Earlier this week, Senator Bob Corker (R-TN) and Congressman Mike Pence (R-IN) expressed support for limiting the mandate of the Federal Reserve to controlling inflation. Corker wants to “direct the central bank to focus solely on price stability.” On Tuesday, Pence introduced legislation for that same purpose (H.R. 6406), noting that policy relating to employment “is the job of the Congress and the President.” These moves are in response to Fed policy, especially its current “QE2” plan, which aims, in part, to boost employment.
Few things are more dangerous for economic stability than Federal Reserve policy, which is both confused and confusing. In particular, Fed officials have made clear that they want to stoke at least a little bit of inflation while at the same time wanting to lower intermediate-term interest rates in a bid to spur economic activity and boost employment.
However, even a high-school economics student knows that the primary factor controlling interest rates for securities of duration of a few years or more—and the fed appears to be targeting roughly the 5-year to 10-year range—is inflation expectations. In other words, the Fed’s stated goal of increasing inflation must, at least to the extent that the market expects it to be successful, work against its stated goal of forcing down intermediate-term interest rates to boost employment.
Thus, with policies that are at war with themselves, the Fed has begun implementing its “QE2” program of quantitative easing, buying treasury securities from banks to put more money into circulation.
The market has been confused as well, with interest rates on the 5-year and 10-year treasury notes first declining and then spiking upward over the last two weeks. The US dollar has also been extremely volatile, first selling off on the rational interpretation that QE2, which essentially amounts to printing money, would debase the value of the currency. But then, both because of the upward spike in interest rates and the turmoil in Europe, particularly surrounding Ireland, the US dollar has gained 5% against the Euro in just the last 9 trading days.
The Fed’s interest in stoking inflation may not be as surreal as it sounds. During my lifetime there has never been a time when the Fed was seriously worried about deflation; policy was always about fighting inflation, not creating it. But deflation would be, if it occurred, an extremely serious problem. It’s a cycle that is difficult to break out of, as Japan has shown with not just one, but arguably two, lost decades. The layman’s version looks like this: Prices start falling so consumers hold off on purchases anticipating lower prices in the future. The lack of consumer demand causes producers to lower prices to encourage people to buy, but those lower prices serve to prove to many that they’re right to keep waiting. And the cycle goes on until … well, that’s the problem, we don’t really know when and how it ends since Japan has tried every stimulative measure it can think of, including keeping short-term interest rates at or near 0% since the late 1990s, without success.
The Fed’s policy confusion is a necessary outcome of its mission statement, which says that the Fed “conduct(s) the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates.”
However, if employment is weak or prices are falling, the Fed will find it extremely difficult to attack the problem without
causing a jump in long-term interest rates. The employment issue is especially problematic because it doesn’t on its own imply already weak long-term rates in the way that falling prices do. This is one reason that including an employment mandate for a central bank is inappropriate.
But it’s not the only reason.
The employment part of the mission statement has a problem in the use of the word “maximum”. If you ask two economists what the US economy’s maximum employment rate is (as a percentage of the workforce), you’ll get at least three answers and as many questions, including whether an unemployment rate below a certain level is likely to spark inflation. (This question will undoubtedly arise even though the “Philips Curve” idea on which it is based has been largely discredited by empirical data.)
Perhaps most importantly, the employment aspect of the mission statement also brings the Fed into a distinctly political area of economics, given that nothing tends to lead to unemployment of Congressmen as much as unemployment of citizens does.
Few things are more destructive to the credibility of a central bank than a perception that its actions are dominated by politics as much as by economics. Unfortunately, this is precisely the path Fed Chairman Ben Bernanke has gone down, with too many press conferences with Obama’s Treasury Secretary Tim “I can’t use TurboTax” Geithner and enacting a QE2 policy which, despite denials from some Fed officials, seems designed in part to weaken the dollar in pursuit of Barack Obama’s goal of increasing American exports and export-related jobs. Of course, all countries want to increase their exports, so a blatant assault on the dollar could lead to an internecine round of competitive devaluation and global instability. This is one reason many economists, both at home and abroad, think QE2 poses more risk than potential reward for the US and global economies.
In short, having an employment mandate is causing the Fed to become overly political and take on policies which are counter to its far more important mission of price stability. Thus, it is heartening to see the proposals from Corker and Pence. The Fed should embrace these proposals because it should want to avoid politics. Bernanke might think that being on TV more frequently than Oprah is fun, but an overly political Fed can only portend future economic turmoil.
Cartoon courtesy of Brett Noel.