Will the Fed Go Tone Deaf When Fine-tuning the Economy?

COMMENTARY Monetary Policy

Will the Fed Go Tone Deaf When Fine-tuning the Economy?

Jul 15, 2014 4 min read

Former Director, Center for Data Analysis

Norbert Michel studied and wrote about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.

Has the economy recovered enough for the Fed to reverse course and start raising interest rate targets? Should it pull the plug on quantitative easing?

The latest Federal Open Market Committee (FOMC) announcement did nothing to settle this debate. Nor did it contain any real surprises.

As expected, the Fed announced it will continue its taper.  Beginning in July, it will purchase only $35 billion worth of bonds ($20 billion in Treasuries and $15 in GSE-issued mortgage backed securities) per month instead of $45 billion.

Further, 12 FOMC meeting participants think 2015 may be a good time to start increasing interest rate targets.  Thirteen had held that view in March.

The FOMC believes “Labor market indicators generally showed further improvement.” It noted, however, that “[t]he unemployment rate, though lower, remains elevated.”

All of these statements are consistent with what Janet Yellen has been saying for months, but this last observation raises a good question.  What is the unemployment rate elevated from?

Econ professors teach that there will always be some unemployment due to various structural issues. (It takes time to find a new job and to acquire new skills, etc.)  Thus there is some “natural rate” of unemployment.  But what, exactly, is that rate?

Prior to the 1990s, many economists thought the unemployment rate could not stay below 5 or 6 percent for very long without it leading to high inflation.  Then unemployment stayed below 5 percent from July 1997 through August 2001 without an appreciable increase in inflation (as measured by the Consumer Price Index).  The question remains open. This debate, though, is nothing compared to the arguments over inflation.

Some argue there has been no appreciable inflation since the Fed began its QE programs, and that no harmful inflation is on the horizon.  This view suggests the Fed should keep its expansionary stance and/or stop tapering its bond purchases.  Others believe there has been inflation and/or it is coming, so they want the Fed to taper and/or reverse its expansionary policies.

A key part of this debate centers on the correct way to measure inflation—an argument that will likely continue for eternity.

Should we measure inflation by the Consumer Price Index (CPI)? And, if so, which one? The “core” CPI that removes food and energy prices?  The CPI that takes out food, energy, and housing?  Instead, maybe we should use the Fed’s preferred measure, which tracks growth in personal consumption expenditures?  Or perhaps we should focus only on the price of gold or a basket of commodities?

Regardless of the measure used, it does appear that recent price increases have been broad based rather than confined to just one or two sectors.  When we consider the annualized rate of growth in the CPI based on the rates reported in April and May (0.3% and 0.4%, respectively), the data project a 4% annual growth rate in inflation, far above the Fed’s supposed 2% target.


This projection highlights the danger of the Fed getting things wrong.  If the Fed continues its expansionary policies and misreads “true” inflation, we’ll likely end up paying much higher prices than usual.

And in spite of what some commentators think, more inflation is not good—no matter what’s happening in Japan.  In fact, inflation destroys wealth.  If purposely inflating prices were a good policy, all the world’s problems could be solved by turning on the printing presses.

More importantly, though, the debate over the “right” inflation and unemployment measures sidetracks from the discussion we should be having.  Namely, should the Federal Reserve be in charge of fine-tuning the economy?

The Fed was created when our economy was largely agricultural. The main idea was for the Fed to stem seasonal currency shortages tied to crop harvests.

 There’s sufficient scholarly research to believe a private-market-based solution was a viable alternative to creating a central bank. Even Alan Greenspan has noted that we didn’t need a central bank because we were on the gold standard.

Nonetheless, within a very short period of time we ended up with the decidedly Keynesian-based notion that the Fed should actively try to calm business cycles.  And it’s been trying to do so for decades, as if the economy were an engine that requires constant adjustment.

But the economy is nothing like an engine.  It’s an amalgamation of millions of people making their own decisions based on their own conditions and expectations.

Neither the Federal Reserve – nor any other government bureaucracy – can successfully orchestrate these activities.  (Incidentally, we’d all be better off if more economists learned the lessons in Duncan Watts’ book, Everything Is Obvious: How Common Sense Fails Us.)

The best that we can hope for right now is a Fed that creates as few unintended consequences as possible.  Unfortunately, such an outcome requires the central bank to operate on a minimal scale, something which it can no longer do.

Not only has the Fed greatly expanded its typical open market operations in the wake of the recent crisis, but it has taken on the responsibility (via the Dodd-Frank Act) of “stabilizing” the entire U.S. financial system.  The Fed’s new so-called macroprudential regulation mandate amounts to deciding the types and levels of risk that financial institutions may undertake.

Many find it appealing to entrust a small committee of enlightened individuals with deciding what are the “correct” levels of unemployment, inflation, and financial risk for the US.  Certainly it’s comforting to think that a small group of experts can institute policies that will keep all of these measures in tune, modulating business cycles so that financial crises are a thing of the past.

But experience shows that is a dangerous fantasy.

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

Originally appeared in Forbes