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Home Publications Blogs Beat the Press The Federal Reserve Board Responds to Bankers

The Federal Reserve Board Responds to Bankers

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Wednesday, 20 August 2014 07:01

The Washington Post had an article on grassroots efforts to try to influence the Federal Reserve Board's decisions on monetary policy. It would have been helpful if the piece provided more background on the Fed's institutional structure and decision-making process.

The Fed's decisions on monetary policy (e.g. raising or lowering interest rates and quantitative easing) are made by the 19 member Federal Reserve Open Market Committee (FOMC). This committee includes seven governors who are appointed by the President and approved by Congress. The term is 14 years, although governors rarely serve out a full term. The chair is one of the seven governors, although their term as chair is just 4 years.

The other 12 members of the FOMC are the presidents of the district banks. These presidents are essentially appointed by the banks within the district. Only five of the 12 bank presidents have a vote. The president of the New York bank always has a vote, with the other 4 voting slots rotating annually among the other 11 bank presidents. This structure ensures that the banking industry's concerns will get a full hearing at Fed meetings. The concerns of workers whose jobs and wages depend on the Fed's decisions may not be heard.

At one point the article discusses public protests against Paul Volcker's decision to raise interest rates when he was chair of the Fed in the early 1980s. It tells readers that the protests did not affect Volcker's decisions at all. Whether or not this is true, that does not mean that the protests had no impact on the Fed's actions. Volcker had to get the support of the majority of the FOMC to get his way on monetary policy. If the protests affected the views of other members then Volcker would have been forced to take these views into account in setting policy. For this reason the focus on Volcker badly misleads readers on the potential impact of public protests.

In assessing the potential impact of public protests on Fed policy it is perhaps worth going back to the 1990s when there were also some public efforts, sponsored by unions and community groups, to influence Fed policy. In the years 1995-1996 the unemployment rate was falling below the 6.0 percent threshold that nearly all mainstream economists considered a floor. The conventional view held that if the unemployment rate fell below this level it would cause inflation to start to cycle upward.

Alan Greenspan, who was not a mainstream economist, was chair of the Fed at the time. He argued that there was little evidence of inflationary pressures and therefore no reason to raise interest rates and slow the economy. He had to overcome the opposition of several prominent FOMC members, including the current chair Janet Yellen, who was a governor at the time. Because there were public efforts to keep interest rates down, Greenspan did not have to worry about a strong consensus in the policy world for raising interest rates. This made it easier for him to carry the day and keep interest rates low.

The benefits from this decision were enormous. By allowing the unemployment rate to fall below 6.0 percent (it eventually hit 4.0 percent as a year-round average in 2000) more than 5 million people were able to get jobs. Furthermore, the tighter labor market allowed tens of millions of workers at the middle and the bottom of the wage distribution to see sustained wage gains for the first time since the early 1970s.

And, for those deficit cultists in Washington, the lower unemployment and more rapid growth led to a large improvement in the budget situation. Instead of the deficit of 2.3 percent of GDP projected by the Congressional Budget Office for 2000, back in 1996, the government actually ran a surplus of 2.5 percent of GDP. This shift from deficit to surplus of almost 5 percent of GDP would be the equivalent of $850 billion in 2014, or to use the full 10-year budget horizon, the equivalent of almost $10 trillion in deficit reduction.

The moral of the story is first, that public pressure on the Fed can have an impact on its decisions, which otherwise are likely to be far too responsive to bankers' concerns about inflation. The second, and at least as important, moral is that the consensus in the economics profession is often completely off the mark. This was certainly true in the 1990s when economists across the political spectrum agreed that the unemployment rate could not fall much below 6.0 percent without triggering inflation. The country would have paid an enormous price if mainstream economists had been able to determine policy back then. There is little reason to believe that the mainstream of the economics profession has a better understanding of the economy today. 

Comments (14)Add Comment
Extremists Defect to Mainstream When Convenient
written by Last Mover, August 20, 2014 9:58

A theme that tends to run through extremists of all stripes, but especially conservatives, is how they flipflop so casually between extremes over time. For example plenty of so called conservatives were dedicated Marxists in the past at one time or other.

As a non-mainstreamer, Greenspan made two critical decisions that could be characterized as one that accidentally turned out right and the other, by his own (lying) words, turned out accidentally wrong - both on a huge massive scale.

