When 200 Ph.Ds congregate under the roof of a small space in Washington, including some well known members of the Federal Open Market Committee (FOMC), continually digesting the economic orthodoxy as they confront real world economics, it is only natural to recede into their comfort zones: to cogitate endlessly without any action, besides finding ways to put more money into the markets or take it out. The brain density per square foot in the Eccles Building on Constitution Avenue could end in system failure from a neural overload.
Execution is often the sacrificial lamb in the intellectual processes in a faculty lounge serving coffee, tea, doughnuts and bagels. This president, a former college professor himself, is also contributing to that culture. So it was with Bill Clinton. The Fed is only far too comfortable with it, itself being a product of the stroke of a pen of another college professor: Woodrow Wilson.
Execution, by nature, is tough business. It is like a crystal which, by theoretical definition, is a perfect molecular structure, but imperfect where it is fractured. The fracture is the imperfection. So it is with execution. The fracture is the decision under imperfect information. Until then there is neither a snow flake nor a grain of salt. That is the nature of economic nature of which government is a part.
Whether a central bank exists as a separate institution or not depending on what the Congress decides, the necessity of the independence of economic policy from the vicissitudes of electoral politics is beyond debate. The politicians should only have limited room to manipulate the economy. It was a monetary policy lesson taught by Paul Volcker and Milton Friedman to Washington and it must be extended to other economic policies as well.
A lot had been recently said about central bank independence during the Bernanke reconfirmation process. That any audits by the United States government would compromise it. The more important point that if a central bank does not execute its independence it is compromising it itself has never been mentioned. So, it is time for the Fed, after the dust of the re-confirmation process has settled, to begin executing central bank independence as permitted under current law, no matter what the law in the future would be, especially in the face of a chronic unemployment forecast extending into 2016.
Under current law, the Federal Reserve is free to change its monetary policy regime to execute its exit strategy from the recent monetary expansion. It has done it before under Volcker and under Greenspan and it can under Bernanke. Under current law, the Fed makes only monetary policy (besides the important but ancillary responsibilities of bank regulation, payments systems and consumer protection). The Federal Reserve has little to do with any other reforms the government must, should or ought to undertake. The Chairman of the Fed only speaks, as a matter of Washington protocol, on other matters only insofar as their implications for money supply.
After the recent misguided and highly politicized public relations campaigns before Bernanke’s re-confirmation on the covers of TIME and Foreign Policy, let alone lobbying by the White House besides some prepping of members of Congress by the Fed by hiring professional Democrat lobbyists (notwithstanding this administration’s self-righteous anti-lobbyist rhetoric as if it only applies to Republican lobbyists on K Street), it is high time the Fed returned to doing its job of making monetary policy. Politics in Washington can be a beguiling funk to get buried in very easily.
Making monetary policy constitutes preparing the markets for withdrawing monetary accommodation at the appropriate time. The Fed’s Vice Chairman Don Kohn quite aptly had pointed out both the Fed’s narrow role in Washington several times before in public speeches as well as more recently the uncertainties surrounding the future path of the federal funds rate. Still, the Fed can be clear, both for sound technical and policy reasons, how much inflation it wants to tolerate especially as the debate about the level of central bank inflation targets becomes heated in Washington with the recent paper by the International Monetary Fund (IMF).
The question before the FOMC is: how much inflation to tolerate explicitly and for how long? There are good reasons why the IMF, besides it incorrect reasoning, is, in principle, correct that central banks, especially the major central banks, must be willing to tolerate a higher level of inflation for the global economy to recover.
The critics are also correct in implying that that could be a slippery slope to ever higher levels of inflation, up and along the 45 degree line on the short run Phillips Curve(s) over time. Then what is the reconciliation between the economic need to tolerate higher inflation and the risk of the slippery slope of stagflation? The central bank’s policy regime, the associated communication and credibility to stand by that communication should the need arise.
The Fed must follow through its recent, but more operational, exit strategy announcement with an explicit number for the upper limit on inflation that it is willing to tolerate. It appears, given the recent economic forecast by the Council of Economic Advisers (CEA) and the Bernanke’s own CBS’ 60 minutes forecast last year, the Fed can tolerate up to 5 per cent inflation, the same as the level which was handed down to Greenspan by Volcker in 1987, before the Great Moderation which has now ended.
With CPI inflation currently at 2.8 per cent for all of 2009, the Fed would have about 2.2 percentage points to go before it can raise rates symmetrically or sharply (compared to how it lowered the rates beginning the fall of 2007) or about 1.2 percentage points to go before it begins the process of raising rates asymmetrically, meaning gradually, beginning at 4 per cent CPI inflation, whatever the state of the economy (not depending on the economic outlook as is often the phrase in FOMC statements), barring extraordinarily negative circumstances.
It is not up to the Fed to worry about inaction in the rest of the government or in the markets, if the central bank and monetary policy is to remain credible, to not take advantage of the central bank’s lenience. It is up to them to figure out how to maximize what they buy, in real terms (not in funny money), with that inflation: will the rest of the government and the markets create an economic environment to buy structural change to intrinsically mitigate inflation or will they remain complacent at 2 per cent growth rate and 8.2 per cent unemployment for the foreseeable future? The White House, the Congress and the markets must do their jobs if the country is to avoid another episode of stagflation or a rebound of the recession should the Fed decide to raise rates to prevent it preemptively.
This is the how of executing central bank independence, given the circumstance. Not everybody can be fooled all the time, but everybody is correct at least some of the time. So is Bernanke on the need for an explicit inflation target and Don Kohn on the necessity of remaining within the narrow scope of the Fed.
Execution is the circumstantial application of analysis.