Alan Blinder, former vice chairman of the Federal Reserve and currently a professor of economics at Princeton University, believes that the Federal Reserve’s unconventional monetary policy since the 2008 financial crisis has been “one of the few national policies that is working well.” Yet, that policy has been characterized by a vast increase in the Fed’s discretionary power, near zero short-run interest rates, and the politicization of credit allocation via a huge program of quantitative easing (QE). Meanwhile, real economic growth has been sluggish compared to other post-WWII recoveries.
Jeb Hensarling (R-TX), chairman of the House Financial Services Committee, launched the “Federal Reserve Centennial Oversight Project” this year in conjunction with the Fed’s 100th anniversary. As part of that project, Committee members Scott Garrett (R-NJ) and Bill Huizenga (R-MI) have introduced the “Federal Reserve Accountability and Transparency Act” (H.R. 5018) designed to rein in the Fed’s discretionary power and reduce policy uncertainty by having the Fed adopt a rules-based approach to monetary policy. As Hensarling notes, “Monetary policy is at its best in maintaining stable, healthy economic growth when it follows a clear, predictable rule or path.”
The central feature of the proposed legislation is to require the Federal Open Market Committee to clearly state and adopt a monetary rule in place of its current purely discretionary stance. The Fed would have a choice among alternative rules but would be required to use the popular Taylor Rule (named after John Taylor, a long-time professor of economics at Stanford University) as its reference point.
That rule would require forecasting potential output, selecting an inflation target (now 2 percent), and making an assumption about the “natural rate of interest” (the equilibrium real fed funds rate). The Taylor Rule currently implies that the near-zero fed funds rate is too low and should be increased. In the absence of an output gap and with inflation at the Fed’s target rate, the Taylor Rule would yield a nominal funds rate of 4 percent, which would be consistent with 2 percent inflation and a real rate of 2 percent. Today real rates are negative.
By using the Taylor Rule as the baseline, H.R. 5018 is implicitly constraining the Fed to an interest-rate target. If the Fed deviates from the Taylor Rule, it would have to explain why and would be audited by the General Accountability Office. Nevertheless, the Fed would still have a large amount of discretion, and no one would be held liable for departing from the adopted rule — whatever it is. Current law regarding the dual mandate (price stability and maximum employment) would continue, although separate legislation has been proposed to end that mandate and adopt long-run price stability as the primary objective of monetary policy.
There are many rules the Fed could choose from, including a simple money growth rule, a price level rule, an inflation target, and a nominal demand rule, in addition to the Taylor Rule. Those rules have all been debated thoroughly in the vast literature discussing rules versus discretion in the conduct of monetary policy.
Fed Chairwoman Janet Yellen dislikes the idea that the Fed would be subject to a rule, even of its own choosing. Financial crises require judgment and a rigid rule may prevent necessary adjustments, she argues. But there are limits to what monetary policy can accomplish, and discretion may instead lead to policies that initiate and accentuate business fluctuations. In her recent testimony before the House Financial Services Committee, Yellen argued, “It would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule.”
In testimony before the Senate Banking Committee, Yellen offered her case for discretion: “The reason we have low interest rates is to deal with a very real problem, namely, the economy is operating significantly short of its potential.” In her judgment, the output gap is large and calls for an activist Fed policy. But the Fed’s own forecasting models failed to predict the Great Recession and continue to be a poor guide to the future path of the real economy.
It is well known that sustained monetary stimulus does not generate real economic growth or reduce unemployment; the stagflation of the 1970s should have ended any romance with the notion of a tradeoff between inflation and unemployment. Likewise, real income growth is consistent with gently falling prices (deflation) if output grows faster than the money supply, as happened during the classical gold standard.
To think that ultra-low interest rates and QE are the cure for unemployment and slow growth is a delusion. Over-regulation, high taxes on capital, massive government spending, enormous policy uncertainty, and crippling unfunded liabilities in entitlement programs need to be addressed as part of the effort to renew U.S. growth and create jobs.
The Fed has acted as a fiscal agent for the bloated federal government, keeping rates low to finance runaway spending. It has also engaged in credit policy by buying up mortgage-backed securities in three rounds of QE. During this exercise in “fine-tuning,” the Fed’s balance sheet has grown from less than $1 trillion to more than $4 trillion. Exiting its unconventional policies is sure to be disruptive; the more so the longer it is delayed.
By keeping interest rates artificially low for an extended period, the Fed has encouraged risk taking, fueled asset prices, and greatly increased the probability of another boom-bust episode. Asset values have far outpaced real income growth in the last several years; a situation that is untenable in the long run. Moreover, real interest rates cannot be held in negative territory without severe damage to the allocation of capital, and must be corrected at some point.