When cornered and forced to reveal the basis of their decisions extremists typically advocate it's better to take risk and do something rather than avoid risk and do nothing, even at the cost of being wrong.

Yet note the contrast between the two extremes of Greenspan, one a wild success and one a disaster, in this context:
Because there were public efforts to keep interest rates down, Greenspan did not have to worry about a strong consensus in the policy world for raising interest rates. This made it easier for him to carry the day and keep interest rates low.


Correct, but in contrast DB has pointed out many times that Greenspan was more responsible for the subsequent housing bubble bust than anyone else for not speaking out against the mainstream from his powerful bully pulpit to easily stop it.

So Greenspan really was a mainstream economist when it was convenient, certainly enough to ignore a non-mainstreamer like DB who was hoisting a very high warning flag at the time about the bubble.
...
written by TheUnMediMike, August 20, 2014 10:17
Good post Dean, but one point --- which was not essential to the thrust of your arguments --- deserves more attention. The "surplus" generated by 2000 was, as I recall, actually attributable to counting SOCIAL SECURITY's surplus (without doing so there would have been a budget deficit). Among other things, references to an overall "surplus" among other things provided an argument for tax cuts.
Bankers don't know much
written by Dave, August 20, 2014 10:22
I was shocked with how dumb the comments coming from governors were when we hit the liquidity trap. There's an inherent conflict that even many good economists don't want to admit. It isn't valid to run the economy based upon bank profits.

Not only is there a conflict of interest in such cases, but most bankers know very little of macroeconomics. Geithner knew very little of macroeconomics. He didn't understand it and he didn't really care. He cared about bank solvency alone. Greenspan was a cult member. Paulson was a crook. Rubin was and is a crook.

How can this be solved to preserve economic freedom and democracy?
RE: Surpluses
written by Dave, August 20, 2014 10:29
To my eye, US budget surpluses cause depressions. The correlation is perfect. After a period of surplus, a financial crisis and recession results.

Without the safe sink for savings in the US government, excess speculation tends to drive us into financial collapse. Rather than a balanced budget amendment, we should have a permanent deficit amendment (not really, but the point stands I think).
Power tends to corrupt
written by ifthethunderdontgetya™³²®©, August 20, 2014 10:48
.
Absolute power corrupts absolutely.

The financial sector of our economy is way too powerful and concentrated in too few hands.

http://tcf.org/blog/detail/graph-how-the-financial-sector-consumed-americas-economic-growth

It isn't just the Fed that is affected, it is all of our policies and politicians.
~

so isn't a rule better?
written by pete, August 20, 2014 10:49
I.e., keep the Fed neutral. The tendency for the use of monetary bubbles to cure unemployment, which the Fed certainly has done, only causes (occasionally) massive disruptions as in the early 80s and in the mid 2000s. Whether the interest group winning the day with the Fed is the bankers, or the homebuilders, or the community activists, or the SEIU, JQ Public suffers in the long run. And there is no way of predicting which group will be more persuasive at any point in time, so there is substantial, some might argue massive, monetary uncertainty. Adding such risk to an already risky economy is unnecessary at best, and dangersous at its worst.

The Fed is essentially an anachronistic institution, created in different times, tweaked during the depression, and again with the addition of the dual mandate. This later tweaking of a bank-run central bank was poorly designed. There is no weighting scheme for the Fed vis a vis how much inflation and unemployment it will tolerate, just some suggestive language leading to conflicts, and resulting political wars, between the two. And adding a direct role for politics into the Fed is a very bad idea. If the desire is for congress to vote on the monetary base, for example, then just say so. I could imagine each year a vote on the monetary base, similar to the debt ceiling. Of course that would be nonsense. Within the constraints of the current institution, set a Taylor-ish rule and stick to it.
Oops.
written by ifthethunderdontgetya™³²®©, August 20, 2014 10:53
.
Let me try to enter that url again:

http://tcf.org/blog/detail/gra...mic-growth
~
...
written by JSeydl, August 20, 2014 12:18
And, for those deficit cultists in Washington, the lower unemployment and more rapid growth led to a large improvement in the budget situation. Instead of the deficit of 2.3 percent of GDP projected by the Congressional Budget Office for 2000, back in 1996, the government actually ran a surplus of 2.5 percent of GDP.


Were the surpluses due to a lower unemployment rate and better wage growth at the bottom and middle or to a bubble in technology stocks? Dean, you have now told both stories - the former celebrates the surpluses while the latter decries them. Which do you really believe?

