The Fed’s June Conference Should Explore a Single Mandate: Monetary Neutrality

COMMENTARY Markets and Finance

The Fed’s June Conference Should Explore a Single Mandate: Monetary Neutrality

May 1st, 2019 4 min read
COMMENTARY BY
Norbert J. Michel, Ph.D.

Director, Center for Data Analysis

Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.
Requiring the central bank to target total spending will not produce perfect economic conditions and solve all problems. Classen Rafael / EyeEm / Getty Images

Key Takeaways

Targeting total nominal spending—instead of inflation—would be the best way to improve monetary policy.

Targeting total spending would help the central bank promote ideal conditions for maximum employment.

Targeting total spending will allow the bank to avoid major monetary policy errors and reduce the likelihood of major contractions and artificial booms.

In June, the Federal Reserve will hold a conference to review its monetary policy strategy, tools, and communications practices. Two sessions will be devoted to discussing maximum employment, an odd fact given that the Fed’s official position is:

the maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the job market. These factors may change over time and may not be directly measurable.

Of course, there’s still a chance that the panelists will delve deeper into why it would be better for the central bank to focus on variables that it can directly measure and that are determined by monetary factors. It is even possible that the panelists will explore why targeting total nominal spending—instead of inflation—would be the best way to improve monetary policy.

As of last week, the largest free-market think tanks in Washington—The Heritage FoundationCatoMercatus, and the American Enterprise Institute—have all endorsed some type of framework that requires the Fed to target total spending. All have pointed out the many advantages of targeting total spending, including:

  • People can more easily reap productivity gains.Targeting total spending allows the price level (overall prices) to decline as productivity improves, thus allowing people to enjoy the benefits of more goods for sale at lower prices. An inflation-targeting central bank, on the other hand, always tries to push the price level higher to avoid falling prices.
  • The central bank responds correctly to negative supply shocks. Negative supply shocks, such as a trade embargo, cause prices to rise as goods become scarcer. A central bank that targets total spending responds correctly in such a situation: It allows prices to rise, thus signaling that goods have become relatively scarce and that there is a strong demand for such goods. If necessary, the central bank that targets total spending also provides the money people need to maintain their level of spending in the face of the supply shock.
  • Monetary policy will be more transparent and easier to understand. Targeting total spending provides clear signals to a central bank, allowing it to change its policy stance with minimal information problems. A central bank simply loosens its stance when total spending falls and tightens when total spending rises. The straightforward nature of this framework would greatly improve the transparency of monetary policy for the general public.

Just as important, targeting total spending would help the central bank promote ideal conditions for maximum employment.

The Fed already acknowledges that nonmonetary factors determine maximum employment, and that these factors are difficult (if not impossible) to measure. Obviously, it would be better for a central bank to focus on variables that it can directly measure and that are determined by monetary factors. Total spending is just such a variable: it is directly measureable, and monetary policy directly affects it.

Furthermore, keeping the level of total spending on a stable trend—the goal of targeting the level of total spending—helps to smooth out economic downturns and avoid artificial booms, thus fostering the economic conditions that are most conducive to maximum employment.

Separately, when employment falls and inflation rises, an inflation-targeting central bank is faced with tightening its policy stance in an already slowing economy, thus worsening an economic downturn. (This problem last arose during the onset of the 2008 financial crisis.) A central bank that targets total spending, on the other hand, avoids this error because it is focused on stabilizing the overall economy.

Regardless, the best way for a central bank to maintain monetary neutrality—supplying the amount of money the economy needs to keep moving, no more and no less—is to target total spending. Changes in total spending reveal the demand for money, thus making it easier for a central bank to supply the correct amount of money people need.

If we are going to have a central bank—and we’re stuck with the Fed for now, like it or not – it would be much better to require the bank to strive for neutrality than to ask it to constantly do things that it should not do (stabilizing prices at either “low” or zero inflation is not a good idea) and things that it cannot do (creating maximum employment, moderating interest rates, stabilizing financial markets, etc.).

Requiring the central bank to target total spending will not produce perfect economic conditions and solve all problems. But neither will any other central bank policy or, for that matter, any purely market-based monetary system that operates without a central bank.

But requiring the Fed to shoot for monetary neutrality through targeting total spending will allow the bank to avoid major monetary policy errors and reduce the likelihood of major contractions and artificial booms. It will do a better job of approximating a market-based monetary system.

People are better served when the federal government remains neutral rather than when it actively tries to boost or slow down economic activity based on the preferences of policymakers and politics. That’s why free market economies are superior to centrally managed ones.

If policymakers want to improve monetary policy, they will require the Federal Reserve to remain neutral by supplying the amount of money the economy needs in order to keep moving—no more and no less. And targeting total spending is the best way to achieve this goal.

This piece originally appeared in Forbes https://www.forbes.com/sites/norbertmichel/2019/04/29/the-feds-june-conference-should-explore-a-single-mandate-monetary-neutrality/#4933d0ca3d90