No Rules Guiding Central Bank Actions

Last Thursday, November 14, two discussions about the policies and practices of the U.S. central bank were occurring only a few miles apart, but they may as well have been on opposite sides of the planet. In the U.S. Senate, a committee was questioning the nominee to become the next chairman of the Fed, while over at the Cato Institute’s Hayek auditorium scholars were looking back over the 99-year history of the Fed and pondering whether the future would be more of the same.

Neither discussion came to grips with the crucial issue of when and how the Fed eventually ends and ultimately unwinds its massive asset purchases, known as QE. What should “fed-watchers” be looking at to conclude that enough is enough, it is time to end “pedal to the metal” monetary actions? The Fed is backpedaling off the idea that there is a magic rate of unemployment that will signal the end is near. Scott Sumner suggests nominal GDP will signal when there is too much heat under the kettle. But then what? Nominal GDP jumped from 2.4% in QII to 4.7% in QIII, as the personal consumption price index went from a small decline in the second quarter to 1.9% increase in the third. Suppose NGDP rises further to 6% or higher in the fourth quarter? What should the FOMC instruct the trading desk to do? There is no Federal funds market; the Fed portfolio has no Treasury bills that can be sold.

My point is that there are no rules guiding central bank actions; there is no one inside or outside the Fed who can say anything meaningful about the future. Meaningful congressional oversight is not possible. Neither foreign exchange nor domestic bond markets are providing discipline. This cannot end well.

Also from this issue

Lead Essay

  • Gerald P. O’Driscoll reviews the history of central banking. He argues decentralized banking is possible, but getting there will be difficult. Under a commodity money regime, central banks are neither necessary nor particularly dangerous, while under a fiat money regime, central banks are capable of exerting substantial influence on monetary policy. The Fed’s use of that influence has been, in O’Driscoll’s words, “unenviable.” Governments have come to depend on central banks to run deficits and spend more than they otherwise could. To do without central banking, however, we will first have to shrink the federal budget itself, and this will be no easy task.

Response Essays

  • Lawrence H. White explains that the Federal Reserve has “dramatically increased secular inflation.” Additionally, it has increased price level uncertainty, while failing either to tame the business cycle or to reduce unemployment. Instead, throughout its history, it has bowed to political pressures and expanded the money supply again and again.

  • Scott Sumner argues that monetary policy needs to respond to crises, and that commodity standards don’t meet that test. He argues that a politically independent central bank tasked with keeping a low rate of inflation will generally be able to fulfill that obligation, and that rigid monetary regimes do much greater harm when they ultimately collapse. In particular, the failures of such regimes have usually been attributed to free-market capitalism, and the result is ever-greater financial regulation.

  • Jerry L. Jordan argues that legislative restraints on monetary policy tend to fail; in this area, we just can’t trust government to watch itself. Standards intended to preserve the value of the currency have all fallen, as legislatures simply find it too convenient to siphon away value through inflation. Jordan is skeptical even of a balanced budget amendment, noting that state governments with such amendments have still come to fiscal grief. One of his most important concerns is that the public right now is dangerously apathetic about this underappreciated issue.