Dick Alford on Opportunities Lost by the Fed

Our colleague Richard Alford comments on recent Fed history and particularly how the organization failed to take notice of the warnings of one of its longest serving bureaucrats — Ted Truman — as he ended decades of service at the central bank.   I worked with Dick at the FRBNY where he contributed to the weekly report for the FOMC on the foreign currency markets.    — Chris

Opportunities Lost
By Richard Alford (rfalford@gmail.com)

Against a backdrop of continued financial fragility and extraordinary policy actions, policymakers are discussing re-balancing global growth, restoring financial stability, and the future of the Dollar as the world’s reserve currency. In 2005, Edwin Truman proposed a list of policy measures that if followed would have reduced the US external imbalance and placed the reserve status of the Dollar on better footing.  Truman’s proposal differed from the standard litany of US fiscal discipline, Dollar adjustment, and increased demand in surplus countries. It called upon the Federal Reserve to slow the growth in US demand. More recent research, by Shin and Adrian, suggests that if the Fed had heeded Truman’s prescription, then monetary policy would have also mitigated the recent turmoil in financial markets.

In short, the Fed ignored external imbalance and the increasingly precarious nature of financial institution balance sheets when it pursued accommodative policy during the bubble years. The Fed disagrees. The official Fed position is that US monetary policy has no role to play in adjusting external imbalances:

“Members of the Committee noted that monetary policy was not well equipped to promote the adjustment of external imbalances …..Fiscal policy had a potentially larger role to play by promoting an increase in national saving, but the adjustment would involve shifts in demand and output both domestically and abroad…..” (FOMC 2004)

Truman pointed to the excess of total demand (gross domestic purchases/”absorption”) over potential output and the more rapid growth of demand relative to the growth of potential output. He concluded that:

“external adjustment is not just about the effects of exchange rates on exports, imports, and trade balances. It is also about slowing the rate of growth of domestic demand (gross domestic purchases) relative to the growth of production (GDP). To achieve any adjustment of the imbalance in real terms as a share of GDP, the growth rate of the former must be less than the growth rate of the latter.”
“… What the Federal Reserve has not acknowledged is that monetary policy has a role to play in slowing the growth of total domestic demand relative to the growth of total domestic supply or domestic output.”

Truman was asserting that it was inappropriate for monetary policy to be stimulative when:

1. US total demand (gross domestic purchases) exceeded potential output: and

2. The growth rate of total demand exceeded the growth rate of potential output.

Truman saw the higher level and the more rapid growth of gross domestic purchases relative to potential output as proof that the problem facing the US economy was not a demand shortfall. US-based economic agents demanded more than the US could produce and too many imports relative to exports. Adjustment would involve lowering US demand (increasing US savings), increased demand abroad, as well as exchange rate adjustments and other steps to increase US international competitiveness. Instead, the Fed stimulated interest-sensitive demand and discouraged savings, while nothing was done to increase US competitiveness, institute fiscal discipline or to encourage the Dollar to adjust. A “domestic” problem was “solved” at the expensive of exacerbating the problems of external imbalance and declining savings. From Truman’s perspective, US accommodative monetary policy was not a remedy, but rather a Faustian-like bargain with short-term benefits and long-run costs.

The policy choices reflected a certain mindset. Globalization has caused changes in the behavior of households (as consumers and suppliers of labor), businesses (especially in the tradable goods sector) and financial intermediaries and markets. Only in the political and policy making classes do people continue to act as if US prices, incomes, and output are determined by solely by domestic factors. US economic policy has been pursued without any regard for external balance, the Dollar or the rest of the world. If Joe and Mary Sixpack and the US commercial, industrial and financial sectors see the need to adjust behavior in light of globalization, why is it that the Fed’s response to challenges arising from globalization consists of a variant of “It’s not my job”? Given the likely course of US fiscal deficits and absence of any Dollar and trade policies, does the Fed really believe that that it can successfully promote full employment, price and financial stability while ignoring the external sector and the economic and financial development in the rest of the world (as well as advice of former and current Fed officials)?

More recently, Shin and Adrian produced a study that dovetails nicely with the Truman piece. In the study, they examined the relationship between behavior of the balance sheets of broker/dealers and real economic activity and the linkage between the Fed funds rate and behavior of those balance sheets. The study presents a body of evidence consistent with the hypothesis that the sustained low Fed funds rate contributed to the increased use of leverage and maturity mismatches that magnified the severity of the financial crisis. The most relevant points are:

• “We find that the growth in broker-dealer balance sheets helps to explain future real economic activity, especially for components of GDP that are sensitive to the supply of credit”

• “Although total assets of the broker/dealer sector is smaller than the total assets of the commercial banking sector, our results suggest that broker-dealers provide a better barometer of funding conditions in the economy , capturing overall capital market conditions.”

