“Then it’s war! Then it’s war! Gather the forces! Harness the horses! It’s war!” – Groucho Marx as Rufus T. Firefly in “Duck Soup.”
A breathlessly headlined Federalist piece, “Conservatives Need To Have It Out Over The Federal Reserve,” offers a tossed data-salad recap of the prewar Austrian-based criticisms (sigh …) of Federal Reserve policy that are currently popular on the right. (I feel really fortunate to have been handed a copy of Milton Friedman’s “Free To Choose” by my high school econ teacher. Thanks, Mr. Roelofs!)
A few observations and thoughts:
1.) Supposedly pro-Fed conservatives like myself think the central bank played a decisive role in both the Great Depression and Great Recession. So, yeah.
2.) That being said, Fed actions since the financial crisis have prevented a worse downturn and an even slower recovery. Here is a mystery: As Scott Sumner points outs, nominal GDP accelerated in 2013 from 2012 — to 4.6% from 3.5% under the weight of “of higher income taxes, higher payroll taxes and the famous “sequester” which reduced government spending.” What explains the speed up? David Beckworth – along with Sumner — makes a strong case that “monetary policy was easily able to offset the 2013 fiscal austerity despite the [zero lower bound]. … This ‘Great Experiment’ of 2013 revealed the potential of monetary policy even at the ZLB. It suggests the Fed could have done more over the past five years to restore full employment. Alas, it did not!” Alas, indeed.
3.) How about a counterfactual? Here are two charts. Each shows a different way in which the US and EZ economies have diverged thanks to the tight-money policies of the European Central Bank vs. the easier Fed.
4.) Since the Fed debate has dovetailed with the silly “Is inflation much higher than what the government says” debate, I would offer this additional data point from “How Much Do Official Price Indexes Tell Us About Inflation?“:
This paper shows that the relationship between the economic concepts of inflation and the inflation indexes reported in official statistics is nonlinear. In particular, changes in the CPI and PCE deflator overstate changes in true inflation when inflation is low, and are only accurate measures when inflation is high.
But whatever. Eggs.
5.) The way forward is not some hopeless effort of misinformed economic nostalgia to “end the Fed.” Rather this, if you want rule-based monetary policy for the 21st century:
Most simply, the Federal Reserve should begin by adopting an approach of “level targeting” of nominal GDP. This doesn’t mean keeping NGDP level, but rather targeting a specified trajectory, such as a 5% NGDP growth path, and committing to make up for any near-term shortfalls or excesses. Thus, if NGDP grew by 4% one year, the central bank would cut rates or engage in quantitative easing until its models yielded an expectation of 6% NGDP growth for the following year. …
Another approach — which would be more radical, but perhaps also more effective — would limit the Fed’s role to setting the NGDP target, and would leave the markets to determine the money supply and interest rates. This would mitigate the “central planning” aspect of the Federal Reserve’s current role, which has rightly come under criticism from many conservatives. To give a simplified overview, the Fed would create NGDP futures contracts and peg them at a price that would rise at 5% per year. If investors expected NGDP growth above 5%, they would buy these contracts from the Fed. This would be an “open market sale,” which would automatically tighten the money supply and raise interest rates. The Fed’s role would be passive, merely offering to buy or sell the contracts at the specified target price, and settling the contracts a year later. Market participants would buy and sell these contracts until they no longer saw profit opportunities, i.e., until the money supply and interest rates adjusted to the point where NGDP was expected by the market to grow at the target rate.
Note: This is an expanded and updated version of an earlier post.