Wednesday, September 21, 2011

The Sport of Fed Bashing

After taking a summer break, I am back to posting on this blog.  Welcome back dear readers.

Today, the Federal Reserve announced that it would extend the average maturity of its holdings of securities (“Operation Twist”). 

Criticizing the Federal Reserve and its chairman, Ben Bernanke has become a popular Washington sport.  Ben Bernanke has been verbally attacked by Republican presidential candidate Rick Perry. The Republican leaders of the House of Representatives and the Senate recently sent Chairman Bernanke a letter strongly advising against further monetary stimulus.  Some Democrats have complained that the Federal Reserve has not provided enough stimulus.

Although I am not an economist, I think that many such comments reported in the press with regard to the Federal Reserve have missed the mark.  With the reassurance that for every two experts who disagree with each other - one must be incorrect, I here post my own thoughts.

The Federal Reserve has the following congressional mandate stated in the Federal Reserve Act:

Section 2A. Monetary Policy Objectives The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.  

I believe the key objective here is stable prices.  Stable prices are a cornerstone of a healthy economy.  When prices fluctuate due to inflation or deflation, this adds noise to the economic system and thus makes business planning much more difficult.  Such uncertainty reduces economic growth and adversely affects employment.  High levels of inflation lead to high interest rates.

I therefore regard stable prices as the core objective of the Federal Reserve Board.  The Federal Reserve Board has the ability to alter the money supply through control of interest rates and more recently by Quantitative Easing – expanding its balance sheet through the purchase of financial assets such as Treasury bonds and thus injecting money into the economy.  Alterations in the money supply in turn alter the general level of prices.  Too much money chasing too few goods results in price levels going up (inflation); too little money chasing too many goods results in price levels going down (deflation).

In my opinion, the prudence of the Federal Reserve’s actions should be judged not by the size of its balance sheets nor by the absolute levels of the interest rates it controls, but by the degree of price stability that results. 

Consider the following analogy.  I want to regulate the temperature in my house.  To this goal I employ both a furnace and an air conditioner.  If one were to judge my performance by observing the behavior of my furnace and air conditioner – one would think I was totally out of control - thermally.  During the summer my furnace is not even on, but during the winter I have it burning fuel with seeming abandon.  Conversely, my air conditioner sits idle all year long and then during the summer is running nearly continuously.  However, if one observed the room temperature in my house and noted that it remained rock stable at 68 degrees year round, one would conclude that I am a prudent genius (of course the thermostats have done all of the work for me).

When the economy slips into recession, in order to prevent deflation the Federal Reserve needs to inject money into the economy.  In good times, the Federal Reserve needs to control the growth of the money supply to prevent inflation.  The Federal Reserve may need to make dramatic changes in policy during times of large economic change.  Of course, the problem is complicated by the fact that there are delays between changes in monetary policy and changes in price levels.

Paul Volcker provided evidence for the success of aggressive action by the Fed.  In 1981 the inflation rate was 13.5% - stagflation prevailed.  Paul Volcker tightened the money supply by raising the federal funds rate up to a seemingly astronomical 20% (the prime interest rate rose to 21.5%).  By 1983 the inflation rate had fallen to 3.2%.  Before Paul Volcker solved the problem, I remember hearing a lecture by Nobel Laureate economist Franco Modigliani who argued that one should not try to reduce inflation – rather that one should try to use extensive indexing to accommodate its effects.  I think that Paul Volcker provided a much more realistic solution – albeit at the expense of some short term pain.

Starting in 2008 with the onset of the financial crisis, Ben Bernanke took many dramatic actions to loosen the money supply, to maintain the availability of credit, and prevent a deflationary spiral and an even more catastrophic financial collapse.  Overall these actions, I believe, were both necessary and effective.

My issue with the current stated policy of the Federal Reserve chairman is that he is targeting an inflation rate of two percent.  I understand that he chose this number because of his fear of deflation.  I, however, see no reason to choose a target inflation rate of anything other than zero.  If the specter of deflation raises its ugly head, I am confident that the Federal Reserve can fend it off by aggressively printing money at the time.

An inflation rate of two percent over the long term can in fact be quite devastating.  For example, consider an elderly couple living primarily off their savings.  The Federal Reserve has now pushed interest rates for low risk assets (insured bank deposits and Treasury securities) to close to zero.  Thus this couple has no interest income and must live off their principal which is being eaten away by inflation currently at a rate of approximately two percent per year. 

Suppose however in few years more normal interest rates again prevail.  Suppose this same couple were to receive a three percent interest rate on their savings, but the inflation rate was two percent.  Of course their real rate of return would be only one percent, but they would have to pay taxes on the three percent nominal interest they received.  If their marginal income tax rate (federal and state) was just twenty percent they would be paying 0.6 percent in taxes, leaving them with a real return after taxes of only 0.4%.  Their effective tax rate on their one percent real rate of return (after inflation) is sixty percent not twenty percent.  Thus even a seemingly low rate of inflation has a devastating effect on individuals who may be the most vulnerable and not able to take the risk of investing in riskier assets.

In summary, judge the Federal Reserve by how well price stability is maintained.  I think over a very difficult past few years the Federal Reserve has overall done an excellent job.  My suggestion, however, is that the long term inflation target should be set to zero.

What the federal government should do to promote economic growth and employment may be the topic of another presumptuous blog post.


  1. I have always had the impression that economic growth requires inflation. Apparently this is a fallacy, in that inflation is driven by an expansion of the money supply, not by increased production. However, I am dubious that the Fed has enough information to regulate the monetary supply in real time such that inflation can be kept to zero.

  2. Dudley - thanks for commenting. The system is complex enough that inflation cannot be maintained at a completely fixed level, but one can target an average inflation rate of zero.