This column has been adapted from testimony given on December 7, 2016 by Mickey D. Levy before the U.S. House of Representatives Committee on Financial Services, Subcommittee on Monetary Policy and Trade.
An assessment of the conduct of monetary policy in recent years provides important lessons for the Fed and its proper role and economic policymaking in general. This is particularly true now that an economic policy regime shift is underway.
The Fed’s unconventional policies in 2008-2009 deserve credit for helping to lift the economy and financial markets from crisis. However, it is striking that in recent years while the Fed’s unconventional policies of sustained negative real Fed funds rate, quantitative easing and forward guidance have successfully stimulated financial markets, lowered bond yields, encouraged risk-taking and boosted asset prices, they have failed in their ultimate objective of stimulating the economy. Nominal GDP growth has actually decelerated to 2.8 percent in the last year from its subdued 3.9 percent average pace of the prior six years, and real growth has languished.
Extending excessive monetary ease well after economic performance normalized and the Fed’s dual mandate was largely achieved has been costly. Instead of stimulating aggregate demand, monetary policies have contributed to mounting financial distortions and disincentives and are inconsistent with the Fed’s macro-prudential risk objectives. Unfortunately, the Fed and financial markets now may be beginning to pay the price for the Fed’s extended excessively easy monetary policy.
Recent trends make it increasingly clear that economic performance has been constrained by factors that are beyond the scope of monetary policy. The economy’s slow growth has much less to do with the Fed than real, nonmonetary issues, particularly growth-depressing economic, tax and regulatory policies. However, the Fed’s excessive monetary ease has not helped and may have harmed economic performance. It has generated mounting financial distortions that eventually must be unwound.
A growing web of government regulations, mandated expenses and higher tax burdens have weighed on banking and the financial sector, business investment, and the broader economic environment. Considered separately, most of these policies have little macroeconomic impact. However, their cumulative effects are large and generally not captured in standard macro models.
While the Fed’s monetary policies have lowered the real costs of capital, the governments’ economic and regulatory policies and related uncertainties have led businesses to raise their hurdle rates required for capital spending and expansion projects. Potentially productive expansion plans have been sidelined. Some government mandated expenses and labor laws have induced businesses to adjust labor inputs, including relying more on part-time workers. With less new capital, employee training has been cut back. Businesses have expanded overseas and bought foreign firms for tax reduction purposes. Businesses have issued more bonds in the Fed’s low interest rate environment, but the proceeds are being used to buy back shares to meet the demands of yield-hungry investors. This raises corporate leverage but not capital spending or productive capacity.
I recommend that the Fed should reset the conduct of monetary policy. It should: 1) raise rates gradually but persistently toward a neutral policy rate consistent with its estimates of potential growth and its 2 percent inflation target, and cease reinvesting its maturing assets, 2) de-emphasize short-run economic and financial fine-tuning and not allow monetary policy to be influenced by global and financial turmoil that does not materially influence US economic performance, 3) shift the focus of its communications, including its official Policy Statements, toward the Fed’s long-run objectives and away from short-run economic and financial conditions that are always subject to volatility, and emphasize that the scope of monetary policy is limited and that the economy is influenced by other factors including the government’s economic and regulatory policies, and 4) shift toward a more rules-based guideline for conducting monetary policy that provides flexibility for the Fed but at the same time avoids the big mistakes of discretionary policy deliberations.
Gradually raising rates would leave monetary policy easy. It would not harm and may even help economic performance. The financial system is awash with excess reserves and the real Fed funds rate is roughly negative 1.3 percent, far below the Fed’s 1 percent estimate of the appropriate long-run real policy rate During prior economic expansions when the Fed has raised rates following monetary accommodation, growth has been sustained. Witness the sustained growth when the Fed raised rates in the early 1980s, mid-1990s, or the mid-2000s. Raising rates would actually stimulate more bank lending and loosen the intermediation process. A clear Fed explanation of why it is normalizing rates—and why there is no need to delay—would boost confidence.
Clarifying a more limited role of monetary policy may not sit well with those who have come to rely excessively on the Fed, but it would constructively reset monetary policy and enhance the Fed’s independence and credibility.
What about fiscal policy? First, the Fed and others have been advocating for fiscal stimulus to boost the economy. It is critically important to distinguish between fiscal reform and fiscal stimulus that simply involves more deficit spending. With the economy in its eighth consecutive year of expansion and growing at a pace close to current measures of potential, and the unemployment rate at or below standard estimates of full employment, countercyclical fiscal stimulus in the form of increased deficit spending is unwarranted and inappropriate.
Second, the focus of fiscal policy should be on tax and spending reforms that raise potential growth. This should involve tax reforms aimed at creating an environment conducive to investment and expansion. Spending initiatives should focus on reallocating spending toward productive activities while reducing wasteful spending, and changing the structure of entitlement programs to lower the government’s future long-run unfunded liabilities. These changes can be made in fair and efficient ways that do not affect current retirees. There is a lot of impetus toward more infrastructure spending. Such initiatives must aim at improvements and upgrades that add to productive capacity and provide benefits that exceed costs, while avoiding the pitfalls and political impulses toward more deficit spending aimed at short-term fiscal stimulus and temporary job creation. Moreover, initiatives that improve education, training and human capital are critically important to improving the nation’s infrastructure.
Third, regarding regulatory initiatives, banking and financial regulations should focus on establishing high capital adequacy standards while easing micro regulatory burdens that constrict bank credit. In the non-financial sectors, reform efforts should involve reducing burdensome regulations that inhibit business investment and expansion and constrict labor mobility and whose economic costs far exceed benefits.
Mickey Levy is the chief economist of Berenberg Capital markets, LLC for the Americas and Asia and a member of the Shadow Open Market Committee. The views expressed in this column are the author’s own and do not reflect those of Berenberg Capital Markets, LLC.
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