The Federal Reserve dilemma
Neo Wicksell implemented by Woodford 2012 has strait jacketed the Fed
This is the second part to The Monetary Frontier on the current crisis at the Federal Reserve due to the mess that adopting the Neo Wicksell monetary thesis and then implemented this thesis by policy outlined by Michael Woodford at the 2012 Jackson Hole soiree.
The first part is here:
Before you consider the following you must form an opinion on Federal Reserve Neo Wicksell monetary policy implemented by Woodford Jackson Hole 2012 policy.
Know what that is fully, then proceed - the prior post made on this subject is above.
It is obvious now that considering not only the the economic response to the Federal Reserve raising Fed Funds from 0% to 5 3/8%, now 4 7/8%, but also the last decade after adoption of Neo Wicksell, the Fed has had no impact on inflation and has failed to reach the stressed inflation target.
This is very very serious statement that threatens the foundation of the US financial system. The country must have a powerful, empowered monetary agency. All will agree that controlling inflation is one of the most important duties of the Fed and why it is provided, by Congress, with such massive powers. But it is provided these powers by Congress and will be judged by Congress first in terms of the ability shown to manage inflation. There is no mention of the Federal Reserve in the US Constitution.
It is then a rather easy task to judge this Fed’s ability to manage inflation, but despite being easy it is very robust method to consider the trailing actual results of changes in Fed Funds to the change in inflation for the last decade. First with Yellen confessing that the Fed failed and was not able to raise inflation to 2% target, and then later with Powell becoming ever more muted in discussing the here and now inflation since 2022. “Cumulative” ( Wicksell phrase), then became “lagging” and then became “restrictive” were used by Powell in front of Congress in describing the efforts to curtail and drop inflation. Weak gruel.
There is now a decade of record that proves that as far as inflation goes, Neo Wicksell monetary policy does not work.
And at some point, certainly by the time of Powell - and might even be the cause of his leaving the Fed - the Fed understands and agrees with this statement that the management of inflation has been a failure since 2014. That means for years now, the Fed has committed perjury in front of Congress during the bi-annual testimony of the Chair before the Senate and the House.
This is a most serious statement as never has the Fed lied to Congress prior to 2014. That Congress is so witless as to not ask the obvious questions - again as per law - is no defense for the Fed in committing perjury.
The market is still successfully contained by the use of Woodford 2012 which is all about what to do when Fed Funds cannot be used , at that time when the main policy tool Fed Funds, was locked at 0%. Then given the success of Woodford 2012 during ZIRP, and though Fed Funds did rise above 0%, the Fed continued to use Woodford 2012 by not changing back to a managed range of Fed Funds, a "corridor system", but stayed with a "floor system" where the Fed would maintain a floor on Fed Funds and not manage Fed Funds to be higher than the floor. This refusal to move to a corridor system is required if the Fed is able to use Woodford 2012 policy tools. A corridor system requires a reaction function, a rule which the Fed will do this or that if Fed Funds get outside the ceiling or that if Fed Funds go beneath the floor, or if inflation changes off of goal. This moves monetary policy from Woodford 2012 forward to only forward guidance and signaling that forward guidance is reasonable by showing strength as applying QE. This is rather than deploying a spot reaction function where every week the Fed has to prove that they are succeeded and have succeeded in delivering the inflation target and then if inflation changes the corridor is changed accordingly. Woodford 2012 states it is good enough to have the market believe you will reach target. Friedman-Taylor requires an reaction function based on a rule and the here and now management and not just future space “belief system”.
This belief system is formed by crafted forward guidance and eliminates the need for a the rule and thereby a reaction function. The Fed believes the elimination of the reaction function based upon a rule results in greatly reducing volatility in the market, for if the corridor is set based upon a reactive rule then all Fed actions will be a surprise and maintain a higher volatility. Therefore a corridor system will raise volatility given the series of ongoing surprises as the corridor is suddenly changed. And these changes have to be done immediately. The Fed feels the corridor system greatly increases volatility/risk and thereby increases the instability of the banking system.
It is the elimination of this instability that has become the Federal Reserve main objective that now supersedes all stated by law goals of inflation and employment. While Woodford 2012 shows and has demonstrated how to deliver lower volatility, there is no economic thesis that lower stability will reduce instability. In fact the opposite occurs where the reduced instability builds and builds in what seems latent forms but then will blows so that the long term realized volatility will be as would have as if the ongoing drop in volatility that Woodford 2012 never occurred. If Woodford 2012 was not applied there would have been periodic crisis and business cycles, but the crisis would be sustainable with tried and true monetary actions that are within the imagination and understanding of Congress.
But this large jump diffusion in volatility from deploying Woodford 2012, as the pent up curtailed "normal" volatility suddenly blows, will now dwarf any response capability of the Federal Reserve. Certainly if the Federal Reserve is still dedicated to Woodford 2012 policy tools and response.
Monetary policy has become a charade.