Chapter 17: Monetary Policy Targets and Goals
The US Federal Reserve has enjoyed a very long period of success, which is to the credit of Alan Greenspan and Ben Bernake, both of whom were supremely competent in managing the federal reserve. They have made the central bank seem infallible. But things were not always this, and the Federal Reserve board has made many gormless blunders under previous chairmen. Prior to Greenspan's appointment in 1986, the US dollar was much more volatile and was the source of much distress and no small numbers of panics and crises.
Those who wish to detract from Greenspan's success will point to factors in the economy such as stability in the commodities markets in general, a slow but steady amount of growth, a lack of serious political crises (no major wars), and various other things to dismiss the stability of being "dumb luck" instead of smart planning - though the author counters that many of these conditions existed for a decade or two prior to Greenspan's appointment, and the national economy (particularly in the 1970s) was a shambles. It's also a chicken-and-egg argument as to whether the stability in capital led to stability in production or vice-versa.
In general, it has been seen that economies as a while go through cycles of high and low activity, and the function of the fed should be to adjust the money supply to mitigate these fluctuations. But very often the fed has been reactionary to the economy, and by acting too late or on the assumption that a trend would continue, its actions often exacerbated rather than mitigated the highs and lows of the market. Academics debate exactly how this was done and whether it was intentional or accidental, but the volatility of the American dollar prior to 1986 cannot be disputed.
It's also noted that the federal reserve was created as a reactionary mechanism, designed to react to crises in the financial sector rather than acting in a way to prevent them from occurring. The reserve has been used to fund the government's war chest for both of the world wars, and to mitigate the financial downturn that inevitably occur in the wake of war. It is no accident that the Great Depression occurred shortly after the first world war and the industrial expansion occurred shortly after the second, and it is argued that the actions of the federal reserve increased the impact of both of these events.
In times of prosperity, the federal government tends to leave the federal reserve to its own devices, but it cannot resist meddling in the economy (generally to appease voters) during a downturn. There are times when it is clear that the fed had become the treasury department's "lap dog" and enabled the federal government to borrow irresponsibly and in unlimited amounts, damaging not only financial markets but also industrial and retail productivity, and brought the national economy dangerously close to a systemic crisis in the 1970s by its inability to respond to economic changes in a timely or effective manner.
In all, one should be careful about regarding the reserve as a genius or a hero. It is neither of those things, and its recent performance is no guarantee that it will continue to be reliable in the future.
Central Bank Goal Trade-offs
The central bank is generally charged with two goals: to create financial stability and promote economic growth. This is clearly a conflict because "stable" means neither shrinking nor growing. As in the investment market, risk must be undertaken in order to earn rewards, and risk means the chance of failure.
In the long run, the goals of growth and stability are generally compatible because populations are slowly growing: each new person is a new consumer (increasing demand for goods) and a new producer (increasing supply of goods), but in the short term there can be fluctuations that leave the central bank uncertain of the course to take until production and consumption balance out. Being too proactive can be as harmful as failing to take action.
The problem is exacerbated because the interests of the public are higher wages and lower prices, which is something that economic intervention cannot provide (wages are a cost of production, so the increase in wages must increase prices) - only advancements in productivity can accomplish this. But most people do not recognize this, and put pressure on their government, who puts pressure on the central bank, to do what is entirely impossible.
There is also the problem of moral hazard - if the central bank steps in to solve everyone's problems all of the time, then people are not inclined to act responsibly because they will always be saved from the consequences of their own greed and irresponsibility. And so it is argued that the central bank ought to be slow to respond and, in some instances, merely stand back and let crises resolve themselves and allow those who have acted stupidly to suffer the natural result of their action.
He then turns on the notion of "full employment" in which every person has a job. This is an entirely nonsensical goal that is likely not good for anyone: it essentially means that there is no labor available for growth and new enterprises and that no progress can be made. In general, economists agree that 5% unemployment is a healthy rate.
Central Bank Targets
Essentially, the central bank chooses one of three goals: to increase, decrease, or maintain the money supply (hence interest, inflation, and economic growth in general). It then decides which of its tools to apply to the task, and lays contingency plans to take other actions if its adjustment was too much or not enough to reach its target.
The author draws an analogy to weight-loss programs: many of them fail to have any effect, or have a short term effect after which everything that was lost (and a bit more) returns, and a few of which cause serious medical damage. Virtually every central bank has at least one miserable failure in its history, and most countries have had one or more central banks fail completely.
Another major problem is that the goals of the central bank are arbitrary and theoretical. There is the vague sense that increasing the money supply by a given amount will have a positive effect on economic activity, but this is by no means guaranteed. The results of any adjustment have proven difficult to predict. And ultimately, the economy has a mind of its own: the consumers buy the things they want in the quantities that they want, and making money easy for financiers and producers to obtain does not necessarily drive consumption.
(EN: A common example of this was the "tax bonus" offered by George Bush in the early 21st century, which put about $300 in the pocket of every citizen. His hope was to create a nationwide shopping spree, but what actually happened is most people used it to pay down their credit cards, which represents past production/consumption.)
Some central banks (such as New Zealand) have simply set a desired range of inflation, regardless of economic conditions, and seeks to maintain the money supply accordingly. The federal reserve does not have an explicit target, but merely assess the current condition to determine whether an increase in inflation might be beneficial. The fed has never been very transparent, so any comment about its goals is speculative.
The Taylor Rule
Many observers speculate that the federal reserve is following the Taylor Rule, named for an economist, that the target for the federal reserve ought to be factored according to the theoretical equilibrium and target inflation, plus an amount that reflects the difference between the current and desired rate and the change in the gross domestic product. Applying this rule mitigates changes to prevent a sudden shock to the financial system and enable the fed to evaluate and change the target rates incrementally.
While the federal reserve is secretive about its operation, it is said that the Taylor Rule neatly explains the economic history of the US since the 1960s. But again, this is speculative: it may be a coincidence, and even if it turns out to be true, the fed is not required to continue to use this rule and may change at any time.