Fed Takes One Step Forward, Two Steps Back

Monetary policy has been out of alignment for some time now -- intentionally so, as FOMC Chair Yellen confirmed during her recent testimony. The Federal Reserve has purposely distorted funding markets after the financial crisis, with an eye towards offsetting its lingering effects.  In theory, this is not unreasonable. But when, in practice, is extraordinary monetary policy too much, too long, too self-defeating, too risky, and too desperate in pursuit of an illusory goal? The expiration date on the Fed’s adventurous policies is long past due.

Let us begin with the good news: the Federal Reserve continues its reduction in quantitative easing, albeit in baby steps. This news is positive because the Fed never provided a full explanation for why the size of its QE3 purchases of government securities -- Treasury bonds and mortgage backed securities (MBS) -- rose in December of 2012 to be $85 billion per month. The best explanation I heard from a Fed official was that, on an annual basis, $85 billion per month is very close to $1 trillion per year, which sounded about right. This central bank mathematics is not inspiring. 

What received surprisingly little attention was how large a position the Fed was taking in the new issuance in these securities markets, which have been suggested to be 70 percent and more of the market. If one of the Fed's objectives was to re-establish confidence in these critical funding markets, and thereby more rapidly underpin the fully functioning capital markets that we need to intermediate robust economic growth, then monopolizing these markets is a peculiar way to facilitate private sector renewal. So tapering away from a bad policy now counts for good policy, albeit with $4 trillion dollars of joy on the Fed's balance sheet which needs to be magically absorbed and digested. 

Sadly, this step forward is countered by two steps back. The Federal Reserve’s dual mandate to foster price stability and maximum employment has long been best understood as follows: price stability provides the best environment for achieving maximum employment. This historical and well-accepted understanding of the dual mandate recognizes that the Fed only directly controls long-term inflation, which should be around two percent by the Fed’s own pronouncement. It is also understood that low inflation supports maximum employment, and labor market activity is outside of the Fed’s direct control. 

Here is the Fed’s first giant step backwards. Since monetary policy has only an indirect effect on the labor market, the current smorgasbord of labor market indicators that currently dominate Fed policy thinking leave the false impression that the Fed is directly, and without cost, capable of exerting substantial influence over them. 

This can only hurt the Fed’s credibility in the long run because its actions have only an indirect influence on employment.  Furthermore, it has, by its own extensive studies, an exceptionally bad record of measuring slack in the economy. Rather, the Fed should emphasize that a host of fiscal, labor market and financial regulatory policies, as well as educational and demographic factors influence the overall labor market and that these are beyond the Fed’s control. Misguided monetary policy is no solution to poor fiscal, labor and regulatory policies. 

The second giant step back is the continuing demotion of price stability as the Fed’s primary objective as the way to deliver the dual mandate. This will ultimately erode the Fed’s long term credibility, with serious consequences. Given the current stance of monetary policy and economic activity, by any historical measure there is upside risk to inflation. 

Forget, for a moment, the alarming size of the Fed’s balance sheet. In the last few years, when any evidence appeared that actual inflation was slightly below the Fed’s long term goal, it took dramatic action. Will the Fed take similarly strong action should any actual evidence emerge of an inflation increase of a similar amount? The asymmetry is worrisome. 

Some economists have called for a temporary moderate rise in inflation to cure our labor markets. Others have called for a permanent rise in inflation to give monetary policy more room to maneuver, so that a zero interest policy environment occurs less frequently. These policy musings neglect the well-established view that higher levels of inflation beget both more inflation uncertainty and more economic uncertainty. 

Only steadfast adherence to the primacy of price stability will establish the Fed’s credibility in the future. We need more steps forward from the Fed, not more steps back.

Gregory D. Hess is President of Wabash College and a member of the Shadow Open Market Committee.

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