Lack of Fundamental Reform

The Fed’s year‐​long review of its monetary policy framework may have been publicized on a grand scale, but it is clear that the review was constructed without any interest in fundamental reform. Quite simply, the dual mandate of price stability and maximum employment was taken as given. In effect, the Fed wanted to give the appearance of doing something useful without committing itself to something that would allow critics to say it had failed later.

With regard to the “maximum employment” mandate, the Fed has never tried to establish a definite numerical value. To its credit, the Fed realizes that, in the long run, the natural rate of unemployment is determined by market forces—not monetary pump priming. As Fed Vice Chairman Richard Clarida stated, in commenting on the newly amended Consensus Statement:

First and foremost, our policy framework and strategy remain focused exclusively on meeting the dual mandate assigned to us by the Congress. Second, our statement continues to note that the maximum level of employment that we are mandated to achieve is not directly measurable and changes over time for reasons unrelated to monetary policy. Hence, we continue not to specify a numerical goal for our employment objective as we do for inflation. Third, we continue to state that an inflation rate of 2 percent over the longer run is most consistent with our mandate to promote both maximum employment and price stability.

A careful examination of the Fed’s performance since 1913, when the Federal Reserve Act was passed, is long overdue. Along with such a review, it would be useful to also consider the case for a rules‐​based monetary regime as opposed to a purely discretionary monetary framework. There are many monetary rules—ranging from a commodity standard to a demand rule (also known as a nominal GDP targeting regime) to a private, free‐​banking regime. Since a demand rule is becoming increasingly popular, I will briefly summarize it.

The Case for a Demand Rule

While there is a case for the Fed to move to a price‐​level target and end inflation targeting, there is also a case for getting rid of the dual mandate and moving to a single mandate—namely, achieving a stable path for nominal income. In calling for a “demand rule,” William Niskanen observed:

It is important to recognize that a demand rule is consistent with any desired price‐​level path, including a stable price level. My primary point is that a demand rule is potentially superior to a price rule, whatever the desired price‐​level path, because of the different response to changes in supply conditions. A central bank following a demand rule would not respond to either positive or negative supply shocks; such shocks would lead to a one‐​time change in the combination of price and output changes in that year, but would not lead to a long‐​term change in the inflation rate. A central bank following a price rule, in contrast, would increase the monetary base in response to a positive supply shock and would tighten the base in response to a negative shock, thereby increasing the variance of output. Similarly, a demand rule is potentially superior to a money‐​supply rule because it accommodates unexpected changes in the demand for money. The general case for a demand rule, thus, is that it minimizes the variance in output in response to unexpected changes in either supply or demand.

One version of a demand rule is to use nominal GDP level targeting, in which the Fed makes up for misses in its desired long‐​run level growth target. For example, if the target is 5 percent and NGDP growth fell below that target, the Fed would allow NGDP to grow by more than 5 percent until the level growth path was once again reached (see Sumner, Beckworth, and Selgin). Alan Greenspan is thought to have implicitly adopted a demand rule from early 1992 through the first part of 1998, during the so‐​called Great Moderation (see Niskanen). The Fed could use QE to offset declines in the velocity of money so that the quantity demanded and supplied of money meshed. Over time, the path of total spending would be more predictable and limited than under average inflation targeting. However, an objection to NDGP targeting is that it introduces slippage between policy actions and long‐​term price stability. The tradeoff is that an NGDP target gives you desirable spending fluctuations but more slippage, relative to what a price‐​level target could deliver.

Reacting to the Pandemic

The lockdown of the U.S. economy, in response to COVID-19, produced a major negative supply shock that put a sudden brake on what had been a robust job market. Unlike the Great Depression, which was initiated by a sharp fall in the money supply, the current recession was initiated by the government lockdown of the economy in response to COVID-19. The rate of spending declined precipitously as the velocity of money took a free fall (Figure 3), reflecting the strong demand for money balances and the increase in uncertainty. Nominal GDP, which had been growing at about 5 percent before the pandemic, went sharply negative (Figure 4). The Fed’s response was to lower its policy rate to the ZLB (0–25 basis points), engage in open‐​ended LSAP, and use its emergency lending powers to supply liquidity to financial markets.

