Not since the Great Inflation of the early 1980s has the Fed been so controversial. Its causal role in the housing boom and bust remains contentious. Other factors aside, the Fed was a poor overseer of the safety and soundness of the financial system. At best, the central bank was a passive bystander during the boom and early stages of the housing bust; it couldn’t even accept that we were in the midst of nationwide housing downturn.
Certainly, the Fed has made many mistakes, but the current era of big government precludes any near‐term possibility of abolishing it, as some would hope. However, it can be improved. At a minimum, the Fed needs to be much more rule‐bound. Targeting nominal GDP (the dollar value of all goods and services produced in the United States, not adjusted for inflation) would be one such rule. That policy would have the advantage of moving the Fed away from targeting a real variable, like employment.
Monetary policy cannot over the medium‐ to long‐term systematically influence real variables, like the number of jobs created. Even in the short run, monetary policy’s track record is mixed at best. Witness the Fed’s inability to generate a normal economic recovery – especially in employment – despite unconventional monetary policy. In contrast, nominal GDP targeting lets the market determine the composition of output and price changes for a given rate of growth of nominal output. In many versions, nominal GDP growth is targeted at five percent annually, with the expectation that over the long run, real output will grow at a trend rate of three percent and prices at two percent on average.