An Unnecessary Fix for the Fed

Legislation in pursuit of 'transparency and accountability' has little to do with either.

By Alan S. Blinder

July 17, 2014 7:26 p.m. ET

The House Financial Services Committee held a hearing on Federal Reserve reform on July 10. The hearing didn't get much press attention. But it was remarkable. While the House can't manage to engage on important issues like tax reform, immigration reform and the minimum wage, it's more than willing to propose radical "reform" of one of the few national policies that is working well.

The bill under consideration is called the Federal Reserve Accountability and Transparency Act. (That's right: FRAT.) To be fair to an otherwise dreadful bill, accountability and transparency are worthy objectives, and FRAT does include some reasonable ideas, such as trimming the news blackouts before and after meetings of the Federal Open Market Committee. But it also includes some corkers, such as requiring public disclosuresin advancebefore entering into international negotiations, disclosures that could make such negotiations next to impossible. How would you like to play your poker hand open?

But the meat-and-potatoes of the House bill has little to do with either transparency or accountability. Instead, it seeks to intrude on the Fed's ability to conduct an independent monetary policy, free of political interference.

As the title of Section 2 puts it, FRAT would impose "Requirements for Policy Rules of the Federal Open Market Committee." A "rule" in this context means a precise set of instructionsoften a mathematical formula—that tells the Fed how to set monetary policy. Strictly speaking, with such a rule in place, you don't need a committee to make decisions—or even a human being. A handheld calculator will do.

In the debate over such rules, two have attracted the most attention. More than 50 years ago, Milton Friedman famously urged the Fed to keep the money supply growing at a constant rate—say, 4% or 5% per year—rather than varying money growth to influence inflation or unemployment.

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About two decades ago, Stanford economist John Taylor began plumping for a different sort of rule, one which forces monetary policy to respond to changes in the economy—but mechanically, in ways that can be programmed into a computer. While hundreds of "Taylor rules" have been considered over the years, FRAT would inscribe Mr. Taylor's original 1993 version into law as the "Reference Policy Rule." The law would require the Fed to pick a rule, and if their choice differed substantially from the Reference Policy Rule, it would have to explain why. All this would be subject to audit by the Government Accountability Office (GAO), with prompt reporting to Congress.

In a town like Washington, the message to the Fed would be clear: Depart from the original Taylor rule at your peril. Federal Reserve Chair Janet Yellen understands this and, as she made clear in her semiannual testimony to the House Financial Services Committee on Wednesday, opposes the bill.

So what is this rule that FRAT would turn into holy writ? It's a simple equation, which starts by establishing a baseline federal-funds rate that is two percentage points higher than inflation; that's about 3.5% now. It then adds to that baseline one-half of the amount by which inflation exceeds its 2% target (that "excess" is now roughly minus 0.5%). Next, it adds one-half the percentage amount by which gross domestic product exceeds an estimate of potential GDP (that gap is controversial but is perhaps minus 4% today). Thus Taylor's mechanical rule wants the current fed-funds rate to be about 3.5 – 0.25 – 2.0 = 1.25%which is vastly higher than the actual near-zero rate.

Fed staff could no doubt concoct an alternative rule that instructed the FOMC to set the fed-funds rate close to zero today, and the committee could pretend it was using that rule. That's transparency?

But there is a deeper problem. The Fed has not used the fed-funds rate as its principal monetary policy instrument since it hit (almost) zero in December 2008. Instead, its two main policy instruments have been "quantitative easing," which is now ending, and "forward guidance," which means guiding markets by using words to describe future policy intentions. If words are the Fed's main policy instrument, how is the FOMC supposed to set them according to a rule? And how can the GAO determine whether that rule resembles the "Reference Policy Rule"?

The Taylor rule probably would give the Fed sensible instructions in normal times. But what about when the world is far from normal

The Fed claimed to be using Friedman's money growth rule during the tumultuous disinflation of 1979-82—with miserable results. Luckily for all of us, the Taylor rule wasn't tried during the 2008-09 financial crisis. That could have been disastrous, effectively tying the Fed's hands just when extraordinary monetary stimulus was most needed. Should we now bet the ranch that the world will remain placid forever?

Conservatives distrust concentrated government power—an idea embraced by our Constitution. They worry that human beings, who are fallible and maybe not even trustworthy, will make poor policy choices. Yes, to err is human. But humans can often recognize extraordinary events and try to adapt. Mechanical rules can't.

