From Our Briefings Newsletter
Are central bankers using a flawed framework to shape monetary policy? In a new paper, "The Case for a Financial Conditions Index," Goldman Sachs Chief Economist Jan Hatzius and his colleague Sven Jari Stehn argue it is time for the Federal Reserve and other central banks to adjust the macroeconomic model they have used since the 1990s. We caught up with Jan to understand why it makes sense to shift from focusing on short-term interest rates to monitoring a financial conditions index.
The article below is from our BRIEFINGS newsletter of 23 July 2018:
Briefly . . . on the Case for a Financial Conditions Index
Jan, your paper argues that a core part of the Fed's current macroeconomic model has broken down. How so?
Jan Hatzius: Since the 1990s, many central banks, including the Federal Reserve, have framed their policy in terms of a model that assigns a central role to the short-term interest rate target, using what is called an IS curve that describes the relationship between the economy's output gap and the real policy rate. But we show that the IS curve for the US has broken down empirically over the past few decades. Recent data show no effect of the policy rate on GDP.
Why is that?
JH: One reason is that the policy rate only has a small direct impact on aggregate demand. Instead, most of the impact of changes in the policy rate occurs indirectly via changes in broader financial conditions, including longer-term interest rates, credit spreads, exchange rates, and equity prices. This suggests that it is useful to monitor a summary measure of how different financial variables – not just the policy rate – affect the real economy. In other words, a financial conditions index.
What are the implications for monetary policy?
JH: The evidence of a breakdown in the relationship between the policy rate and GDP means that the framework underlying the current orthodoxy among central bankers – and even the framework underlying the estimation of the neutral policy rate – is potentially flawed. If the policy rate does not have a significant impact on economic activity, why should we believe that a particular path for the policy rate will keep the economy at full employment and inflation at target? And how can we even determine whether a particular policy rate is expansionary or restrictive?
But how can the Fed influence growth if short-term rates no longer have an effect?
JH: Our work finds that monetary policy innovations – measured as changes in Treasury yields in one-hour windows around announcements from the Federal Open Market Committee – remain highly significant predictors of changes in the financial conditions index. So Fed officials can influence financial conditions via monetary policy innovations, even though they cannot control them just by setting a path for the funds rate. For example, a hawkish monetary policy innovation typically raises long-term interest rates, reduces equity prices, and strengthens the dollar. As a result, our financial conditions index tightens notably in response to hawkish policy news, and vice versa in response to dovish announcements.
This means that the Fed can use such innovations to target a path for financial conditions that is consistent with a return of the output gap and ultimately inflation to levels consistent with the Fed's dual mandate. In such an FCI-focused framework, it is no longer appropriate to project an unconditional path for the funds rate along the lines of the Fed's "dot plot" that shows policymakers' current expectations. Instead, the Fed should indicate that the funds rate and other monetary policy instruments will be whatever they need to be in order to generate a path for financial conditions that keeps output and inflation at mandate-consistent levels over time.