Richard W Fisher: Uncertainty matters (with reference to kinky monetary
policy, two nickels and a dime)
Remarks by Mr Richard W Fisher, President and Chief Executive Officer of the Federal
Reserve Bank of Dallas, before the Causes & Macroeconomic Consequences of Uncertainty
Conference, Dallas, Texas, 3 October 2013.
* * *
The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System.
The speaker is indebted to Dallas Fed Senior Vice President and Principal Policy Advisor Evan Koenig for his
input in developing the themes articulated in this speech.
Thank you, Evan [Koenig]
It is a pleasure to share this platform with John Taylor. I first met John at a Carnegie
Foundation seminar when he was Undersecretary of the Treasury; I have been among the
legions of his admirers ever since. He is thoughtful, no-nonsense and, importantly, dedicated
to making monetary policy work with maximum efficacy. We at the Dallas Fed are grateful
that he chairs the advisory board of our Globalization and Monetary Policy Institute. And we
all, as Americans, are grateful for his service and dedication to our country. Thank you, John,
for being the good patriot and man that you are.
Uncertainty matters
Uncertainty matters. A lot.
This won't be a surprise to many of you. The first thing you are taught in any MBA program,
be it at Stanford, where I earned my degree, or anywhere else, is that "business" is the
process of managing under conditions of uncertainty. All business executives worth their salt
organize their teams and resources to minimize uncertainty of factors under their control; and
they develop contingencies and operating tactics and strategies for factors over which they
have no direct control. Obviously, the less-clear external influences are, the greater the
degree of angst about budgeting and planning for the future. Even the saltiest of helmsmen
cannot confidently navigate a ship in a dense fog.
Going back to the earliest days of the current recovery, my business contacts have regularly
complained of the fog of uncertainty emanating from Washington: They have consistently
cited fiscal and regulatory uncertainty as major impediments to capital investment and
expanding payrolls. Given uncertainty about the implications for overhead of the Affordable
Care Act and other government mandates, they've complained of not knowing what their
all-in labor and other costs will be and of how that lack of knowledge has made long-term
employment planning nearly impossible. I'm sure that many of you have heard similar
complaints - or have voiced them yourselves.
What you may not realize is that until quite recently, economists who study business cycles
and monetary policy paid scant attention to the effects of uncertainty on aggregate job and
output growth. The profession's standard models assume that the economy is populated with
households and firms that are identical to one another, or that people and businesses can
insure away individual risk and so are effectively, theoretically, identical. It's become
standard practice, too, to assume that decision-makers are hyper-rational in how they form
their expectations of future policy and future events; they are assumed to fully understand
how the economy works. To be sure, the economy is subject to shocks, so that its course is
unpredictable. But that uncertainty, according to this school of theory, is of no real
consequence for households' decisions about how much to save and consume, or
businesses' decisions about how much to hire and invest. The technical term is "certainty
equivalence": In standard models, choices depend on what you expect will happen and not
on the degree to which you are confident in your predictions.
Such thinking is far removed from reality and, thankfully, there's increasing recognition of that
fact. A variety of uncertainty indexes have been developed and their importance in theory
and in practice examined.1 Pretty uniformly, these studies suggest that changes in
uncertainty have significant economic effects and that uncertainty has been elevated in
recent years.
In theoretical analyses, the impact of uncertainty is especially great when realistic financial
and informational frictions prevent risk from being spread optimally. Because of such
frictions, for example, debt contracts often require that borrowers post collateral. When
uncertainty increases, so do collateral requirements, tightening credit and increasing the
value of "safe" assets relative to other assets.2
There's more than one type of uncertainty. There's uncertainty about future average tax rates
on investment income, for example, or the future pace of average labor productivity gains.
This is aggregate uncertainty. There is also uncertainty that widens the distribution of asset
returns across firms or the distribution of income prospects across households, while leaving
aggregate average asset returns and aggregate average productivity prospects unchanged.
This is cross-sectional uncertainty. Finally, there's the uncertainty that you feel when you
think that you understand how the world works and then discover that you don't because
something happens that you thought unlikely to happen.3 In the extreme, these are "black
swan" events: the "oh spit" moments we experience when we realize that we have
fundamentally and disastrously miscalculated.
