This guest commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics
The extraordinary monetary policy actions in the wake of the financial crisis exemplify Milton Friedman’s warning that “Any system which gives so much power and so much discretion to a few men, that mistakes — excusable or not — can have such far reaching effects, is a bad system.”
Consistent with Friedman’s warning, the Bernanke Fed has engaged in policies that have produced a number of dangerous distortions that threaten economic stability. This essay introduces a new approach to monetary policy that, if adopted, would significantly reduce the likelihood that the Fed would engage in such actions in the future. I call my approach economic reality-based monetary policy (ERMP). I explain what ERMP is and why it would significantly reduce the likelihood that the Fed would make mistakes that could have far-reaching effects.
ERMP requires the Fed to specify a set of fundamental economic realities and commit to conduct monetary policy within the limits implied by these realities. To see how ERMP works and how it would limit the Fed’s actions, assume the Fed committed to conducting monetary policy in accordance with the following economic realities:
- Reality #1: Credit is most efficiently and effectively allocated by the market and, hence, by economic fundamentals.
- Reality #2: Interest rates determine the allocation of credit. Hence, interest rates are best determined by the market.
Actions that the FOMC takes to affect interest rates necessarily distort interest rates and the allocation of credit and economic resources. The purpose of the Fed’s interest rate policy is to distort interest rates and the allocation of credit.
The problem arises when the Fed pursues its policy too aggressively and far too long. Together these realities imply that policy actions taken to affect interest rates should be limited in both magnitude and duration.
For example, if the FOMC had agreed to conduct monetary policy consistent with these realities, it may not have reduced its funds rate target to 1 percent in June 2003. Even if it did, it would have been reluctant to keep it there for a year. It might not have kept the target at 3 percent from September 1992 to February 1994, either.
The FOMC would have been more reluctant to engage in quantitative easing for the expressed purpose of allocating credit to specific markets. It almost certainly wouldn’t have kept its funds rate target near zero for six and a half years after the recession ended. Nor would it have engaged in its forward guidance policy, i.e., committed to keep interest rates low for an extended period, for the purpose of reducing long-term yields.
A Better Way: What Would "Economic Reality-Based Monetary Policy" Do?
ERMP wouldn’t prevent the FOMC from temporarily engaging in aggressive credit allocation in times of crises. However, the Fed would have to provide a strong case that financial markets are significantly impaired. But it almost certainly would prevent the Fed from engaging in such actions years after markets had stabilized.
ERMP preserves Fed independence while simultaneously enhancing its accountability. Because policymakers’ actions are constrained by economics, there is less need for direct governmental oversight. For example, there would be no reason for Congress to enact the Fed Oversight Reform and Modernization Act (H.R. 3189).
ERMP would make the Fed more accountable because it has committed to conduct policy in a matter that is consistent with these realities. If the FOMC were to take actions that appear to be inconsistent with the stated economic realities, it would have to explain its actions to Congress and to the public. Oversight and accountability are achieved without creating a governmental bureaucracy.
ERMP also has the advantage that it neither requires nor restricts how the FOMC implements monetary policy. For example, many prominent economists, including several Nobel Prize winners, have endorsed Section 2 of H.R. 3189, that requires the FOMC to implement policy using a specific FOMC-determined policy rule.
Under ERMP the FOMC can adopt a specific policy rule or continue to rely on meeting-to-meeting discretion. It can target inflation, the price level, or nominal GDP. ERMP constrains how aggressively the policy can be pursued. It does not constrain how policy is conducted.
I strongly recommend the FOMC to adopt ERMP. If it doesn’t, legislation should be enacted to require it. Such legislation could list the set of economic realities or it could require the FOMC to establish the list. I believe the list should include the two I mentioned — I believe that nearly all economists and financial market analysts would endorse these realities. However, it’s likely that agreement could be reached on a somewhat longer list.
My proposal will produce better monetary policy, and better monetary policy outcomes, because it constrains policymakers’ actions to be consistent with economic realities. ERMP will make monetary policy more predictable, the Fed more accountable, and protect the Fed’s independence—it will fix a bad system.
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.