The perils of monetary policy and its discontents

Excessive criticism could harm stabilisation policy

The long-awaited return to greater price stability is underway. Politicians, economists and analysts have understandably turned their focus to monetary policy in recent years, which has received withering critique from many angles.

In a recent Republican presidential candidate debate, Florida’s Governor Ron DeSantis declared: ‘I’m also going to rein in the Federal Reserve. They have helped create with their reckless monetary policy what we have faced since the Covid-19 pandemic… They botched it… The Fed should focus on stable prices. They are not an economic central planner for the American people.’

Other critiques abound. Central banks let inflation get out of hand, necessitating the shift to painful steep rate hikes. Recent central bank portfolio losses represent a fiscal burden and demonstrate the lack of wisdom in deploying quantitative easing and accommodative monetary policy. Monetary and fiscal policies overlap and governments should coordinate the two. Central bankers are unelected, lacking accountability.

Many of these critiques contain elements of truth, but they often reflect complaints rather than solutions. Though debate will hopefully stimulate reviews of where central banks went wrong and how monetary policy frameworks might be improved, societies must guard against unbounded complaints harming stabilisation policy and public welfare.

Unprecedented circumstances

The Fed and European Central Bank were obviously late in tackling inflation. Bill Dudley, former Federal Reserve Bank of New York president, recently gave the Fed an ‘A-’ for where it stands now, but a ‘D-’ for its tardiness. Yet, allegations the Fed is not pursuing price stability and is engaged in central planning could only come as a shock to the Federal Open Market Committee. Further, suggestions that a ‘dual’ – rather than ‘single’ – mandate does not allow sufficient focus on price stability would cause added astonishment given that there is no inconsistency between full employment and price stability.

While major central banks are lambasted for their foibles in excessively viewing pandemic inflation as transitory, second guessers are loathe to acknowledge that major central banks faced unprecedented circumstances. Supply chain disruptions, the enormous shift from demand for services to goods and then back to services associated with the pandemic, and Russia’s subsequent invasion of Ukraine and its impact on commodity prices were extraordinary developments. These forces extend well beyond demand pressures for which monetary policy is best equipped. Generous fiscal support was also a factor, as Larry Summers and Olivier Blanchard have argued.

With interest rates having steeply risen across all maturities, central banks are now incurring large portfolio losses. Critics legitimately argue these losses are in part a fallout from the highly accommodative policies of the last 15 years, including quantitative easing, and could strain fiscal authorities because some central banks may need to be recapitalised or at least will not provide seignorage profits to Treasuries. But central bank profits, at least in the US, have been quite large in past years, swamping current losses.

Figure 1. Central bank profits outweigh losses in recent years

Federal Reserve operations and US Treasury remittances

Source: Federal Reserve Board

Further, central bank profits and losses are not ends in and of themselves. Rather, these are incurred in conducting monetary policies aimed at fulfilling mandates.

At times, the underlying debate appears to be about the wisdom of QE. But just as rate policy is a monetary policy tool, the same is true of balance sheet policy. Given deflationary shocks and central banks operating at the zero or effective lower bound, QE can be seen as having brought spreads down, boosted wealth effects and enhanced monetary policy transmission. The distributional consequences of QE will warrant reflection in central bank reviews. Still, central banks had little choice but to forcefully use all tools in pursuit of their mandates, even if it was not as effective as with rate policy. Now, the Fed and ECB face tough choices about quantitative tightening and shrinking balance sheets.

Fed ‘independence’

Explicit coordination of monetary and fiscal policies could be a dangerous slippery slope. For example, US fiscal policy is an utter mess, reflecting both major political parties’ unwillingness to behave responsibly. Coordination in this context could simply mean pressure from politicians on an ‘independent’ Fed to purchase Treasuries and shield themselves from the consequences of their inattention to stabilisation policy.

Fed officials are also criticised as unelected, unaccountable and ‘independent’. Though its officials are indeed unelected, the Fed operates in an accountability framework. Fed governors are nominated by the White House and confirmed by the Senate, just like the Secretary of the Treasury. The Fed’s dual mandate was Congressionally established. The chair is required to testify twice a year before Congress. That is but the tip of the iceberg of Fed interactions with the legislative branch. The Fed’s ‘independence’ is thus limited to its instruments, not its goals. However, regional Fed presidents are not subject to this accountability framework.

Undoubtedly, there are many other critiques that can be levelled at central banks. Regardless, economies require flexible tools for stabilisation policy. In the US, for example, fiscal policy cannot play that role, except perhaps in crises, given executive and legislative branch disarray and administrative lags. Thus, monetary policy must assume that flexible role – even if central banks are hardly infallible. That doesn’t mean that central bank practices, let alone the Fed’s, should remain as they are – further steps can be taken to strengthen accountability frameworks, improve transparency and communications, better forecasting techniques and fortify monetary policy frameworks.

Central banks have an obligation to conduct strenuous reviews and improve their operations, but critics should be careful not to throw out the baby with the bathwater.

Mark Sobel is US Chair of OMFIF.

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