Refocusing the Fed

October 10, 2013

One hundred years after its founding, the Federal Reserve's policy activities are proving to be quite different than originally envisioned. Although the Fed's original purpose was primarily to provide liquidity during financial crises and ensure a low and stable rate of inflation, it is now expending more energy on targeting lower unemployment and higher growth. Monetary policy, however, is ill-suited to achieving these goals. The next Fed chair needs to turn the rising tide of dissatisfaction with Fed policy by returning it to its primary purpose of controlling inflation and reducing uncertainty, says John Makin, a resident scholar at the American Enterprise Institute.

Makin suggests the following ideas for improvement:

  • In the aftermath of the 2007-2008 financial crisis, the Fed has emphasized the goal of full employment and has, since 2012, committed to a zero interest rate target until unemployment falls at least to 6.5 percent. These targets are not all achievable given the Fed's available policy instruments and the result is rising disillusionment over the Fed's capability.
  • The inflation target should be set at 1.5 percent, with allowed deviations in the short run over a 0.5 to 1.5 percent range. This is lower and more specific than the Fed's current 2 percent objective, but the unambiguous pursuit of low and stable inflation benefits the economy and reduces the market's persistent fear of inflation risks.
  • The Fed's communication of its methods and goals should be confined to official Federal Open Market Committee (FOMC) statements, with the only amplification coming at the chairman's press conference after each meeting of the FOMC.

The next Fed chair needs to remind markets that the Fed's primary responsibility going forward is ensuring low and stable inflation while reducing the uncertainty that plagues the economy.

Moving forward, efforts to improve the economy should come from Congress. Having somewhat reduced the budget deficit, Congress needs to focus on tax reform that will encourage growth and entitlement reform that will also encourage growth by reducing uncertainty about prospective deficits and the way they are financed.

Source: John H. Makin, "What Now for Monetary Policy?" American Enterprise Institute, October 3, 2013.

 

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