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Don’t Expand the Federal Reserve’s Mandate
Instead of trying to solve political problems, the Fed should focus on monetary policy
By Scott Sumner
The Federal Reserve has traditionally focused on monetary policy and bank regulation. Now there are increasing calls for the Fed to address other issues, such as climate change and economic inequality. But the Fed should move in the opposite direction—reducing its role in policymaking by focusing exclusively on monetary policy and relegating ordinary banking regulation to other authorities.
Those advocating a more aggressive role for the Fed tend to focus on two arguments. First, they say the Fed’s monetary policy mandate should expand beyond its traditional focus on stable prices and maximum employment. Second, they argue the Fed should address issues such as climate change, asset price bubbles and economic inequality. However, further politicization of the Fed would be dangerous and counterproductive, reducing Fed independence and leading to more economic instability.
The Limits of Monetary Policy
Monetary policy has an important role to play in stabilizing price levels and reducing economic instability caused by the business cycle. Because the effects of policy can be so dramatic, there is a tendency to overlook the fact that there are important limits to what monetary policy can accomplish. Here are some things monetary policy can do:
Monetary policy can target nominal aggregates such as inflation or nominal GDP growth, even in the long run.
In the short run, monetary policy can influence real variables such as real interest rates, real wages and real output. This is because wages and prices are sticky (that is, slow to adjust) in the short run, and hence nominal shocks have real effects, at least until wages and prices have fully adjusted.
Equally important, however, are the many things that monetary policy cannot do:
Monetary policy cannot influence real variables in the long run. In other words, in the long run, money is neutral.
Monetary policymakers are not better than markets at predicting asset price movements.
Because issues such as climate change and economic inequality are long-run problems, we should be extremely skeptical of claims that these problems can be addressed with monetary policy. For instance, one common mistake is to assume that low interest rates favor less affluent people. But the Fed cannot control real interest rates in the long run, which is the time frame that matters for economic inequality. The same applies to real wages, which in the long run are determined by nonmonetary factors such as productivity growth.
But can monetary policy boost real wages in the short run? There have been times when monetary policy did boost real wages for a brief period, including the early 1930s and 2009. But these gains came at a high cost: much higher unemployment. In both cases, a tight money policy caused prices to fall unexpectedly. Because nominal wages are sticky in the short run, the fall in prices led to a temporary increase in real wages. Unfortunately, the number of workers who benefited from those higher real wages declined sharply, as the tight money policies also led to dramatically higher unemployment.
It also seems unlikely that the Fed can use discretionary monetary policy to stabilize asset prices. Fed officials have no more ability to predict asset price movements than do private-sector investors. Without the ability to predict future movements in asset prices, the Fed has no reliable model for how to use monetary policy to prevent asset price bubbles.
The Fed once attempted to pop an asset price bubble, however, with disastrous results. During 1928 and 1929, Fed officials repeatedly raised their interest rate on loans to banks, with the objective of reducing what they saw as inflated stock prices. At first the policy had little effect, and stock prices kept rising. Interest rates rose to a peak of 6% in September 1929, at which point the economy fell into a deep depression.
The lesson of 1929 was that the Fed could not use monetary policy to reduce asset prices without severely damaging the broader economy. Monetary policy is too blunt an instrument. Since that time, the Fed has focused primarily on a narrower set of macroeconomic objectives, including price stability (defined as 2% inflation) and maximum sustainable employment. Finding a balance between the inflation and employment objectives is already a difficult task. Adding other objectives to monetary policy would make the Fed’s job almost impossible.
The Fed’s Role in Banking Regulation
Given the limitations of monetary policy, there is increased interest in using other Fed tools to address issues such as climate change, asset price bubbles and inequality. The limitations imposed by the long-run neutrality of money do not necessarily apply to banking regulation. In principle, regulators can affect some real variables, even in the long run. Nonetheless, it would be unwise for the Fed to expand its regulatory reach; indeed, it has already assumed far too many responsibilities.
There are at least three major flaws in plans to use banking regulation to address issues where there is no political consensus in Congress. First, the Fed lacks the expertise to address complex problems such as climate change, asset bubbles and economic inequality. Second, political decisions should be made by elected officials, and the Fed has no legislative authority to address climate change and inequality. If the Fed were seen as taking sides on highly political issues, then it would run the risk of losing its independence. Third, issues such as climate change and inequality have only tangential effects on the stability of the banking system, and any effect they do have is best addressed by increasing the amount of capital banks must have on hand, not micromanaging which loans banks will or will not make.
Fed officials justify their interest in climate policy with the claim that climate change poses risks to the stability of the financial system. In fact, there is almost no evidence for that claim. Furthermore, it is difficult to see how Fed regulatory actions would have any significant impact on climate change. Large American banks are not heavily exposed to carbon-intensive industries. And the Fed has much more powerful tools for reducing risk in the financial system, such as higher capital requirements.
It appears that the Fed is using the financial risk argument as a cover for a political decision to act where Congress has refrained from acting. There are far more effective solutions available if Congress chooses to address climate change, such as carbon taxes. The Fed has no authority to regulate in an area where Congress has refused to act.
An Alternative Path Forward
Monetary policymaking has enormous implications for economic welfare. In the past, Fed policy errors have led to periods of deflation and also to periods of very high inflation. It is not an overstatement to suggest that no area of economic policymaking is more consequential than monetary policy. Furthermore, unlike with issues such as climate change, asset price bubbles and economic inequality, on monetary policy the Fed has no option to abstain from acting. The Fed has a monopoly on the issuance of fiat money (the monetary base), and hence there is no such thing as the Fed “doing nothing” when it comes to monetary policy. Even a decision not to change interest rates or not to change the money supply is effectively a monetary policy action.
Unfortunately, monetary policymaking is an exceedingly difficult task, which explains why the Fed has often made serious errors. While expertise is no guarantee of success, it seems clear that we should want to have only the very best people making decisions where the consequences of a policy error could exceed a trillion dollars.
The Bank of England has separate policymaking committees for monetary policy and banking policy, because very few people have expertise in both fields. This seems sensible. Instead, the U.S. seems to be moving in the opposite direction, with the Fed becoming involved in more and more issues beyond its traditional focus on monetary policy.
In a recent essay, Michael Belongia and Peter Ireland suggested shrinking the Fed, which might be one way to refocus the Fed on monetary policy issues. In their proposal, the number of regional banks would be reduced from 12 to 5. The responsibility for regulating all but the very largest banks would be delegated to the Treasury. This would allow the Fed to concentrate on its core area—monetary policy.
When the Fed was created in 1913, the U.S. was still on the gold standard, and the Fed was not expected to engage in “monetary policy” in the modern sense of the term. For instance, a 2% long-run inflation target is almost impossible to achieve under a gold standard, where the long-run trend rate of inflation is roughly zero. Instead, the Fed was created to help stabilize the banking system during periods of stress.
As the U.S. gradually transitioned from a gold standard to a fiat money regime, the Fed became increasingly involved in macroeconomic stabilization. Fiat money has no automatic stabilizing properties; the central bank must choose the appropriate trend rate of inflation. As the Fed’s role expanded over time, it began taking on other responsibilities not envisioned by Congress in 1913. At the same time, federal deposit insurance reduced the need for a lender of last resort.
Mission creep is a problem in any large, sprawling organization such as the Federal Reserve. One advantage of downsizing the Fed is that it would remove some of the temptation for the Fed to engage in policy overreach. Narrowing the Fed’s focus to monetary stability will allow it to do its most important job more effectively. It will also help to preserve political independence, which would eventually be threatened if the Fed continued to engage in policymaking without congressional authorization.