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Policy Hub: Macroblog provides concise commentary and analysis on economic topics including monetary policy, macroeconomic developments, inflation, labor economics, and financial issues for a broad audience.

Authors for Policy Hub: Macroblog are Dave Altig, John Robertson, and other Atlanta Fed economists and researchers.

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September 23, 2022

How Has the Market Responded to Restoring Price Stability?

Note: The author thanks Mark Jensen and Larry Wall for their help with this post.

The Federal Open Market Committee (FOMC) implements monetary policy chiefly through changes in its federal funds rate target, and market participants form expectations about the evolution of future monetary policy decisions based on data they think are relevant to policymakers. Between the June and July FOMC meetings, incoming data started to suggest some parts of the economy might already be feeling the effects of tighter monetary policy. On the other hand, data since July tell a different story, one that suggests the FOMC still has a way to go in its efforts to fight inflation and restore price stability. So how have market participants interpreted these disparate pieces of data, and what could they mean for future monetary policy decisions?

In this post, I use the Atlanta Fed's Market Probability Tracker to understand how data since the June and July FOMC meetings have affected the market's expectations about the path of future monetary policy, similar to the analysis I did with Atlanta Fed economist Mark Jensen in a Macroblog post late last year. As another Atlanta Fed colleague, Mark Fisher, and I discussed in a Notes from the Vault article, the Market Probability Tracker generates estimates of the expected federal funds rate path based on eurodollar futures and options on eurodollar futures. Eurodollar futures and options deliver a three-month LIBOR (the London interbank offered rate) interest rate average, which is closely linked to the federal funds rate. Additionally, eurodollar futures and options are among the most liquid of financial instruments, with contracts that are expiring several years in the future regularly traded. As a result, the Market Probability Tracker generates our best estimates of expected rate paths by incorporating all the available data that the market believes will affect future policy decisions.

Figure 1 below uses the expected rate paths produced by the Market Probability Tracker to illustrate how market expectations between the June and July FOMC meetings responded to new information about the economy. The solid black line in figure 1 below shows the federal funds rate path expected by market participants after the FOMC's meeting press conference on June 15 video fileOff-site link. The black dotted and dashed lines represent, respectively, expectations after Fed chair Jerome Powell's Senate Banking Committee testimony on June 22Off-site link and after the release of the US Department of Labor's weekly report of unemployment insurance initial claims Adobe PDF file formatOff-site link on June 30. Although economic updates occurred throughout the intermeeting period (the New York Fed maintains a list of important releases going back to 2018 in its Economic Indicators Calendar), the changes in expectations on these two dates best summarize the overall change in the market's expectations. Lastly, the solid orange line represents expectations following the FOMC's press conferenceOff-site link on July 27. I also include (shaded in gray) the target range of 225 to 250 basis points announced at that meeting.

Starting with the black dashed line, after the June FOMC meeting, market participants expected the federal funds rate target range to reach 375 to 400 basis points by the first quarter of 2023 and then fall 75 basis points over the course of the next two years. During his June 22 Senate Banking Committee testimony, Chair Powell said that an economic downturn triggered by rate hikes to tame inflation was "certainly a possibility," although he added that such a downturn was neither the Fed's intent nor, in his view, necessary. His statement was important, albeit qualitative, information for the market because the FOMC in the past has often responded to economic downturns by lowering interest rates, which market participants interpreted as lower overall federal funds rates in the future (represented by the dotted black line). Expectations fell even lower after the Department of Labor's June 30 report hinted at a moderating labor market, with initial claims near five-month highs (represented by the dashed black line). By the July FOMC meeting (represented by the orange line), market participants further expected rate hikes to end this year and then fall 100 basis points during the next two years, as subsequent initial unemployment claims reports remained elevated and the July 21 Philadelphia Fed's manufacturing survey showed a drop in activity.

Figure 2 shows the Market Probability Tracker's estimates of the federal funds rate path expected by market participants following the July FOMC meeting (the solid orange line). It also shows the expected rate path following the August 5 release of the July employment situation reportOff-site link from the US Bureau of Labor Statistics (represented by the dotted black line), the expected rate path following the September 8 release of the initial unemployment claims report (represented by the dashed black line), and the expected rate path following the September 13 release of the August consumer price indexOff-site link (represented by the dot-dash line). Much like figure 1, these dates best summarize how market participants reacted to the evolving data since the July FOMC meeting (despite many other data releases occurring throughout the intermeeting period). Lastly, the solid black line represents the expected rate path on September 20, the day before the press conference following the FOMC meeting.

