Yin/Yang at the Federal Reserve

Several months ago I supported Ben Bernanke when his re-nomination as Chairman of the Fed came under fire. While others such as Simon Johnson called for his removal, I wrote that I instead wanted to see more focus on systemic incentives. Put a bit differently, I believed we were being more reactive in our approach to the financial crisis than pragmatic about how thousands of mostly well-meaning citizens -- both public and private -- could have made such collective decisions as led to collapse.

This remains a key issue in need of attention, and it requires deep thinking about whether assumptions used to pass legislation over the past 40 years still hold.

Interestingly, a few days ago I was surprised to come across a letter by Senator Sherrod Brown indirectly addressing part of this through a question I share about the Fed's dual mandate (hat tip Yves Smith). Writing to Secretary Geithner and Director Summers under the backdrop of the Dodd bill and key openings at the Fed, the Senator explained:

As Chairman of the Senate Banking Committee's Subcommittee on Economic Policy, with jurisdiction over the Federal Reserve System's monetary policy functions, I am acutely aware of the importance of monetary policy at the Fed. Both the full Banking Committee and the Economic Policy Subcommittee have examined the causes of the financial crisis and the resulting effects on lending, access to credit, and employment. The evidence presented to the Committee about the role that Fed policy decisions played in the financial crisis and the economic downturn has led me to conclude that the Fed's monetary policy has focused almost entirely on controlling inflation rather than maximizing employment and that the Fed has too often put banks' soundness ahead of its other responsibilities.

In concluding that the Fed regularly prioritized inflation control over maximum employment, Senator Brown was in fact making a direct swipe at the core short-term yin/yang at play within our modern central banking system.

To understand how these forces work, we must first understand that our modern Fed (as restructured by Humphrey-Hawkins in the 1970s) was designed for most practical purposes to have two core mandates, the "pursuit" of (a) maximum employment and (b) stable prices. By cause and effect, most other duties laid out in its mission statement -- including maintenance of long-term interest rates, safety in our banking system, containing systemic risk and providing services to depository institutions -- had been considered either derivative of, or related to, price stability. (Whether this is still the case is another matter.)

These core mandates were also what one might call "dueling" in nature, the logic for which can be traced to a paper written by William Phillips in 1958 called "The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom." In his paper, Phillips put forth an outline for the "Phillips curve" which described an inverse (though non-linear) relationship between unemployment and inflation.

If this relationship were to hold perfectly, the Fed was indeed the best repository of both mandates -- with its powerful toolkit over money supply, the Fed could simply adjust policy until achieving the balance for these opposing but equally important goals.

In practice however, even Phillips noted weaknesses in the relationship; namely, it was effective only in the short-run and within a tight band considered "normal" conditions. (For a worthy read on the technical underpinnings of modern Fed policy, see The Taylor Rule and the Transformation of Monetary Policy by the Kansas City Fed).

Unfortunately the current economic conditions are far from normal. Furthermore, I fear that over time the Fed's dueling mandates have taken their toll on the human side of central banking, the result being (metaphorically, if not actually) that the Fed must now make almost daily calculations reflecting the tradeoff between "protecting consumers" and "protecting banks." This was not the original intent of the 1970s overhaul and it's also a terrible conundrum in which to place an institution.

In concluding his letter, Senator Brown states three characteristics he believes should define any new member selected for the Fed's governing committees:

  1. Recognition of the causes of the financial crisis before it occurred
  2. Demonstrated dedication to protecting consumers and maximizing employment
  3. Commitment to releasing e-mails related to the Fed's involvement in the AIG bailout

Of the three, I can only wholeheartedly support the final point.

On the first, I would argue that just because someone was correct once it does not prove that person will be correct again. While this is a useful criterion to explore, making it the #1 requirement appears to be more about political optics than helpful substance.

On the second, I would agree in spirit if not practice; increased consumer protections are definitely not a bad thing. However, I am concerned they would ultimately prove ineffectual at the Fed under future crises or even normal operations -- consumers need a strong, independent agency that does not have inherent conflict within its core mission statement. Conversely, the Fed needs clarity to focus on its best strengths relating to price stability.

On the third, I couldn't agree more; checks and balances are a fundamental component to our government. For the most part, the debate over Fed transparency has been dominated by two camps, one for "accountability" and one for "independence." I respect the Fed and believe it can (and needs to) have both.

-- The author is a Partner at Belstone Capital and editor of The Polifinancial Times, where this article has been co-published.