What we would ask Chairman Powell at the Humphrey-Hawkins hearings
Once again, we have questions we would like answered.
Its that time of year again, the time of year when the Chair of the Federal Reserve goes before the House Financial Services and Senate Banking Committees to deliver the Semi-Annual Monetary Policy Report, otherwise known as the Humphrey-Hawkins hearings. We here at Mercatus remain 0 for 0 in winning elections, so we will not be able to ask questions directly. But that doesn’t stop us from having questions. More specifically, my gifted colleagues have questions, and I just put them up here, because I live to serve. So, here they are:
The Balance Sheet and Operating System
For more on this topic, see here (note this link goes live at 6am EST 3/5/24)
The Fed’s balance sheet has grown significantly over the last 20 years, from about $800 billion in 2005 to $7.5 trillion today (Figure 1). A sizeable portion of the balance sheet—$4.66 trillion—is comprised of U.S. Treasuries.
Prior to the Great Recession, the Fed had a “scarce reserve” operating system where the Fed maintained a relatively small balance sheet and adjusted the federal funds rate primarily by buying and selling T-Bills. In 2008, the Fed abandoned this approach in favor of an “abundant reserve” operating system where the Fed maintains a large balance sheet because it pays banks interest on the reserves held at the Fed. Under this abundant reserves approach, the Fed adjusts the interest rate on reserves to manipulate the federal funds rate.
Many advanced economy central banks, including the Fed, the Bank of England, the Swiss National Bank, and the European Central Bank (ECB), are now experiencing losses on their large balance sheets. Some are now reconsidering the wisdom of maintaining large balance sheets and, as result, the operating system that goes along with them. The ECB, for example, is currently reviewing its operating framework and considering a tiered reserve system where only some of the reserves would earn interest at the central bank. This would minimize losses at the ECB and reduce banks’ demand for reserves.
1. Has the Federal Reserve also considered something similar to a tiered reserve system, or least considered taking another look at its operating system? If not, why?
2. How does the Fed think about the optimal size of its balance sheet? What considerations underlie the reasoning and under what conditions does the Fed think it’s appropriate to expand or contract the balance sheet?
3. By extending its balance sheet so large, the Fed has effectively become a public debt manager that helps determine the debt maturity structure and interest rates on a sizable part of the public debt. Do feel that Congress has given the Fed authority to play this role? Do you feel you have the democratic legitimacy to be managing about a quarter of the national debt?
Figure 1
(American Action Forum https://www.americanactionforum.org/insight/tracker-the-federal-reserves-balance-sheet/)
On the Taylor Rule and Nominal GDP Targeting
For more on this topic, see here
The Taylor Rule calls for adjusting the Fed’s target rate in response to inflation (specifically how far current inflation is from the Fed’s target) and the output gap (the difference between real GDP the level of economic output the economy could sustain without overheating). If inflation is above the target, or output is at risk of overheating, the rule suggests raising interest rates. Conversely, if inflation or output is below target, it recommends lowering interest rates.
Throughout 2021 and early 2022, the Fed kept the federal funds rate well below where the original Taylor rule (and popular modifications of it) indicated it should be. Now, the federal funds rate is close to the various prescribed rates but is forecasted to stay above them through 2026.
4. Does the Fed regret not more closely following Taylor rules in 2021 and 2022 as inflation surged?
5. Is the Fed concerned that the federal funds rate is forecasted to be meaningfully above Taylor rule rates over the next couple of years?
In November, Chair Powell observed in a speech that monetary policy should “look through” supply shocks such as pandemic-related supply chain disruptions and the Russia-Ukraine War. However, he also observed that it can be “challenging to disentangle supply shocks from demand shocks in real time.” This can make it difficult to follow the Taylor Rule in real time.
6. Have you and your colleagues considered alternatives to the Taylor rule, such as nominal GDP targeting – i.e., keeping total spending in the economy on a steady path – which allows the short-run inflation rate to fluctuate in response to supply shocks, while still anchoring medium-run and long-run inflation expectations?
The Philips Curve and its Limitations
For more discussion on this (and other topics), see here
The Philips Curve—coined in 1958— describes an inverse relationship between the inflation rate and the unemployment rate. This means as inflation decreases, unemployment tends to increase, and vice versa. Over time, economists have found several problems with the Phillips Curve, including its inability to account for the role of expectations, the possibility of having both high inflation and high unemployment (stagflation), and its poor predictive power in the long term as the relationship between inflation and unemployment may not be stable or consistent. These challenges have been met over the years with a host of respecifications of the Phillips curve, the latest being nonlinearity or sudden shifts that sharply alter the curve's implied inflation-unemployment tradeoff.
7. Given these failings, why does the Fed have an unfailing faith in the Phillips curve as a guide to understanding the transmission of monetary policy to inflation? The curve has exhibited pronounced instability for decades, which undermines its usefulness as a guide, yet Fed communications about inflation continue to be framed almost entirely in Phillips curve terms.
On Fed Independence
For more on this topic, see here
Before 2007, Fed lending rarely exceeded a few billion dollars. But during the financial crisis of 2007–2009 and the COVID-19 pandemic, it expanded dramatically and was extended well beyond the traditional scope of banking system counterparties. Although such interventions are sometimes described as “monetary policy tools,” they have gone well beyond monetary policy’s traditional role in extending liquidity to the financial system.
This has become particularly apparent in the operation of the 13(3) emergency lending facilities. As Professor Hal Scott observed before the House Financial Services Committee on February 15th, “it [is] very hard to say who was responsible for the design of [the] Mainstreet [lending facility]. Was it the treasury, or was it the Fed? ...it’s very hard to pin responsibility.” This conflation of monetary and fiscal policy responsibility is troubling.
8. Is the current inflationary episode due—at least in part—to credit-related political entanglements that have sapped the Fed’s political capital and impeded the Fed’s pursuit of monetary stability?
9. Did the Fed’s contribution to the design of COVID-19 fiscal stimulus measures make the Fed hesitant to counteract the stimulus by tightening monetary policy promptly in 2021?
How Fiscal and Monetary Policy Interact
For more on this topic, see here
There is growing recognition that monetary and fiscal policies interact more significantly than was historically appreciated. This has implications for policymakers throughout government, and it would be helpful to know how Fed officials think about these interactions in the conduct of monetary policy.
10. Given the growing concern about the long-term trend of fiscal policy and its potential impact on inflation and interest rates, how do you see the role of monetary policy evolving in response to fiscal challenges? Specifically, how might the Federal Reserve balance its dual mandate of price stability and maximum employment in the context of increasing fiscal deficits and debt levels?
11. Does it matter for the Fed’s ability to control inflation whether rapidly growing interest payments on outstanding debt get paid through higher taxes/lower spending or through further expansion of government debt?
12. Do the CBO’s projections of chronic primary deficits over the next 30 years threaten the Fed’s plans to return inflation to target?
13. How does the Fed view the inflationary impacts of fiscal expansion: does inflation arise entirely from overheating or does the issuance of government debt play an additional role?
On the Fed’s Multiple ‘Mandates’
Under Humphrey-Hawkins, the Fed has a dual mandate to ensure price stability and promote full employment. Under Dodd-Frank, the Fed has significant responsibilities to support financial stability. It is unclear to what extent these responsibilities ever conflict.
14. Do actions taken by the Fed to promote financial stability ever conflict with its dual mandate? If so, which actions should take precedence? Should Congress look into this issue?