Wednesday, August 31, 2011

The Fed's Mandate (an Explanation for Sen. DeMint)

Sen. Jim DeMint is describing the Fed's emergency lending during the financial crisis as a "shadow TARP."  In an opinion column for Politico, he writes:
The U.S. government was never meant to be a giant lender for the world’s most powerful banks.
Actually, that is exactly what the Fed was originally meant to do.  The preamble to the Federal Reserve Act is:
An Act To provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.
"Furnish an elastic currency" is another way of saying that the Fed should be a "lender of last resort" - lend money to banks whose funding sources can suddenly disappear in financial crises in order to prevent the system from collapsing.  The Fed was founded because the frequent financial "panics" of the late 19th and early 20th century made clear that the US needed a central bank to perform this function.

During the financial crisis, the Fed performed this function with ingenuity and determination, and we would be in a very different - and much, much worse (think "Mad Max") - world if it hadn't.

What is questionable is whether the Fed is fulfilling section 2A of the Federal Reserve Act (added in 1978), "Monetary Policy Objectives": 
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Some of us believe that the Fed could be doing a better job (or at least try harder) of getting us closer to "maximum employment".   Somehow DeMint manages to be concerned that the Fed is failing to achieve "stable prices".  He says:
Americans are feeling inflationary pangs at home, too. The congressional Joint Economic Committee found that since the Fed launched its program of quantitative easing in late November 2008, the value (trade weighted) of the U.S. dollar has declined 14 percent, which translates into higher food and fuel costs.
The graph below shows inflation, measured by the CPI (though I think a 'core' measure, which would show lower inflation recently, is a more appropriate guide for monetary policy) and the unemployment rate.
By historical standards, unemployment is very high now, while inflation is low (and the little tick upward at the end will likely vanish as the effect of the oil price increase earlier this year dissipates).

DeMint also approvingly cites the criticism of Chinese and German government officials:
Leaders from around the world have openly complained about the way the U.S. is intentionally weakening the dollar, since doing so cheapens the value of U.S. debt they hold. After the second round of quantitative easing was announced, Chinese Vice Finance Minister Zhu Guangyao said America “does not recognize, as a country that issues one of the world’s major reserve currencies, its obligation to stabilize capital markets.

German Finance Minister Wolfgang Schaeuble was more blunt, calling the Fed “clueless.”
DeMint appears to believe that US monetary policy should heed the criticism of foreign government officials. Perhaps the mandate of the Fed be changed to focus on the interests of other countries.  I think some people may believe that it should, since the US dollar is the global "reserve currency", but if we're going to do that, we might as well abolish the Fed and turn US monetary policy over to the United Nations.  It doesn't appear that the wording of the Federal Reserve Act is explicit on this point, but I think its pretty well understood that the language quoted above about "the economy", etc., refers to the US economy.  If they don't like our monetary policy, China and Germany (and everyone else) are free to choose other assets to buy.

This San Francisco Fed Economic Letter from 1999 describes nicely how and why the Fed's mandate has evolved.  It might be good reading for Senator DeMint.


The Arthurian said...

Great post! "Actually, that is exactly what the Fed was originally meant to do." Perfect!


Bill C said...

Thanks. I see alot of things I disagree with, but rarely as perfect in their wrongness as DeMint's piece.