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From Banking and Finance Law Daily, March 17, 2017

Has the Fed veered off course with monetary policy? House Subcommittee queries

By Colleen M. Svelnis, J.D.

The House Financial Services Subcommittee on Monetary Policy and Trade has held a hearing to check in on the Federal Reserve’s treatment of monetary policy. The subcommittee hearing, "Sound Monetary Policy," is intended to determine whether the Fed has departed from conventional monetary policy, how the Fed can facilitate an orderly return to a conventional balance sheet, and how monetary policies can reliably support economic growth going forward. Subcommittee Chairman Andy Barr (R-Ky) stated that the Fed’s monetary policy today "is a policy that creates uncertainty instead of clarity. It is a policy that has weighed on productivity from its start a decade ago."

Full employment target. Josh Bivens, Ph.D., Research Director for the Economic Policy Institute, testified that the "sound approach to monetary policy has been (and remains) targeting genuine full employment." According to Bevin, even though the U.S. economy "has improved markedly since the trough of the Great Recession, and is not that far from genuine full employment," the Fed should not shift to a more contractionary policy stance "until we’ve achieved durable full employment."

Bivens looked at the Fed’s policy actions over the past decade, which were aimed at boosting aggregate demand and spurring a faster and full recovery from the financial crisis. According to Bivens, the Fed "acted earlier, more aggressively, and with a more sustained focus than other policymakers—particularly fiscal policymakers." He believes that without their actions, the recession would have been longer and the recovery slower. Bivens stated that the Fed’s primary job should be to aim for maximum employment, and the Fed should only shift to a "less-expansionary monetary policy stance" if inflation increases.

100percent error rate. John Allison, Executive in Residence at the Wake Forest School of Business, spoke about his belief that the Fed’s monetary policies "caused the Great Recession, distort[ed] markets, and harm[ed] the ability of American firms and families to reliably plan for the future." Allison stated that during his career "the Fed has a 100 percent error rate in predicting and reacting to important economic turns, which is not surprising. It is trying to arbitrarily set the single most important price in the economy—the price of money. This price affects every economic decision."

According to Allison, the Fed has a problem because it has undertaken a massive expansion of the money supply. "If the economy begins to improve and the Fed does not withdraw the tremendous reserves it has created from the banking system, rampant inflation will follow. If it does withdraw the reserves quickly, interest rates will rise rapidly."

Inflation target. Marvin Goodfriend, Professor of Economics at Carnegie Mellon University, explained how the Fed and the economy would benefit from a greater commitment to price stability as embodied in the inflation target. Goodfriend testified that sound monetary policy requires a credible commitment to price stability, which in practice has come to mean committing to an inflation target. The Fed did this in 2012, setting a 2 percent inflation target.

According to Goodfriend, the Fed created policy risks for the economy by failing to secure the credibility of its inflation target, the Fed:

  • increases risk inherent in using the federal funds rate to influence longer-term interest rates, and thereby degrades the capacity of monetary policy to stabilize employment and inflation over the business cycle;
  • invites a re-emergence of cyclical "inflation-fighting" risk premia in longer-term interest rates with potentially adverse effects on employment and inflation; and
  • forces households to guard against inflation risk, and thereby greatly increases household financial insecurity over a working lifetime and in retirement.

Policy ‘not effective.’ John B. Taylor, Stanford University, Hoover Institution, and former Undersecretary of the U.S. Treasury for International Affairs testified that the Fed’s departure from conventional monetary policy "began during the ‘too low for too long’ period of 2003-2005 when the Fed held the federal funds rate well below what was indicated by the experience of the previous two decades of good economic performance."

Taylor outlined the issues he had with the policy direction the Fed has taken since the financial crisis, which he says were "not effective" and maybe even "counterproductive." He described how the Fed purchased large amounts of U.S Treasury and mortgage backed securities in 2009, financed by increases in reserve balances, "which enlarged the Fed’s balance sheet." The Fed continued these large-scale asset purchases and held its policy interest rate near zero. Taylor also stated that the Fed utilized forward guidance, but changed the methodology several times, increasing uncertainty.

Taylor supports monetary reform such as the FORM Act which would require the Fed to "describe the strategy or rule of the Federal Open Market Committee for the systematic quantitative adjustment" of its policy instruments. He stated that "research shows that if such legislation had been in place in recent years, the Fed would have had to explain the deviations, which would have likely reduced their size."

MainStory: TopStory FederalReserveSystem FinancialStability FOMC

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