July 10, 2017

Demystify the Fed

Scott Sumner

Ralph G. Hawtrey Chair of Monetary Policy

A simple reporting policy would help illuminate the Federal Reserve's monetary missteps.

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A number of proposals to make the Federal Reserve more accountable have surfaced recently, but what sort of accountability is appropriate for a central bank such as the Fed?

A central bank's most important role, by far, is the conduct of monetary policy. A small miscalculation can have serious consequences for the economy. For instance, in 2011, the European Central Bank enacted a couple of quarter-point increases in its target interest rate, and this helped tip the eurozone into a serious double-dip recession.

Central banks have other roles as well, but monetary policy is the area where accountability is most needed. For this reason, the Fed should periodically self-evaluate previous policy decisions and report its findings to Congress.

Even Fed officials concede that the central bank has made serious policy errors in the past. Indeed, former Fed Chairman Ben Bernanke suggested that the Fed was mostly to blame for both the Great Depression of the 1930s and the Great Inflation of 1966-81. Not surprisingly, Fed officials are much less willing to acknowledge mistakes made during their own tenures in office.

It would be foolish to focus public policy on assigning blame. Rather, what's needed is a system of accountability that would lead to better public policy over time. That is more likely to occur if Congress has a clearer idea of exactly what the Fed is trying to do. Fed officials do periodically report to House and Senate committees, but unfortunately our representatives often don't know the right questions to ask about monetary policy.

Suppose the Fed were instructed four times each year to self-evaluate its previous policy decisions. Congress could ask the Fed to report whether, in retrospect, the monetary policies adopted one or two years previously were too expansionary, too contractionary or about right. An overly expansionary policy is one that leads to too much spending, and an overly contractionary policy leads to too little spending. This report could be prepared at one of the Federal Open Market Committee meetings, which occur eight times a year. The Fed would also describe the data points that led to this evaluation.

Some economists don't see the point of this exercise, but that's precisely because they already understand what the Fed is doing. Unfortunately, most people do not.

Inflation has averaged 2 percent since 1990, and yet, very few Americans understand that this occurred because the Fed caused it to happen. By using monetary policy to control the total amount of spending in the economy (called aggregate demand), the Fed is able to target inflation and employment – the dual mandate which it was given by Congress. The Fed influences total spending by adjusting the money supply and short-term interest rates. In the short run, a boost in the money supply that reduces interest rates will lead to more spending in the economy.

While economists see the Fed as the main institution responsible for steering inflation and other variables, many non-economists tend to see the Fed as just one factor among many. In their view, Fed actions are more like a series of gestures, which may or may not impact aggregate demand. Thus, when there is a catastrophic decline in aggregate demand, such as during 2009, few point fingers at the Fed.

Another set of economists, meanwhile, excuses the Fed's policy failures, such as in 2008-09, by pointing to negative economic shocks like the banking crisis. That's perfectly OK, but the central bank still needs to go on record indicating whether, in retrospect, monetary policy in 2007 and 2008 should have been more expansionary, despite those shocks.

Furthermore, it seems pretty obvious that aggregate demand was slower than the Fed would have liked from late 2008 all the way through 2013, if not longer. Thus, under my proposal, the Fed would have been in the awkward position of reporting that, in retrospect, policy was too contractionary for more than 20 consecutive quarters – more than five years!

It is also possible that the Fed might admit to missing its target, but use the excuse that it was out of ammunition. Yet during that 2008-13 period, the Fed consistently claimed that it had plenty of ammunition. And for good reason: It had adopted a number of policy decisions that were effectively contractionary, such as paying interest on bank reserves, as well as prematurely ending the first two so-called quantitative easing programs.

And even if the Fed did claim to be out of ammunition, that would lead to a very useful discussion with Congress. Why are you out of ammunition? What other powers would the Fed need to hit its congressionally mandated goals? Does the Fed need assistance from fiscal policymakers? What about the authority to pay negative interest on reserves (as other central banks have done)?

This conversation could lead to policy reforms that make it easier for the Fed to achieve its policy goals. For the first time, Congress and the Fed could have an intelligent conversation on monetary policy.

All organizations need to study their past decisions and learn from mistakes. Thus, this proposal is likely to be less controversial than previous attempts at accountability, such as the "audit the Fed" movement. And to its credit, the Fed has already learned a lot from the (contractionary) policy mistakes made in the early 1930s, as well as the overly expansionary policy of the 1960s and 1970s.

But policy is still far from perfect. It's already clear that the Fed misjudged the economy during the banking crisis and focused on the wrong issues during 2008. There is still plenty of room for improvement.