(Originally published here.)
Janet Yellen has finally been nominated to serve as chairman of the Federal Reserve. That may make her the world’s most powerful woman, although she will be only one member of a committee of independent-minded central bankers. The Wall Street Journal’s thorough account of the Fed’s internal debates this year reveals that the rest of this committee has significant influence.
According to the Journal, several members of the Federal Open Market Committee, which sets monetary policy, became concerned that the prospect of unlimited asset purchases was distorting financial markets. Starting in the spring, these members, led by Jeremy Stein, a Harvard professor appointed by President Barack Obama, mounted a campaign to begin tapering the Fed’s bond buying before the end of the year.
After reading this narrative, the Economist’s Ryan Avent concluded that the U.S. central bank is a “clown show.” While there are plenty of legitimate criticisms one can make about Fed policymaking over the years, Avent’s misses the mark. This sort of simplistic reasoning assumes central bankers only need to manage a single trade-off between the rate of consumer price inflation and the level of joblessness. The real world, however, is far more complex.
The Federal Reserve’s mandate is maximum employment, stable prices and moderate long-term interest rates (whatever that means). That’s pretty vague to me, which probably explains why the Fed has had so much leeway over the years to do whatever it thinks is best for the economy. While the precise meanings of “maximum employment” and “stable prices” remain undefined, the biggest source of ambiguity is the time-frame. Certain policies might temporarily suppress the unemployment rate but end up sowing the seeds of trouble down the road.
For example, the Fed’s accommodative policies in the 2000s may have mitigated the collapse in business investment after the end of the tech bubble, but this brief reprieve came at the cost of soaring private indebtedness and a financial sector that blew itself up. Fed policymakers knew they were playing with fire but thought the risk was worth taking. Those who want more details should closely read what Donald Kohn said on pages 56-58 of the transcript of the Fed meeting that took place on March 16, 2004.
Needless to say, Kohn and those who supported him turned out to be incorrect. Knowing what has happened since, what should a central banker who cares about the dual mandate have done in the 2000s? I certainly don’t know, but it seems pretty clear that they should have done things differently.
Many Fed policymakers appreciate the complexity of these trade-offs and are trying to grapple with them in the context of today’s environment. High unemployment and sluggish increases in consumer prices would suggest that the Fed should step on the gas. On the other hand, risk-takers in the financial sector may end up overextending themselves and sow the seeds of another crisis. In a thoughtful blog post, Paul Krugman recently expressed dismay that policymakers are now forced to choose between temporary bouts of full employment punctuated by catastrophic crises or long periods of depression. Avent, however, seems to think it is inappropriate for policymakers to consider anything other than current employment and consumer prices.
These issues are contentious — just read the minutes from the Fed’s most recent meeting if you don’t believe me — because no one fully understands how the Fed’s actions actually affect the economy. The traditional view is that central banks can control the inflation rate by adjusting borrowing costs for households and businesses. In theory, higher interest rates make the economy weaker and slow down inflation while lower rates mean faster price increases and more jobs.
The problem with this traditional model is that it ignores how monetary policy is actually transmitted from financial markets to regular people. Tobias Adrian and Hyun Song Shin have shown that monetary policy affects the growth of financial firms and their willingness to use leverage. Mark Dow, a macro trader and former economist at the International Monetary Fund, thinks that the Fed’s impact is mostly psychological. “If we all understood monetary policy better,” he says, “the Fed’s policies would be working far less well.”
These insights are important but an incomplete guide to policymakers. Officials who are trying to understand these complex transmission mechanisms and the various trade-offs involved should be given the benefit of the doubt, not disparaged as fools by journalists.
(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)