The Fed: What Should We Do?

There were two articles out on Wednesday morning that discussed the Federal Reserve and the role of the Federal Reserve in the economy. One was in the New York Times and focused upon Paul Volcker, “To Treat the Fed as Volcker Did,” and the other was in the Financial Times, “Deflation risk boosts case for inflation target." Each of the articles recommended that the mandate of the Federal Reserve be changed from focusing upon inflation and full employment to just focusing upon inflation.

The basic argument of the articles is that focusing upon keeping inflation low and unemployment low is “structurally contradictory,” to quote the New York Times article. Whereas I agree with the fact that forcing the Fed to attempt to achieve these two objectives is “structurally contradictory” and that this dual mandate should be eliminated, I believe that we need to go even further in terms of the Fed’s mandated objective.

The Federal Reserve should be concerned with stable prices but there are problems with the use of inflation as the target of monetary policy. One of the problems is measurement. To use the Consumer Price Index [CPI] is troublesome. First, it is an index and is a constructed measure. Since it is an attempt to measure what happens during a period of time it is constructed in terms of “flow” variables and not “stock” variables.

The major example of this is the price of housing, which needs to be the price of a “flow.” The flow of housing services consumed by consumers over a period of time, and not the price of the “stock,” simply the price at which a house sells for. Since there are many owner occupied houses in America, the price of the housing services like rent, must be estimated. How good this estimation is, particularly during a bubble like the one we have experienced in the past eight years, is questionable. In addition, the rental component is a relatively large one in the CPI because the consumption of housing services is a large portion of the consumer’s budget.

Second, there is the question about whether or not we should be concerned with the total CPI or only with the “core” CPI. By eliminating two of the more volatile components of the CPI, we certainly get a more stable view of the movement in the prices of basic consumer goods. However, does this really reflect the true rate of inflation that the consumer has to live with?

A third point alluded to above, is the problem of “asset bubbles.” Asset bubbles occur in asset prices, not the price of the services…like the price of a house, not the rent one pays for the services one consumes over a period of time. Policymakers have a problem focusing on, say, rental prices, and the price of assets at the same time. There is no measure to balance the behavior of the two prices in terms of policy decisions. Hence, the dilemma that the Federal Reserve’s Open Market Committee has in making decisions as to the stance of monetary policy. Thus, I have problems with the idea that the central bank should focus on an inflation target as the sole objective of monetary policy.

What, then, do I recommend as a policy target for the Federal Reserve in its conduct of monetary policy? I believe that the policy target of the Federal Reserve should be the value of the United States dollar in foreign exchange markets. My support for this is…none other than…Paul Volcker. Volcker has written that

A nation’s exchange rate is the single most important price in its economy...So it is hard for any government to ignore large swings in its exchange rate….

[This quote is from the book by Paul Volcker and Toyoo Gyohten, Changing Fortunes: The World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), page 160.]

There are two basic reasons for the Fed to focus on the nation’s exchange rate. First, a nation’s exchange rate is based upon the expectations of market participants. Market participants have expectations about relative rates of inflation in different countries around the world and are willing to put their money out into the market based on these expectations. The inflation rates they are interested in are not only related to “flow” prices but to “stock” prices, as well. Thus, international investment managers move money around based upon inflation in asset prices as well as consumer prices.

The value of the United States dollar began to decline in early 2002. It declined almost steadily - with some periods of stability - into the summer of 2008. Something was going on in the United States economy relative to other countries during this period of time. As Volcker argues, “it is hard for any government to ignore large swings in its exchange rate,” and yet the United States government did just that!

My point is that participants in international financial markets were trying to tell us something. Market participants reacted to the huge deficits created by tax cuts and the ‘war on terror’ and the extremely low interest rates supported by the Federal Reserve by selling dollars. In terms of inflation, they were telling us that the inflation, taking place in the United States was going to be substantial relative to the inflation that was going to occur in other countries. Although this inflation did not seem to get out-of-hand in terms of the Consumer Price Index, other things going on in the United States, like the housing bubble, did.

Markets tell us something and we need to pay attention to them! Markets swings are based upon future expectations rather than on historical data as is used in the construction of price indices. We need to observe market prices and attempt to understand what the market is trying to tell us. My argument is that this is more relevant to the conduct of monetary policy than is focusing upon an inflation rate based on the historical record. I agree with Volcker's statement that:

A nation’s exchange rate is the single most important price in its economy.

Therefore, I believe that the Federal Reserve should target the value of the United States dollar for the conduct of monetary policy. This does not mean that the target should be a fixed one. Conditions change, the economic policies of other countries may vary, and there may be other reasons such as the pricing of oil by the oil cartel or war breaking out somewhere in the world.

In addition, this leads to my second point, which is that the United States must act as a partner in the world. Focusing upon the exchange rate forces the policy makers, when they are determining the direction of monetary policy, to consider what other nations are doing. America has ignored other nations over the past eight years until the current crisis began to unfold. We cannot afford to go forward into the future independent of what the rest of the world is doing. See my post of November 1, 2008, “The Need for an American Economic Strategy.”

One final point about the Federal Reserve at this time: I believe that Chairman Ben Bernanke should step down as Chairman of the Board of Governors of the Federal Reserve System so that the new President can appoint a Chairman of his own choosing. Confidence and trust is going to be important for the success of the new President and I do not believe that Bernanke provides these commodities. My own choice for the new Chairman of Board of Governors is Timothy Geithner, the current President of the Federal Reserve Bank of New York. Geithner is not an academic and has been through many storms, not only in his current position, but also in the Rubin Treasury Department. I think he would be an excellent choice and would come into the position with the confidence and trust of participants in international financial markets as well as in governmental circles around the world.