Over the first 100 years of Federal Reserve System history, the United States enjoyed both price stability and the absence of banking crises in only about a quarter of those years. Two main influences explain persistent Fed failure: politicization of Fed decisions (especially to elicit Fed assistance in accomplishing short-term fiscal or electoral objectives of the Administration), and model misspecification (reflecting the limits of Fed knowledge about the economy). Worldwide, one can see similar connections between political pressures or model misspecification, and central banks’ most egregious historical failures which produce inflation spikes and banking crises. The worrying evidence is not only historical. There is ample evidence that central banks today are suffering acutely from the twin risks of politicization and modeling fads.
A sad consequence of Fed politicization has been the willingness of economists, inside and outside the Fed, to throw inflation targeting policy under the political bus. The Fed’s vocal focus on current labor market conditions, vaguely defined, is a clear reflection of political pressures that are driving the Fed to demonstrate its commitment to boosting employment.
There are considerable political pressures, in addition to concerns about short-term unemployment, that are likely to further constrain Fed tightening as inflation rises. The Fed’s balance sheet contains massive quantities of long-term Treasury bonds and mortgage-backed securities (MBS). Rising expectations of inflation alongside increases in real interest rates could produce a sharp rise in long-term interest rates (which the Fed does not control). As interest rates rise, Fed open market sales of its long-term assets may be constrained by the Fed’s desire to avoid recognizing capital losses on those assets. Such capital losses, in theory, should have no economic consequences for monetary policy, but Fed insolvency would have potentially important political consequences, as it would invite attacks by Fed critics about imprudent policies and their costs to taxpayers.
Many economists have been slow to express concern about the Fed’s politicization, or criticize its rejection of inflation targeting, or highlight the risks from its purchases of long-term bonds and MBS. More broadly, many economists seem to have little interest in articulating or defending policy principles that should guide the Fed during difficult political times (the only times when defending them really counts). Principled critics would have noted the uncertainties about structural unemployment in the wake of the crisis, and pointed to the danger of targeting labor market conditions based on unreliable Fed estimates of a low structural unemployment rate. At the zero interest rate bound, principled critics would have supported the use of quantitative easing (QE), when inflation was below target, but they also should have insisted on the Fed avoiding buying MBS in executing its QE operations. They would have criticized the Fed for usurping the roles of Congress and the Administration, which should control fiscal policies related to subsidizing MBS or influencing the term structure of Treasury interest rates. They would have noted that forward guidance was based on the faulty premise that one can gain credibility by breaking a promise. They would have pointed to the political risks that the Fed brought upon itself by filling its balance sheet with long-term Treasuries and MBS, and the future inflationary risks that those political risks entail.
What measures would be helpful for making central banks less susceptible to intellectual fads and counterproductive short-term political pressures? The realistic goal of monetary institutional design should be to establish clear objectives for central banks and hold them accountable for achieving them. To promote independence, focusing monetary policy on the single objective of long-term price stability is essential, and fully compatible with minimizing long-term unemployment. Removing central banks from the financial regulatory and supervisory process will also bolster their independence. Ensuring greater diversity of life experience in central bank leadership and a process that gives voice to dissent would be helpful inoculations against intellectual fads. None of this will be accomplished easily, not least because government officials typically have little interest in promoting central bank independence.
Charles W. Calomiris is Henry Kaufman Professor of Financial Institutions at Columbia University and a visiting economist at the research department of the International Monetary Fund. The views presented here should not be attributed to the IMF.
The article above was adapted from Professor Calomiris’s remarks to the IMF Spring Meeting. Full video of his remarks is available here.
