The job of the Fed is to do two things: maintain price stability and provide the optimal monetary supply for maximum employment.  To do this, the Fed uses interest rates to control the supply and velocity of money. If no one is using the money, velocity is zero and there is no inflation. In fact, there can very easily be deflation.

With that in mind, the following article will give us some insight into why the Fed is doing what it’s doing and where the  ideas came from.

Woodford’s Theories Rooted in Japan Slump Embraced by Bernanke

The Federal Reserve is buying mortgage-backed securities and has stated it will keep interest rates low until unemployment falls. The Bank of Canada under Mark Carney likewise made an explicit promise about how long rates would be held down, and Carney is now bringing this practice to the Bank of England. The European Central Bank, led by Mario Draghi, has refined how it communicates its interest-rate intentions.

There’s a pattern here, Bloomberg Markets magazine will report in its October special issue on the 50 Most Influential people in global finance. Key central banks, faced with subpar growth and little room for further rate cuts, are embracing the research of one man: Columbia University economist Michael Woodford.
“His approach to monetary economics is the one that’s being followed, one way or another, at many of the world’s central banks,” says Richard Clarida, a colleague of Woodford’s at Columbia, a former U.S. assistant Treasury secretary for economic policy and an adviser to Pacific Investment Management Co. “Mike is the leading monetary theorist on the planet right now.”

Woodford, 57, has wrestled for more than two decades with the question of how central banks can promote growth once short-term rates have been cut to zero — including during a stint at Princeton University from 1995 to 2004. The Ivy League school in New Jersey was the place to be if you were an up-and-coming economist around the turn of the millennium.

Princeton Thinkers

Ben S. Bernanke, future chairman of the Fed, was there. He had recruited Woodford from the University of Chicago. Paul Krugman, who would go on to win the Nobel prize in 2008 for his research on trade, also was at Princeton. Lars Svensson, later a deputy governor of the Swedish central bank, was a visiting professor. And their big topic of discussion was Japan. Ten years after the bursting of a property-price bubble, the country was mired in deflation. Short-term interest rates had been cut as far as they could go, and the monetary authorities were at a loss about what else to do.

The Princeton professors had plenty of ideas. Bernanke leaned toward having the Bank of Japan gobble up assets as a way of pumping money back into the economy. Woodford was skeptical that would do much. He favored a strategy called forward guidance. He wanted Japan’s central bank to promise to keep interest rates pinned near zero until the country’s economy had fully recovered from its bust and had conquered deflation. The aim of such a communications strategy would be to convince companies and consumers that growth will pick up and prices will stop falling — and induce them to spend rather than hoard cash.

Jackson Hole

At the time, Japanese policy makers paid the American academics little mind. They began a program of quantitative easing in 2001, ramping up slowly and then abandoning it five years later, and they didn’t embrace any forward-guidance principles.

Jump forward to August 2012, to the Fed’s annual ideas confab in Jackson Hole, Wyoming, in the Teton mountains. The focus at this meeting was on this conundrum of what central banks can do when rates have already been cut to nothing, what policy makers call the zero bound — only now Japan was not the sole example.

The Fed had cut rates effectively to zero at the end of 2008, and yet the U.S. recovery from the worst economic trauma since the Great Depression had been discouragingly slow. European central bankers were searching for new policy tools as well, as the region slipped into recession.

Woodford’s Advice

The academic presentation that made the biggest splash at Jackson Hole was Woodford’s. The professor questioned the efficacy of the central bank’s purchases of Treasury securities and suggested that any further buying of assets should be concentrated on mortgage-backed debt, to help the housing market. He also called for a revamp of the Fed’s communications strategy to solidify its commitment to returning the economy to full health.

At its next meeting, in September 2012, the Fed announced it would start to buy $40 billion of mortgage securities per month. In December, policy makers junked their statement that they would keep rates low until the middle of 2015 and instead pledged low rates until certain economic goals are met — the strategy Woodford had articulated. The Fed promised to hold rates at zero at least until unemployment falls to 6.5 percent, as long as inflation isn’t forecast to rise above 2.5 percent.

