It’s Time to Evaluate the Fed

The lack of a clear guide for monetary policy, reliance on flawed theory and a failure to predict the financial crisis are good reasons to make changes at the U.S. central bank.
August 21, 2015 • Commentary
This article appeared in Caixin Online on August 21, 2015.

The U.S. Constitution gives Congress the power “to coin money” and “regulate the value thereof.” On that basis, Republican Congressman Kevin Brady and Republican Senator John Cornyn have introduced legislation to create a Centennial Monetary Commission. The bipartisan body would “examine the United States’ monetary policy, evaluate alternative monetary regimes and recommend a course for monetary policy going forward.”

The Centennial Monetary Commission Act of 2015 was voted out of the House Financial Services Committee by a margin of 35 to 22, on July 29, and will go to the House floor for a full vote, mostly likely in September.

After more than 100 years, it’s time for Congress to evaluate the Federal Reserve’s performance and ask, Can we do better?

Congress created the Fed in 1913, when the United States was still on the gold standard. Since then, the United States has moved to a pure fiat money system, and in 1977 Congress amended the Federal Reserve Act to give the Fed a dual mandate to achieve both price stability and maximum sustainable employment. Section 2A of the amended Act, however, also holds the Fed responsible for ensuring “moderate long‐​term interest rates.” Thus, the Fed has three mandates, not two.

For many years, the Fed did not mention the objective of maximum employment in the Federal Open Market Committee statement. It was assumed that the central bank’s best route to economic growth and full employment was to maintain price stability by limiting the increase in the quantity of money to the economy’s long‐​run growth potential.

Paul Volcker was outspoken in that regard. In 1981, as chairman of the Federal Reserve Board, he told the Senate Committee on Banking, Housing and Urban Affairs: “We will not be successful, in my opinion, in pursuing a full employment policy unless we take care of the inflation side of the equation while we are doing it … I don’t think that we have the choice in current circumstances — the old trade‐​off analysis — of buying full employment with a little more inflation. We found out that doesn’t work.”

Rapid monetary growth led to high inflation in the 1970s and rising unemployment, contrary to the popular idea of a negative relation between inflation and unemployment, as specified in the Phillips curve. The experience of stagflation supported F. A. Hayek’s theory that inflation distorts price signals and causes malinvestments that are later revealed in recession. Milton Friedman also recognized the possibility of a positively sloped Phillips curve in his 1976 Nobel lecture.

In 2002, William Niskanen, in a path‐​breaking article in the Cato Journal, found that there is “no tradeoff of unemployment and inflation except in the same year” and that “in the long term, the unemployment rate is a positive function of the inflation rate” — thus confirming Hayek and Friedman’s conjectures. Instead of a 2 percent inflation target, Niskanen, a former member of president Ronald Reagan’s Council of Economic Advisers, recommended “a monetary policy targeted to achieve a steady growth of aggregate demand at a zero inflation rate” as “consistent with the lowest possible sustainable unemployment rate.”

Nevertheless, the Fed still adheres to the negatively sloped Phillips curve as a policy guide. According to Atlanta Federal Reserve President Dennis Lockhart, “I think a policy maker has to act on the view that the basic [negative] relationship in the Phillips curve between inflation and employment will assert itself in a reasonable period of time as the economy tightens up” — that is, inflation should increase as unemployment falls. The problem is that the Fed has been trying to increase inflation for more than six years while unemployment has gone from 10 percent to near 5 percent. The logic of the Phillips curve may be “compelling” to Lockhart, but is a poor guide to policy.

Monetary policy is a blunt instrument to stimulate the real economy. Economic growth depends on nourishing market‐​friendly institutions including private property rights, the rule of law, moderate tax rates and free trade. Consumption is the end of production, and money lubricates the commerce that makes consumption possible. If the monetary system is malfunctioning, commerce will slow and prosperity will suffer. That is why sound money and banking are so important for sustainable development.

Since the 2008 financial crisis, the Fed has grown more powerful and its balance sheet has gone from less than US$ 1 trillion to more than US$ 4 trillion. Yet, quantitative easing and ultra‐​low interest rates have not led to robust growth. After more than six years, U.S. real GDP grew by a mere 1.5 percent in the first half of this year and the growth of labor productivity is stuck at 0.7 percent, far below its long‐​term average of 2.5 percent a year. The post‐​2009 recovery has been the weakest on record since World War II.

Although it is often heard that the Fed’s unconventional monetary policies have boosted the economy, the evidence suggests that they have slowed economic growth. By paying interest on excess reserves and ramping up macro‐​prudential regulation, the Fed has sterilized much of the increase in the monetary base, which is held at the central bank rather than being lent out for private investment. Meanwhile, ultra‐​low interest rates have discouraged saving and investment, thus slowing capital accumulation and reducing the growth of labor productivity and real output. The Fed’s unconventional monetary policies have also distorted interest rates, encouraged risk taking, and created asset bubbles in stocks and bonds.

The lack of any clear guide for monetary policy, continued reliance on a flawed Phillips curve theory, and the failure to foresee the financial crisis (which the Fed itself helped create) should incentivize Congress to pass the Centennial Monetary Commission Act and submit a report with recommendations for improving the current monetary and regulatory regime. To quote the late Milton Friedman, “Monetary policy is too important to be left to central bankers.”

About the Author
James A. Dorn

Vice President for Monetary Studies, Senior Fellow, and Editor of Cato Journal