What’s Wrong With the Federal Reserve?
Published in Wall Street Journal
By allowing its monetary policy to be influenced by elected politicians and market speculators, the Federal Reserve is putting its independence at risk. It is also neglecting basic economics, which was a great strength of its current chairman, Ben Bernanke.
Consider the response to last week’s employment report for June—a meager 80,000 net new jobs created, and an unemployment rate stuck at 8.2%. Day traders and speculators immediately clamored for additional monetary easing. Even the president of the Federal Reserve Bank of Chicago joined in.
To his credit, Mr. Bernanke did not immediately agree. But he failed utterly to state the obvious: The country’s sluggish growth and stubbornly high unemployment rate was not caused by, nor could it be cured by, monetary policy. Market interest rates on all maturities of government bonds are the lowest since the founding of the republic. Banks have $1.5 trillion in cash on their balance sheet in excess of their legally required reserves—far more than enough to meet any unsatisfied demand for loans that bankers regard as prudent.
Consider also how, in the summer of 2010, the Fed allowed itself to be spooked by cries about a double-dip recession and deflation. It added $600 billion to banks’ reserves by buying up federal Treasurys and mortgage-backed securities. Today, $500 billion of those reserves remain on bank balance sheets, and most of the rest of the dollars are held by foreign central banks. Not much help to the U.S. economy. By early autumn 2010, it had become clear that fears of a double-dip recession and deflation were just short-term hysteria.
One of the Fed’s big mistakes is excessive attention to the short term, over which it has little influence. As I researched the central bank for my “History of the Federal Reserve,” I was dismayed to find hardly any discussions in the minutes of its policy arm, the Federal Open Market Committee, about what members expect to happen a year from now as a result of whatever actions it is taking today.
True, the staff provides forecasts about the future, but these are made before policy action is decided. Former Fed Chairmen Paul Volcker and Alan Greenspan told the staff several times that its inflation forecasts based on the Phillips Curve—which theorizes a trade-off between inflation and employment levels—were not useful. But the Phillips Curve is still central to the inflation forecasts that Messrs. Volcker and Greenspan found useless.
The problem with the short term is that data reported today are subject to revision, or reflect only transitory changes. The better economic data last winter are one of many examples. Would the reported improvement in the economy persist? We didn’t learn the answer until weaker data reported this spring. Is the slowdown persistent or temporary? We can only guess.
Executing monetary-policy changes in response to transitory data is a mistake. The late Nobel laureate economist Milton Friedman taught that monetary policy operates with long lags. Actions today have their main effects much later. By then the data often support a very different story.
The other big problem at the Fed is staying mum about the real cause of the high current unemployment rate—fiscal policy.
Today’s economic problems are serious, but the Fed can’t do much about them if these problems are not monetary. Very expansive monetary policies did help during the crisis of 2008-09, but they’re not what is needed now. To get out of our bad economic situation, we need coherent long-term fiscal policy, especially entitlement reform.
With mortgage rates lower than ever and housing showing very sluggish recovery, what can be gained by dropping the mortgage rate another small fraction? Business investment is held back by uncertainty. No one can reliably calculate tax rates, health-care costs, and the regulatory burden until after the election, if then. How can corporate officers calculate expected return when they cannot know these future costs? How is more monetary stimulus today supposed to help?
From about 1985 to 2003, the Fed achieved relatively stable growth, short, mild recessions, and low inflation by more or less following the Taylor Rule, which specifies (to simplify) what interest rate the Fed should establish in response to the expected inflation rate and the unemployment rate. Rule-based monetary policy brought us a far better economic outcome than discretionary ups and downs. The Fed should commit to that rule and follow it.
The policies that are really needed are on the fiscal side. Instead of more short-term stimulus, we need a government that puts us on a path toward a balanced budget over time, mainly by reducing spending. Instead of denigrating and then ignoring House Budget Chairman Paul Ryan’s courageous effort at entitlement reform, the administration should put a program on the table to control our deficits.
Evidence is growing that many think higher inflation is in our future. One sign is the premium that investors pay to hold index-linked Treasury bonds that protect against inflation. Another is the shift by asset owners from holding money to holding equities and real assets, or claims to real assets. What many call “bubbles” cannot occur without this shift occurring
One of the many costs of the Fed’s excessive attention to the near-term is that it will wait until after the inflation is upon us before it does anything to stop it. The Fed’s view is that by raising interest rates enough, it can stop any inflation. True, but not entirely relevant. Will the politicians, the public, business and labor accept the necessary level of interest rates? Much history says: “Don’t count on it.” Better to adopt something like the Taylor Rule and begin gradually reducing the banking system’s excess reserves now.
Mr. Meltzer, a professor of political economy at Carnegie Mellon University’s Tepper School, is a visiting fellow at the Hoover Institution. He is author of “A History of the Federal Reserve” (University of Chicago Press, 2003 and 2009) and “Why Capitalism?” (Oxford University Press, 2012).