Financial Evolution and the Declining Effectiveness of US Monetary Policy Since the 1980s
Abstract
This dissertation argues that the effectiveness of US monetary policy has been decreasing since the beginning of the 1990s. This is in contrast to the literature which either argues that it has not weakened or that the weakening started much later. There have been two very important trends in the relationship between the Fed policy rate and the financial markets. I call them "dual decoupling", namely decoupling between the Fed rate and prices of financial assets on one hand, and the Fed rate and quantities in financial markets on the other. Both of them mean increasing the degree of endogeneity of price and quantity determinations in financial markets independently of the Fed. In other words, the influence of the Fed in determining the prices and quantities of financial assets has decreased considerably. This study claims that these developments are the direct product of four factors: i) the transformation of the US financial system, ii) increasing competition, iii) increasing centralization tendencies, and iv) decreasing balance sheet constraints on financial firms. These factors can be understood as the result of four other very interrelated dynamic forces: i) rapid innovation in financial markets, ii) deregulation trends in the regulatory framework, iii) policy choices of the Fed, and iv) increasing financial integration. The first chapter is an introduction. The second chapter sets out the theoretical groundwork for the dual decoupling argument. The third chapter develops a theoretical framework to investigate the implications of decreasing balance sheet constraints on financial firms. It also presents a simulation framework that shows the possibility of decoupling between Fed policy tools and expansion of the balance sheets of financial markets. The fourth and fifth chapters provide strong empirical evidence related to gradual decoupling between the Fed rate and prices of assets in US financial markets. This study also presents evidence that foreign capital flows can even affect interest rates within the US. In this vein, foreign capital flows might have been one of the factors behind especially low long-term interest rates in the period after 2001. Moreover, the findings of this paper indicate that as opposed to Bernanke (2004) and many others, it is not plausible to argue that "improvements in the execution on monetary policy can plausibly account for a significant part of the Great Moderation." Although this dissertation is silent about the reasons behind the Great Moderation, it makes a strong case against the argument of monetary policy improvement. This reading of developments in US financial markets and monetary policy does not fit the story being told by most economists. Most of them believe that central banks, and specifically the Fed, are very powerful in fine-tuning their economies. For them, as long as central banks control their official interest rates, they have enough leverage to affect their own economies. Most of the current macroeconomic modeling practices and monetary policy advices are based on this strong belief. Therefore, if the arguments developed in this study are true, the relevance of the dominant current macroeconomic modeling and monetary policy advices based on these models should be reconsidered.