By Elham Saeidinezhad
Bagehot, “Money does not manage itself.”
In this year’s Jackson Hole meeting, the Fed announced a formal shift away from previously articulated longer-run inflation objective of 2 percent towards achieving inflation that averages 2 percent over time. The new accord aims at addressing the shortfalls of the low “natural rate” and persistently low inflation. More or less, all academic debates in that meeting were organized as arguments about the appropriate quantitative settings for a Taylor rule. The rule’s underlying idea is that the “market” tends to set the nominal interest rate equal to the natural rate plus expected inflation. The Fed’s role in this equation is to reduce or increase this market rate by changing the short-term federal funds rate whenever the inflation deviates from the target. The goal is to stabilize the long-run inflation. The Fed believes that the recent secular decline in natural rates relative to the historical average has constrained the power of the federal funds rate to achieve this mandate. The expectation is that the Fed’s decision to tolerate a temporary overshooting of the longer-run inflation to keep inflation and inflation expectations centered on 2 percent following periods when inflation has been persistently below 2 percent will address the framework’s constant failure and restore the magic of central banking. However, the ongoing issue with the Taylor rule-based monetary policy frameworks, including the recent one, is that they require the Fed to overlook the trends in the credit market, and only focus on the developments in the real economy, such as inflation or past inflation deviations, when setting the short-term interest rates. Rectifying such blind spots is what money view scholars were hoping for when the Fed announced its intention to review the monetary policy framework.
The logic behind the new framework, known as the average inflation targeting strategy, is that inflation undershooting makes achieving the target unlikely in the long run as it pushes the inflation expectations below the target. This being the case, when there is a long period of inflation undershooting the target, the Fed should act to undo the undershooting by overshooting the target for some time. The Fed sold forecast (or average) targeting to the public as a better way of accomplishing its mandate compared to the alternative strategies as the new framework makes the Fed more “history-dependent.” Translated into the money view language, however, the new inflation-targeting approach only delays the process of imposing excessive discipline in the money market when the consumer price index rises faster than the inflation target and providing excessive elasticity when prices are growing slower than the inflation target.
From the money view perspective, the idea that the interest rate should not consider private credit market trends will undermine central banking’s power in the future, as it has done in the past. The problem we face is not that the Fed failed to follow an appropriate version of Taylor rule. Rather, and most critically, these policies tend to abstract from the plumbing behind the wall, namely the payment system, by disregarding the credit market. Such a bias may have not been significant in the old days when the payment system was mostly a reserve-based system. In the old world, even though it was mostly involuntarily, the Fed used to manage the payment system through its daily interventions in the market for reserves. In the modern financial system, however, the payment system is a credit system, and its quality depends on the level of elasticity and discipline in the private credit market.
The long dominance of economics and finance views imply that modern policymakers have lost sight of the Fed’s historical mission to manage the balance between discipline and elasticity in the payment system. Instead of monitoring the balance between discipline and elasticity in the credit market, the modern Fed attempts to keep the bank rate of interest in line with an ideal “natural rate” of interest, introduced by Knut Wicksell. In Wicksellians’ world, in contrast to the money view, securing the continuous flow of credit in the economy through the payment system is not part of the Fed’s mandate. Instead, the Fed’s primary function is to ensure it does not choose a “money rate” of interest different from the “natural rate” of interest (profit rate capital). If lower, then the differential creates an incentive for new capital investment, and the new spending tends to cause inflation. If prices are rising, then the money rate is too low and should be increased; if prices are falling, then the money rate is too high and should be decreased. To sum up, Wicksellians do not consider private credit to be intrinsically unstable. Inflation, on the other hand, is viewed as the source of inherent instability. Further, they see no systemic relation between the payment system and the credit market as the payment system simply reflects the level of transactions in the real economy.
The clash between the standard economic view and money view is a battle between two different world views. Wicksell’s academic way of looking at the world had clear implications for monetary policy: set the money rate equal to the natural rate and then stand back and let markets work. Unfortunately, the natural rate is not observable, but the missed payments and higher costs of borrowing are. In the money view perspective, the Fed should use its alchemy to strike a balance between elasticity and discipline in the credit market to ensure a continuous payment system. The money view barometer to understand the credit market cycle is asset prices, another observable variable. Since the crash can occur in commodities, financial assets, and even real assets, the money view does not tell us which assets to watch. However, it emphasizes that the assets that are not supported by a dealer system (such as residential housing) are more vulnerable to changes in credit conditions. These assets are most likely to become overvalued on the upside and suffer the most extensive correction on the downside. A central bank that understands its role as setting interest rates to meet inflation targets tends to exacerbate this natural tendency toward instability. These policymakers could create unnaturally excessive discipline when credit condition is already tight or vice versa while looking for a natural rate of interest.