The cowardly Fed
The Federal Reserve is plagued by cowardice and rote institutional thinking.
That was, once again, the subtext when Federal Reserve Chair Janet Yellen gave congressional testimony on Wednesday. She gave little away, but did nothing to suggest the Fed will change its mind about the course it has plotted for years: a series of modest interest rate hikes, driven by an unjustified fear of inflation, after keeping rates at near-zero for years.
Now, on its face, the pro-rate-hike case is solid enough: Job creation and the unemployment rate continue apace. So why not stick to the Fed's rate-hike plan after so many years of near-zero interest rates? But look deeper, and the plan seems crazy: Wage growth and labor force participation remain meager. And that's after eight years of painfully slow recovery. Not to mention decades of soaring inequality and stagnant middle-class incomes. The American economy is definitely not great again.
Yes, America's immediate financial crisis has passed. But the economy its still in dire need of aid. Yet Yellen and her compatriots are paralyzed by a temperamental (rather than political) conservatism.
As Ryan Avent lays out in the journal Democracy, this refusal to go out on a limb defined the Fed's entire response to the Great Recession. And the problem goes right to its core as an institution.
Yes, the Fed cut interest rates to zero for years, poured trillions into banks' balance sheets, and bought up trillions more in financial assets through quantitative easing. But as much as these moves shocked many people in American politics, they were all also well within the toolbox the Fed had become accustomed to using. Yellen and other Fed officials could've announced they were ditching the Fed's 2 percent inflation target for 3 percent or even 4 percent. Or they could've at least said explicitly, many times over, that they were willing to tolerate inflation significantly over 2 percent for a few years. They could've done more quantitative easing, or expanded the program to buy up foreign assets, which could've boosted the recovery by closing the trade deficit. They could just not hike interest rates now.
But they didn't. And they're not.
Avent rightly locates this timidity in the Fed's nature as an institution. The whole justification behind turning monetary policy over to a central bank is the fear that politicians, left to their own devices, will be undisciplined, and shower job and wage growth on voters. In short, they'll deficit spend us into hyperinflation. Officially, the Fed has a dual mandate to moderate inflation while maximizing employment. But our collective narrative for why the central bank has this role implicitly sends Fed officials the message that controlling inflation is the priority, while employment can go by the wayside. Which is exactly how the Fed has behaved.
Now, plenty of people (including yours truly) actually think this debate tends to overstate the Fed's power to manage the economy, and only a massive fiscal stimulus from Congress could've truly healed the economic wounds of the Great Recession quickly. But the Fed definitely has the power to squash the effects of a stimulus with higher interest rates. So even if Congress had done its job, the Fed's timidity about inflation might still have hamstrung the recovery.
So what to do about all this?
The first thing we need is an attitude adjustment on how to treat the Federal Reserve. A majority of the officials that vote on monetary policy are nominated by the president and confirmed by the Senate. But politicians, activists, commentators, and voters often ignore this process, treating it as a question of abstract expertise that should be above the street fighting of everyday partisan politics. Given the enormous consequences of Fed policy for American livelihoods, this is nuts. Everyone should be treating Fed nominees with the same importance, focus, and ideological aggressiveness they already bring to Supreme Court nominations.
As for Fed officials themselves, they need to start showing some creativity and courage.
Fed officials are already free to announce a higher inflation target. Or a willingness to tolerate an extended overshoot of that target. Avent suggests they could even change their target entirely: Instead of pursuing particular rates of inflation and unemployment, the Fed could target nominal gross domestic product. Each year, the Fed would aim for the economy to hit a progressively bigger size in current-dollar terms. If they fell short of their target in a given year, politicians could point to the gap and give Fed officials a dressing down in Congress. They could even replace the officials for their failure.
Catching up to next year's nominal GDP target would also force the Fed to tolerate higher inflation in pursuit of more job and wage growth.
Finally, we should overhaul the process by which Fed officials are picked. At the national level, the voting officials who aren't selected by the president and the Senate are drawn from the regional branches. We have two choices here: We could reform the institution so all officials who vote on monetary policy must go through the confirmation process, or we could restructure the regional banks so that no officials there are selected and drawn solely from the financial industry, as many currently are. Instead, regional officials should be drawn from the full sweep of American life: community activists, academics, business leaders, union and labor representatives, and more.
Handing management of the macro economy over to a quasi-independent body like the Fed is justified on the grounds that such a job is too important to leave to politicians. But the course of the macroeconomy determines whether everyone has jobs, how their wages grow, and what opportunities they can find. It determines the fates of millions of lives, families, and communities. That's a matter of morality and politics, not just technocracy.
As Avent points out, there have been times when macroeconomic policy seriously reformed its ways — think of Franklin Roosevelt scrapping the gold standard to combat the Great Depression. But those times didn't come when the technocrats at the Fed decided internally that they'd made a mistake. They came when pressure for an economy that works for everyone, brought to bear by politicians and the masses alike, became overwhelming.
By insulating the Fed from democratic politics, we've insulated it from the force of that demand.