The Federal Reserve is shrouded in obscurity. That’s partly its fault—but it’s partly progressives’ fault, too.
Bored by the proceedings at the Republican National Convention in St. Paul one day in 2008, I decided to try to gather some color down the road in Minneapolis, where Ron Paul and fellow dissident conservatives and libertarians were holding a counter-convention at the Target Center. At one point a speaker thundered that Barack Obama and John McCain “both have a lot to learn about Austrian business-cycle theory.” The crowd went delirious with cheers, and soon chants of “end the Fed” echoed throughout the arena.
It was funny at the time. A bunch of cranks talking about their crank monetary theories and espousing a crank prescription.
Today, Paul is the chairman of the House Subcommittee on Monetary Policy.
And though the House GOP presumably won’t be pressing the full Paul agenda of eliminating the Federal Reserve System and returning the United States to the gold standard, his ascension to the job isn’t a pure coincidence, either. House Republicans don’t assign chairmanships by strict seniority, and in the past, GOP leaders had kept Paul away from too prominent a role in monetary matters. Now he’s getting a seat at the table and Paulite views that see the Fed as pursuing dangerously inflationary policies are moving toward the mainstream.
As recently as 2009, the Federal Reserve’s emergency efforts to keep the economy afloat were sufficiently uncontroversial that Time named Chairman Ben Bernanke its Person of the Year. Earlier that summer, Barack Obama chose to reassure markets by leaking—well in advance of the need to make a decision—that Bernanke would be reappointed to lead the central bank. And yet, by the time the confirmation vote was actually held in late January 2010, Bernanke got in by a margin of just 70-30, the slimmest of any Fed chief ever. That nearly half of Senate Republicans voted no is especially striking when you consider that he was originally put in the job by George W. Bush, had previously chaired Bush’s Council of Economic Advisers, and before that had done an earlier stint in a lesser Fed role, again at the behest of Bush.
At the time it was possible to interpret this reversal on the part of so many GOP senators as just another sign of partisanship run amok: They were opposing him simply because Obama was the one doing the nominating. But as the economy slowed again in 2010, and the Fed initiated a new round of so-called “quantitative easing” (QE)—central bank purchases of long-term Treasury bonds to increase the money supply and stimulate the economy—it became clear that Republicans were genuinely moving toward a critique of the whole idea of stimulative monetary policy. This was striking because stimulative monetary policy had been since Milton Friedman’s day the main conservative alternative to Keynesian fiscal stimulus.
In mid-November, the conservative economics think tank e21 released “An Open Letter to Ben Bernanke” complaining that his policies risked currency debasement and inflation. True, e21 is not itself a particularly influential or well-known institution, but the letter was co-signed by influential journalist/tactician Bill Kristol; Kevin Hassett from the American Enterprise Institute; Douglas Holtz-Eakin, founding president of the new American Action Network, intended to be the right’s answer to the Center for American Progress; and other heavy hitters. Shortly thereafter, Indiana Congressman Mike Pence and Tennessee Senator Bob Corker, both Republicans, joined the party, criticizing quantitative easing and urging that the Fed’s mandate be shifted from its current dual focus on inflation and employment to a single focus on price stability.
On the merits, these conservative complaints are absurd. After then-Fed Chairman Paul Volcker and Ronald Reagan beat inflation in the early 1980s, annual increases in the Consumer Price Index (CPI) hovered around 4 percent per year for the rest of the decade. After the recession of the early 1990s, the Fed held inflation mostly below 3 percent for almost 20 years. Since the onset of the Great Recession in December 2007, the CPI’s rate of increase has been steadily lower than even that. At the same time, unemployment has been sky-high, real growth has been first negative and then disappointingly slow, and overall consumer demand has been well below the pre-crisis trend. The idea that a time of unusually high unemployment and unusually low inflation would be a good moment for monetary policy-makers to start caring less about growth and more about price stability, especially when we already have price stability, is bizarre.
In response, Paul Krugman has called on progressives to “denounce Republican attacks on the Federal Reserve and defend the Fed’s independence.” But we need something better than a simple circling of the wagons around the powers that be. After all, people are angry for the very good reason that economic performance is currently very bad. And unlike a lot of the targets of popular anger in the Obama era, from autoworkers to hedge fund managers, America’s central bankers are in fact the ones who are supposed to deliver decent macroeconomic outcomes.
Most important, for all the flaws in the right’s current critique of the Fed, they’re correct to point to the need for accountability. The idea of a central bank that’s “independent” of day-to-day politics is a good one, but too often that’s come to mean a central bank that’s immune from criticism or meaningful supervision. The Federal Reserve System’s current vague mandate needs to be replaced with a specific target, defined in law. The public and the politicians we elected need to be prepared to hold the system accountable for achieving the target, and Congress needs to accept responsibility for picking a target that leads to good outcomes. Most of all, progressives need to start caring about the Fed and engaging in the debate over what it does.
The Fed and Its Works
Everybody knows that the Federal Reserve chairman has an important job, but few people understand what the institution he supervises actually does. The overall system undertakes a variety of activities, of which by far the most important is to set monetary policy: adjusting the quantity of money available to the economy.
This is done by the Federal Reserve’s Open Market Committee (FOMC), which is composed of the seven members of the Federal Reserve Board of Governors (the chair, the vice-chair, and five other governors), plus the president of the New York Fed and, on a rotating basis, the presidents of four of the other 11 regional Fed banks.
Each of the regional Feds has its president selected by its own board of directors. These boards, in turn, are composed of three classes of directors. Class C directors are appointed by the Board of Governors in Washington. The Class A and Class B directors are appointed by the member banks, with Class A directors representing banking interests and Class B directors representing local economic interests. The governors who sit in Washington are appointed by the president and confirmed by the Senate.
