How Central Bankers Think

When I read Charles Evans's most recent speech, I was struck by these two sentences:

Whenever the economy operates below its potential, the key mechanism that returns the economy back to potential is a fall in real interest rates. This decline reduces the supply of saving and boosts the demand for investment, resulting in increased spending.

Ben Bernanke tells us about how the Fed can speed the adjustment to "potential:"

Generally, if economic weakness is the primary concern, the Fed acts to reduce interest rates, which supports the economy by inducing businesses to invest more in new capital goods and by leading households to spend more on houses, autos, and other goods and services. Likewise, if the economy is overheating, the Fed can raise interest rates to help cool total demand and constrain inflationary pressures.

Those two quotes encapsulate the dominant school of central banking thought on the FOMC. We could even write this down formally - it's simple. Here are three equations that describe the economy and what monetary policy does, according to Evans, Bernanke, Kocherlakota, and I think Rosengren and Yellen, at least:

(1) r = R - i
(2) u = f(r-r*)
(3) I = i + g(r-r*)

In equations (1)-(3),

r = real interest rate
R = nominal interest rate
i = anticipated inflation rate
u = unemployment rate
r* = efficient real interest rate
I = actual inflation rate
f(.) is an increasing function
g(.) is a decreasing function

In this model, R is set by the Fed, i is exogenous, and r* is exogenous. Equation (1) is a Fisher relation. The real rate is the nominal rate minus the anticipated inflation rate. When the Fed says that "inflation expectations are well-anchored," what they mean is that i is independent of how the Fed sets R (as the Fed can always say reassuring things about how it is committed to price stability, apparently). Thus, when the Fed moves the nominal rate R, the Fed thinks it moves the real rate in lockstep.

The economically efficient real interest rate r* is what Woodford would call the "Wicksellian natural rate." In Woodford's world, this would be the equilibrium real interest rate if all wages and prices were flexible. This may or not be what Bernanke has in mind - he tends to leave unspecified the sources of the inefficiencies he is trying to correct. Equation (2) states that the unemployment rate rises if there is an increase in the difference between the actual real interest rate and the efficient real interest rate. But how do we know what r* is? From Charles Evans's point of view, that's easy. If Fed policy stayed unchanged (so that r is unchanged), and the unemployment rate went up, r* must have gone down.

Equation (3) states that the the current inflation rate is the anticipated rate of inflation, plus a term that depends negatively on the difference between the actual real rate and the efficient real rate. Therefore, if the real rate is above the efficient rate, the inflation rate will be low. Implicit in equations (2) and (3) is the Phillips curve - a central part of FOMC religion. FOMC statements and public discussion by Fed officials are replete with Phillips curve language. Note that changes in R which translate into changes in the same direction in r will move u and I in opposite directions - a movement along the Phillips curve.

Some readers will recognize the similarity between equations (1)-(3) and the three equations that some New Keynesian researchers work with. Typically the three New Keynesian equations are: (i) IS curve; (ii) Taylor rule; and (iii) Phillips curve. What I wrote down above is roughly the same idea, and that's no accident. What Woodford and his disciples did was to essentially reverse-engineer actual Fed policymaking. That's why central bankers are infatuated with New Keynesian economics - it rationalizes what they do.

Here is how the FOMC sees its current predicament. r* is really low, making u really high. The optimal thing to do would be to lower R to reduce r and reduce u. But R = 0 and can't go lower. Solution: There are long-term Rs that we can go after, which are currently above zero. Let's buy long-maturity assets and lower long-term Rs instead. You can read about that in Bernanke's speech.

But what's wrong with this approach? These ideas may be easy for Fed officials to explain to the Rotary club, but if you recite the ideas enough you start to believe them. How can anyone think that our current problem is that efficient real interest rates fall far below actual real interest rates? A short rate of -2% is too high? Why? TIPS yields of -1.65% (5 year) or 0.37% (30 year) are too high? Again, why? No one thinks that monetary policy has any long run consequences. Over what horizon do FOMC members think that they can essentially peg a real interest rate? Didn't exploitation of a perceived Phillips curve tradeoff get us in trouble in the past? Aren't we worried about that? Why did Phillips-curve "theory" become the dominant theory of inflation among policymakers? Why did monetary theory disappear? We know there are problems with the targeting of monetary aggregates, but surely most of us think that exchange in some class of assets is what drives long-run inflation. Where's the money?