Black swans induce paradigm shifts: The world - or, at least, our thinking about the world -
is never the same again. The Great Depression was one such event. The housing-market
collapse that began in 2006 and then spilled over to financial markets is another. If the
U.S. government defaults on its debt later this month, we'll have a third example. The
unthinkable will have become real, and the "full faith and credit" of the United States will be a
mirage rather than accepted fact.
There are myriad other events that, on a much smaller scale, lead people to question their
understanding of the rules. For example, the recent decision of the Federal Open Market
Committee (FOMC) to maintain the pace of its large-scale asset purchases in the face of a
generally improving labor market outlook and a widespread perception within financial
markets, right or wrong, that the Fed had telegraphed a dialing back of the rate of purchases
may have increased uncertainty about the future path of monetary policy. That was one
argument raised against the decision not to taper. I know, because I made the argument, and
I was not alone.
1
Uncertainty indexes are described and analyzed in the following recent papers: "Measuring Economic Policy
Uncertainty," by Scott R. Baker, Nicholas Bloom and Steven J. Davis, unpublished manuscript, 2013;
"Surprise and Uncertainty Indexes: Real-Time Aggregation of Real-Activity Macro Surprises," by Chiara Scotti,
unpublished manuscript, 2013; "Fiscal Volatility Shocks and Economic Activity," by Jesús
FernándezVillaverde, Pablo Guerrón-Quintana, Keith Kuester and Juan Rubio-Ramírez, unpublished manuscript, 2012;
"Risk Shocks," by Lawrence Christiano, Roberto Motto and Massimo Rostagno, National Bureau of Economic
Research, NBER Working Paper no. 18682, January 2013; and "Uncertainty Shocks Are Aggregate Demand
Shocks," by Sylvain Leduc and Zheng Liu, Federal Reserve Bank of San Francisco Working
Paper no. 2012-10, January 2013.
2
NBER Macroeconomics Annual
See "The Leverage Cycle," by John Geanakoplos, in 2009, vol. 24, Daron
Acemoglu, Kenneth Rogoff and Michael Woodford, eds., Chicago: University of Chicago Press, 2010,
pp. 1-65. See, also, "Reviewing the Leverage Cycle," by Ana Fostel and John Geanakoplos, Yale University,
Cowles Foundation Discussion Paper no. 1918, September 2013.
3
This type of uncertainty is analyzed in "Understanding Uncertainty Shocks and the Role of Black Swans," by
Anna Orlik and Laura Veldkamp, unpublished manuscript, 2013.
Most real-world fiscal and regulatory uncertainty is a mix of aggregate and cross-sectional
uncertainty. Given the aging of the U.S. population, we know that the revenues required to
finance entitlement programs will certainly have to increase in coming decades. "Entitlement
reform" may ameliorate the problem but won't eliminate it. Government purchases will have
to be cut, relative to baseline projections, and tax revenues will certainly have to be
increased. But exactly which programs will be cut and which taxes increased, and when, is
unclear and has been further muddled by the behavior of fiscal policy makers these past few
days.
The financial crisis and subsequent recession exacerbated these problems by increasing the
outstanding stock of debt. U.S. federal government debt held by the public has increased
from 34 percent of potential GDP at the business-cycle peak in first quarter 2001 (shortly
before the 9/11 attacks) to 36 percent in fourth quarter 2007 (just prior to the Great
Recession) to 70 percent of potential GDP today.
This increased debt has been manageable as a result of a substantial fall in interest rates.
Indeed, interest on the public debt has trended downward from 4.7 percent of potential GDP
in 1990 to 3.2 percent in 2007 to just 2.1 percent in 2012 as the average interest rate on
Treasury securities has dropped from 9 percent to 5 percent, then to its recent level of
21⁄2 percent. Rates obviously cannot continue to fall, though, so the cost of servicing debt is
sure to increase, even if the size of the debt relative to the economy stabilizes.
The canary in the mine: capital investment
Capital investment is the economy's canary in the mine because it's often the first thing to
succumb to uncertainty. Also, once undertaken, capital investment is costly to reverse.
