Strategic Review and Beyond: Rethinking Monetary Policy and Independence

This article is based on the Homer Jones Memorial Lecture delivered at the Federal Reserve Bank of St. Louis, March 4, 2020.

Abstract

I survey monetary policy strategy, regulation, and central banks' mandates and independence. I do not think strongly negative interest rates, vastly expanded quantitative easing, or extensive forward guidance can or should stimulate in the next recession. I advocate a price-level target and that the Fed fix the spread between indexed and nominal debt. I argue for a large balance sheet of interest-paying reserves, achieved via a flat supply curve, though I argue that the Treasury should issue reserve-like debt as well to take up much of that role. Central banks should avoid the temptation toward ever-expanding roles including "macroprudential" policy, discretionary credit cycle management, asset price targeting, and using their regulatory power to advance social and political goals such as climate change and inequality. Only limited scope of action to areas of agreed technocratic competence will salvage central banks' and international institutions' useful independence.

This is an exciting moment to think about central banks and monetary policy. The Fed and many other central banks are undergoing a formal strategy review. More broadly, the community that studies monetary policy has entered a period of fundamental rethinking. I'm grateful for this opportunity to put together my thoughts and to reflect together on the answers.

I'll start with the easy question, monetary policy. Then I'll move on to regulation, and finally we'll think about central bank mandates and independence. I will end up contradicting just about every tenet of current consensus opinion, well articulated, for example, by Bernanke (2020). Well, examine the logic and evidence and decide for yourself.

A theme underlies my thoughts: We have learned a lot in the 12 years since the financial crisis. Some of these lessons are slowly percolating into policy. I mostly take these lessons to their logical conclusion. 

In 2007, the question was wide open: What happens if interest rates hit zero and the Fed cannot lower interest rates? What happens if the Fed pays interest on reserves—deposits that banks hold at the Fed—and increased reserves by 3,000 percent, from $10 billion to $3 trillion? Every mainstream school of thought—monetarist, old ILSM Keynesian, new-Keynesian—predicted massive deflation or inflation or great volatility in these events. Yet nothing of the sort happened. The long quiet slow recovery decisively disproved these ideas. Yet the vestiges of these ideas still guide central banks' policy thinking and review. How we think going forward must incorporate the lessons of this clear experiment. 

Twelve years of reflection about regulation in the wake of the crisis have taught us that we can stop financial panics forever, without turning the financial system into a sclerotic regulated utility, featuring lots of leverage, tight regulation, and inevitable rounds of crisis and bailout. I'll show you how. It's time to complete that agenda.