Congress must accept its constitutional responsibility for sound money, not delegate the authority to an “independent” Fed.
Kansas City Fed President Esther George and Dallas Fed President Richard W. Fisher have warned of the danger to the real economy of holding rates too low for too long. Meanwhile, Philadelphia Fed President Charles Plosser has pointed to the value of adopting a transparent rule to guide the FOMC’s decisions and reduce uncertainty. His support of a rules-based approach to monetary policy, including the selection of a specific rule like the Taylor Rule, is in sharp contrast with Blinder who sees H.R. 5018 as “radical” even though it still allows the Fed wide discretion and lacks an effective enforcement mechanism.
In a fiat money world, central banks need to be constrained in order to safeguard the long-run value of the fiat monies they supply. Given the difficulty of macro-forecasting and the temptation to monetize government debt, a rules-based approach to policy is desirable — not radical. H.R. 5018 is a step in the right direction, but it is a timid approach to reform. What is needed is a more radical, in the sense of fundamental, reform of the present U.S. monetary regime.
The reform process must start with the recognition that under Article 1, Section 8 of the Constitution, Congress is given the power “to coin Money” and “regulate the Value thereof.” At the time of the constitutional convention, it was widely understood that the term “Money” meant metallic money, not fiat money. The dollar was to be defined in terms of full-bodied money, and it is clear the Framers intended a commodity standard (either silver or gold, or both), not a pure discretionary government fiat money regime. Congress needs to return to the Constitution and use its authority to protect the purchasing power of the dollar.
By delegating wide discretion to the Fed and severing the dollar from any link to gold or silver, Congress has abandoned its responsibility for sound money. Today there is no independently defined unit of account, no convertibility of the dollar into a base metal, and little trust in the future value of the dollar as inflation erodes its purchasing power. The Fed’s target is not zero inflation; it’s 2 percent per year, and some think it should be higher.
At the birth of the Fed in 1913-14, the U.S. was still on the gold standard. That standard was diluted over the years and ended completely in 1971 when President Richard Nixon closed the gold window. Since that time inflation has been persistent and the dollar has lost 83 percent of its purchasing power even by biased official statistics. The Fed has also gained substantial powers — especially after the 2008 financial crisis.
It is time to consider binding the Fed by a rule — or even abolishing it and moving to a decentralized monetary system with free banking (i.e., private currency competition without onerous legal restrictions). However, even a timid reform proposal such as H.R. 5018 is enough to scare Fed Chairwoman Janet Yellen and former vice chairman Alan Blinder, and many others.
Section 2A of the amended Federal Reserve Act states: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The Fed has put most of the weight on restoring full employment, but that objective is outside the limits of what the Fed can do, and has nothing to do with Congress’s power to maintain (“make regular”) the value of money.
The Fed is not independent in any meaningful sense: it is monetizing government debt and its policies have allowed big government to get bigger. That is not what the Framers of the Constitution had in mind. The classical gold standard helped limit the size and scope of government and allowed markets to determine the quantity of money in circulation and interest rates; it was a passive, non-activist monetary regime based on simple rules (defining the dollar in terms of gold and providing for convertibility and free capital flows).
Today’s pure fiat money regime is activist in spades. By artificially lowering interest rates, the Fed is distorting relative prices, creating asset bubbles, and depriving savers of the real income they expected under normal circumstances.
Irving Fisher, a prominent supporter of a rules-based monetary regime in the early 20th century, recognized that “as soon as any particular government controls a paper currency bearing no relation to gold or silver, excuses for its over-issue are to be feared.” Milton Friedman, in remarks published by the House Republican Research Committee in 1984, argued that “the best change of all would be to abolish the Fed completely, and simply have zero creation of high-powered money and no discretionary powers anywhere.” He also argued: “As I read the original Constitution, it intended to limit Congress to a commodity standard.”
To move from the present pure discretionary government fiat money system to a rules-based regime, Congress must accept its constitutional responsibility for sound money, not delegate the authority to an “independent” Fed. The place to start is to pass Rep. Kevin Brady’s legislation for establishing a bipartisan Centennial Monetary Commission to examine the Fed’s 100-year performance and to explore alternative monetary rules for a stable-valued money. In that regard, it would be wise to listen to the chief architect of the Constitution, James Madison, who wrote in 1831: “The only adequate guarantee for the uniform and stable value of a paper currency is its convertibility into specie.”