The Fed in a Corner, by Tim Duy: Over the years, I have warned a seemingly
countless number of undergraduates that Fed's hold on monetary independence was
tenuous at best. Independence is not guaranteed by the Constitution. Congress
made the Fed, and Congress can unmake the Fed. The Fed could only maintain the
privilege of independence if policymakers pursued policy paths that fostered
maximum, sustainable growth. Deviating from such paths would have consequences.
The Fed is quickly learning the extent of those consequences, as Congress
launches an assault on the Fed's independence.
Some find the loss of support for the Fed puzzling.
Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what
they should have done:
First of all, from the day after the collapse of Lehman Brothers, the policies
followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S.
administrations have been very helpful. They have been good ones. The
alternative--standing back and watching the markets deal with the
situation--would have gotten us a much higher unemployment rate than we have
now. Credit easing by the Fed and support of the banking system by the Fed and
the Treasury have significantly helped the economy: have kept things from
getting much worse.
The Fed earns accolades from academics for its handling of the crisis, in
particular since the Lehman failure. Fair enough; I have few quibbles with
policy since last fall. But what about the years before Lehman, when the
crisis was building? Where was the Fed then? Did they abdicate
regulatory responsibility? How did banks develop such incredible exposure
to off-balance sheet SIV's? How could the Fed ignore increasingly
predatory lending in the mortgage market? What exactly was Timothy
Geithner, then president of the all important New York Fed, regulating and
supervising? Clearly not Citibank.
To be sure, there were plenty of other regulatory failures along the way, but
the Fed - an independent Fed - should have been in a much better position to
raise regulatory and supervisory roadblocks during the debt build-up compared to
other, more politically susceptible agencies. The Fed's independence
should have allowed it to be a leader, not a follower. Ideological
objections to regulation, apparently,
prevented the Fed from looking for problems in their own backyard.
Rapid debt creation was justified as a response to asset appreciation, with
little concern that the connection might just be a bit more self-reinforcing.
The resulting crisis left the Fed struggling to keep the ship afloat - and in
that struggle the Fed stepped too deep into the realm of fiscal policy in an
effort to keep the trains running on time. But that mission creep was
simply incompatible with the Fed's desire for secrecy. This was all to
predictable: Like it or not, you cannot commit literally billions of
dollars of taxpayer money and in the process secretly funnel money through AIG
to the investment banking community without expecting just a little blowback.
The last I checked, this was still a democracy.
Worse now for the Fed is the impression that monetary authorities work first and
foremost for Wall Street. Of course, Fed officials see this a bit
differently - they see supporting Wall Street as their mechanism for supporting
Main Street. Ultimately, without the former, the latter is locked out of
capital markets, and economic chaos follows. The purpose of Wall Street is
supposed to be to channel investment funds into Main Street. But most
Americans no longer view Wall Street as ultimately working in their best
interests - maybe correctly. This is the same Wall Street that
aggressively pushed garbage loans onto the American people as policymakers
praised the wonders of financial innovation. When did the purpose of
finance evolve into simply a mechanism to enrich the relative few at the expense
of many? And when did policymakers embrace this view? As Paul
Krugman has noted, the
cannot envision a world not dominated by the magic of structured finance.
Yet this is a world tht failed us to completely.
Ultimately, can you really blame Americans if they have lost their faith in the
supposedly omnipotent Federal Reserve?
Now the Fed's relationship with the public is a mess. And I suspect it is
going to get much worse. Free Exchange
succinctly identifies the new challenge:
An independent central bank is crucial. Political control of monetary policy
must inevitably lead to accelerating inflation and long-run economic
instability. But at the moment, the American economy could use an increase in
expected inflation. And a real threat to Fed independence would almost certainly
deliver it, either because markets would anticipate increased political
influence on monetary policy ever after, or because the Fed would seek to fend
off pressure from Congress by easing further, which amounts to the same thing.
But we don't actually want there to be a real threat to Fed independence,
because that way uncontrolled inflation lies.
The Fed has made it clear that unemployment is expected to remain unacceptable
high in the medium run while disinflationary pressures persist. Yet
policymakers have also made it clear that they believe they have done all they
can, or are willing, to do to combat unemployment. They equate credibility
with maintaining a 1.7-2% inflation target. Couldn't credibility be
consistent with a 4% inflation target? And wouldn't such a target be more
appropriate in a zero interest rate world? But alas, challenging the Fed
now with their independence at stake will only convince policymakers to dig in
their heels more aggressively.
What if the only way to get the Fed to do the right thing is to strip them of
their independence? It is a real possibility, although disastrous in the
long-run. Yet look at the dithering from the Bank of Japan,
still faced with a deflationary environment years and years after they
pushed to zero rates:
It was no coincidence that the new government of Yukio Hatoyama chose the day
when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of
noise on the issue. Both the deputy prime minister and finance minister made
concerned comments. Their unspoken message to the BoJ was clear: remove
monetary-stimulus measures at your peril. At the end of its two-day meeting, the
BoJ left its policy rate unchanged at 0.1%, and continued to use other measures,
such as buying government bonds, that it believes make monetary policy
But the BoJ does not give the impression it is particularly concerned about
prices. It believes there are not yet clear signals of a deflationary mindset in
corporations or the public at large, and that a recovery in private demand will
eventually pull the economy out of its slump.
Good Lord, we have been talking about pulling Japan out of its slump for TWO
DECADES! Fear of inflation combined with a perception that acquiescing to
a higher inflation target would be akin to losing monetary independence has kept
BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain.
Is the Fed headed to the same place? Maybe.
I don't think the Fed can regain the trust of the public while at the same time
protecting the secrecy of their actions to save Wall Street (moreover, it is not
clear that such secrecy is now needed in any event). The relationship
between policymakers and financiers is now seen as far too cozy from the
perspective of the public. I think the Fed needs to make clear that they
work for the people, not for Wall Street. A strong statement by Federal
Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too
big - that we should no longer tolerate the expansion of financial firms to the
point that they pose systemic risk - would be a good start. Simply put,
Bernanke's choice set is dwindling - either risk losing independence, or step up
to the regulatory and policy plate like you intend to hit one out of the park.
If Wall Street is no longer working for Main Street, it is time to side with
Posted by Mark Thoma on Saturday, November 21, 2009 at 01:17 AM in Economics, Fed Watch, Monetary Policy |