Gauti Eggertsson, a former New York Fed researcher and occasional co-author with Woodford, says the Columbia professor’s ideas permeate recent central bank actions. “He is probably one of the best-known, most influential economists that noneconomists are not aware of,” says Eggertsson, who’s an associate professor at Brown University.

Law School

Woodford didn’t set out to become an economist. He majored in physics at the University of Chicago and then earned a law degree at Yale University in 1980. Because so many of his Yale professors cited the importance of economic concepts, he decided to study the subject at the Massachusetts Institute of Technology.

“I got excited about economic problems and didn’t look back,” Woodford says. While still at MIT, he won a John D. and Catherine T. MacArthur Foundation fellowship, or genius prize.

Following MIT, Woodford taught at Columbia and then the University of Chicago. After economist Frederic Mishkin was named director of research at the Federal Reserve Bank of New York in 1994, he asked Woodford, newly arrived at Princeton, to be one of his advisers. This high-powered kitchen cabinet included Bernanke, Clarida and Christopher Sims, who later won the Nobel prize.

Economics Text

In 2003, Woodford published an equation-laden book titled “Interest and Prices: Foundations of a Theory of Monetary Policy” (Princeton University Press). It has come to be known as the bible of modern monetary economics, San Francisco Fed President John Williams says. He has a joke he likes to tell about Woodford that shows how eager central bankers are to embrace the ideas he advocates. Williams compares himself to an Olympic gymnast who works hard on a routine, performs it well in competition and sticks the landing. Woodford is the judge, holding up his score: a seven. He tells the gymnast Williams, “You did a good job, but you’re not quite where you need to be.”

That’s more or less what Woodford says about recent Fed actions. He welcomes the Fed’s intention to taper off its purchases of Treasury securities and mortgage debt, though he says the central bank could be clearer about the rationale.

“As the Fed’s balance sheet gets bigger, the bar to justify additional purchases does start getting higher,” Woodford says. “This could have been made clearer from the beginning, avoiding confusion about the significance of tapering now.”

Significant Improvement

While saying that the Fed’s current guidance on interest rates is a “significant improvement,” Woodford sees problems with tying the policy to progress on reducing joblessness. As unemployment falls toward 6.5 percent, the Fed will be forced to explain what it will do, especially if, as Woodford suspects, it doesn’t want to raise rates at that time.

He says the Fed should adopt a broader goal: returning total economic output — nominal gross domestic product, in economist parlance — back to the trend it would have been on if the recession hadn’t occurred.

In Europe, Draghi said on July 4 that the ECB expects to keep its key interest rate where it is now, at 0.5 percent or lower, for “an extended period of time.” That was a step toward Woodford’s monetary formula.

And in the U.K., when Carney testified to Parliament in February, after being selected to become the next governor of the Bank of England, he invoked the academic. Defending the use of central bank interest-rate commitments, he referred his questioners to Woodford’s Jackson Hole paper in particular. In early August, Carney committed the central bank to keeping interest rates at a record low until unemployment reaches 7 percent.

Japan Pledge

Even Japan, the case study on the minds of the Princeton thinkers more than a decade ago, has taken some of Woodford’s advice. The strategy Bank of Japan Governor Haruhiko Kuroda began in April, as the government seeks to remedy what’s now a quarter century of sputtering growth, combines Bernanke’s recommended asset purchases with the type of communication Woodford favors, a pledge to push inflation to 2 percent.

Woodford is about as close to the world’s monetary powers as one can be from a seat in academia. Bernanke referred to him as a friend while explaining, at a September 2012 press conference, that Woodford’s research shows how forward guidance can be the central bank’s most powerful tool once rates have been cut to near zero.

Woodford says he doesn’t get much opportunity these days to talk to Bernanke, as the Fed chairman is surrounded by security and watches his every word. In the calm of his office on the Columbia campus, Woodford says he’s happy as an academic and doesn’t covet a policy-making job.

“Having the ability to be an outside critic and have an outside stance is one that I enjoy a lot,” he says.