Investment has certainly been unusually sluggish in the wake of the recent recession. Going
back to when our data begin, in 1947, net investment as a percent of GDP has fluctuated
around a constant mean of 5.6 percent.4 It boomed in the late 1990s, reaching 8.1 percent of
GDP, its highest level in over 50 years. The only higher quarter on record was the second
quarter of 1950 (shortly after John Taylor and I came into this world, although I am not
implying causality). Its peak during the 2001-07 expansion was an unremarkable
6.9 percent, but the subsequent plunge was unprecedented in the post-World War II data:
The U.S. capital stock actually shrank during the second half of 2009. Relative to its
5.6 percent long-run average, net investment as a percent of GDP fell by twice as far as it
had in any prior postwar recession.
More to the point, the recovery in investment has been exceptionally anemic. Today, four full
years after the trough of the recession in second quarter 2009, net investment as a percent
of GDP is still only 3.2 percent - a level typical of past recession lows. Net investment as a
percent of GDP was last at or above its 5.6 percent long-run mean 61⁄2 years ago.
Small wonder then that nonfarm payroll employment has been slow to recover too. Through
August we had restored less than 80 percent of the 8.7 million jobs lost during the Great
Recession. Less well known is the fact that real GDP per capita only recovered its
prerecession peak this past summer.5 That's 51⁄2 years to make up the ground lost during the
recession. Previous post-WWII recoveries never required more than nine quarters maximum.
A Dallas Fed analysis suggests that the recent financial crisis and its aftermath put the U.S.
back by more than an entire year's worth of output, an equivalent of more than $120,000 per
American household.6
Baker-Bloom-Davis and better comprehending uncertainty
And what of uncertainty? I mentioned earlier that we now have several uncertainty indexes.
One of these, focused on measuring policy uncertainty, was developed by our moderator,
Nick Bloom, together with Scott Baker at Stanford and Steven Davis of the University of
Chicago. The index is based on three different types of information: (1) a count of articles
referencing uncertainty, the economy and policy that have appeared in prominent U.S.
Dallas Morning
newspapers (including the nation's premier paper, the News); (2) a weighted
count of tax-code provisions that are scheduled to expire; and (3) the extent to which
professional forecasters disagree with one another about future levels of inflation and
government purchases.
The Baker-Bloom-Davis index begins in January 1985 and runs through the present. High
values of the index signal an elevated level of economic policy uncertainty. From 1985
through 2007 - prior to the 2008-09 recession - the index has a mean of 94, and it exceeds
150 only 2 percent of the time (one month in 50; just six times in over 23 years). The index
rose to above-average levels in the fall of 2007 and stayed at or above 94 - but below 150 -
through the summer of 2008. Then, between August and September 2008, the index nearly
doubled, rising from 96 to 188. Since September 2008, the index has at no time dropped
below 100, and it has exceeded 150 on 31 occasions - more than half the time. It has soared
above 200 twice: for two months in 2011, coincident with that year's debt-ceiling debate, and
in December 2012, when a compromise implementation of sequestration was being
hammered out. It'll be interesting to see what happens with the index in the wake of the past
week's developments (or lack thereof) in Washington.
The point is that starting with the collapse of Lehman Brothers in September 2008, economic
policy uncertainty has been consistently high, and half the time it has been extraordinarily
high. It's difficult to prove "beyond a reasonable doubt" that this elevated uncertainty is
causally related to the weak recovery we've experienced. But the hypothesis is surely
sensible, the timing is certainly auspicious, and enough careful confirming analysis has been
done to say that the preponderance of evidence favors the proposition that not just recent
policy decisions, but also the manner in which those decisions were arrived at, have been a
significant hindrance to economic expansion.
The Kinky Stuff: monetary policy
As to monetary policy, I would submit there are several links between monetary policy and
economic uncertainty. First, though, some background.
Ordinarily, monetary policy works by influencing the current and expected near-term levels of
short-term interest rates. Once short-term interest rates hit zero, however, the Fed turned to
unconventional policies. By using massive purchases of longer-term Treasuries and agency
mortgage-backed securities, these policies helped hold down term premia and support the
tried
housing recovery. Simultaneously, the Fed tried - and I emphasize because the
message seems to have been garbled in the minds of some intended recipients - to
influence expectations of its own behavior once asset purchases have run their course.
These "asset-purchase" and "forward-guidance" policies are relatively unfamiliar, and their
impact is uncertain.
One implication is that aggregate fiscal shocks - and, hence, also aggregate fiscal
uncertainties - are likely to have outsize effects in current circumstances. Contractionary
fiscal policy that would ordinarily drive down interest rates, providing offsetting stimulus to
private expenditure, will have a larger-than-typical economic impact because this "crowding
in" is absent once interest rates are confined to the zero lower bound. Expansionary fiscal
policy, similarly, will fail to "crowd out" private expenditure if interest rates hold steady.
