The Floundering Federal Reserve

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Meltzer 3Dr. Allan H. Meltzer is an American Economist and the Allan H. Meltzer professor of Political Economy at Carnegie Mellon University’s Tepper School of Business. He is the author of a large number of academic papers and books on monetary policy and the Federal Reserve Bank. Dr. Meltzer’s two volume books, “A History of the Federal Reserve”, are considered the most comprehensive history of the central bank.   He is considered one of the world’s foremost experts on the development and application of monetary policy. Currently he is also President of the Mont Pelerin Society. Dr. Meltzer originated the aphorism “Capitalism without failure is like religion without sin. It doesn’t work.”

This is a monthly column written by Professor Meltzer for Defining Ideas of the Hoover Institution.

It is posted in

In late August, I again spent 3 days with central bankers from all over the world at the annual meeting sponsored by the Kansas City Federal Reserve Bank. The spectacular, scenic beauty at the Grand Teton National Park, Wyoming, is one of the world’s most beautiful places. The meetings attractions include stimulating discussions of economic policy in addition to the spectacular scenery and wonderful hiking.

This year’s central topic called on participants to discuss ways to improve future monetary policy operations. A major concern is about ability to respond effectively to a recession if the current low interest environment continues. Central bankers have learned to lower interest rates to encourage borrowing in recessions and to raise rates when inflation threatens or occurs. Because interest rates are close to zero in all the developed countries, some market participants fear that central banks will be powerless to act. Chair Yellen tried to reassure them.

One possible answer might be to adopt substantially negative interest rates. Switzerland, Japan, and the European Central Bank have negative interest rates currently. A conference paper by my Carnegie Mellon colleague Marvin Goodfriend analyzed how negative interest rates can be made more effective. Chair Janet Yellen of the Federal Reserve opposes the use of negative rates, but she may be forced to change her mind if a recession comes while market rates are low.

Current Federal Reserve policy actions flounder about without clear direction. The Fed calls this “data driven.” On days that the market receives positive news suggesting that the economy will expand, markets expect that the Fed will raise the short-term interest rate by ¼% before the end of the year and possibly this month. On other days, the new data suggest that growth is slowing, so the expectations of an interest rate increase seems less likely.

These daily shifts in anticipations are the main reason for the Fed’s floundering, costly policy. The worst example comes at the start of each month when the Department of Labor releases the monthly report on job growth and hours worked. This is a very noisy number. Very often the government will announce a large monthly increase in jobs, more than 200,000 only to have the announcement revised the following month by 100 percent or more. Market participants chatter about the announcement but ignore the fact that the announcement is subject to large change, so it provides very little accurate information. Market watchers know that the Federal Reserve gives close attention to the number, so they do too.

The result is that uncertainty about interest rates and future economic activity increases unnecessarily. Much better practices are available and have been used in the past. Most of the better practices could be restored, if the Federal Reserve chose to improve its performance..

The procedures I have in mind were in place during most of Alan Greenspan’s terms as Chair of the Federal Reserve’s Board of Governors. Greenspan adopted a medium term strategy. He did not ignore the weekly and monthly data announcements, but he focused his actions on the expected medium term values of inflation and unemployment. From 1986 to 2002, he guided policy operations by generally following a rule or strategy developed by Hoover’s John Taylor.

The result was the best performance in the Fed’s 100 year history. Inflation remained low, and the economy grew at a good rate. Recessions occurred, but they remained mild and recoveries came promptly. Uncertainty about the future declined. Economists recognized the improved stability by calling the period The Great Moderation.

Basing policy actions on Federal Reserve judgment has never done as well. We get poorer results, slow response to emerging inflation and greater uncertainty about future interest rates.

Unfortunately, Greenspan gave up his successful strategy during the final years of his chairmanship. His successors were faced with the crisis of 2007, partly a result of poor Fed judgments.

After responding to the crisis with massive increases in reserves, the Fed could have restored a medium term strategy. Instead they adopted the less effective, less informative, less desirable short-term focus they call “data driven.”.

One result has been surrender of Federal Reserve independence. When the 1913 Congress debated the Federal Reserve Act, one of their main concerns was to prevent the new central bank from becoming a major source of inflation. To sustain central bank independence. Congress imposed two restrictions. The classical gold standard had become the law in 1900. In the Federal Reserve Act Congress added a total prohibition against Federal Reserve direct loans to the Treasury.

