Too many of us have taken for granted that central banks ought to be most interested in macroeconomic stability, rather than price stability. It's an understandable mistake; central banks do pay lip-service to the goal of stable growth, and the Fed even has a nominal (ha!) dual mandate—full employment is, supposedly, as important as price stability.The Fed is only interested in bondholders who want to make sure that their fixed interest rate bonds will hold their value. The don't care about unemployment or the youth wanting to get into the job market. They only care about their piles of wealth. That's who really plays the pipe to which Bernanke and the Fed dance the dance of fools.
It should be clear that this isn't how the Fed behaves. Yesterday's policy announcement is a real puzzler if one assumes that the Fed is interested at all in full employment or macroeconomic stability. It makes perfect sense once one realises that the Fed is solely and entirely interested in price stability. When the Fed initiated QE2, it wasn't responding to high unemployment, which had been high for months on end. It was responding to a sustained drop in inflation expectations. A Fed interested in macroeconomic stability would not have allowed QE2 to end in June, as nominal growth was still below trend and unemployment remained high. But a Fed focused solely on price stability couldn't help but get nervous about upward movement in core inflation. And yesterday's policy announcement was far too timid to push nominal GDP growth back to trend. It was, however, perfectly tailored to arrest the sudden, precipitous decline in inflation expectations. The ECB is playing a similar game, albeit in a more procyclical fashion, due to its choice to target headline, rather than core, inflation.
I think there's a good chance that future economists will look back on the choice to stick with price stability as the central bank's goal as a strange and counterproductive norm, in much the same way current economists marvel at the disastrous central bank policies of the past. For now, America seems to be stuck with a Fed that's content to keep the American economy bumping along in statis, falling ever farther behind potential growth, so long as inflation stays nicely contained between 1% and 2%. It will fall to some future Ben Bernanke to apologise for present mistakes.
Wednesday, August 10, 2011
The True Master Who Pipes the Tune to which the US Federal Reserve Dances
Here is a bit from a post on the Free Exchange blog at the Economist site: