September 8, 2014 | Commentary on Budget and Spending, Federal Spending, Federal Reserve

Is the Federal Reserve Running On Empty?

Politico ran an attention-grabbing headline last week: The Mystery Woman Who Runs Our Economy.  The article itself offered an interesting look at what makes Yellen tick, but the title presupposed way too much.

No single person or committee runs our economy, no matter how hard the Federal Open Market Committee tries.  Far from harmless, this notion that someone in Washington is flipping switches to control the economy prevents Congress from imposing meaningful reforms on the central bank.

Many scholars believe, for example, that imposing a policy rule on the Federal Reserve’s Open Market Committee could improve the Fed’s performance relative to the purely discretionary monetary policy the Fed currently practices.  It’s a legitimate debate worth having.

Yet, when Reps. Bill Huizenga (R-Mich.) and Scott Garrett (R-N.J.) introduced legislation in July (H.R. 5018) to impose a rule on the Fed’s Open Market Committee, they were instantly met with jeers.  Chair Yellen called the idea a grave mistake and MIT Professor Simon Johnson likened the bill to the Spanish Inquisition.

The catch, though, is that H.R. 5018 would allow the Fed to pick its own policy rule.  Any rule that it wants.  It would also let the Fed stop following the chosen policy rule as long as it publicly articulates the reason for changing course.  In other words, the Fed could always deviate from the policy rule that it previously set.

Such loop-holed restraint is about as benign as Congress could get, yet even this sort of reform will be nearly impossible as long as opponents can rely on the common misperception that the Fed “runs the economy.”

The real irony here is that if the Fed actually were running the economy, we’d have plenty good reason to fire it.

The Great Depression, the Great Stagflation, and now the Great Recession have all happened on the Fed’s watch.  But we’re supposed to ignore these inconvenient facts and rest assured that the Fed has learned from previous mistakes and can now fix everything.

To gauge how badly the Fed has performed, let’s review its record since 1978.  Starting with that date, the Fed was required by law to: “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

This phrase refers to the so-called dual mandate that the Fed has operated under since the Federal Reserve Act was amended in 1977, even though it doesn’t really mandate any specific targets and it actually refers to three economic variables instead of two.

While there are certainly many different ways to assess how well the Fed has met this mandate, some very basic methods can give us a rough idea of how the Fed has fulfilled its charge.

We can, for instance, compare commonly used economic variables in the post-WWII years, before and after the Fed received the dual mandate.

The average unemployment rate from 1948 to 1978 was 5.1 percent, with a standard deviation (a common measure of variability/stability) of 1.39.

From 1979 through the end of July 2014, the average unemployment rate was 6.4 percent with a standard deviation of 1.6.  Result: Higher, more variable unemployment.

How about price stability?

The rate of change in the CPI, one common measure of inflation, paints a similar picture.  From 1948 to 1978, the average inflation rate was 3.54 percent with a standard deviation of 3.1.  In the post-1978 period, it has averaged 3.64 percent with a 2.77 standard deviation. Result: A small reduction in variability, but not in the typical rate of inflation.

I should also point out that I’m being kind to the Fed by using these inflation figures. If we were to consider the value of the dollar in terms of its purchasing power, the results are much less favorable to the Fed.  In fact, they’re abysmal.

The dollar has lost nearly all of its purchasing power since the Fed was created in 1913, with a large portion vanishing after Bretton Woods came apart in 1971.

What about interest rates?

Measured by (monthly) 10-year Treasury rates, both the average and the variability have increased during the Fed’s dual mandate era.  The pre-1978 period average rate was 5.21 percent with a standard deviation of 1.81, and the post 1978 period had an average rate of 6.73 with a standard deviation of 3.16.

On balance, these figures suggest things have gotten worse since the Fed was given its so-called dual mandate.

These admittedly simplistic measures are not offered as “proof” of anything.  But they stand as evidence that people should at the very least begin a serious debate regarding the Fed’s effectiveness.

(For those interested, there’s also more sophisticated research that suggests the Fed has not done so well.)

Given that the Fed has direct control over only one of the monetary aggregates, the base, it shouldn’t really surprise anyone that there’s a legitimate policy debate here.

 - Norbert Michel is a research fellow at The Heritage Foundation’s Roe Institute for Economic Policy Studies.

About the Author

Norbert J. Michel, Ph.D. Research Fellow in Financial Regulations
Thomas A. Roe Institute for Economic Policy Studies

Originally appeared in Forbes