In the eight weeks since the July FOMC meeting, the data that the Committee said it would use to evaluate future policy moves came in much stronger than expected. Rather than moderating, labor markets appeared to tighten, with the Bureau of Labor Statistics reporting a 526,000 increase in nonfarm payrolls in its July jobs report and the Department of Labor reporting a decline in initial unemployment claims throughout August that culminated, in the September 8 report, in their lowest reported levels since May. The consumer price index for August, which many had expected to fall on a month-over-month basisOff-site link, showed inflation increasing 0.1 percent from July. The less-volatile core measure of inflation that excludes gasoline and food prices also rose 0.6 percent from July, twice the expected rate. Given the data's direction leading up to the September FOMC meeting, market participants expected a more aggressive pace of rate hikes through the end of the year, from 325 basis points after the July FOMC meeting to nearly 450 basis points. They also expect rates to remain much higher for much longer, with rates at the end of 2025 near 350 basis points—which would be at least 100 basis points higher than the 225 to 250 basis points that the chair described as the "neutral" policy rate at his July press conference.

Figure 3 shows the Market Probability Tracker's estimates of the federal funds rate paths that market participants expected the day before the press conference following September's meeting (the solid black line), and after the press conference on September 21 Adobe PDF file formatOff-site link (the solid orange line). Chair Powell, in his opening remarks, commented that tight labor markets "continue to be out of balance" with demand and that "price pressures remain evident across a broad range of goods and services." The information contained in both the press conference and the material released by the Committee did not significantly change market expectations about the future path of monetary policy, which already incorporated recent data on inflation and labor market conditions.

Turning back to the question posed by this post's title, the rate path movements seen in reaction to the incoming data show that, initially, market participants expected rate hikes to end in 2022. But the data, which came in much stronger after the July FOMC meeting, led the market to expect the Fed to raise rates higher than had been expected following the June FOMC meeting. Market participants also expect the Fed to keep those rates much higher for longer in order to cool demand—as Chair Powell put it in his August 26 speechOff-site link at the Jackson Hole economic policy symposium, "until we are confident the job is done."

More importantly, the movements in the rate paths highlight the insights we can gain from the Market Probability Tracker into how information about the economy affects the market's expectations of future monetary policy decisions. Chair Powell observed during the June press conference that "monetary policy is more effective when market participants understand how policy will evolve." With the rate paths produced by the Market Probability Tracker each day, we can begin to make that assessment.

August 31, 2022

Lessons from the Past: Can the 1970s Help Inform the Future Path of Monetary Policy?

People in monetary policy circles sometimes use the phrase "long and variable lags" to describe the delayed impact of the Fed's main policy tool on demand and inflation. The popularization of that phrase can be traced to a speech by Milton Friedman during the 1971 American Economic Association meetings, and since then people usually use it to describe the impact of Fed policy on economic output and inflation. Yet, during that speech, when summing up his work on the subject, he noted that "...monetary changes take much longer to affect prices than to affect output," adding that the maximum impact on prices is not apparent for about one and a half to two years.

Since Milton Friedman, many economists have studied these "long and variable lags" (including former Fed chair Ben Bernanke). And, while the length of the lag has proven "variable" as first suggested, the main result still rings true. Changes in the stance of monetary policy have the largest impact on output first and then, much later, on inflation. A large literature bears out this assertion. Bernanke et al. (1999) and Christiano, Eichenbaum, and Evans (2005) point to a two-year lag between monetary policy actions and their main effect on inflation. Gerlach and Svensson (2001) report an approximately 18-month lag in the euro area, while Batini and Nelson (2001) estimate that changes in the money supply have their peak impact on inflation in the UK after a year.

That context is especially useful for monetary policymakers to keep in mind as they navigate the economic challenges of the pandemic. In a span of just two and a half years, the US economy has suffered its sharpest post-WWII decline in economic output, a subsequent rapid resurgence in demand, a dramatic disconnect between labor supply and labor demand, widespread supply and shipping constraints, and an inflation rate that has surged from roughly 1.5 percent to 9 percent in the past 17 months. And, despite current strong job growth and the highest inflation this country has seen in 40 years, worries over a potential recession mount (as evidenced by the number of questions Chair Powell was asked about the "r word" in his press conference Adobe PDF file formatOff-site link following the most recent meeting of the Federal Open Market Committee). These beliefs partly reflect the rapid shift in the fiscal and monetary policy stance over the past year. In response to the pandemic, Congress approved a stimulus package of $5 trillionOff-site link, while the Fed expanded its balance sheet by roughly the same amount. But now, the federal deficit has fallen more than 81 percentOff-site link in first 10 months of 2022 fiscal year compared to 2021. In turn, the Fed has embarked on policy normalization, raising interest rates well into the range of neutral and drawing down its balance sheet (actions known as quantitative tightening).

Although "this time is different," we might be able to gain insights into the appropriate path of monetary policy by revisiting the past. At the time of Milton Friedman's 1971 speech, the economy was coming out of what many economists saw as a policy-driven recessionOff-site link , which followed a period of fiscal tightening to make up for large government outlays for the Vietnam War and a sizeable slowing in money growth as the Fed attempted to quell rising inflation. Today, the main policy tool is the federal funds rate, but prior to the early 1980s, changes in the money supply were the primary instrument. (Monetary aggregates—that is, growth in the money supply—formally replaced bank credit as the primary intermediate target of monetary policy in 1970. At the time, the fed funds rate played only a secondary role and was used as guideline in day-to-day open market operations, aimed at smoothing short run volatility.) In the run-up to the 1969–70 recession, the Fed tightened policy, slowing the growth in the money supply from 8 percent on a year-over-year basis to just 2 percent (the associated increase in the fed funds rate was roughly 4.5 percentage points, to 9 percent). Yet, as quickly as the Federal Open Market Committee tightened policy in the late 1960s, it more than reversed course in response to a sizeable increase in the unemployment rate during the recession. By late 1971, the money supply was surging again, up 13 percent on a year-over-year basis.

