Whither monetary policy?

26 Sep

Last week, we posted on the Fed’s “Operation Twist”, its latest attempts at stimulating the US economy through manipulation of borrowing rates. There was much to be said about this, both in terms of its limited effect and the ways in which it was going about its business. Moves by Central Banks, even if limited in their overall impact, still have the potential to redistribute wealth. We noted that in so far as the Fed’s approach has been to moderately inflate away debt, this also means inflating away wage increases achieved over this period.

This discussion about inflation and the Fed’s interventions in the crisis is worth extending further. One important point is that for all of its creativity in manipulating interest rates, the Fed’s overall approach has involved a conservative assessment of its own mandate. A graphic produced by The Economist a couple of weeks ago provides a useful illustration of this.

Formally speaking the Fed is meant to pursue the twin goals of low inflation and low unemployment. In the policy wonkery literature on central banking, this makes the Fed a less “hawkish” institution than, say, the European Central Bank, whose own mandate only extends to price stability and not to growth as such. A feature of the current crisis in Europe has been that the ECB has had to venture well beyond its mandate, playing a role in managing the crisis that has little to do with inflation in the Eurozone. The Federal Reserve, in contrast, has appeared more concerned about prices than about jobs. In this crisis, the low unemployment goal of the Fed has been breached dramatically, with unemployment over 3% points above what economists consider to be the US’s “natural” (i.e. non-inflationary) level of unemployment (around 6%) for the last two years. Had the Fed overshot to the same degree on its inflation goals, Bernanke would have been subject to the most scathing of criticism. There is evidently a bias, both in the Fed and outside, towards keeping a lid on prices, even at the cost of rising unemployment.

In the discussion about the Fed’s quantitative easing program, it is worth keeping this in mind. It points to the broader issue of the Fed’s mandate and its particular interpretation of that mandate. It also points the fact that today, for all the manipulation of interest rates downwards, we are perhaps beginning to reach the limits of what low interest rates can achieve (see here and here for discussion of what monetary policy options are available under liquidity trap conditions). Can the Fed really stimulate the US economy in the way that it would like through reducing borrowing costs? One reason why the Fed may be reluctant to modify its existing inflation targets in favour of a higher rate or to switch to the monitoring of nominal GDP instead (see rational for this here) is that it may not think it will help in bringing unemployment down. We may have reached the limits of what interest rate policies can achieve but the Fed doesn’t seem to have anything else up its sleeve.

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