Second, because the zero bound complicates the conduct of monetary policy and
shortcircuits fiscal crowding out, it introduces a "kink," or discontinuity, in the economy's behavior.
The existence of a kink means that uncertainty matters even if ordinarily it would not:
"Certainty equivalence" no longer applies. When real growth and/or inflation prospects are
weak - so that the economy is operating near the zero bound - downside risks to growth and
inflation loom larger than they ordinarily would. More-aggressive-than-usual policy responses
may be appropriate to avoid the negative implications of an encounter with the zero bound.
Paradoxically, though, once the lower bound on interest rates is binding, a
less-than-usuallyaggressive monetary policy response may be appropriate. I have tried to articulate this in
FOMC meetings ever since we started down the path of quantitative easing, drawing on
anecdotal reports from my CEO contacts and what I thought was common sense. But my
arguments fell on deaf ears until my more learned counterpart at the San Francisco Fed,
John Williams, produced a formal study that posited that the aggressive use of unfamiliar
policy tools like quantitative easing and Operation Twist add to aggregate economic
uncertainty and, if applied at all, should be deployed more cautiously than our more familiar
tools.7
Large margins of error
In general, the objective of monetary policy is to provide households and firms with an
economic environment that makes it attractive to use money as medium of exchange and
store of value. Since many private contracts, including labor and debt contracts as well as
capital expenditure commitments, extend out several years, a multiyear policy perspective is
needed. A multiyear perspective is especially important when the economy may encounter
the zero bound. The explanation is that by interfering with the normal conduct of monetary
policy, the zero bound increases the likelihood that policy will miss its objectives year after
year in the same direction, so that the errors accumulate over time.
Over the past five years, for example, PCE inflation has averaged 1.2 percent per year. The
FOMC's announced long-term inflation objective is 2.0 percent. Over a single year, the
difference between 1.2 percent and 2.0 percent inflation is inconsequential. Over five years,
though, that small difference cumulates to a 4.26 percentage point difference in the price
level, which is not insignificant, perhaps, if back in 2008 you took out a mortgage with a
fiveyear balloon. Alternatively, nominal GDP growth over the past five years has averaged
2.4 percent per year, when ordinarily one might have expected 4.5 percent average annual
growth (2.5 percent real growth plus 2.0 percent inflation). Again, the difference is
inconsequential in any given year. Accumulated over five years, though, the level of nominal
income today is fully 12 percent below what might reasonably have been expected when
mortgage and auto loan agreements were made back in 2008.
Kindly note that I am not advocating any change to the FOMC's 2 percent inflation target. My
point is simply to highlight the longer-term consequences of what might appear to be
smallish, shorter-term deviations from the norm. Business operators plan capital expenditure
and payrolls not in one- or two- or even three-year increments; they plan and budget over
longer-term horizons. The nominal stability that people need if they are going to negotiate
multiyear contracts is a multiyear nominal stability. A policy that "lets bygones be bygones"
from year to year may not achieve this kind of stability, especially when policy options can
become constrained, in the short term, by the zero bound. A policy that takes a longer-term
perspective and is properly communicated and executed - so as to instill confidence that
monetary policy will hew to a 2 percent inflation target rather than fixate on the run-rate of the
past four quarters or the outlook for the next four - may better supply the longer-term comfort
that households and businesses need to plan and budget. Such a policy would reduce the
uncertainty that monetary policy as it is currently conducted spawns and would be more
effective in doing its part to assist in economic expansion.8
A dime between two nickels
I hope this is enough to get a conversation started. I will now turn the microphone over to
John Taylor. In doing so, I am reminded of Ross Perot's quip when he was placed between
Bill Clinton and George H.W. Bush for a predebate photograph in the 1992 presidential
election. Noting that Mr. Perot was substantially shorter than the other two men, a reporter
asked him how he felt. His reply: "I feel like a dime between two nickels." In contrast,
compared to John Taylor, I feel like an intellectual dwarf - a mere penny sitting on the dais
next to John's $100 bill brain. And I'm talking about the new, difficult to replicate $100 bill that
will be released next Tuesday. Please join me in welcoming John Taylor to the podium.