Wanted: Long-Term Rules for the Short-Sighted Fed

The Cato Journal’s Spring/Summer 2012 volume on “Monetary Reform in the Wake of Crisis” is not to be missed. Contributors include Allan Meltzer, John Allison, James Grant, George Selgin, and Judy Shelton, among others. You could think that so much has transpired since this went to print, more QE, more EU summits, more “Fed twists” that its value has decreased. Not so, however.

For example, Allan Meltzer, author of the magisterial history of the Fed entitled A History of the Federal Reserve, has an essay “Federal Reserve Policy in the Great Recession” that is chock full with insight on the Fed’s behavior of recent years. The essay also limns a way forward to a rule-driven, discretion-limited Fed. The main theme is that “Overresponse to short-run events and neglect of longer-term consequences of its actions is one of the main errors that the Federal Reserve makes repeatedly.” Meltzer charges that the Fed in the Great Recession has engaged in credit allocation and distorted credit markets, incurred an unprecedented volume of long-term assets, evaded the dual-term mandate, engaged in debt management, among other acts. In so doing, the Fed has done things “that are not the responsibility of a central bank.”

Meltzer charges that the Fed has departed from its central role as “Lender of Last Resort.” Instead of being content with managing the currency supply in the wake of the downturn and the ongoing paralysis of our economy, the Fed has chosen to manipulate the credit markets. Thus Meltzer argues that:

Purchasing more than $1 trillion of long-term mortgages is credit allocation. How can the mortgage-related securities be sold later when inflation rises while the housing market remains in trouble? The Fed has no plan. Selling Treasury securities to finance mortgage or other purchases is a fiscal operation. The monetary base doesn’t change, and the purchase reduces the interest payment made to the Treasury. Selling two-year Treasuries to finance purchases of longer-term bonds also doesn’t change reserves or money. It is debt management and should be left to the Treasury.

The near-term dogs the Fed, Meltzer repeatedly argues, leading it to pursue QE2, which benefited market speculators who bought long-term bonds beforehand and then profited. Similarly, the attempt to “twist the yield-curve” by buying long-term debt and selling short-term debt is debt management policy and not properly within the Fed’s wheelhouse. Here, too, the Fed did not achieve its near-term objective. “[I]n advance of the Fed’s announcement, the market again lowered bond yields, so nimble speculators gained. How does that help the economy or the unemployed?” Documenting the reasons for this particular failure, Meltzer points to the last bit of twisting the Fed did in the 1960s. The follow up study concluded the policy failed.

[T]he Treasury market is a large, active market. Traders sell what the Treasury buys and buy what the Treasure sells, thereby reversing the change in yields that the Fed wants to achieve. The speculators profited from the Fed’s announcement, but lost if they held Treasury bonds very long. Soon bond yields were higher than before the announcement.

Meltzer looks at other problems tied to this near-term thinking, but concludes that, ultimately, politics is to blame. “From its very beginning the Federal Reserve Board has been the conduit for political influence.” This, coupled with constant attempts to lessen the role of Fed Bank presidents and directors (here’s looking at you Barney Frank) adds to the myopic outlook of the Fed and leads it to ignore money growth and long-term consequences. The dual mandate adds to the problem. However, Meltzer notes, that Volcker’s policy is still the best because “unemployment and inflation rise together.” So reducing inflation also brings down the unemployment rate. On this point

The longest period of low inflation and relatively stable growth that the Fed has achieved was the 1985-2003 period when it followed a Taylor Rule. Discretionary judgments, on the other hand, brought the Great Depression, the Great Inflation, numerous inflations and recessions. The Fed contributed to the current crisis by keeping interest rates too low for too long.

So here is the beginning of a long-term rule, clear and known, fixed and able to be enforced. Unfortunately, Dodd-Frank makes it worse, replacing fixed rules with discretionary rule by regulators. Instead, Meltzer notes, the key to reducing risks and failures of large banks is to “require more equity capital” tied to the size of the portfolio. “This proposal penalizes size to reduce large risks to the public.”

So Bagehot’s Rule, Taylor’s Rule, capital requirements evenly enforced can be the return of something called the rule of law. Unfortunately, as Meltzer concludes, “In my study of Federal Reserve History, it is rare to find the Fed making rational plans. The present is no exception.”