The FOMC’s mandate, as defined by the Federal Reserve Act, is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” This is conventionally called a “dual mandate” in that it references both employment and inflation. (Foreign central banks often have a single mandate to focus on inflation. Some describe the mandate in qualitative terms—like the United States does—whereas others have specific numerical targets.) The Fed pursues its mandate through so-called “open-market operations”—the buying and selling of bonds. In normal times, the Fed sets a target for short-term interest rates, announcing an intention to make them either higher or lower. Then it follows up with sales or purchases of short-term bonds. Buying bonds drives rates down, and selling them pushes rates up. But just as crucial as the Fed’s actions—if not more so—is the body’s announcement of its actions. After a meeting, the FOMC releases a statement describing its intention to shift rates up or down by a certain amount. Since market participants know exactly what the Fed is trying to do, private traders start buying or selling on the assumption that the Fed will hit its target, meaning that the quantity of bonds actually bought or sold by the Fed is rather modest in practice because private investors do most of the lifting. Purchasing bonds puts more money into the economy, creating conditions of “easy money,” and is known as “easing.” Selling bonds makes money “tight” by pulling it out of the economic system.
When short-term rates are nearly zero, as has been the case recently, the Fed can’t generate looser money through this method. But it does at such a moment have the option of buying or selling longer-dated bonds and trying to influence the economy. When the Fed does this, it sets not a target interest rate but a target quantity of bonds to be purchased—hence the term “quantitative easing.” By misguided journalistic convention, a “normal” action to reduce rates from 3.75 percent to 3.50 percent is termed “cutting interest rates,” whereas recent QE measures were reported by some in the media in near-apocalyptic terms as the Fed printing billions of dollars and purchasing vast amounts of bonds. These descriptions are not inaccurate, exactly, but they lack context—printing money and buying and selling bonds are what the Fed does all the time.
The Unaccountable Fed
Politicians talk about jobs all the time. President Obama seems to talk about them in every other speech, while Republicans constantly talk of the “job-killing” effect of Democratic policies. The truth is that questions about creating jobs ought to be directed at the Federal Reserve, the federal agency that’s been charged with primary responsibility for stabilizing the economy. Recessions normally come about because the Fed raised interest rates to curb inflation, and they normally end when the Fed cuts interest rates to spur growth. At times, fiscal policy—such as the stimulus passed in 2009—enters the picture as an additional means to stoke demand.
But even then the monetary authorities are crucial. Most of the time one would worry that demand created by a higher federal deficit would be offset by the fact that more borrowing raises interest rates, stifling growth. This is the technical version of the man on the street’s objection to stimulus that “the money has to come from somewhere.” Appealing though this idea may be, it is in fact false. As Bernanke put it in a 2002 speech, “[T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.” By using this technology, the Fed can ensure that interest rates stay low even in the face of large deficits.
This free lunch is available amidst deep recessions because such events are defined by the widespread idling of resources. A recession means the country has able-bodied people who aren’t working, factories that aren’t running, and office space and storefronts that are vacant. Fiscal and monetary stimulus aims to mobilize that excess capacity. When there is no excess capacity, printing money to keep rates low will simply lead to inflation. The country’s ability to produce money may not be limited, but its ability to produce goods and services is, and inflation is what happens when the government attempts to stimulate demand above the country’s ability to produce. Increasing productive capacity is the key to long-term prosperity, but adequately matching demand to current capacity is the key to the short-term employment and economic growth picture.
Clearly, the Fed bears enormous responsibility for the health of the economy. But the way the current system works, the Fed’s members are hardly ever held accountable when the Fed fails to live up to that responsibility. The current Great Recession is, like all passing economic disasters, a major failure of macroeconomic stabilization. On the one hand, in its role as bank regulator, the Fed clearly failed to prevent widespread misbehavior. On the other hand, as a monetary policymaker, the Fed let inflation expectations fall well below customary levels even as output and employment were plummeting. Yet so far the key monetary policy-makers have been reappointed, and discussion of the issue has been dominated by cranks warning of nonexistent inflation and pushing for antiquated ideas like a gold standard. And the Fed did, in fact, engage in a flurry of unfamiliar activity to support the economy. So at the very time the collapse in output suggested the need for even more unorthodox monetary expansion, the aggressive expansion itself invited criticism that too much money was being created or that the Fed was simply continuing an unduly cozy relationship with the banking sector.
Much of the blame lies with the Fed’s current statutory mandate. Simply put, it is maddeningly vague. The interpretation of both “maximum employment” and “stable prices,” as well as the correct balance between the two, is up for grabs. Some FOMC members (or some members of Congress) may decide that 2 percent inflation is too high and the concept of “stable prices” should be re-interpreted to mean something closer to 1 percent or 0 percent inflation. Alternatively, many or most FOMC members may believe that the kind of more drastic QE measures that would be necessary to boost growth and inflation to target levels would be too politically damaging to undertake. Most plausible of all is that we’re currently experiencing some combination of the two. Some members probably regard sky-high unemployment as a price worth paying for the goal of a reduced rate of inflation, while others would prefer to do more but worry about the politics. The result is to leave the FOMC semi-paralyzed and unable to offer a fully coherent account of its own conduct. A candid description of internal disagreements and the resulting policy compromise would ameliorate the communication problem, but at the cost of undermining the aura of unanimity that the Fed relies upon to preserve its credibility and independence.
Nobody can say the FOMC is doing a bad job because nobody can say definitely what its job is. Not only the committee itself, but each individual member thereof, is free to define the FOMC’s mission freelance. Policy-making is essentially an accountability-free zone.
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