In a speech this week to the Economic Club of New York former Federal Reserve Chairman Paul Volcker delivered a punishing blow to the misguided monetary activism of the Bernanke Fed. This is the best speech on economic policy you will read this year.
Volcker has under his belt the wisdom of over 60 years of experience in monetary policy. In addition he brings loads of common sense and humility to the table—two ingredients in short supply at the Bernanke Fed. Volcker can see the shortcomings of the misguided approach that Dr. Bernanke and is erudite allies at the Fed have pursued. You can read the entire speech here. The important excerpts are included below. Emphasis is ours.
No doubt, the challenge of orderly withdrawal from today’s broader regime of “quantitative easing” is far more complicated. The still growing size and composition of the Fed’s balance sheet implies the need for, at the least, an extended period of “disengagement”. Moreover, the extraordinary commitment of Federal Reserve resources, alongside other instruments of government intervention, is now dominating the largest sector of our capital markets, that for residential mortgages. Indeed, it is not an exaggeration to note that the Federal Reserve, with assets of three and a half trillion dollars and growing, is, in effect, acting as the world’s largest financial intermediator, acquiring long-term obligations and financing short-term, aided and abetted by its unique privilege to create its own liabilities.
Beneficial effects of the actual and potential monetization of public and private debt, the essence of the QE program, appear limited and diminishing over time. The old “pushing on a string” analogy is relevant. The risks of encouraging speculative distortions and the inflationary potential of the current approach plainly deserve attention. All of this has given rise to debate within the Federal Reserve itself. In that debate, I trust sight is not lost of the merits – economically and politically – of an ultimate return to a more orthodox central banking approach.
I do not doubt the ability and understanding of Chairman Bernanke and his colleagues. They have a considerable range of tools and instruments available to them to manage the transition, including the novel approach of paying interest on excess reserves, potentially sterilizing their monetary impact. What is at issue – what is always at issue – is a matter of good judgment, leadership, and institutional backbone. A willingness to act with conviction in the face of predictable political opposition and substantive debate is, as always, a requisite part of a central bank’s DNA.
Those are not qualities that can be learned from text books. Abstract economic modeling and the endless regressions of econometricians will be of little help. The new approach of “behavioral” economics itself is recognition of the limitations of mathematical approaches, but that new “science” is in its infancy.
A reading of history may be more relevant. Here and elsewhere, the temptation has been strong to wait and see before acting to remove stimulus and then moving toward restraint. Too often, the result is to be too late, to fail to appreciate growing imbalances and inflationary pressures before they are well ingrained.
There is something else beyond the necessary mechanics and timely action that is at stake. The credibility of the Federal Reserve, its commitment to maintain price stability and its ability to stand up against pressing and partisan political pressures is critical. Independence can’t just be a slogan. Nor does the language of the Federal Reserve Act itself assure protection, as was demonstrated in the period after World War II. Then, the law and its protections seemed clear, but it was the Treasury that for a long time called the tune.
In the last analysis, independence rests on perceptions of high competence, of unquestioned integrity, of broad experience, of non-conflicted judgment and the will to act. Clear lines of accountability to the Congress and the public will need to be honored.
Moreover, maintenance of independence in a democratic society ultimately depends on something beyond those institutional qualities. The Federal Reserve – any central bank – should not be asked to do too much, to undertake responsibilities that it cannot reasonably meet with the appropriately limited powers provided.
I know that it is fashionable to talk about a “dual mandate” — that policy should be directed toward the two objectives of price stability and full employment. Fashionable or not, I find that mandate both operationally confusing and ultimately illusory: operationally confusing in breeding incessant debate in the Fed and the markets about which way should policy lean month-to-month or quarter-to-quarter with minute inspection of every passing statistic; illusory in the sense it implies a trade-off between economic growth and price stability, a concept that I thought had long ago been refuted not just by Nobel prize winners but by experience.
The Federal Reserve, after all, has only one basic instrument so far as economic management is concerned – managing the supply of money and liquidity. Asked to do too much – for instance to accommodate misguided fiscal policies, to deal with structural imbalances, or to square continuously the hypothetical circles of stability, growth and full employment – it will inevitably fall short. If in the process of trying it loses sight of its basic responsibility for price stability, a matter which is within its range of influence, then those other goals will be beyond reach.
Back in the 1950’s, after the Federal Reserve finally regained its operational independence, it also decided to confine its open market operations almost entirely to the short-term money markets – the so-called “Bills Only Doctrine”. A period of remarkable economic success ensued, with fiscal and monetary policies reasonably in sync contributing to a combination of relatively low interest rates, strong growth, and price stability. That success faded as the Viet Nam war intensified, and when monetary and fiscal restraints were too late and too little. The absence of enough monetary discipline in the face of overt inflationary pressures left us with a distasteful combination of both price and economic instability right through the 1970’s – not inconsequentially complicated further by recurrent weakness in the dollar.
We cannot “go home again”, not to the simpler days of the 1950’s and 60’s. Markets and institutions are much larger, far more complex. They have also proved to be more fragile, potentially subject to large destabilizing swings in behavior. The rise of shadow banking, the relative decline of regulated commercial banks, and the rapid innovation of new instruments have all challenged both central banks and other regulatory authorities around the developed world. But the simple logic remains: it is, in fact, reinforced by these developments. The basic responsibility of a central bank is to maintain reasonable price stability – and by extension to concern itself with the stability of financial markets generally.
In my judgment, those functions are complementary and should be doable.
I happen to believe it is either necessary nor desirable to try to pin down the price stability objective by setting out a single highly specific target or target zone for a particular measure of prices. After all, some fluctuations in prices, even as reflected in broad indices, are part of a well-functioning market economy. The point is no single index can fully capture reality, and the natural process of recurrent growth and slow-downs in the economy will usually be reflected in price movements.
With or without a numerical target, broad responsibility for price stability over time does not imply an inability to conduct ordinary counter-cyclical policies. Indeed, in my judgment confidence in the ability and commitment of the Federal Reserve (or any central bank) to maintain price stability over time is precisely what makes it possible to act aggressively in supplying liquidity in recession or when the economy is in a prolonged period of growth well below potential.
Credibility is an enormous asset. Once earned, it must not be fritted away by yielding to the notion that a “little inflation right now” is a good thing to release animal spirits and to pep up investment. The implicit assumption behind that Siren call must be that the inflation rate can be manipulated to reach economic objectives – up today, maybe a little more tomorrow, and then pulled back on command. But all experience amply demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse. Credibility is lost.
I have long argued that central bank concern for “stability” must range beyond prices for goods and services to the stability and strength of financial markets and institutions generally. I am afraid we collectively lost sight of the importance of banks and markets robustly able to maintain efficient and orderly functioning in time of stress. Nor has market discipline alone restrained episodes of unsustainable exuberance before the point of crisis. Too often, we were victims of theorizing that markets and institutions could and would take care of themselves.
Jeremy Jones, CFA
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