• “.. we go on to examine the determinants of balance sheet growth. We find that the level of the fed funds target rate is key. The fed funds target determines other relevant short-term interest rates, such as repo rates and interbank lending rates through arbitrage in the money market…..We find that low short-term rates are conductive to expanding balance sheets.

• “Our findings hold implications for the financial stability role of monetary policy. To the extent that the financial system as a whole holds long-term, illiquid assets financed by short-term liabilities, any tensions resulting from a sharp synchronized contraction of balance sheets will show up somewhere in the system…The pinch points will be those institutions that are highly leveraged and who hold long-term illiquid assets financed with short-term debt…”

• “.. the expansion and contractions of balance sheets have both a monetary policy dimension in terms of regulating aggregate demand, but also a financial stability dimension. Therefore, contrary to the commonly encountered view that monetary policy and policies toward financial stability should be conducted separately, the perspective provided by our study suggests that they are closely related. They are, in fact, two sides of the same coin.

• “We believe that focusing on the conduct of financial intermediaries is a better way to think about financial stability, since it helps us ask the right questions. Concretely, consider the following pair of questions:

Question 1. Do you know for sure there is a bubble in real estate prices?

Question 2. Could the current benign funding conditions reverse abruptly with adverse consequences for the economy?”

• “One can answer “yes” to the second question even if one answers “no” to the first.”

• “In any case, for a policy maker, it is the second question that is the more relevant. Even if a policy maker were convinced that the higher price of housing is fully justified by long-run secular trends, policy intervention would be justified if the policy maker also believed, if left unchecked, the virtuous cycle of benign funding conditions and higher housing prices will go too far, and reverse abruptly with adverse consequences for the economy.”

From the Shin and Adrian perspective, financial intermediaries responded to the Fed’s low interest rate policy by increasingly borrowing short term to finance the purchase of longer-dated assets. The expansion of the balance sheets exerted downward pressure on longer-term interest rates which in turn stimulated the real estate and durable goods sectors. It also led to increased leverage, and growing concentrations of liquidity risk and maturity mismatches across a range of financial interemediaries. In short, the Fed stimulated economic activity in the short run, while setting the stage for the losses, real and financial, that stemmed from the financial crisis.

The Shin and Adrian study also serves to draw attention to an anomalous aspect in the Fed’s view of its role as guardian of the safety of the financial system. The Fed’s position is that interest rate policy is for price stability only and that its contribution to enhanced financial stability should be limited to the re-regulation of the financial sector. Due in part to the consensus among economists, subsidies, “Pigovian taxes”, and auctions play an important part in virtually every other area of regulation or government intervention in market-based activities. “Price” is viewed as a necessary means of incenting socially optimal behavior increasing efficiency and discouraging negative externalities. However, the economist-dominated Fed has seen fit to permit its inner lawyer to run wild. It proposes to regulate the use of leverage, maturity mismatches and prevent the over reliance on short-term funding in a framework that specifically precludes any role for short-term interest rates. Despite the fact that short-term interest rates are the price of leverage, and a determinant of the profitability of many maturity mismatches . In fact, the Fed wants to retain the ability to set the Fed funds target rate at levels, i.e. zero nominal, that not only encourage the use of leverage and maturity mismatches, but are lower than rates that were associated with excessive leverage and maturity mismatches in the recent past.

Together the Truman and Shin and Adrian pieces suggest that the US (and world) is now and may in the future pay a high price for the Fed decision to ignore external balance and financial stability when it sets monetary policy.

Edwin Truman. “Postponing Global Adjustment: An Analysis of the Pending Adjustment of Global Imbalances.”, IIE Working paper 05-6


Tobias Adrian and Hyun Song Shin, Financial Intermediaries, Financial stability and Monetary Policy. Present at the Kansas City Fed 2007 Jackson Hole Conference.


Before joining PIE, Edwin M. Truman was assistant secretary of the treasury for international affairs (1998–2000). He directed the Division of International Finance of the Board of Governors of the Federal Reserve System from 1977 to 1998. From 1983 to 1998, he was one of three economists on the staff of the Federal Open Market Committee. He has been a member of numerous international groups working on international economic and financial issues, including the Financial Stability Forum’s Working Group on Highly Leveraged Institutions (1999–2000), the G22 Working Party on Transparency and Accountability (1998), the G10-sponsored Working Party on Financial Stability in Emerging Market Economies (1996–97), the G10 Working Group on the Resolution of Sovereign Liquidity Crises (1995–96), and the G7 Working Group on Exchange Market Intervention (1982–83).

Hyun Song Shin is the Hughes-Rogers Professor of Economics and Associate Chair in the Economics Department of Princeton University. Before joining to Princeton in 2006, he was Professor of Finance at the London School of Economics.
Tobias Adrian is Assistant Vice President of the Federal Reserve Bank of New York, with the Capital Markets Function of the Research Group.. He has contributed to the NY Fed’s financial stability policy and to its monetary policy briefings. Tobias Adrian holds a Ph.D. from MIT and an MSc from LSE. He has taught at MIT and Princeton University

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