Later this week, monetary-policy disciples – at least those who agree with the Fed – will gather around the campfire atop Jackson Hole to ponder the question set before them: whether monetary-policy transmission has been effective and, since it’s awesomely obvious it hasn’t, what might be done about that. The plan is clearly to float trial balloons in the clear mountain air to see if the Fed’s thinking about the new plan slated for 2025 is any better than that which lay behind its disastrous 2019 monetary-policy rewrite. Those allowed into these August precincts will have much of value to say this time around much as they sought to do the last time the Fed asked for all their views. Odds are, though, that Jackson Hole will not consider three non-econometric phenomena that lie behind recent policy misfires: economic inequality, NBFI migration, and the strong counter-cyclical impact of Fed supervisory policy.
Why do these matter so much?
First to economic inequality. The last time the Fed rewrote its monetary-policy model, it deigned to consider economic inequality, but promptly dismissed any reasons to worry. There were, though, lots of them.
The 2019 inequality exercise suffered from the same problem as most Fed models: reliance on representative-agent, not heterogeneous data showing distributional disparities. This approach thus reaffirmed blithe convictions that anything that keeps employment high and inflation in check is good for lower-wealth and -income households because it’s good for everyone else. See my book for why that’s grievously wrong and recent Fed policy for how much damage it does when the Fed sweeps inequality under the rug.
This damage isn’t just to lower-prosperity households – it’s also to the Fed. Assumptions that easing policy will support sustainable, robust growth are wildly off-base when lower rates lead as they did and will to still more investments by high-wealth households in financial assets such as equities and bonds that no longer promote capital formation. The reasons why this relationship is broken are as complex as those for why the Phillips Curve fell apart, but thus it is.
Further, spending doesn’t meaningfully slow when rates go up because most American households are already buying little more than necessities and those that can afford discretionary expenditures don’t finance their purchases with debt thanks to all the wealth they’ve accumulated thanks to ultra-low rates and the market and home-ownership booms they spawned. The wealth effect works, but only for the wealthy and not as the Fed presumes in its continuing commitment to trickle-down policy.
The impact of economic inequality is reason number one why Fed policy won’t work if the Fed fails to take it into meaningful account. Reason number two is the transformation of the financial system from the bank-centric one on which the Fed still counts to one in which NBFIs often play a dominant role.
See, for example, how tighter monetary policy hasn’t staunched the willingness of unregulated NBFIs to make trillions of loans at newly-high rates to a market eager to get them to cover all the debt it amassed when rates were low. And, once, households held all their savings in bank accounts that ebbed and flowed much as the Fed bid them to do. Now, wealthier households largely hold assets outside bank deposits in assets such as mutual funds that do not transmit monetary policy in anything like Fed lock-step.
What’s the third reason? It’s the inherent contradiction between telling banks what to do on the supervisory front and assuming they’ll still do what you want them to do in order to transmit monetary policy.
This has been a push-pull ever since the great financial crisis. Part of the Fed’s effort to restore macroeconomic growth was massive unconventional accommodation, but this hit an obstacle as big as Grand Coulee Dam because banks faced an onslaught of new rules designed to curb the high-risk activities needed to restart a traumatized economy in the absence of fiscal stimulus. All the money the Fed flung into the economy and all of the real rates below zero didn’t jump-start growth – they encouraged banks to throw money back into central-bank deposits, leaving an open field for NBFIs that of course raised all the systemic risks that evidenced themselves in 2020.
Tighter monetary policy also backfired for banks after years of ultra-accommodation because poor supervisory policy allowed undue holdings in low-rate investments and hundreds of billions of losses that, when unhappily realized last year, spawned yet another systemic crisis. Should the Fed have kept policy easy if it knew what it should have known about huge unrealized losses to protect banks? Of course not – this would have sent inflation still higher given all the errors poor models made in predicting it and its permanence. Still, the contradictions are evident and the temptations to succumb are great at an institution making both monetary and supervisory policy.
So far, the mighty monetary-policy culture at the Fed always wins out over the supervisors, and maybe that’s just as well given the Fed’s woeful supervisory record. But, not heeding supervisors can have cataclysmic consequences – I know for a fact that some at the Fed joined those at the OCC in the mid-2000s warning of a looming housing crisis, but nothing daunted the Greenspan/Bernanke “great moderation.” Oops.