Betting Against the Fed

This article appeared in the September 7, 2009 issue of Forbes.

The Federal Reserve is scrambling to convincethe public that it is not a secretive institution that actsat the behest of Wall Street, but the public isn't buyingthe Fed's line. According to a Gallup Poll conducted inmid-July, the Fed received the lowest approval rating ofthe nine government agencies and departments evaluated — evenlower than the Internal Revenue Service.

Trying to show the softer side of the central bank, Fed ChairmanBen S. Bernanke took us on a tour of his hometown of Dillon,S.C. on a 60 Minutes segment in March, and in July he fieldedquestions from newsman Jim Lehrer and an auditorium full of peoplefor more than an hour in a televised town hall meeting.

Both events were carefully choreographed — and unprecedented.During his face time Bernanke explained many things, includingthe Fed's strategy for shrinking its balance sheet and withdrawingthe ocean of excess reserves from the banking system. Unfortunately,he did not address my main beef with the bank: that it clings to aflawed inflation-targeting regime with a horrible history of monetarypolicy failures.

In pursuit of inflation targeting — the idea that monetary policyshould be geared to keeping the annual core inflation rate in arange of, say, 0% to 2% — the Fed has been much more tolerant ofinflation than it has of deflation. In November 2002 then governorBernanke and then chairman Alan Greenspan misdiagnoseda benign cyclical dip in the price level. Fearing deflation, the Fedpanicked, and by July 2003 pushed the Fed funds rate down to athen record low of 1%, where it stayed for a year, allowing a floodof liquidity to hit the economy and the housing bubble to inflate.The Fed ignored economic theory developed by Austrian economistssuch as Nobel laureate Friedrich Hayek, who demonstratedthat there was such a thing as a "good deflation," which occurs duringa productivity boom. It was just such a boom, coupled withan improvement in the U.S. terms of trade, that was putting downdownwardpressure on the core inflation rate.

More monetary blundering occurred after the Dubai G7 Summitin September 2003, when the U.S. got other Western nationson board to pressure China to allow its currency to appreciate againstthe dollar. The 2004 elections were approaching, and the outcomeof key contests in the Rust Belt, according to President Bush's advisors,hinged on whether China could be forced to alter its fixedyuan-dollar exchange rate of 8.28. Surprisingly, the Fed was drawninto what is normally the exclusive domain of the U.S. Treasury — the dollar's exchange rate.

The Bush Administration's weak dollar policy, endorsed by theFed, brought with it not only a dollar rout but also an explosion incommodity prices. Perhaps the commodity price surge explains whythe Fed was behind the curve in lowering the Fed funds rate — somethingthat pushed the economy into a steep recession well beforethe collapse of Lehman Brothers one year ago. By the start of 2007weak aggregate demand was signaling a recession, but the Fed keptthe funds rate at 5.25% until mid-September 2007. It's not surprisingthat the economy tanked.

Never mind these missteps. The Obama Administration hasproposed rewarding the Fed for its failures by crowning it the nation'ssystemic regulator — a sort of financial regulatory czar. But manyin Congress demand a closer peek inside the central bank.

Congressman Ron Paul (R–Tex.), along with 282 cosponsors,has introduced a bill that would require the Government AccountabilityOffice to audit the Fed. The Fed claims that auditing wouldimperil its independence.

Milton Friedman weighed inon central bank independence ina 1962 essay, "Should There Be anIndependent Monetary Authority?"Friedman's conclusion: "Thecase against a fully independentcentral bank is strong indeed." Asfor letting in some sunshine, thelate senator Patrick Moynihan(D–N.Y.) had it right: "Secrecy isfor losers."

As we await the outcome of the battle over Fed transparency,we should ponder a recent conclusion of Carnegie Mellon's AllanMeltzer. As the author of the authoritative A History of the FederalReserve, he has observed that the Fed responds "decisively to theunemployment rate but not to the inflation rate." As long as unemploymentremains elevated, expect loose monetary reins and moreinflation.

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Steve H. Hanke

Steve H. Hanke is a professor of applied economics at the Johns Hopkins University and a senior fellow at the Cato Institute in Washington, D.C.