whose convenient message (to politicians) seemed to be that developed countries could afford significantly more debt at current interest rates. Be that as it may, the consequence was a massive resource transfer to the private sector (i.e., to households, firms, and banks). In the United States, disposable personal income went up while bankruptcies fell, both firsts for what was ostensibly an economic downturn. Cash savings and pent-up demand have risen to extraordinary levels. With spending focused initially on goods,