The Fed 3.0
When the Fed was created in 1913, the US was still on the gold standard. Under that policy regime it made no sense to think in terms of ideas such as inflation targeting. In the long run, the price level under the gold standard is determined by global factors, well beyond the Fed’s control. (Although even then the Fed had some ability to control prices in the short run.)
In March 1968, the US adopted a fiat money regime. At first the Fed did not know how to operate the regime, sort of like giving a sports car to a 14-year old boy. By the 1980s, they mostly figured out how to keep inflation relatively low and stable, at least on average over several years. (They still know how in 2022, but for some inexplicable reason have simply chosen not to do so.)
I have a new paper in a Cato Institute book entitled Populism and the Future of the Fed, edited by James Dorn. In this paper, I argue that the Fed’s mandate should be clarified to address new issues raised by the zero interest rate environment. Here are a few points:
1. The Fed’s so-called “dual mandate” is actually a triple mandate, with the call for “moderate long-term interest rates” often overlooked. We should take this mandate seriously and avoid any policy target that would lead to the ultra-low interest rates that we see in countries such as Japan, Germany and Switzerland. That means the inflation target should be higher than zero in a world with ultra-low real interest rates (i.e., this world.)
2. Congress needs to clarify the Fed’s role in macroeconomic stabilization during periods of zero interest rates. Is a large balance sheet appropriate? Should the Fed do whatever it takes to stimulate the economy at zero rates, or should they defer to fiscal policy? Which assets should the Fed be allowed to buy? These issues never came up during 1968-2008, as no one envisioned a situation where the Fed would have to do QE to achieve its inflation target.
3. The zero rate environment also makes the argument for level targeting much stronger than before. NGDP level targeting would be great, but even flexible average inflation targeting (which is similar to NGDPLT) would be fine. It’s a pity that the Fed recently abandoned FAIT.
I offer several recommendations:
1. Congress could tell the Fed to confine its asset purchases to Treasuries when interest rates are positive, but allow the Fed to buy as many assets as necessary to achieve a stable monetary policy when rates are stuck at zero.
2. Congress could explicitly allow the Fed to pay negative IOR if necessary, although the policy goal should always be positive interest rates. Any use of negative IOR should be directed at raising longer-term nominal market interest rates.
3. The Fed should focus on stabilizing inflation and employment, and not adopt additional goals in areas such as financial market stability, inequality, and the environment. As Carola Binder and Christina Skinner recently explained, mission creep has become a big problem at the Fed.