January 14, 2018
At a time when the inflation rate has been consistency been well below the Federal Reserve Board’s 2.0 percent target, Donald Trump has nominated Marvin Goodfriend to fill one of the Fed’s vacant governor positions. Goodfriend argues that the Fed’s major policy failure has been that it has inadequately convinced the public of its commitment to fighting inflation.
This seems more than a bit otherworldly, but in the era of Donald Trump, anything is now possible. In Congressional testimony given last year Goodfriend complained:
“If in years past the Fed had been fully committed to price stability as embodied in an inflation target, retirees would be in a much better position today. Years ago, households would have been advised and willing to hold a significant share of their lifetime savings in long-term nominal bonds paying a safe nominal rate of interest. Households could have counted upon the fact that the nominal return would have been locked in purchasing power terms. The promised nominal interest rate, having incorporated a 2% inflation premium to offset the steadily depreciating purchasing power of money at the Fed’s inflation target, would have delivered a safe long-term real return upwards of 3% per annum.
“Instead, the Great Inflation called the Fed’s commitment to price stability into question as it decimated the real return on long term nominal bonds. Responsible households have since steered away from saving in long-term nominal bonds to protect themselves from inflation risk. To avoid inflation risk, households have shortened the maturity of their interest-earning savings and reached for more return in equity products, forced to accept the risk of ultra-low short-term interest rates and volatile equity prices in the bargain.”
This one is worth stepping back from and taking a deep breath for a moment. We have just gone through a long period following the Great Recession in which the unemployment rate was needlessly kept higher than necessary primarily due to lack of adequate fiscal stimulus, but also a monetary policy that was less aggressive than it could have been in trying to boost demand.
But Goodfriend’s complaint isn’t about unemployment, it is about excessive inflation, even though inflation has been consistently below the Fed’s target. And we get this complete non-sequitur that because of people’s fears about inflation that they have shied away from holding long-term bonds, which Goodfriend tells us should offer a 3.0 percent real interest.
Let’s get out the intro textbook here. Suppose Goodfriend is right and people don’t hold long-term bonds because of the inflation risk. This means less demand for long-term bonds. When the demand falls for an item, shoes, cars, or bonds, the price falls. When the price of a bond falls, the interest rate rises.
The current nominal yield on a 30-year Treasury bond is a bit less than 3.0 percent. With an inflation rate in the neighborhood of 2.0 percent, this translates into a real interest rate of around 1.0 percent. In other words, Goodfriend wants to believe that somehow because of people’s inflation fears the interest rate on long-term bonds is lower than it would be if the Fed had followed his preferred course. There might be some planet on which that line of argument makes sense, but I have never heard of it.
The other area in which Goodfriend’s views are unusual is his desire to have the Fed use negative interest rates as a tool to boost the economy when it faces a severe downturn, like the Great Recession, and the short-term interest rate directly under the Fed’s control is already at zero. The Fed responded to this “zero lower bound” problem in the Great Recession through quantitative easing: buying up large amounts of longer-term Treasury bonds and mortgage-backed securities insured by Fannie Mae and Freddie Mac.
Goodfriend opposed quantitative easing and argues for negative interest rates as an alternative. While this is not necessarily a bad route to go, Goodfriend suggests negative interest rates can best be accomplished with a tax on money. The idea is that people would be taxed for holding money so that the cash people held would be worth 1–2 percent less after a year. This should discourage people from holding cash and instead spend their money.
The problem with the approach suggested by Goodfriend is that it is likely to hit low- and moderate-income people hardest since they are the ones most likely to be holding cash. People with more money are likely to be able to find mechanisms to avoid this tax. The result is that the cash tax would have relatively little impact in boosting the economy and it would be paid primarily by those who could least bare the burden.
In Donald Trump’s America, that sort of approach to monetary policy may make sense, but not anywhere else. Hopefully, the Senate will give Goodfriend’s views on monetary policy careful consideration before they vote on his nomination as a Fed governor.
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