WARNING: This article has some jargon. You’re not alone if you find monetary policy confusing, but it doesn’t have to be. Get my free glossary demystifying monetary policy here, or the complete book, The ABCs of the Austrian Business Cycle here ($2).
I recently interviewed David Henderson of EconLog about President Trump’s appointment of Stephen Moore to the Federal Reserve. We talked about taxes, deficits, supply side economics, and why Moore might not be cut out for central banking.
Moore, a pro-Trump partisan, has taken flak for a recent WSJ op-ed where he argues that “The Fed is a Threat to Growth.”
David is basically optimistic about the current economy and thinks that Moore has the right idea when it comes to taxes (lower the rates, broaden the base).
Counterintuitively, there’s more money to spend on government services when the people are left free to grow their own businesses without a heavy tax burden. Since government spending remains remarkably constant (~20% of GDP, David notes), even progressives should agree that we are better off trying to “grow the pie” than “soak the rich.”
A government that governs best is that which governs least. Similarly, the central bank that stabilizes best is that which actively “stabilizes” the least. Too much financial central planning leads to economic uncertainty, leading individuals and businesses to delay their spending decisions until they know what to expect.
Thus, David thinks someone like NYU “free banking” guru Larry White or George Selgin would be better choices for the Fed since they could articulate how the central bank distorts economic growth, and advocate monetary policy that would be as neutral as possible.
Given that we are unlikely to abolish the Fed anytime soon, we need to restrict central banks to principles and rules so that other interests besides sound money (i.e., currency with stable value) don’t creep in.
In other words… the First Rule of Central Banking is: You do not politicize the central bank.
The second rule of central banking is: You do not politicize the central bank.
Third rule of central banking: Never reason from an interest rate change.*
Fourth rule: Limit discretion.
These would be my rules if I were in charge of the Fed, but in this fallen world our central bank instead has two (often conflicting) mandates — price stability and maximum employment. Sometimes this is formulated as the “maximum employment that is compatible with price stability,” meaning the employment goal is subsumed under the priority of keeping the economy from either inflation or deflation.
During the Obama years, the Fed probably could have done more to boost output without pushing inflation above its historical average of 2–3%. In fact, inflation fell briefly below 0%, indicating that they were failing to achieve either plank of the dual mandate.
The more astute pointed out that this could be achieved with a rule, like strict inflation targeting or NGDP targeting. Using real-time data from futures markets, the Fed can see when the economy is getting too hot or cold, and this can trigger automatic action to stabilize prices in either direction. Operating by a rule, rather than discretion, makes it harder for politics to influence the Fed — something both sides have been guilty of when they want to give a sitting President from their party a boost.
Moore’s appointment to the Fed after his anti-Fed op-ed looks like a blatant instance of Trump politicizing its function — trying to get the bank to inflate the economy so that he will win re-election. But Moore says that Trump’s pro-market policies, including free trade, have brought back sustainable growth, and that tight monetary policy is threatening to choke it off.
The op-ed is gated so I’ll quote it liberally:
“The last major obstacle to staying on this path is the deflationary monetary policy of the Federal Reserve. The deflation began with quarter-point interest-rate increases in September and December. These hikes caused a severe dollar shortage, a fall in commodity prices, and a rapid slowing of growth — accompanied by wild swings in the stock market.
Markets reacted violently to the Fed’s inexplicable interest-rate increases, sending the price of commodities tumbling by 15%, including everything from oil, soybeans and orange juice to steel, lumber and copper. Stocks fell by the same amount in nominal terms, pushed down by deflation.
…Even the consumer-price index has been flat or slightly negative for the past three months, and inflation remains way below the Fed’s 2% target. The latest Treasury inflation-protected securities spread indicates investors believe inflation will stay below the Fed’s target for many years to come.”
Moore’s critics have pointed out that we haven’t had deflation in overall prices, but with falling commodity prices and declining inflation expectations it’s not hard to understand why Moore would write like this. It is a bit strange that all of the people who talked about the dangers of deflation have been silent of late. Then he writes:
“…The solution is obvious. The Fed should stabilize the value of the dollar by adopting the commodity-price rule used successfully by former Fed chief Paul Volcker.”
Several bloggers have also taken issue with Moore’s memory of the 80s, finding no evidence that then-Fed Chairman Paul Volcker had a commodity price target in mind when he raised interest rates.
Stephen Moore's Other Volcker Rule - Alt-M
George Selgin looks at Stephen Moore’s rememberance of the Volcker years and concludes that it is fuzzy at best. alt-m.org
My reading is that Volcker did rely heavily on commodity prices as an indicator of the stance of monetary policy when the broad monetary aggregates became unreliable on account of the instability of velocity. Recall that M x V = P x Y, where M is money supply, V is Velocity, and [P x Y] is nominal GDP. If velocity is unpredictable, the central bank can’t just steadily grow the money supply and expect the economy to remain stable. They need other indicators. Commodity prices provide real-time data and are generally a leading indicator of other kinds of inflation.
Trump apparently read Moore’s op ed and liked it so much he appointed him to the Federal Reserve Board, a move that has brought nearly unanimous mockery from the economics profession, and condemnation of the on-going politicization of the Federal Reserve. Greg Mankiw says that while Moore is an amiable guy, he doesn’t have the “intellectual gravitas” of, oh I don’t know… Greg Mankiw.
It’s true that Moore doesn’t fit the mold of an academic, but as I point out in my book, The ABCs of the Austrian Business Cycle, academics don’t have the best track record of stabilizing recessions either.
The more damning criticism of the appointment is that Moore’s reasons for wanting to loosen monetary policy could be used by any future Fed appointees whose loyalty to the President who appointed them causes them to inflate temporary bubbles. This would boost output and thus the President’s re-electability, but lead to long-run inflation.
Moore’s suggestion of a commodity-price-targeting rule *could* bode well for the future of Federal Reserve policy, though. Sticking to a commodity price targeting rule would limit the Fed’s ability to inflate future bubbles, and since commodity data is available in real time, you could basically automate the Fed.
However, a commodity price target would also make the economy vulnerable to supply shocks, which raise inflation for reasons that have less to do with monetary policy than real factors. Moore admits as much in his op ed, writing:
Yes, there will always be sudden spikes and dips of certain commodities — as when the Organization of the Petroleum Exporting Countries holds back oil supply to drive up the price. The value of using an index of some 19 commodities is that no one can manipulate all of them at once.
Or, we could adopt a nominal GDP target that allows prices of some things to rise without forcing the Fed to tighten monetary policy overall.
Trump often seems to do the right thing for the wrong reasons, or else pretends to have the wrong reasons in mind when he negotiates for a certain policy — such as slapping tariffs on China with the intention of eliminating all tariffs, both ways.
In this case, he may be supporting Moore and his plan for commodity-price targeting because it happens to suggest looser monetary policy in the current environment — a very bad reason, because of the dangers of politicizing the Fed. But if such a rule were implemented, it could also pave the way for a more rigorous rules-based approach to central banking like an NGDP target down the road.
Find this article confusing? You’re not alone — monetary policy is confusing, but it doesn’t have to be. Get my free glossary demystifying monetary policy here, or the complete book, The ABCs of the Austrian Business Cycle here ($2).
*This has been referred to a “Sumner’s law” after Scott Sumner, who notes that there are times when falling long-term interest rates are a sign of tight monetary policy. Since people expect lower future inflation, they also demand less future interest. Listen to my interview with David for an explanation of this so-called “Fisher Effect.”