Fill out the brief form below for access to the free report.

Plosser on Reforming the Fed

Article by Matthew Denhart November 21, 2013 //   5 minute read

The time has come for a hard look at U.S. monetary policy. After all, next month marks the 100-year anniversary of the creation of the Federal Reserve System. Given this momentous occasion, the Cato Institute dedicated its annual Washington, D.C., monetary conference to the question: “Was the Fed a Good Idea?”

The conference opened with a keynote address from Charles Plosser — President and CEO of the Federal Reserve Bank of Philadelphia — whose remarks (a transcript is available here) suggested that the Fed indeed plays an important role in monetary policy, but that it suffers from institutional defects that sometimes create perverse policy outcomes. Reform could equip the Fed to better encourage strong economic growth.

In Plosser’s mind, the Fed’s dual mandate to promote price stability and maximum employment represents its most substantial institutional defect. Plosser believes that the monetary policy is fundamentally ill-equipped to address fluctuations in employment — especially in the short term. He argues that when the central bank does attempt to use its powers to alter short-term employment, such efforts usually prove ineffective. Such was the case in the 1970s when, despite easy money policies, unemployment remained high. America’s current situation of stubbornly high unemployment despite aggressive expansionary monetary policy also supports Plosser’s view.   

But that’s not the worst of it. What’s truly lamentable is that Fed policy could prove effective at maintaining stable prices. But by using monetary policy in a futile effort to improve the nation’s employment prospects, other areas of the economy become distorted and price instability ensues.

Plosser says that Americans have come to expect too much from their central bank. What’s needed is a better defined Fed mandate that focuses only — or at least primarily — on price stability.

Even with a more reasonable mandate, though, other institutional features must be present for the Fed to be successful in maintaining stable prices over the long term. Namely, the Fed must keep its independence and stay free of Congress’s political interference. At the same time, however, the Fed needs to be held more accountable for its policy decisions.

How might it be possible to achieve these seemingly contradictory goals?

Plosser sees rule-based policy making as the best approach. Under Plosser’s system, the Fed — not Congress — would define the rules it intends to follow. But the Fed would be required to report its rules to Congress, making it accountable for actually following the rules it sets, or forcing it to explain to Congress and the American people why it deviated from its own rules framework. This would create much more certainty in the markets.

Other reforms would also make the Fed more effective. First, the Fed should not engage in quasi-fiscal policy by purchasing things like mortgage-backed securities. This type of policy-making, Plosser believes, belongs in the political process. Second, the Fed’s power as “lender-of-last-resort” should be greatly limited. Plosser thinks that too much discretion in this area creates moral hazard in financial markets — i.e., by guaranteeing that large financial institutions will not fail, the Fed encourages more risky behavior that in turn increases the likelihood of financial collapse. Discretion also creates uncertainty because the lender-of-last-resort power is often applied in an arbitrary fashion that saves some companies while allowing others to fail.

Plosser’s focus on a limited Fed mandate, coupled with more predictable rule-based policymaking echoes the approach other economists, such as John B. Taylor, have promoted in recent years. As the Fed turns 100 it is important to have leaders like Plosser and Taylor who make the case for alternative monetary policy. The 4% Growth Project will continue to follow the monetary debate in coming months as it examines proper monetary policies for stronger growth.