All this week, people anxiously awaited results from the Federal Reserve’s Federal Open Market Committee meeting in Washington, D.C. Though many expected the FOMC would decide to finally raise interest rates and begin to normalize monetary policy, on Thursday it was announced that rates would remain near zero.
For months, this decision has been subject to speculation, due perhaps to mixed messages from some of the Fed’s top officials. Continued miscommunications from the Fed are weakening the FOMC’s credibility and signaling to investors that the Fed lacks a clear strategy. Such unpredictability and reliance on the decisions of 12 individuals inevitably leads to resource misallocations and mal-investments. Falling stock markets indices are perhaps a signal of this.
Such are the pitfalls of the Fed’s short-sightedness and undisciplined discretion. To foster a healthy economy, the Fed should instead provide clear forward guidance, in the form of adherence to pre-determined rules that guide its actions, while it pursues beneficial long-run objectives—namely, price stability. Nobody understands this better than another group of economists that also met in Washington this week, the Shadow Open Market Committee.
On Wednesday, while members of the FOMC debated whether or not the Fed should raise interest rates, three members of the SOMC, Columbia University professor Charles Calomiris, MIT professor Athanasios Orphanides, and Wabash College president Gregory Hess, spent two hours at a briefing on monetary policy sponsored by the Manhattan Institute and the Joint Economic Committee. The JEC covers an array of economics policy topics, including the Fed.
Throughout its history, the Fed has been pressured by both voters and policymakers alike to obtain maximum employment and keep prices stable. Since 1977, the Fed has been tasked with a dual mandate to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” In other words, the Fed must take actions to simultaneously pursue both inflation and employment targets.
Although this is politically appealing, honoring both parts of such a mandate is not only often contradictory, it is unrealistic, as the SOMC members told the audience. The Fed, similar to all other central banks, has only a limited ability directly to influence employment.
Political pressures to neutralize Washington’s vast fiscal mistakes and improve America’s ailing economy have led the Fed to depart from the consensus shared by Fed chairs Paul Volcker and Alan Greenspan. Both held that a commitment to low and stable inflation is the best contribution that monetary policy can make to sustained economic growth. The Fed has instead engaged in short-sighted, experimental monetary policies that have more often than not been unsuccessful. Instead of basing policy on each monthly jobs figures release, the Fed should pursue a clearly-stated goal of low and stable inflation though a pre-determined inflation target.
This means that, rather than increasing the Fed’s role in today’s economy, Calomiris explained, politicians and policymakers need to realize the limits of what a central bank can achieve. Politicians avoid forcing central banks to follow clear rules precisely because doing so would cripple their ability to influence monetary policymakers. However, there is a movement in Washington led by Rep. Kevin Brady (R-TX) to reevaluate the monetary policy status quo.
The so-called Centennial Monetary Commission would examine how monetary policy has fared over the Fed’s first 100 years and consider alternative monetary policy regimes.
At this point, the SOMC members pointed out that there is no politically-feasible reason to push the United States towards a gold standard or free banking organization. Instead, the previously-mentioned shortfalls in Fed policy can be combatted by eliminating, or at least reinterpreting, the Fed’s dual mandate in a way that makes price stability its sole policy objective. That monetary policy will continue to be conducted by the Fed should be taken for granted—however, the idea that a rule-based system cannot replace discretion should not.
By publicly adopting a monetary policy rule, or systematic policy, that 1) focused on a long run inflation target 2) recognized that monetary policy can be used over the medium term as a tool for stabilization, harmful discretion can be avoided. As Orphanides noted at the SOMC briefing, “the adoption of simple monetary policy rules can tackle uncertainty about the economy and avoid the adverse consequences of discretion.”
Moreover, as Columbia University professor Charles Calomiris stated, “high levels of inflation, or volatile inflation, results in lower output and higher unemployment.” By making price stability its main, or sole, priority, the Fed would keep inflation necessarily low, thus helping to maximize future output and long-term employment. That is, after all, why Nobel Prize-winning economist Milton Friedman was a vocal advocate for price stability.
Targeting price stability eliminates uncertainty about long-run changes in the price level. This helps prevent monetary policy from having disruptive effects on the real economy and financial markets. Growth tends to be stronger when investors do not have to spend time trying to guess a central bank’s next move.
Dissenting views to the FOMC’s consensus should be welcomed in an era of low growth. The need for reform is even more pressing given that, as Carnegie Mellon University professor Allan Meltzer has shown, over the first 100 years of Federal Reserve history, the United States enjoyed both price stability and the absence of banking crises in only about a quarter of those years. The best place to start moving towards a sound monetary policy system is by reevaluating the Fed’s impossible, ineffective dual mandate.
This piece originally appeared in Forbes.com