By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
In reaction to the OPEC-engineered oil price spikes of the 1970s, which economists would depict as external negative supply shocks to the US economy, the Fed pursued expansionary policy with an eye to insulating US income. The unintended consequences were the double-digit inflation of the late 1970s and then the anti-inflation fight and the painful, costly recession of the early 1980s. As a result of this episode, central banks increasingly pursued inflation-only targeting.
Since at least the early 1990s, the US has experienced a positive long-lived external positive supply shock. Globalization and a semi-fixed dollar exchange rate led to imported disinflationary pressures. Employment and capital utilization rates came under pressure as US manufactured goods were replaced by lower-cost alternatives in the US and world markets. The Fed uses so-called Taylor rules to evaluate where to set interest rates, and those lead it to focus on unemployment, inflation and inflationary expectations. It set interest rates policy as if the downward pressure on inflation and employment stemmed from declines in demand by US based economic agents and were not the result of increased external supply. To put it more simply, its implicit US-only focus meant it ignored how a rising level of cheap imports was keeping US prices lower than they would be otherwise.
This incomplete assessment in turn led it to set an overly expansive monetary policy and convince itself that all was well when imbalances were building up in the US and with our trade partners. The Fed succeeded in temporarily stabilizing inflation and US GDP (the Great Moderation). However, it failed to exercise its regulatory and supervisory responsibilities even as monetary policy encouraged the buildup of leverage and maturity mismatches. Of equal importance, monetary policy promoted growth via asset price inflation and debt-financed spending even as purchases of final goods and services by US based economic agents exceeded US potential output by as much as 6% and the trade deficit- to-GDP ratio exceeded levels associated with crises. In short, expansionary Fed policy (largely driven by the impact of globalization) contributed to financial instability, depressed private savings and encouraged the unsustainable trade deficit. Once again, unintended consequences of monetary policy were very costly.
The Fed repeated the policy mistake it made in response to the OPEC oil shocks of the 1970s. It tried to use tools of domestic counter-cyclical aggregate demand management to insulate US incomes and prices from an external supply shock. Only this time it was positive supply “shock” was structural i.e., globalization.
After almost two decades of “A strong dollar is in the US interest,” the Fed setting policy as if US prices and incomes were exclusively determined domestically and the trade deficit reaching 6% of GDP in 2005-6, US policymakers have finally started to wake up to the fact that US is not an economic island.
But what has the Fed learned? QE2 is another attempt to increase US GDP and employment by generating additional domestic demand via asset price increases and wealth effects, but the wealth effects are likely to be small and fleeting. (See Hussman here.) More to the point, the Fed has also apparently decided to use QE2 to de facto exceed its legal mandate and co-opt Dollar policy. Fed is apparently setting policy with an eye to reducing the value of the dollar relative to other currencies in order to promote income growth. In short, after decades of setting policy as if the dollar and the rest of the world did not matter, the Fed now wants to manipulate the value of the Dollar and alter the global financial landscape. In doing so, it risks both the consequences of a setting off a change cascade of competitive currency devaluations as well as importing inflation. It also reduces incentive to of the Executive and Legislative branches to act while at the same complicating what is their job.
The global response to this attempt to shift the cost of adjust on to other countries has been decidedly negative. After enjoying all the benefits of the “exorbitant privilege” associated with being the bank of issue of the world’s reserve currency, the Fed now seeks avoid the responsibilities that go along with being the issuer of the reserve currency. It is as if the Fed wants to prove that there is a “free lunch” after all.
What should the Fed have done in the 1970s, during the bubble years? What should it do going forward? Bernanke recently wrote in a Washington Post Op-Ed: “The Federal Reserve cannot solve all the economy’s problems on its own.” The Fed should have acted in a manner consistent with that observation in the 1970s and through the bubble years. It should act that way now.
The Fed is ill-equipped to deal with external supply shocks and imbalances. The Fed should not have tried to insulate the US from the global developments. It should have passed the ball to those responsible for external economic policy: Treasury, the White House and the Congress.
Would unemployment have been higher given globalization and in the absence of the Fed policy response? Yes, but not as high as it is now. Would the US have experienced asset price bubbles and a financial crisis? It is possible, but they would not have been as large or destructive. Would the Fed be faced with the need to employ unconventional monetary policy? It is very unlikely. If the Fed had not masked the affects of globalization on the US economy, the appropriate policy makers would have had more pressing incentives to address the external imbalances. Furthermore, the policymakers would have been addressing imbalances more manageable in size and without the complications of the financial crisis.
The Fed is ill-equipped to deal with external supply shocks as witness by the unintended consequences of polices pursued in the 1970s and then during the years prior the recent crisis. It should avoid policies that seek to offset or correct external developments.
The Fed should refocus its efforts on its regulatory responsibilities and on offsetting swings in domestic animal spirits that might adversely affect US economic performance. Fed policy should not be aimed changing the global economic landscape. Given history and the limitations of monetary policy, the Fed should stand aside and leave external economic policy to the appropriate elected officials.