Also, it doesn't seem exactly fair to say that while the institutional setup of the Fed means that bankers on the board are going to favor a high unemployment rate, labor can offset this by protesting more. Why should the burden be on labor to protest? A better institutional setup would allow the masses to elect representatives to participate diectly on the board.
It was both lower unemployment and the bubble
written by Dean, August 20, 2014 12:44
Joe,

both the drop in the unemployment rate and the bubble were important in the shift to surplus. I would have to double-check the numbers, but I believe that a 1.0 percent drop in the unemployment rate is ordinarily associated with a decline in the deficit of around 1.0 pp of GDP (higher tax revenue, lower benefits). This means that a bit less than half would be do the drop in the unemployment rate.

Not all the rest was the bubble. Health care costs were less than projected as were interest payments. My guess is that the effect of the bubble and the lower than projected unemployment were probably close to even.

On the governing structure -- sure, it would be great to make it more democratic. But for now, it is what it is.
Nice Post
written by Jerry Brown, August 20, 2014 1:12
You have a great post at Aljazeera America which I saw because Mark Thoma linked to it. Could you provide a notice at Beat the Press of your other posts when possible? I hate to miss them.
...
written by JSeydl, August 20, 2014 2:57
Sure, I understand. But you're implicit assumption is that the drop in the unemployment rate and the bubble were independent of one another. We may have a problem if Greenspan not tightening led to a drop in the unemployment rate (which raised workers' wages) but also to the creation of the bubble. "Not tighening" means keeping liquidity flowing, which can create bubbles - I know, sort of an Austrian view, but there's some truth to it. I know that your answer would be that monetary policy should remain loose when slack is high and that any impending bubbles can be "talked down" by central bankers. But if the bubbles keep coming up - because there's too much liquidity! - then we do have the risk that the central bankers may miss some of them and therefore may be unable to talk them down.

Anyway, I agree with the policy recommendation - tightening in the late-90s probably would have been a bad idea. But just highlighting that the situation may not always be so clear-cut. Workers at the bottom and middle after all are going to be hurt badly when a bubble bursts, even if they benefitted greatly when the bubble was inflating.
I don't think it is that hard to see dangerous bubbles
written by Dean, August 20, 2014 3:19
Joe,

I think there is a mythology that bubbles are hard to spot. It might be difficult to determine if the the price of silver or bitcoins are being moved by irrational bubbles, but these don't matter for the economy. It matters when there is a bubble in an asset that is important enough that it actually can move the economy.

That was true of stocks in the 90s and housing in the last decade. This was easy to see in the data given the surge in investment, especially in tech, in the late 1990s and 2000, and the explosion in residential construction in the last decade. Of course both bubbles also led to consumption booms due to the wealth effect.

I don't see how an observant central banker can miss a bubble that is actually moving the economy. For this reason, I think the answer to the 90s and 00s was to keep the foot on the accelerator because the economy needed to grow, but shoot at the bubbles.

FWIW, I don't think it was necessary for Yellen to shoot at the bubbles in junk bonds and social media companies, but I'm still glad she called them out in her testimony. It is a great test to see the impact of Fed statements of this sort on markets.
...
written by JSeydl, August 20, 2014 3:51
Ha, yea I must say that deep down I agree. It's funny cause I'm working on a project right now about when a central bank should be concerned about bubbles; and I brought up the idea that central bankers should be concerned about them only when they move the real economy, taking a page from you. The response of my colleagues was to say that bubbles that aren't clearly driving the real economy can still have impacts that central bankers should care about and that raising interest rates may be the only way to address them. When pressed, my opponents argue by using fancy language like "one-sided markets" and "interconnectedness" and "disruptions to the bank lending channel", all the while not being able to provide one historical example of a bubble that wrecked the real economy without first clearly driving it. Sigh, the things one has to deal with as a bank economist...

Best,
Joe
...
written by watermelonpunch, August 20, 2014 11:02
Nice Post
written by Jerry Brown, August 20, 2014 12:12
You have a great post at Aljazeera America which I saw because Mark Thoma linked to it. Could you provide a notice at Beat the Press of your other posts when possible? I hate to miss them.


On the top & left here, there are links to news & multimedia & opeds, etc. Most of it winds up on those pages. You can also get Google News alerts on "Dean Baker", but that will also send you links to where Dean Baker is quoted - not just stuff he's written himself.

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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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