The Fed's quick and stark policy reversal became a recurring theme in the 1970s. During the decade, the Fed quickly pivoted between battling high unemployment and high inflation, what many economists refer to as "stop-and-go" policiesOff-site link. Charts 1 and 2 clearly show these shifting stances as they occurred again in the run-up to and aftermath of the 1974–75 recession. Chart 1 plots the year-over-year growth rate in the money supply (M2) and the unemployment rate, and chart 2 plots the growth in the money supply against the year-over-year growth rate in consumer price index inflation.

These charts depict three points that remain salient today. First, the "stop-and-go" policies of the 1970s clearly highlight the "long and variable lags" that changes in monetary policy have on inflation. Money growth plateaus at high levels three times during the late 1960s through the 1970s: in 1968, 1972, and in the mid-1970s. Each of those periods is followed by a subsequent surge in inflation, prompting a sustained tightening of monetary conditions. But as soon as inflation began falling, the Fed quickly reversed course with a bold expansion in the money supply that overshadowed the one originating the previous cycle, citing spikes in unemployment along with a lagged decline in inflation as justifications for these reversals.

If we smooth through some of the cyclical dynamics, there was a sustained upward drift in both the unemployment rate and inflation. In the mid-1960s, both inflation and the unemployment rate were around 2 percent. And 1980 inflation was over 10 percent and the unemployment rate had drifted up to 6 percent.

This period's upward drift in unemployment and inflation ran counter to the era's prevailing wisdom, which held that higher inflation was simply the sacrifice needed to lower the unemployment rate, and vice versa, An insightful essayOff-site link by former Atlanta Fed economist Mike Bryan covers this period in depth. He writes, "The stable trade-off between inflation and unemployment proved unstable. The ability of policymakers to control any ‘real' variable was ephemeral. This truth included the rate of unemployment, which oscillated around its ‘natural' rate. The trade-off that policymakers hoped to exploit did not exist."

Why didn't this stable tradeoff exist? Part of the answer is that the unemployment rate fluctuates around an unobserved natural rate. (Fed chair Jerome Powell's 2018 speechOff-site link offers an accessible discussion of these unobservables.) But the other part of the answer that is particularly salient at the moment is that by the mid- to late 1970s, after enduring a sustained period of rising unemployment and inflation, people began to expect higher inflation rates.

Chart 3 plots one-year-ahead inflation expectations alongside inflation and money growth using data from the Livingston SurveyOff-site link, a twice-annual survey of a small group of professional economists that the Philadelphia Fed has conducted since the end of WWII. And here the upward drift in inflation expectations is striking. By 1980, inflation expectations had risen 10 percent. Our interpretation of these data is that the rapid reversals of policy that characterized Fed actions during the 1970s never allowed inflation to fall back to the 1 to 3 percent range that was the norm after the end of the Korean War. As a consequence, the expectation that inflation would not recede into the background eventually became embedded into the psyche of Americans. People who lived through this experience simply anticipated higher future inflation rates, with that expectation embedded into their price-setting and wage-bargaining decisions.

Now, history here is messy. A number of caveats and confounding factors contributed to the unfavorable economic outcomes of the 1970s. Fed historians such as Allan Meltzer argue that the prevailing Fed chair at the time, Arthur Burns, did not consider monetary policy as ultimately responsible for such high inflation. Instead, the chair pointed to unions' wage-bargaining power first and, in particular, "cost-push" shocks (that is, energy and food shortages) later as the responsible party. (And indeed, this "cost-push" theory of inflation, so prevalent at the time, merits further exploration since assuming that spikes in energy prices might have contributed to the unanchoring of inflation expectations makes sense.)

Yet, in the case of oil price shocks, there is a counterpoint. The breakdown of the Bretton Woods accords ultimately drove the sustained increase in oil prices, and their breakdown can be seen in the era's robust money growth at the time. The breakdown of these accords created a run on the dollar amid fears of inflation. The price of gold took off as many investors were scrambling for an inflation hedge. Interestingly, the increase in the price of oil actually followed the spike in the price of gold and other commodities.

The historical evidence suggests that by 1970, the attempt to defend the dollar at a fixed peg of $35 per ounce, established by the Bretton Woods agreements, had become increasingly untenable, and gold outflows from the United States accelerated amid sustained inflation and trade/fiscal deficits. The run on the dollar forced President Nixon to effectively "close the gold window," making the dollar inconvertible to gold in August 1971. One month later, OPEC communicatedOff-site link its intention to price oil in terms of a fixed amount of gold. Hence, the increase in the money supply, spurred by the run-up in gold prices, exacerbated the increase in the dollar price of oil and led to the high inflation that followed. OPEC was slow to readjust prices to reflect this depreciation. However, the substantial price increases of 1973–74 and 1979 largely returned oil prices to the corresponding gold parity (see chart 4), which, again, was then seen as an inflation hedge.

