Rules over politics at the Fed
When Democratic Sen. Jon Tester of Montana announced last Friday that he would vote against Larry Summers’ putative candidacy for Fed chairman if it came before the Senate Banking Committee, he put a dagger in Summers’ Fed career before it even started. Tester would have made the fourth Democratic nay vote in the committee, and it is highly unlikely that Republicans would have taken up the slack to push through a Summers nomination.
So over the weekend, Summers wisely withdrew from the horserace, telling President Obama that the confirmation process would be too political and acrimonious.
Some Democrats blame Summers for financial deregulation during the Clinton-Rubin 1990s. Other Democrats simply want Janet Yellen to be the first female Fed chair. And Republicans blame Summers for authoring the $1 trillion Obama stimulus-spending plan that piled on new debt without generating a real economic recovery.
But actually, President Obama doomed this candidacy months ago with his repeated rebuttals to attacks on Summers. A buzz then developed that a Chairman Summers would be Obama’s guy; sort of the way Arthur Burns was Dick Nixon’s guy years ago. And that turned out to be a disaster.
Fed chairmen have to be independent, ready to make tough decisions. So what would have Obama said to Summers about higher interest rates and slower money growth in the next couple of years? Would Summers have had the independence to pull it off?
We’ll never know. But we do know that the stocks markets rallied big time on the Summers withdrawal. Markets think Yellen will be an easy-money dove and that Summers would have been the tight-money hawk. But stocks have no way of knowing this, because neither Yellen nor Summers have suggested a rules-based monetary policy that will prevent serious financial crises while stabilizing inflation and maximizing growth.
In the 1980s and 1990s, a rules-based monetary strategy worked very well. Economists have called the period the Great Moderation. Yet as bright as they are, Yellen and Summers are big government and big Fed fine-tuners, meddlers and tinkerers. And that’s exactly what we don’t need from the next Fed chair.
Instead, we need a rules-based approach that will guide the Fed through the difficult period of shrinking a $3.7 trillion balance sheet and a $2.2 trillion volume of excess bank reserves, and raising the zero interest rate.
Can this be done in an orderly manner? Or will financial markets panic over this return to normalcy?
Well, there are a number of monetary rules, all based on market action rather than government action, which can put the Fed back on the right track. For example, if the Fed had used the Taylor Rule over the past dozen years, we never would have seen the boom-bust cycle that virtually wrecked the financial system and economy. Stanford economist John Taylor uses a combination of inflation and real growth to target the federal funds rate and the money supply. And his rule warned from 2001 to 2006 that Fed target rates were too low, the dollar was collapsing, and housing and other real assets were ballooning on their way to popping. His rule predicted the worst economic crisis since the Great Depression.
But other price rules — driven by forward-looking, inflation-sensitive, market-price signals — were telling the Fed the same thing. With gold soaring and the dollar plunging, a commodity-price rule — such as the one Wayne Angell and Manley Johnson instituted while they were Fed governors from roughly 1985 to 1995 — would have warned Alan Greenspan that he was on the wrong track.
For most of American history, a reliable “King Dollar” and sensitive commodity prices, including gold, have been important market-price signals to guide Fed policy. (More often than not, Ben Bernanke ignored these signals.) And we can now add to that the “market monetarists,” a new group that advocates nominal-GDP targeting, which is a combination of inflation and real growth and is somewhat akin to the Taylor Rule.
The key point here is that the next Fed chair should employ consistent targets rather than big-Fed tinkering. Ironically, Yellen, the supposed dove, has talked about the usefulness of a modified Taylor Rule. And equally ironic, Larry Summers has written that independent central banks have the best low-inflation track records. Yet Summers was clearly too political to get the job, and Yellen’s dovish feathers follow her everywhere.
I doubt if there’s a single Obama advisor telling the president to appoint someone who believes in monetary rules. That’s too bad. A clear price rule is exactly what the Fed needs to get out of this mess.