A More Inflexible Fed Would Cause More Crises

November 18, 2015 11:30 AM

Having saved the US economy from a second Great Depression, the Federal Reserve has become a political scapegoat in the Congress for its own failures to secure the recovery. Rather than improving our tax code, investing in our future, or simply passing a budget that is little more than avoiding default, the House is prioritizing so-called "reform" of the Fed.  Just as throughout the global financial crisis and recovery, Congress is abdicating its economic responsibilities to the American people and attacking one of the few policy institutions that worked instead.

Both Republicans and Democrats have already curtailed the ability of the US central bank to respond proactively to any financial crisis that starts outside the traditional banking system. They have done this by restricting the Fed's ability to lend to troubled institutions in a crisis—even though such lending is the very essence of why the central bank exists: The Fed was created in response to the recurrent financial panics in the United States culminating with the huge Panic of 1907.

Now, there are new legislative efforts trying to force the Fed to follow strictly a narrow policy rule when setting monetary policy even in normal times—and report to Congress in a very literal-minded short-term way about any deviations from that rule. That threatens to extend such restrictions to another basic Fed function, the setting of official interest rates. Doing so raises the probability of higher unemployment, greater economic volatility, and recurring financial crises.

More closely examined, any imposition of a simplistic rigid policy rule with mechanistic monitoring will only serve to politicize monetary policy to an unprecedented extent. And that, for good reason, is almost universally seen in the economics profession as something that would inevitably lead to ongoing higher inflation and bigger, more frequent boom-bust cycles.

The Federal Reserve should be held to account by Congressional oversight. And the current format of disclosures, hearings, and testimony has worked well, producing the most transparent Fed in its history, the lowest multiyear average inflation rate since the 1950s, and the creation of 13.5 million private-sector jobs since February 2010. The Fed has delivered on its mandate to pursue price stability and full employment in the face of unprecedented financial shocks.

All so-called rules for Fed monetary policy of the type now being advocated suggest the Fed should have raised interest rates long ago based on a mechanistic focus on unreliable simple forecasts of inflation and growth. Yet US inflation, a key metric for some of those who would like the Fed to abandon its employment mandate, remains persistently below the Fed's 2 percent target, and the United States is only now approaching full employment. Furthermore, history shows that when countries adopt a strict anti-inflation rule coming out of a crisis, they cause severe recessions—politicians caused havoc by successfully inducing such movements in the United Kingdom in 1923, the United States in 1928 and 1929, Japan in 2000, and the euro area in 2011.

The real world is a complex place. Driverless cars would veer from side to side and cause crashes if their guidance algorithm was limited to just maintaining the distance from the car in front of them, instead of assimilating more information as they went. The US economy cannot be safely run on auto-pilot either, especially given international developments and financial shocks, which narrow targets do not take into account.

Any effort to limit US monetary policy to an inflexible rule with politicized short-term oversight should be opposed. There is legitimate debate to be had on the need for and merits of various proposed reforms to the Fed, particularly in the realm of financial supervision. But there is no room for debate about the sheer economic irrationality of subjugating independent monetary policy to any simple-minded, rigid rule—doing so would bring severe harm to the workers, savers, and investors in the US economy.

Adam S. Posen is president of the Peterson Institute for International Economics. The opinions expressed here are solely his own and not necessarily those of any members of the Institute's staff or Board of Directors.