In this context, it's worth noting that the OPEC oil embargo following the Yom Kippur WarOff-site link lasted just a few months, but the price increase was permanent. Similarly, the drop in oil production following the Iranian Revolution was negligible, as Saudi Arabia increased production to offset most of the decline. Contrast these episodes to the Gulf War in 1990. Oil prices doubled during the conflict (July–October) but went back to previous levels once the war ended.

In sum, Arthur Burns leaned heavily into the notion that these cost-push shocks—and not Fed action—were ultimately responsible for inflation, effectively ignored the "long and variable" lags of monetary policy, misread the monetary dynamics, and reacted expediently to the real-side damage that high energy prices wreaked on the economy.

So let's fast-forward to today. The fiscal response to the onset of the pandemic was quite forceful—$5 trillion by most countsOff-site link—and at least on par with significant wartime spending. As these transfers and disbursements hit households' wallets and businesses' ledgers, money growth surged higher than 25 percent—peaking well above, though not as sustained as, the high money-growth periods during the 1970s (see chart 5). And we've seen a sharp surge in inflation that has gone well beyond pandemic-related supply constraints and shipping bottlenecks that affected certain production inputs such as computer chips. As of July 2022, roughly three-quarters of consumers' market basket rose at rates in excess of 3 percent (and two-thirds of the market basket increased at rates north of 5 percent). These levels are on par with those we saw during the Great Inflation of the 1970s.

The Committee has begun an aggressive campaign to squelch this inflation threat, hiking rates in each of the last four meetings by a cumulative 2 percentage points along with implementing plans to reduce the size of the Federal Reserve's balance sheet. It has also indicated that more policy tightening is to comeOff-site link. If history is any guide, at least in broad strokes, it will take some time before recent policy actions begin to affect inflation.

And here, it appears that the FOMC is very attuned to the lessons from the Great Inflation period. In a recent speech at Jackson HoleOff-site link, Chair Powell noted, "Our monetary policy deliberations and decisions build on what we have learned about inflation dynamics both from the high and volatile inflation of the 1970s and 1980s, and from the low and stable inflation of the past quarter-century." Perhaps more importantly, he emphasized, "Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy."

June 24, 2021

Workshop on Monetary and Financial History: Day Two

In yesterday's post, I discussed the first day of the Atlanta Fed's two-day virtual workshop on monetary and financial history. In today's post, I'll discuss the workshop's second day.

Day two began with a paper presentation by Chris Cotter of Oberlin College and discussion by Hugh Rockoff of Rutgers University. Cotter's paperOff-site link ("Off the Rails: The Real Effects of Railroad Bond Defaults Following the Panic of 1873") analyzes the knock-on effects of railroads' bond defaults stemming from the 1873 financial panic. About one-quarter of all U.S. railroads defaulted on their bonds then. The paper's data set combines data on bond defaults with geographic data on national banks operating in areas served by the defaulting railroads. The main result of the paper is that even though banks did not (and legally could not) hold railroad bonds, the presence of a defaulting railroad in the area served by a bank tended to contract the loans and deposits at that bank. The railroad bond defaults thus exerted systemic, negative effects on the U.S. banking system despite lack of direct exposure of banks' portfolios to the bond defaults.

In the discussion, Rockoff agreed with the paper's conclusion but proposed that the paper could be strengthened by including case studies to check for their consistency against historical narrative. Rockoff also suggested a robustness check of comparing the effects of the 1873 panic to those of an 1877 nationwide railway strike. The post-1873 economic contraction was also one of the longest in U.S. economic history, Rockoff noted, so it would be interesting to know how much the railroad bond defaults contributed to the postpanic slowdown in economic growth.

The next paper presentationOff-site link was by Lee Ohanian of the University of California, Los Angeles, with a discussion by Angela Redish of the University of British Columbia. The paper ("The International Consequences of Bretton Woods Capital Controls and the Value of Geopolitical Stability," coauthored with Diana Van Patten of Princeton University), Paulina Restrepo-Echavarria of the Federal Reserve Bank of St. Louis, and Mark L.J. Wright of the Federal Reserve Bank of Minneapolis) models the world economy using a three-sector general equilibrium model (the United States, Western Europe, and the rest of the world) and uses this model to measure the impact of the Bretton Woods system of exchange controls. These controls were present from the end of the second World War until 1973, and in the model, these controls show up as taxes ("wedges") on the intersector movement of capital. The main result of the paper is that these wedges redirected very large amounts of capital away from the United States as compared to a first-best allocation, reducing growth and consumption in the United States but increasing them elsewhere. Aggregate global welfare was also reduced. Ohanian argued that despite its large domestic cost, the United States was willing to tolerate such a system for geopolitical reasons.

