Wednesday, September 21, 2011

Politics and the Fed

Research and practice indicate the it's best for central banks to be independent of the political process.  In fact, since the 1990s, central banks in most economies have become more independent.  Exceptions include Venezuela and Argentina - two countries now experiencing very high inflation.  Recently, the Fed has come under increasing criticism from politicians from both the left and the right.  While Presidents Reagan and Clinton honored Fed independence, the times seem to be changing.

Yesterday, the Republican leaders of Congress, in a move not seen in recent history, sent a letter to the Fed that urged it not to engage in any further stimulus.  It should be noted that they added that if further stimulus is implemented, it should make the case for the stimulus.  Of course anyone who follows the Fed knows that the Fed always makes the case for its policy by releasing a statement explaining its policy decision (you may disagree with its case, but it provides support for its decision).  Why would the Fed want to engage in stimulus?  It expects inflation to be close to its stated goal (close to 2%) while economic growth and unemployment are awful (do I think they should do more stimulus today?  Keep reading).

On the left, Rep. Barney Frank wants to keep Fed district presidents from being voting members since he thinks they tend to focus more on inflation than economic growth.  However, many Fed district presidents are the strongest proponents of more stimulus (president of Boston Fed, Chicago Fed, etc).

Though I may not agree with every decision that the Fed makes, members of the Fed are thoughtful and have a much better understanding of the economy and monetary policy than members of Congress and most politicians.  For example, a presidential candidate explained that he doesn't like Ben Bernanke because he thinks there's too much government spending.  Of course, Ben Bernanke is not involved in government spending.  There are many other examples in which politicians have displayed a lack of understanding of monetary policy (as well as other issues!).  Shouldn't elected officials have a say in what the Fed does?  The President and Congress set the guidelines for Fed policy and have given it two mandates - low inflation and low unemployment.  Congress can change that to a single mandate of low and stable inflation.  One of the early supporters of that approach was Ben Bernanke.  However, he recognized that, since other factors can have temporary effects on inflation and policy takes time to have an effect, low and stable inflation is an intermediate term goal (in other words, a change in Fed policy today would have a significant impact on inflation until 2012, so it need to consider the likely direction of inflation instead of the current rate).  Would a single mandate have kept the Fed from implementing QE2?  Ben Bernanke has emphasized that one of the primary motivations behind QE2 was to prevent deflation, so a single mandate linked to inflation wouldn't have made a difference.

Should the Fed implement more stimulus today?  If I was a voting of the Fed, I  would vote no (I also leaned against QE2).  Monetary policy is very stimulative already and most of the current economic problems today won't be solved by even looser policy.  The Fed may want to save their remaining ammunition in case of another crisis (which may result from sovereign defaults in Europe).  One last point - is inflation out of control and, as Newt Gingrich state in a recent debate, is Ben Bernanke engaging in a highly inflationary policy?  The facts thus far indicate that inflation has been lower under Ben Bernanke than almost any other Fed chair.  In addition, financial markets expect inflation to remain under 2% per year for the next decade (based on the TIPS market).  Also, while some economists have tried to make the case for higher inflation (more than 2%), Bernanke has rejected that approach and emphasized that the Fed still seeks a medium term goal of 2% inflation.  So Bernanke's goal is clearly not higher inflation.

Though I would have made different decisions than Ben Bernanke and the Fed, I think Bernanke is being unfairly maligned as politicians look for easy targets to blame for the state of the economy.