Whatever Will We Do About the Fed?

Federal Reserve Building, Washington DC         Photo Credit:  Flickr.com/wwarby

Last September 10, I commented on Senator Richard Shelby’s Financial Regulatory Improvement Bill in A More Accountable Fed. Greg Ip in The False Promise of a Rules-Based Fed reported the bill was passed last week by the House of Representatives. A section-by-section summary of the bill can be found here, and the contents of the entire bill can be found here. Now, despite the seemingly boring topic promised by the bill’s title, a conflict of epic dimensions is forming over its passage. At stake is whether the progressive Left can continue to depend on the Fed to pursue New Keynesian monetary policies. Our unfortunate experiences with the Fed’s Zero Interest Rate Policy (ZIRP) and Quantitative Easing (QE), however, seem to require we force the Fed away from this direction. At the very least, Congress should take some of the Fed’s discretion on monetary policy away from it and instruct them to use a monetary rule.

The Federal Reserve under the New Keynesians

Ever since the end of the 1970s stagflation, the Keynesians have incorporated many of Milton Friedman’s monetary criticisms fundamentally into their theories. In the process, the neo-Keynesians of the 1950-1980 period morphed into the New Keynesians with a new neoclassical synthesis. The really new aspect of these theories is in a description of the economy that is different in three time periods after the beginning of a recession/depression.

1. Immediately after the start of an economic crisis while the value of money is relatively unchanged, the New Keynesians use the classical Keynesianism of the 1930s and 1940s to describe the economy and to prescribe economic policies.
2. As soon as money’s value begins to change appreciably with either inflation or deflation, New Keynesians change their description to one that puts inflation/deflation at the very heart of their theory. I described this theory in the posts Inside the Mind of a New Keynesian, New Keynesian Adjustments for Inflation, How New Keynesians Explain 1970s Stagflation, and Failures of New Keynesian Economics. In this theory, the deviation of the inflation rate from a desired inflation rate and of GDP from a prescribed “potential GDP” are connected to an interest rate the Fed would want to impose through a Policy Reaction Function, or PRF. The PRF is the key determinant of the Fed’s monetary policy, as the Fed would adjust the quantity of money  by either imposing the desired interest rate as the Fed Funds Rate, by changing the reserve requirements of member commercial banks, or by open-market operations by buying or selling (primarily) government securities. See the post The Federal Reserve: What It Is for a more thorough description of Federal Reserve operations.
3. In the long term, as the recession/depression fades away, the New Keynesians take the theory of neoclassical economics as the proper description.

One point of Sen. Shelby’s bill is to compel the Federal Reserve to choose a specific  monetary rule for their PRF and inform Congress of their choice. In addition should the Fed’s Federal Open Market Committee (FOMC) ever change the monetary rule they are using, they must inform the appropriate committees of Congress. The part of the bill involving these new reporting requirements can be found in Title V, Section 501(b)(2)(B). There, you will find that included in quarterly reports will be:

A Misapprehension of What Monetary Policy Can Do

At the heart of the Federal Reserve’s malfeasance has been Keynesians’ illusion they could utilize monetary policy to generate economic growth without doing a great deal of economic damage. This has been equally true of the neo-Keynesians as well as the New Keynesians. Greg Ip epitomizes this delusion in the post I cited earlier. He expresses the often-stated belief that monetary policy must be crafted differently for every economic situation, and therefore the Federal Reserve must be given maximum discretion when deciding on policy. Yet, depending on the era, this belief has led Keynesians either to greatly degrade the ability of money to play its needed roles, or in the last seven years to hold real interest rates at the “zero lower bound” to allow asset bubbles to inflate and national savings to erode.

Whenever monetary policy is primarily used to stimulate economic growth, there is always the chance that the economic value of the dollar will be allowed to vary. If the dollar suffers either inflation of deflation, all three of its roles as a medium of exchange, a store of value, and as a unit of account must necessarily suffer, as I discussed in The Ideal Monetary Policy. In the last seven years, the Fed has avoided this particular problem by trapping most of the newly created money (about 80% of new QE money) in excess federal reserves. However, at the same time they did not achieve much of anything in generating growth. In the forlorn hope they could get growth going by just keeping both short-term and long-term real interest rates at zero a little longer, they enabled the creation of asset bubbles and greatly discouraged national savings.

In the many decades over which we have attempted to encourage growth with increasing money supply, we should have learned by now that this is an inappropriate instrument for that purpose. Monetary policy appears good for one thing only: the maintenance of a constant value of money. Leave the encouragement of growth to more appropriate tools, such as tax cuts and reform, and the cutting of unnecessary economic regulations.

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