Redish noted in her discussion that while Bretton Woods is commonly thought of as an exchange-rate regime, in practice capital controls were necessary to afford countries some degree of monetary autonomy under fixed exchange rates. Redish also noted that the capital controls took many different forms and a closer examination of which types of capital controls were actually implemented could amplify the paper's message. She suggested that the high level of aggregation in the model obscures some potentially important cross flows of capital (for example, inflows into Germany are netted against outflows from the United Kingdom). The paper's counterfactual simulations are striking, but additional narrative could improve them. While supportive of the paper's overall conclusions, Redish noted that one unmodeled benefit of fixed exchange rates was reduced exchange rate volatility, which could have promoted capital formation. Another unmodeled benefit of Bretton Woods could have been a reduced incidence of financial crises stemming from "hot money" flows, which ideally could be weighed against the costs of inefficiently allocated capital.

The second invited lecture of the conference was presented by Catherine Schenk of the University of Oxford. Schenk's presentation described a multiyear research project that will collect and analyze data on global correspondent banking, especially as it developed in the post-WWII era ("Constructing and Deconstructing the Global Payments System 1870–2000"). The presentation focused on events during the 1960s and 1970s. The expansion of foreign exchange trading during this era led U.S. banks to found a technologically advanced, privately owned, large-value payment system (CHIPS) in 1970. Schenk explained how CHIPS enabled banks to settle the rapidly growing volumes of U.S. dollar payments from foreign exchange trading and facilitated the expansion of the global correspondent banking system. She also described how problems with CHIPS and certain other features of the correspondent banking system came to light in 1974 with the failure of a German bank, Bankhaus Herstatt. The Herstatt failure revealed the extent of the expanded correspondent system and also highlighted potential risks arising from unsettled foreign exchange trades, creating new challenges for banking regulators.

The audience discussion focused on changes in the regulatory environment coinciding with or following the Herstatt failure. William Roberds pointed out that a longer-term consequence of Herstatt was the founding of CLS in 2001 as a mechanism for coordinating foreign exchange settlements. Schenk noted that the Basel Committee on Bank Supervision was formed shortly after 1974, leading to global coordination in bank capital requirements and other supervisory standards. Robert Hetzel pointed out that 1974 witnessed another watershed bank failure, that of Franklin National, which like Herstatt was also heavily exposed in foreign exchange transactions. Responding to a question by Alain Naef (Banque de France), Schenk argued that many of the problems banks faced with foreign exchange operations in the 1970s simply resulted from a technical inability to handle an increased transaction volume. Michael Bordo noted that the technical changes in transaction technologies during this period interacted with economic forces to create profound changes in global banking.

Alain Naef of the Banque de France presented the final paperOff-site link of the second day ("Blowing against the Wind? A Narrative Approach to Central Bank Foreign Exchange Intervention"). Owen Humpage of the Federal Reserve Bank of Cleveland discussed it. The paper considers the effectiveness of Bank of England foreign exchange interventions over a sample running from 1952 until 1992, using daily data the Bank has recently made available. The Bank intervened on almost 80 percent of trading days during the sample, and most interventions were not publicized. The Bank intervened to influence the exchange rates of the pound against the dollar and deutschmark. Interventions were offset (sterilized) through domestic open market operations. Naef's presentation highlighted the main result of the paper, which is that interventions were usually ineffective when they attempted to go against market trends, in which case they were estimated to succeed only 8 percent of the time.

In the discussion, Humpage placed Naef's results in the context of the extensive literature on sterilized foreign exchange intervention. He noted that many traditional theories of sterilized intervention are oriented around the idea that such interventions could serve as a signal of a central bank's private information or intent. These theories would not seem to apply to the sample Naef analyzed, however, in which interventions were rarely publicized. He also noted that endogeneity concerns are common to this type of study. He recommended an alternative empirical approach focusing on the probability of certain market movements following an intervention, which could allow for a broader range of explanatory variables (for example, whether an intervention was coordinated with other central banks). Humpage also suggested additional clarification as to whether interventions in the data set were undertaken on the initiative of the Bank of England or the UK Treasury. Lastly, he noted that despite the apparent ineffectiveness of sterilized intervention, there are long stretches in the data where pound exchange rates appear to be pegged, indicating that there may be some unmodeled interactions between Bank policy and the foreign exchange markets that should be taken into account in the analysis.

The workshop concluded with a panel discussion video fileOff-site link of the potential impact of central bank digital currencies (CBDCs). The first panelist, Michael Bordo, proposed that the introduction of CBDCs could be as transformative as the introduction of circulating, central-bank-issued currency in the 17th and 18th centuries. Bordo said that while there was a role for private digital currencies, CBDCs could play a stabilizing role in the digital monetary landscape. He also suggested that CBDCs could also expand the options available for monetary policy, facilitating (for example) negative policy interest rates or tiered interest rates on central bank liabilities.

