Saturday, April 25, 2009

Goodfriend Principles

To maintain the Fed’s independence in monetary policy and its ability to successfully fight inflation (and deflation) the Fed and the Treasury need to sign a Federal Reserve Credit Policy Accord, says economist Marvin Goodfriend. He offers six principles to guide such an accord.

By Robert Stowe England

April 25, 2009

A call for a Federal Reserve Credit Policy Accord between the Fed and the U.S. Treasury was issued yesterday (April 24) by Marvin Goodfriend, professor of economics and chairman of the Gailliot Center for Public Policy at the Tepper School of Business at Carnegie-Mellon University in Pittsburgh.

He was speaking at a symposium conducted by the Shadow Open Market Committee ( at Cato Institute in Washington, D.C.

Goodfriend’s concern was aimed at the Fed’s decision to provide more than $1 trillion of credit through the Term Asset Lending Facility (TALF) and other arrangements. The effort includes loans to banks and other financial institutions, as well as loans to special purpose entities to finance the acquisition of commercial paper and asset-backed securities.

These Fed lending efforts are “pure credit policy.” The endeavor is “therefore, taking a fiscal action and invading the territory of the fiscal authorities,” namely Congress and the U.S. Treasury, Goodfriend stated in his paper titled “We Need an ‘Accord’ for Federal Reserve Credit Policy.”

By expanding into fiscal matters, the Fed risks increased political interference that could undermine its ability to continue its successful management of monetary policy, including fighting the considerable inflationary policies that some are predicting from trillions of dollars of monetary and fiscal stimulus in the last six months, Goodfriend said.

Treasury and the Fed did, in fact, issued a four-point joint statement March 24 indicating agreement on the the role of the Federal Reserve in preserving financial and monetary stability, a step that garnered very little notice in the press at the time. The text of the statement can be found at this link:

The joint statement concludes with a notice that ultimately the facilities set up by the Federal Reserve to improve the functioning of credit markets, known as the Maiden Lane facilities, should will be removed or liquidated by the U.S. Treasury.

Goodfriend said "it is a matter of urgency" to expand the March 24th agreement to include the six principles he outlined to the symposium.

The six principles are as follows:

1. As a long run matter, a significant sustained expansion of the Fed credit policy beyond ordinary, temporary last resort lending to banks is incompatible with sustained Fed independence. The Fed should adhere to a ‘Treasuries only’ asset acquisition policy except for occasional and limited discount window lending to banks.

2. The Treasury and the Fed should agree to co-operate, as soon as the current credit crisis allows, to shrink the central bank’s lending reach by letting Fed credit programs run off or by moving them from the Fed’s balance sheet to be managed elsewhere in the government. Any further expansion of Fed credit programs in the current credit crisis should be undertaken by agreement with Treasury to minimize the risk of committing to a course of action that proves subsequently to be ill-advised.

3. The Fed has employed monetary policy in the service of credit policy in the current emergency by creating over 1 trillion dollars of bank reserves to finance its credit policy initiatives, with the possibility of more to come before the credit crisis ends. The Treasury and the Fed should co-operate so that the Fed’s fiscal support through its credit policy initiatives for banking and credit markets does not undermine price stability.

4. To strengthen the nation’s commitment to price stability, the Treasury and the Fed should agree on a long run inflation objective to anchor inflation expectations against rising inflation or deflation. Such an agreement will not only improve the effectiveness of monetary policy, it will help hold down the inflation premium that the Treasury must pay to borrow long term.

5. The Treasury should help the Fed to secure the power of “interest on reserves” to put a floor under the federal funds rate. The Treasury and the Fed should do so by making sure that every institution that trades in the federal funds market holds deposits at the Fed and receives interest on these deposits as set by the Fed. This institutional fix is necessary to guarantee the Fed’s operational power to raise its federal funds rate target against inflation, regardless of the size of the Fed’s balance sheet. (See footnote)

6. The Treasury and the Fed should agree as soon as possible to co-operate as above to credibly secure the commitment to price stability so that the Fed can act preemptively, flexibly, and aggressively in the short run against either inflation, or a deepening contraction and deflation, whichever proves to be the greater risk. The credibility of monetary policy to act aggressively against deflation, if need be, depends crucially on the Fed having the power to raise interest rates against inflation if and when that should become the problem.

Marvin Goodfriend, “Interest on Reserves and Monetary Policy,” Federal Reserve Bank of New York Policy Review, (May 2002), pp. 77-84.

Copyright 2009© by Robert Stowe England


Auburn Traycik said...

It would be interesting to know how those present at the symposium responded to Goodfriend's presentation.

Caliban said...

There was, in fact, some discussion and disagreement about Marvin Goodfriend’s Principle 4. You can see some of the details below in my transcript of Marvin Goodfriend’s responses to a question by a member of the audience named John, who did not give his full name. There are further comments by Bill, who also did not full identify himself. If I am able to fully identify both John and Bill I will update this post with their full names. Meanwhile, their comments merit some consideration.


[National Bureau of Economic Research co-chair] Anna [Schwartz, who gave a presentation by phone] very helpfully supplied in her paper a copy of statement that Treasury and the Fed put out in March and it says that nothing that they are doing now under this ‘unusual and exigent circumstances’ – it says they must constrain the exercise of monetary policy as needed to foster maximum sustainable employment and price stability.