The gold standard did not survive the Great Depression. The Federal Reserve discovered it could circumvent the prohibition on lending directly to the Treasury by buying Treasury securities in the market after they were issued. Eventually open market operations—buying and selling government securities—became the Fed’s main means of managing interest rates.

The Fed financed WWII spending by buying Treasury securities at relatively low interest rates. Few would question giving precedence to the war effort. Political pressure to keep low interest rates delayed any increase for five years after the war. Since 2008 the Fed has thrown away any claim to independence by holding market rates near zero and purchasing more than $4 trillion of securities. No plan exists for reducing the more than $ 2 trillion of idle reserves currently sitting on foreign and domestic bank balance sheets. That is a potential for future inflation.

Making good decisions about interest rates and money is a very difficult and challenging job. The effect of today’s choices on inflation, unemployment, and economic activity occur long after decisions are taken. Skilled economists try to forecast the future, but forecast errors are large. That’s another big reason for choosing a strategy that works well in the medium term. That gives markets information to guide their planning and a clearer idea of what conditions are likely a year or two ahead.

My answer to the Fed’s question, what should policy do in current circumstances, is to return to the medium term strategy that Paul Volcker used effectively to reduce inflation in the 1980s and that Alan Greenspan used with great success from 1986 to 2002. One reward for following an effective policy is less criticism from Congress, markets, and the public because policy helps the economy to achieve maximum real growth with low inflation. Chairman Hensarling and the House Financial Services Committee has led the way by calling on the Fed to adopt and follow a rule of its own choosing. That forces the Fed to adopt and announce a medium term strategy.

Currently, some in Congress and several Fed watchers have reopened issues that have returned many times. What role should the regional Reserve Banks have in decision making? Should their presidents be appointed by the President of the United States instead of chosen by their directors and approved by the Board of Governors?

To get legislation approved in 1914, President Wilson proposed a compromise that sought to balance the widespread concern that political control of interest rates and money would risk inflation against the fears of farmers and others that a privately run central bank would charge high interest rates that squeezed borrowers. From the start, the public regarded the Board in Washington as much more responsive politically than the regional banks. Originally, bankers ran the regional banks,. That ended long ago. Many are run by economists or lawyers. Labor unions and civic groups serve as directors and the bank presidents bring citizen and community perspectives to the policy discussion. Over time, the Board’s influence has increased, actions are more politicized at considerable cost to the public.

Instead of weakening the further independence of the regional banks, Congress should strengthen that influence. One simple way to do that would be to allow the twelve Reserve Bank presidents to vote at each meeting. Current rules limit the number to 4 plus New York’s president. That gives the politicized Board a majority.

Finally, Congress should change the way we protect the safety and soundness of the financial system. Since 2008 and passage of Dodd-Frank legislation, the Federal Reserve has substantially increased the number and burden of financial regulations. As the cost of regulation rose, thousands of small and medium sized banks closed. These banks have been an important source of loans to new and small business, so the economic cost is large.

Regulation encouraged consolidation of the largest banks. The banking system has become more cartelized and less competitive. And the plethora of regulation is unlikely to avert a future crisis because regulators are slow to recognize and slower to act against emerging crises.

Two major changes should be made to protect the public, avoid bank bailouts while increasing banking safety and soundness. Repeal Dodd-Frank. All but the very largest banks are protected by deposit insurance that banks as a group provide. They should be free of the many new regulations. The largest banks are too big for the deposit insurance system. These banks held 15 to 20 percent equity capital before the deposit insurance system started. Since deposit insurance doesn’t protect them, they should be required to restore equity capital to 15 percent of total assets. Bank shareholders and management, not government and taxpayers, then becomes responsible for bank safety.

Our financial system and policies are far from adequate. The Kansas City Fed offered an opportunity for a thorough look at the costs and benefits of major reforms. Unfortunately, most of the participants didn’t respond to the challenge.

Reform is overdue. In the recent past, the Federal Reserve increased bank reserves by trillions of dollars of excess reserves that sit idle. It has no idea about how it will remove them before they start a new inflation. It threw away its independence to finance the administration’s huge budget deficits, contrary to the Federal Reserve Act and every principle of central banking. And it required small and medium sized banks to close rather than pay he high cost of regulation.

The public deserves better. The Congress should provide major reforms.

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