The second panelist, Warren Weber, began with the observation that 80 percent of the world's central banks are now at least considering issuing central bank digital currencies, most to be eligible for use in retail (consumer) transactions. Motivating factors for this development include the declining use of physical currency in some countries and Facebook's proposal to create a private digital currency (originally named Libra and now named Diem). A related motivating factor is the concern central banks have about financial stability risks that private digital currencies pose. Weber discussed this last issue in the context of two historical episodes when privately issued paper currency was commonplace and currency issued by central banks was not (in the United States between 1786 and 1863 and in Canada between 1817 and 1890). Weber argued that many private currencies in circulation during these periods failed to meet the definition of "safe asset" since their value tended to fluctuate, and sudden losses of value could occur when an issuing bank failed or suspended payments. However, private currencies became more reliable after more stringent regulation was introduced (1863 in the United States and 1890 in Canada), and in both cases this heightened reliability was accomplished without the introduction of central bank currency. On the basis of these experiences, Weber argued that CBDCs were not necessary for reliable digital currencies to exist, although CBDCs could be desirable on other policy grounds.

The third panelist in this session was François Velde of the Federal Reserve Bank of Chicago. Velde discussed CBDCs in the context of the general history of central bank money. He argued that central bank money historically arose to fill gaps in existing monetary systems (resolving ambiguity about units of account, facilitating payments, or boosting governments' fiscal capacity), and that historically, most central banks have shied away from involvement with retail payments other than the provision of paper currency. If CBDCs become prevalent, then they will still need to be oriented around provision of a stable unit of account, Velde noted, but an unanswered question is whether a widely accessible CBDC would fundamentally alter the relationship between private and central bank money. History suggests that governments and central banks will have some degree of involvement with digital currency, as with other forms of money, but the extent and form of this involvement are yet to be determined. Velde concluded with the observation that monetary innovations often have not resulted from conscious policy decisions but from a combination of underlying societal trends and chance occurrences.

In the subsequent panel discussion, Gorton argued that the more interesting types of available digital currencies are stablecoins, which purport to maintain a constant value against a central bank currency such as the U.S. dollar. Gorton argued that to be fully credible, stablecoins will need to operate under some degree of regulation, and, as the use of stablecoins expands, lawmakers may face the issue of whether stablecoin issuance falls under the purview of bank regulation. He noted that in to promote its state-issued digital currency, China has effectively shut down private digital currency issuance. Gorton and other panelists predicted that much of the future success of digital currencies would derive from more convenient cross-border payments—for example, along international supply chains. Bordo argued that even within domestic markets, digital currencies including CBDCs could offer efficiency gains over existing payment channels. If private digital currencies become sufficiently widespread, however, Bordo argued that they could interfere with central banks' ability to conduct monetary policy.

Velde then noted that the challenges facing digital currency adoption remain daunting, with mainstream acceptance probably requiring some degree of regulation to establish sufficient scale and credibility. Gorton agreed, but said that the example of money market mutual funds showed that such regulation could be challenging to get right. A question was posed as to whether governments' fiscal demands might also promote interest in CBDC issue, to which Velde said current low rates of interest on government debt do not provide strong incentives for governments to seek seigniorage through CBDC issue. Weber and Gorton suggested that what we might see instead of CBDCs are traditional banks moving into the issue of digital currencies as these become more widely accepted.

In the audience discussion, Peter Rousseau (Vanderbilt University) proposed that early U.S. monetary history showed that government regulation was not necessary to establish functional currencies, and that problems such as those that arose with pre–Civil War state banknotes could be minimized with modern technologies such as the blockchain. Chris Meissner (University of California, Davis) questioned whether, from a political economy point of view, private digital currencies would be allowed to become widespread enough to compete with CBDCs. Gorton responded by saying that in countries such as the United States, it will not be politically feasible to outlaw private digital currencies. Hugh Rockoff then remarked that CBDCs could facilitate fiscal transfers and Bordo said that in general, financial inclusion could be bolstered through CBDCs. Maylis Avaro (University of Oxford) noted that there did exist an historical example of such "retail outreach" by the Banque de France, which offered consumer accounts. Mark Carlson (Board of Governors) questioned whether the technological feasibility of fiscal transfers through CBDCs might affect central bank independence.

Larry Wall (Federal Reserve Bank of Atlanta) observed that the increased cross-border efficiency of CBDCs could lead to increased competition between central bank currencies. Bordo stated that the historical pattern of dollarization supported Wall's hypothesis, and Gorton suggested that one major reason that China has been accelerating development of its digital currency is to promote cross-border usage and international acceptance of the yuan.

June 23, 2021

Workshop on Monetary and Financial History: Day One

On May 21 and May 22, the Atlanta Fed hosted a virtual workshop on monetary and financial history. The workshop was organized by Michael Bordo (Rutgers University), William Roberds (the Federal Reserve Bank of Atlanta), and Warren Weber (formerly of the Federal Reserve Bank of Minneapolis and currently a visiting scholar at the Federal Reserve Bank of Atlanta). The workshop featured presentations on the history of money, banking, finance, and central banking. Six papers were presented along with two invited lectures. Both days of the workshop concluded with a panel discussion of contemporary policy issues from a historical perspective.

