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From Banking and Finance Law Daily, December 8, 2016

Fed monetary policy strategy questioned by House subcommittee

By Colleen M. Svelnis, J.D.

The House Monetary Policy and Trade Subcommittee took a closer look at the Federal Reserve’s recent monetary policy strategy. The hearing, titled "Unconventional Monetary Policy," was held on Dec. 7, 2016. Subcommittee Chairman Bill Huizenga (R-Mich) opened the hearing, stating that "[e]conomic opportunity reliably increases when monetary policy adheres to its vital duty—that is, facilitating commerce, wherever it shows promise." Huizenga also stated that, recently, "monetary policy has not only ignored this duty, it continues to ignore the consequences of ignoring this duty." According to Huizenga, today productivity has been cut in half, compared to previous living standards that doubled every generation. He asserted that this is "neither normal nor acceptable."

Mission creep. Charles Plosser, Visiting Fellow at the Hoover Institution, Stanford University, and Former President and CEO of the Philadelphia Fed, testified that the Fed’s mandate has experienced "mission creep" over the last decade, which has expanded "the scope for discretionary action and the opportunity for political interference."

Plosser discussed the challenges to central bank reforms and asked how a democratic society can work to preserve central bank intelligence while ensuring it has adequate tools for success and can be held accountable to the public. He suggested three ways to do this that will lead to clearer communication and a better understanding of monetary policy without undermining political independence:

  • simplify the goals;
  • constrain the tools; and
  • make decisions more systematic.

Plosser stated that, around the world, central banks "are being asked to solve all manner of economic ills, from fiscal crises in Europe to low productivity and structural challenges in Japan and the U.S. I think this is a mistake and potentially dangerous for the institution and the economy."

Don’t rollback reform. Testimony submitted by Dr. Simon Johnson, Professor at Sloan School of Management at the Massachusetts Institute of Technology, emphasized that Congress "should be attempting to strengthen the safeguards in the Dodd-Frank financial reform legislation." According to Johnson, repealing or rolling back this legislation "poses a major fiscal risk – and it also raises the probability that the Fed would again have to enter unchartered territory with monetary policy."

Departure from established policy. John Taylor, a Professor of Economics at Stanford University testified that the opportunity for monetary reform is better than it has been in years. Taylor traced the Fed’s current monetary policy strategy back to the sustained low interest-rate period of 2003-2005. During that time, the Fed held the federal funds rate "well below what was indicated by the experience of the previous two decades of good economic performance."

According to Taylor, the Fed’s recent period "can be characterized as a deviation from the more rule-like, systematic, predictable, strategic and limited monetary policy that worked well in the 1980s and 1990s." Taylor stated that the Fed began giving forward guidance and changed the methodology several times, which increased uncertainty. "Monetary policy should be normalized," said Taylor.

Taylor insisted that the Fed should transition to a sound rules-based monetary policy like the one that worked in the past "while recognizing that the economy and markets have evolved." Taylor stated that sound rules-based monetary policy and good economic performance go hand in hand.

Failure in ultimate objective. Mickey D. Levy, Managing Director and Chief Economist at Berenberg Capital, focused his testimony on the Fed’s departure from "conventional" monetary policy and "how monetary policy can reliably support economic growth going forward." Levy grants that the Fed’s "unconventional policies" helped lift the economy after the financial crisis, but maintains that, in recent years, the Fed has failed in its "ultimate objective of stimulating the economy."

Instead of stimulating aggregate demand, monetary policies have contributed to mounting financial distortions and disincentives and are inconsistent with the Fed’s macro-prudential risk objectives.

Levy listed reasons why the Fed’s policies have not stimulated faster growth and how the Fed could change its conduct of monetary policy, including suggestions for strengthening the economy. According to Levy, "a growing web of government regulations, mandated expenses and higher tax burdens have weighed on banking and the financial sector, business investment and the broader economic environment."

Levy recommended that the Fed reset the conduct of monetary policy by doing the following:

  • raising rates gradually but persistently toward a neutral policy rate consistent with its estimates of potential growth and its two-percent inflation target, and cease reinvesting its maturing assets;
  • de-emphasize short-run economic and financial fine-tuning and not allow monetary policy to be influenced by global and financial turmoil that does not materially influence U.S. economic performance;
  • shift the focus of its communications, including its official Policy Statements, toward the Fed’s long-run objectives and away from short-run economic and financial conditions that are always subject to volatility, and emphasize that the scope of monetary policy is limited and that the economy is influenced by other factors—including the government’s economic and regulatory policies; and
  • shift toward a more rules-based guideline for conducting monetary policy that provides flexibility for the Fed but at the same time avoids the big mistakes of discretionary policy deliberations.

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