Tuesday, April 30, 2013

Taylor on monetary policy

John Taylor has a lovely little blog post, encapsulating so much in a few sentences. An excerpt with comments (emphasis mine)
...there is a crucial issue which explains much of the enormous difference of opinion between critics and supporters of the Fed’s current policy. Critics such as me and Allan Meltzer ... argue that monetary policy should focus on a clear strategy for the instruments of policy. A goal for inflation or other measures of macro performance is not enough if it is simply part of a whatever-it-takes approach to the instruments. Such an approach results in highly discretionary and unpredictable changes in policy instruments with unintended adverse consequences, as we have been seeing in recent years.

Supporters such as Adam Posen... are just fine with the Fed using, even year after year, a whatever-it-takes approach to the instruments of policy as long as there is an overall goal. With such a goal in mind, so their argument goes, the central bank can and should always intervene in any market, by any amount, over any time frame, with any instrument or program (old or new), and with little concern for unintended consequences in the long run or collateral damage in the short run (say on certain groups of people or markets) as long as it furthers that goal.

Critics are very concerned about those unintended consequences and collateral damage; they are also concerned about an independent government agency wielding such a great deal of power as it carries out a year-after-year whatever-it-takes approach. Supporters are much less concerned.
I have always had this problem with nominal GDP targets, inflation targets, and so forth. Ok, the Fed adopts your target. Now what? If nominal GDP doesn't do what the Fed wants it to do, what should the Fed do about it? Talk more? (Monetary policy is starting to look more and more like foreign policy here).

Taylor points out a deeper danger. The Fed's "mandate," the list of its "goals," keeps expanding. Beyond just inflation and unemployment, now the Fed is in charge of "financial stability," managing "systemic risks," the health of specific markets (mortgages, exports), the health of specific institutions (too big to fail banks), the diagnosis and pricking of bubbles (when not the deliberate stoking of such bubbles), management of the details of every part of financial system (how swaps get traded, for example) and surely coming soon a federal anti-crabgrass mandate.  The list of things the Fed can do in pursuit of these goals is getting bigger and bigger too, while the power of its conventional instruments (setting short rates, quantiative easing) is diminishing.  If the Fed doesn't think banks are lending enough, and to the right people, in pursuit of one of its many goals, what stops them from using their regulatory power to just go tell the banks who they should lend to?

We have told the Fed to attain unattainable goals, and given it great power to do "whatever it takes" in their pursuit.  The Fed seems to go along. It's fun to be given so much power, in the short run at least.  But in a democracy, the price of great independence must be limited power, and the Fed will soon have to choose. Congress already limited some of the Fed's powers after some "whatever it takes" of the financial crisis.

Taylor, of course, would like the Fed limited to the instrument of short-term rates, and to follow the Taylor "rule" for setting them. But the principle is larger than that instance.