In this post, I'll discuss events from the workshop's first day, and in another post tomorrow I'll discuss day two of the workshop.

The workshop opened with a paper presentation by Ryland Thomas of the Bank of England and discussion by Clemens Jobst of the University of Vienna. The paper was titled "What You Owe or Who You Know? The Recipients of Central Bank Liquidity during the English Crisis of 1847," and its authors were Mike Anson (Bank of England), David Bholat (Bank of England), and Kilian Rieder (the Austrian National Bank). It focused on the Bank of England's responses to an 1847 financial panic. This episode is of interest to central bank historians because it was the first panic in which the Bank of England was subject to legislation (the Bank Charter Act of 1844, also known as Peel's Act) that limited its ability to extend credit in crisis situations. The paper analyzes the actions of the Bank during the panic, using a data set of credit actions (discounts and advances) hand-collected from the Bank's archives. The presentation emphasized that the constrained bank was able to provide emergency liquidity by rationing credit along several dimensions. In particular, the bank's credit actions discriminated against parties such as bill brokers, firms dealing in agricultural commodities, and firms located outside London, while favoring banks, London firms, and firms associated with bank directors. Ultimately these actions proved insufficient to stem the panic, however, and constraints on the Bank had to be eased by a government decree ("Chancellor's letter").

In his discussion, Jobst noted that the paper's results go against a traditional view of the 19th-century Bank of England as an arms-length ("frosted glass") lender. He also suggested that the paper's data set could uncover to what extent the structure of the London bill market shifted during the 1847 panic, with traditional dealers in bills ("bill brokers") apparently becoming disintermediated during the panic. Finally, Jobst noted that the 19th-century Bank used its interactions with the bill market in a quasi-macroprudential fashion, to maintain a sense of risk preference in the market as well as to exert control over the market. The paper's data set could thus be used to reveal the information available to the bank in its policy decisions as well as its resulting policy actions.

The second paper of the workshop was presented video fileOff-site link by Marc Flandreau of the University of Pennsylvania and discussed by William Goetzmann of Yale University. The paper ("How Vulture Investors Draft Constitutions: North and Weingast 30 Years Later") focuses on sovereign debt negotiations following a default by Portugal in 1828. The paper describes how a contender for the Portuguese throne was then able to obtain new loans from Portugal's London creditors during 1830–33, despite Portugal's recent default. In his presentation, Flandreau showed that a key aspect of the loan renegotiation was an 1827 British law that allowed a creditors' committee to control a defaulter's access to the London market, strengthening the creditors' bargaining position. The presentation also described how such control then allowed "vulture" investors in Portugal's defaulted debt to later earn large returns on their investment, and how the repayment of the renegotiated debt imposed high costs on Portuguese taxpayers.

In the discussion, Goetzmann observed that the 1827 law effectively inserted collective action clauses into the original Portuguese debt issue, even though the debt did not contain such clauses. Goetzmann also displayed a copy of a later (1855) lending agreement between the Portuguese crown and London creditors, which contained similar clauses to the contracts described in the paper, indicating that patterns documented by Flandreau persisted. Goetzmann then noted that cooperation between sovereign creditors was not unique to London, and he described how early (1790s) loans from Amsterdam creditors to the United States were subject to similar types of collective agreements. He further noted that many sovereign debt issues previously negotiated in Amsterdam were defaulted on during the Napoleonic period, creating a debt overhang problem and increasing the attractiveness of London as an alternative market for sovereign loans. International competition between sovereign lenders must therefore be considered as a constraining factor in the structure of sovereign loans.

Gary Gorton of Yale University delivered the workshop's first invited lecture, in which he described his research project with Ping He of Tsinghua University ("Economic Growth and the Invention of the Term Loan"). The focus of this research is the advent of term bank loans in the United States during the 1930s. Before that time, most business loans tended to be very short term—three months maturity or less—but could be rolled over at the discretion of the lending bank. Gorton noted that the 1930s witnessed rapid productivity growth in manufacturing concomitant with the expansion of term lending. He then presented a general equilibrium model that incorporates the growth effects of these two developments. In the model, an increase in bank term loans can result from an increase in financial efficiency (an improvement in banks' ability to predict borrowers' performance). Fitting this model to U.S. banking and macro data suggests that as much as one-third of economic growth during the 1930s resulted from an increase in financial efficiency experienced early in the decade.

Audience discussion of this result focused on regulatory changes as possibly contributing to the strength of the estimated financial efficiency effect. Among the changes mentioned were the debut of the Securities and Exchange Commission (which imposed new regulatory requirements on bond issues, raising the attractiveness of bank financing) and the Federal Deposit Insurance Corporation (which lowered the chances of an insured bank being caught in a run, making term lending less risky for banks).

