Monetary Policy Lessons

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 I am no stranger to advising monetary authorities, having spent the past two decades as Permanent Secretary of the Federal Advisory Council. The FAC, established in the original 1913 Federal Reserve Act, is tasked therein to advise the Board of Governors on, among other matters, monetary policy. What follows distills five interrelated lessons, especially relevant to macroeconomists, that I have learned.

First is the necessity of a macro analytic blueprint capable of effectively guiding stabilization efforts over the broad range of circumstances. The bad news here is mainstream theorists have been doing a lousy job providing models that help, not hurt, effective policymaking. The good news is the emergence, in the GEM Project, of a macroeconomics that is both coherent and stabilization-relevant.

Generalized-exchange theory uniquely microfounds the central role of active nominal-demand management in containing welfare loss associated with macro shocks, no matter what their origins. (Chapter 10) By contrast, mainstream coherent market-centric theory, accepted by most macroeconomists within the Fed, provides no causal link from nominal disturbances to involuntary job loss and recognizably-sized movements in employment, output, and profit. Consensus modeling cannot produce recognizable business cycles and is, consequently, a wellspring of misleading stabilization advice. The profession must figure out how to return to the early Keynesian policy-centrality of total spending.

The second lesson is related. Consensus thinking implies that extreme total-spending instability is inherently uninteresting. Even after the Great Recession, the research topic has attracted remarkably little attention. Focusing instead on macroprudential tools, which the Project easily demonstrates will not prevent future Great Recessions, provides a better fit with mainstream modeling. The implicit message to monetary policymakers has long been that the metamorphosis of stationary into nonstationary demand disturbances (SDD→NDD) can be ignored. By contrast, the GEM Project establishes the crucial importance of the nature and consequences of acute instability, especially the badly underappreciated role played by the credibility of the central bank’s trend real-side objective. Mainstream theorists still largely ignore that the resolution of the 2008-09 SDD→NDD crisis required making the Fed’s trend employment objective credible to investors/lenders. (Chapters 6, 10)

Third, it follows that guidance from mainstream theorists is especially problematic when they assert, as they always do, the primacy of central banks’ low-inflation objective. Generalized-exchange macroeconomics rejects that foolishness, identifying the badly inadequate information on economic activity embodied in the inflation data. The GEM Project motivates a necessary reconfiguration of the monetary framework that has long dominated thinking in the academy:

Establish explicit, credible nonstationary employment and inflation objectives, providing coequal real and nominal macro anchors for forward-looking behavior throughout the economy. Operationally, the real and nominal regimes are each best specified as ranges, with more urgency assigned to getting within the range (once either indicator is displaced) and greater patience for properly locating employment and inflation within its target span.

The Fed leads the world in taking the dual mandate seriously. But that is not enough. The FOMC, as well as other stabilization authorities, must closely focus on providing analytical and empirical guidance for the effective management of nominal demand in response to the range of macro shocks and their propagation, seeking to maintain their real and nominal credibility. Intertemporal primacy between the employment and inflation goals is contingent on the current state and best-practices projection of demand growth and its nominal-real breakdown.

Despite the Kydland-Prescott time-inconsistency theorem, the pursuit of the dual objectives of high employment and low inflation is not particularly difficult for an independent central bank. (Chapter 10) Lalonde and Parent’s (2006) dual-mandate framework is illustrative. It is relevant here that GEM modeling demonstrates the stagflation decade to be badly misunderstood as a showcase example of time inconsistency. (Chapter 4)

Fourth, the beneficial role of monetary interventions in helping economies break out of stagnation is usefully informed by the generalization of exchange. (Chapter 5) Given their coherent market-centric modeling, mainstream theorists must maintain, wrongly, that stagnation must be always understood as a real phenomenon.

The fifth lesson concerns strategy execution.  The Fed should have, but has not, been building on its remarkable 2008-09 stabilization success in order to prepare for inevitable future acute-instability crises. In particular, the central bank should be much more proactive with Congress in support of the real side of its dual mandate. It should explicitly focus on assembling an increasingly powerful demand-management toolkit. It should also be communicating, to investors and lenders globally, its enhanced capacity and institutional commitment to halt and reverse future collapses in nominal demand while such disturbances are being spontaneously organized. Once keystone meaningful wage rigidity is more widely understood in the academy to be coherently derived from axiomatic model primitives, mainstream theorists’ own rules of engagement will mandate incorporation of the GEM analysis. Broad support from leading macroeconomists, reminiscent of the heyday of the Early Keynesians, would enhance Fed credibility and communication, especially with Congress and the media. Tighter constraints on what is reasonable in macro debates, again reminiscent of the early Keynesian era, would follow from reconstructing consensus macro thinking in the academy to be stabilization-relevant.

Think about it. Broad acceptance of coherent market-centric DSGE theory by Fed economists, from the top down, has inevitably damaged the central bank’s capacity to sustain the credibility of its real-side mandate and, ultimately, its effective management of macro instability. Analytic thinking that arbitrarily confines rational exchange to the marketplace has especially discouraged adequate investment in, and sufficient urgency about, modeling the continuous-equilibrium channel through which adverse nominal disturbances, stationary and nonstationary, induce involuntary job, wage income, and profit loss. Longstanding inattention to the ‘mystery of money’ forced Bernanke’s response to the 2008-09 crisis to be an ad hoc, albeit inspired, exercise. We all know that reliance on ad hockery is dangerous. The research staffs at the Board and the twelve District Banks should wake up, recognize the profound limitations of consensus macro thinking, and redirect their efforts to analysis that is relevant to stabilizing highly specialized economies.

Blog Type: Policy/Topical Saint Joseph, Michigan


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