There is another conservative principle in which I've always believed: If it ain't broke, don't fix it. Monetary policy is one of the few things in today's Washington that "ain't broke." The mischievous FRAT wouldn't fix it.

Mr. Blinder, a professor of economics and public affairs at Princeton University and former vice chairman of the Federal Reserve, is the author of "After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead" (Penguin, 2013). 

July 17, 2014 6:34 pm

US uses capital markets sanctions to cut deep into Russian economy

For weeks, the Obama administration has been searching for “scalpelsanctions that will cut deep into Russia’s companies and economy as punishment for its actions in Ukraine but avoid significant blowback against American businesses.

The latest package of sanctions on Russia, which were unveiled on Wednesday, make use of a new weapon in the US armoury: blocking some of Russia’s most important companies from raising long-term finance in the US.

Judging by the swift and angry reaction from Russia to the new round of US sanctions over Ukraine, the administration has succeeded in its first goal of inflicting economic penalties on Russia. But it might not have insulated the US from retaliation.

While many Russian government officials and tycoons derided a first wave of sanctions announced in March as meaningless, they voiced concern that the new measures will hurt the Russian economy.

“The sanctions that have been applied today in fact mean a blow to major Russian companies that are leaders in their sectors, be it the energy or the banking sector,” said Andrei Kostin, chairman of state-owned VTB, Russia’s second-largest lender. Quite a significant negative effect will be caused to the global financial banking system as a whole and our economic co-operation.”

In private, Russian business leaders are even more outspoken. A senior official at a large Russian state bank said sectoral sanctions were equivalent to an act of war. “You cannot just look at the purely economic and financial impact. It will develop into some illogical and completely blown-out-of-proportion fight,” he said.

He added that Russia was likely to respond harshly to full sectoral sanctions with measures such as nationalising assets of US oil companies and banks in the country. Citibank will just disappear here overnight,” he said.

One reason for the panic is the sense that Washington is using an asymmetrical weapon by exploiting its dominant position in the global financial system. The first wave of sanctions introduced in March already gave Russia a flavour of how powerful an instrument this can be. The earlier measures were limited – they froze the assets of some Russian government officials and business leaders and barred US persons from carrying out transactions with them.

But the fear of harsher steps to come effectively froze Russian banks and corporates out of the international capital markets overnight. International bond issuance out of Russia almost dried up, and foreign banks became reluctant to extend new credit lines.

With western governments slow to proceed to the next stage, the situation had relaxed in recent weeks, allowing state lenders Sberbank, VTB, Gazprombank and Promsvyazbank to raise fresh funds. “The appetite on the international capital markets is smaller but there is still appetite,” the senior state banker said earlier this week.

That could now change for Russian corporates, which have to repay $95.4bn in foreign debt before the end of the year. “For the four directly affected companies, access to the global market is much more limited, and investors are also likely to start placing a political risk premium again on all Russian companies, so the cost of borrowing will go up,” said Vladimir Tikhomirov, chief economist at BCS Prime, a Moscow brokerage.

A senior US official said that one purpose of the new sanctions was to make investors and companies more cautious about dealing with Russia.

“I think we are anticipating both direct costs with respect to those entities and for the market to recognise the seriousness with which we’re taking the situation,” he said.

At the same time, the new sanctions have been tailored to address some of the concerns of the US business community. For example, the measures do not prohibit equity deals with Rosneft and Novatek, the two Russian energy companies targeted on Wednesday. That could help US energy groups as well as Morgan Stanley’s planned sale of its oil merchant trading business to Rosneft.

Gazprombank, one of the sanctioned banks, has $2bn in foreign debt due before the end of the year. It had planned to refinance a $1bn syndicated loan due in 2014 but there are concerns that it may need to abandon this. A $1bn Eurobond is due in December.

VEB, also a target of sanctions, has $1.3bn in foreign debt due in 2015 and $1.1bn in foreign debt due in 2016. It has $15.4bn in debt maturing in 2032.

VEB’s strategy has been to rely heavily on US dollar wholesale funding,” suggesting that the government may now have to lend VEB money from its reserves, as it did during the 2008-2009 financial crisis, says Ivan Tchakarov, chief economist at Citibank in Moscow.

Mr Tchakarov predicts the central bank could potentially go ahead and raise rates now “which means it’s going to be even more difficult for companies and consumers to borrow”.

Copyright The Financial Times Limited 2014.