The final paper of the first day of the workshop was presented by Marco Del Angel of California State University, Los Angeles, and was discussed by Kim Oosterlinck of the Université Libre de Bruxelles. The paper ("Do Global Pandemics Matter for Stock Prices? Lessons from the 1918 Spanish Flu," coauthored with Caroline Fohlin (Emory University) and Marc Weidenmier (Chapman University), focuses on the effects of the 1918 influenza pandemic on U.S. stock prices. The paper uses a new weekly stock price data set compiled by the authors, as well as data on death rates during the influenza pandemic period (1918–20). Del Angel presented results from vector autoregressions that show a persistent negative response of stock prices to upticks in pandemic deaths, even when the autoregressions incorporate series on war news obtained by filtering contemporary press reports. This same pattern holds when stock prices are disaggregated to the sectoral level. Negative pandemic developments thus exerted a strong negative effect on stock prices.

Several people in the audience argued that the paper's results might be affected by changes in Federal Reserve policies during this period. In the discussion, Oosterlinck suggested Fed policy could be incorporated through the inclusion of an interest rate series in the autoregressions. Oosterlinck also noted that the persistent effects of pandemic shocks on stock prices indicate an apparent inefficiency in markets' ability to process the economic impact of pandemic developments, a surprising pattern that merits some further discussion in the paper. He also recommended an event-study approach to analyzing stock price movements, which could exploit regional variation in influenza outbreaks, as a complement to the paper's existing econometric methodology.

The first day concluded with a panel discussion of the COVID-19 pandemic and ensuing policy responses. The first panelist was Alan M. Taylor of the University of California, Davis. Taylor's remarks drew on his recent paperOff-site link on historical pandemics ("Longer-Run Economic Consequences of Pandemics," coauthored with Sanjay Singh of the University of California, Davis, and Òscar Jordà of the Federal Reserve Bank of San Francisco). Taylor and his coauthors survey a number of pandemics starting with the Black Death (1331–50) and conclude that their effects are different from the other major category of demographic shock: wars. Pandemics tend to make labor scarce relative to capital (wars can do the opposite), exerting downward pressure on returns to capital and interest rates. Moreover, these effects tend to persist. Taylor argued that these patterns are consistent over centuries of data and that we should expect similarly persistent effects from the COVID-19 pandemic.

The second participant in the panel was Ellis Tallman of the Federal Reserve Bank of Cleveland. Tallman noted that the pandemic has resulted in a historic U.S. debt expansion comparable to that seen during World War II. Tallman also noted that following the WWII expansion, U.S. fiscal and monetary policy turned more conservative, with the Korean War largely financed through tax increases. He observed that prospects for renormalization of policy were more uncertain under current circumstances and that the extraordinary magnitude of recent policy responses raised the issue of capacity to respond to possible future crises. Commenting on Taylor's work, Tallman observed that the rapid deployment of vaccines meant that fundamentals for a strong recovery were more favorable now than in many historical pandemic events.

The last panelist in the session was Gary Richardson of the University of California, Irvine. Richardson agreed with Tallman's comment that the availability of modern medical technology suggests that a stronger recovery might be expected now than what followed past pandemics. Another unusual feature of the COVID-19 pandemic has been that its death toll has been concentrated in older individuals, many of whom had left the labor force, again suggesting less impact from labor scarcity than experienced in earlier pandemics. Richardson also contrasted U.S. policy paths following the two world wars, arguing that policy after World War I was more "hands off," whereas policy following World War II was more consciously aimed toward a transition to the restructured peacetime economy. In his view, the current situation is more reminiscent of the post-WWI scenario.

In the subsequent audience discussion, Michael Bordo suggested that the post-WWII scenario is more like current circumstances, particularly with respect to the inflation outlook. Owen Humpage (Federal Reserve Bank of Cleveland) pointed out that post-WWII Fed policy was more accommodative than is commonly recognized due to the presence of the "even keel" policy of stabilizing prices on newly auctioned Treasury debt, initiated after the 1951 Fed-Treasury accord. Taylor agreed with the other panelists that modern medical technology has improved the fundamentals for recovery as compared to past pandemics, but he suggested that the traumatic experience of the COVID pandemic could have persistent behavioral effects—on, for example, patterns of consumption. Responding to Bordo, Richardson argued that while the Fed has the tools to control inflation, its independence is likely to come under pressure from both political parties, complicating the inflation outlook. Robert Hetzel (Federal Reserve Bank of Richmond) suggested that recent increases in the money stock also point to an increase in underlying inflation, as occurred immediately after both world wars, but Richardson argued that this would depend on the extent of earlier patterns of consumption behavior returning after the pandemic. Taylor mentioned that forecasts of inflation based on money growth have not done well in recent decades. Another issue discussed was whether the COVID-19 pandemic was more comparable to the 1957–58 influenza pandemic, which had relatively mild economic effects, than earlier pandemics, when modern medical technology was not available. Taylor suggested that because there have been relatively few modern pandemics, it is not possible to answer this question with high statistical confidence.

In tomorrow's post, I'll cover the presentations and discussions in the workshop's second day.