 

Note: M2 velocity is the ratio of quarterly nominal GDP to the quarterly average of the M2 money stock. Source: St. Louis Fed, FRED

 

 

 

Source: St. Louis Fed, FRED

At near‐​zero interest rates, and under the influence of the Fed’s promise to keep rates low for the foreseeable future, asset prices have performed well even as the economy has languished. The Fed’s move to average inflation targeting is intended to provide further assurance that the Fed will keep rates lower for longer, thus supporting financial markets, encouraging leverage, and subsidizing risk. The hope is that average inflation targeting will push inflation above 2 percent, reduce real interest rates, and stimulate consumption and investment. However, there are risks involved. Keeping rates artificially low could further inflate asset prices, distort the allocation of capital, lower productivity, and increase debt. Eventually, the Fed’s pseudo wealth effect would be revealed as the financial boom became a bust.

Moving to an NGDP level target would improve the monetary policy framework, but even that rule is constrained by the Fed’s floor system and the payment of interest on excess reserves (IOER).[1] Abolishing IOER (while retaining interest on legal reserves) would improve the monetary transmission mechanism, so that changes in base money could have a greater impact on nominal income. Rather than expand the Fed’s responsibility into unchartered waters via fiscal QE (Selgin), ending the dual mandate and focusing on stabilizing long‐​run nominal income growth would help reduce the uncertainty inherent in a purely discretionary central bank, with a drift toward inflation and fiscal QE.

The Fed recognizes that the Phillips curve is a poor policy guide and that the natural rate of unemployment is ultimately determined by markets. However, in order to satisfy Congress, the Fed must act as if it has greater control over real variables than it actually does. Thus, while the Fed is hesitant to claim that it can give an accurate numerical value to its “maximum employment” mandate, Chairman Powell is not shy in proclaiming: “In conducting monetary policy, we will remain highly focused on fostering as strong a labor market as possible for the benefit of all Americans.”

As an agent, the Fed must abide by congressional mandates. The Fed is therefore constrained in considering fundamental reform in its review of the monetary framework. Congress must initiate major changes in the monetary regime, but is reluctant to do so, especially in light of its incentive to have the Fed monetize debt, keep rates low, and engage in fiscal QE. There have been calls for establishing a commission to carefully examine the Fed’s monetary performance over more than a century, but nothing has been done. Instead of having the Fed review its “strategy, tools, and communication practices” every five years, as recommended by the FOMC, it is time for Congress to step up to the plate and not only examine the Fed’s performance but discuss alternatives to the current dual mandate. Considering NGDP targeting is only one possible rules‐​based alternative.

Conclusion

Under the current monetary regime, the size of the Fed’s balance sheet no longer reflects the stance of monetary policy (see Plosser). Unconventional monetary policy has increased the Fed’s balance sheet from less than $900 billion before the 2008 financial crisis to more than $7 trillion today. The Fed held its policy rate near zero for 7 years, from 2008 to 2015, and it is now back to zero—and plans to stay there. Instead of adhering to its “price stability” mandate, the Fed has drifted into accepting 2 percent inflation as the norm, and now is committed to average inflation targeting.

The Fed’s message that rates will stay near zero for a long time—and that inflation will be allowed to exceed 2 percent to make up for past misses—is meant to increase inflation expectations. But, if the Fed’s primary mandate is long‐​run price stability, should it be the job of the Fed to spike inflation?

Average inflation targeting is the result of a superficial review of the Fed’s framework. All it does is increase the scope for monetary discretion. The vagueness in “average” makes it even harder to show that the Fed has failed, again, like an unfalsifiable “scientific” claim.