The end of gradualism?

Back in 2004, on the heels of the Fed’s tightening cycle, Ben Bernanke gave a speech in defense of “gradualism”—the idea that, under normal circumstances, economies are better served when central banks adjust their policy rates gradually, moving in a series of moderate steps in the same direction.

Yet, current gossip has it that this thinking may be shifting.. in other words, the Fed may be open to the idea of what Bernanke called in that speech the “bang-bang” approach: Raising rates in a more aggressive manner, instead of a well-televised “measured pace”.

Before I go any further, I should reiterate the word “gossip”, since I, at least, have yet to see a Fed speech expressing this view explicitly. But what I want to do here is to ask whether there is any reason to revisit the case for gradualism, esp. in the aftermath of the financial crisis.

So let’s look at the rationale for gradualism in the first place… Ben’s speech lays it all out.

One reason stems from the uncertainties under which policymakers operate: Uncertainty about the true state of the economy in “real time”, e.g. due to noise in the data, difficulties in measuring variables such as the output gap, etc; and also, uncertainty about the exact impact of policy actions on the economy (i.e. uncertainty about the accuracy of an economic model’s specification and/or the precision of the estimated structural parameters).

Because of this, gradual policy adjustment is preferable to a more aggressive approach, as it allows policymakers to observe the impact of their actions and avoid potentially destablizing “overshootings”.

A second reason has to do with the monetary authorities’ ability to influence the term structure of interest rates (and, therefore, financial conditions) in the presence of forward-looking market participants. The argument goes that, when investors are forward looking, the mere expectation of a series of small, measured interest rate increases in the future will lead to higher rates across the yield curve today—i.e. the Fed does not NEED to raise rates aggressively in one go to achieve a desired increase in long-term yields.

The advantage of gradualism here is that the Fed can achieve tighter (or looser) financial conditions without prompting an unnecessary spike in the volatility of short-term interest rates.

A third reason has to do with financial stability—ensuring that banks, firms and households are not exposed to large capital losses from undue swings in bond markets. Only here, the optimal policy response is not just gradualism, but gradualism combined with transparency in central bank communications about its intended policy path. As Ben put it in 2004:

“the FOMC can attempt to minimize bond-market stress in at least two ways: first, through transparency, that is, by providing as much information as possible about the economic outlook and the factors that the FOMC is likely to take into account in its decisions; and second, by adopting regular and easily understood policy strategies”.

So what, if anything, has changed since then that might prompt a shift in the Fed’s thinking?

One possible change could be renewed attention to the so-called “risk-taking channel” of monetary transmission—the idea that monetary policy can affect agents’ risk-taking behavior, leading, for example, to potentially unsustainable increases in leverage and/or a deterioration in the quality of banks’ assets.

In my view, attention to the risk-taking channel would be a very welcome development, especially in light of the recent experience and the destabilizing effects of careless risk-taking by both banks and households. However... I have a feeling that the implications for monetary policy have little to do with the pace of adjustment (ie the gradualism vs. bang-bang debate) and more to do with the level of policy rates.

To see this, one has to examine the channels through which monetary policy affects risk-taking behavior. To this effect, a recent BIS paper discussing this link seems to suggest that it’s the levels of interest rates that matter for risk-taking behavior.

For example, low interest rates raise asset prices (through lower discount rates), increasing the value of collateral and, in turn, the willingness of banks to extend more credit to the non-financial sector (the financial accelerator effect). Similar effects can lead to perceptions that bank balance sheets are healthier, making bank funding cheaper and encouraging them to raise their leverage to potentially damaging levels (esp. if they can “creatively” bypass capital requirement restrictions by shifting risky assets off balance sheet!).

In addition, low interest rates for an extended period could encourage investors to search for yield by shifting capital towards higher-risk investments. This may be because of inertia in asset managers’ performance targets, which often focus on nominal returns (e.g. for institutional/contractual reasons); and/or “money illusion”—ie when investors are slow to absorb the fact that lower interest rates are simply a response to lower inflation.

Note that little has been said here about the effect of a given pace of change in interest rates on risk-taking behavior. It’s all about the levels.

So what are the implications for policy?

Well, for starts, emphasis on the risk-taking channel of monetary transmission throws fresh light on the (in)appropriateness of the Fed’s monetary stance back in 2003-06. First, by keeping rates low for a long period, the Fed likely contributed to the "search for yield" cult defining that period. More importantly, even when the Fed did raise rates, the impact on financial conditions (and risk-taking behavior) was very limited: Volatility declined steadily to historic lows, while long-term yields only rose temporarily in 2004, only to resume their decline later in 2005.

Now, to anyone as familiar with monetary theory as the Fed Chairman and his entourage, this should have raised the red flags about the workings of the transmission mechanism. Instead, the Fed was busy making up names for this new wonderful state of affairs: The Great Moderation… the conundrum… etc.

Criticisms aside, the point is that, given that the level of interest rates affects risk-taking behavior (with potentially damaging effects, if left untamed), monetary policy would have to be “blunter” (to use Bernanke’s expression) when the risk environment is exceptionally benign.

But back to gradualism... For all the implications for the level of interest rates, the inter-linkages between monetary policy and risk-taking behavior seem to say little about the appropriateness of the gradualist approach. So in the absence of a compelling framework that associates a transparent and steady (if not *that* measured) pace of policy adjustment with risk-taking behavior, I have a hard time understanding why the Fed would wish to change tack vis-à-vis gradualism.

Maybe it is just gossip after all. But if it’s not, I hope we get a darn good explanation beforehand.