Now, Marvin, your suggestion [is] that Treasury and the Fed together should agree on low long-run inflation objectives to anchor inflation expectations, etc. The Fed-Treasury statement, [however,] very correctly focuses on both price stability and maximum sustainable employment. I say correctly because that’s their big goal [complication] and politically I think they really have no choice but to always put that goal mandate up there.

I wrote numerous articles about their search at the Fed with how to deal with the question of having an inflation target without setting an employment target, which they certainly don’t want to do. And I think your Principle 4 actually, if you were to [adopt it, would do more to] compromise the Fed’s independence than enhance it because you’re asking the Treasury to sign on to whatever inflation target they have. And I think would set up a firestorm on the Hill at a time when the Hill is already motivated, as you point out, to get very involved in this thing.

Marvin Goodfriend:

Here’s what’s different. The Fed is using monetary to help the Hill, to help Congress finance its huge deficit. They want to keep the inflation premium down. This is the same game that was argued for years, whether we have a line inflation target to stabilize the macro-economy. We’re in a game now where we have massive proposed fiscal spending.

It’s a different element to this accord I’m focusing on. I’m focusing on the $1 trillion of money the Fed to help the government finance its deficit in the emergency. So it’s not going to do the Treasury or Congress any good not have a clear message to keep the inflation premium down. The worst thing that could happen for fiscal policy is to have the inflation premium start to move up.

So, I think the ground rules for this discussion of inflation-targeting have changed radically in the last nine months. I take your point. I think the ground rules have changed because in this emergency the Fed has become a fiscal agent. And the government very much needs the Fed’s help. It needs price stability to hold down the cost of the stimulus.


One of the things that’s very distressing about this situation is that there’s an enormous lack of understanding by the public about what has happened. The way I view is this. Fiscal policy has long had credit programs at lots of different times – Small Business Administration loans, student loans [inaudible], a whole slew of them I just have them all in my head.

So, these non-bank credit programs could have been and should have been brought by Congress.

Congress could have voted $1.1 trillion to buy mortgage-backed securities. The reason Congress didn’t vote it is very old-fashioned reason.

Because Congress thought that the program, which would require $1.1 trillion of additional federal debt to finance, it would be subject to what budget discipline there is. But there would be some budget discipline because a lot of people would be concerned about issuing that much Treasury debt to finance that program.

So, instead, the Federal Reserve, consulting with the Treasury and Congressional leaders, said,
well, we can do it. And we can do it by printing money. Now that’s the bald fact of what has happened.

Now, it would be a very precedent for the Federal Reserve to be given the power to issue its own debt because that would allow such programs to continue into the indefinite future any time that the appointees of the Federal Reserve board though it was a good idea without any Congressional appropriations process whatsoever.

So what ought to be done here to unwind this thing is that Congress should vote to take over the mortgage-backed securities program. I think that’s the most important one because it’s the largest single program. It’s scheduled to go to $1.1 trillion.

And because the assets are long-term assets, the Federal Reserve has said it will not sell those assets into the market. So, if the Fed is not going to sell them it is going to have to go through various contortions to mop up the bank reserves that have been created.

So what ought to be done at this point is that Congress should vote to take over the program. It should issue debt, then have cash to buy these assets off the Fed’s balance sheet. And, as that payment came in, it would extinguish bank reserves in the process. That would transfer the program to the place where it ought to have been placed to begin with, run by the Treasury or by HUD or whoever is going to administer these programs and hold these mortgage-backed securities.

But then it would be very explicit what the financing arrangement is. Now, we have this program that if it had been done by a banana republic, would have occasioned enormous IMF criticism of madly creating money to finance a government program for a particular sector of the economy. But that is my way of looking at what is being done by the Fed.

Bennet T. McCallum (Carnegie Mellon University):

Most of the things that most of us want to say begin with the words ‘Congress should,’[inaudible] how do you bring it about?


The issue there is that the Federal Reserve may argue that this is a – and it does argue that this is an essential program. But what it ought to do is to make the case before Congress. It ought to make that case and say this is a very large expenditure. We understand that. We believe that is essential to bring the economy back to normal function. But the Federal Reserve, in cahoots with Congress really, is printing money to finance it, [which] is very, very unfortunate. And, what the press needs to do, in talking about this, is to explain to people that we are printing money to do a program that Congress refuses to do itself. That’s what’s really happening here.

If we had the budget discipline to issue government bonds to do it, that wouldn’t be very much budget discipline, but at least it would make it very clear what is happening in the country versus handling it by printing money.

Caliban said...

Two names in my post are quoted but not fully identified. I can now identify them:

John, who asked the question that begins the selected transcript of the Q&A session that is provided in the second comment, is John Berry of Bloomberg.

Bill, whose responses are quoted in the partial transcript, is William Poole, who is a senior fellow at the Cato Institute, Senior Advisor to Merk Investments and Distinguished Scholar in Residence at the University of Delaware.

According to Cato's web site, prior to joining Cato, Poole was the president and chief executive officer of the Federal Reserve Bank of St. Louis. He represented the Bank on the Federal Open Market Committee (FOMC), the Federal Reserve's chief monetary policymaking body.