ECON430-Topic #1: SOTU, Sound Money, and the Fed

After watching the State of the Union address, and the GOP rebuttal, you should consider the role that the economic crisis played in getting us to this point. Obama didn’t mention many cyclical or monetary factors, but rather emphasized growth in his speech. Notably, the GOP rebuttal did address monetary policy when Paul Ryan called for sound money. Tom Iacono at Seeking Alpha discusses what Ryan is reaching for when calling for sound money in his speech and recent writings. Ryan is calling for the use of a basket of currencies to be used when setting monetary policy alongside an explicit inflation target. Changing the Fed’s policy mandate is a direct challenge to the current dual mandate of the Federal Reserve. Some members of the FOMC, such as Charles Plosser support changing to an explicit inflation target.

Questions you might try to think about:

  • I asked this question in a previous blog, but you might want to consider it here given Ryan’s recent comments. Should rules be set to manage monetary policy? If so, what or who would help out in times of crisis if you even think anyone should intervene. You might consider the case of Iceland to examine the aftermath of not bailing out the banking system as many other countries have done.
  • Would the Fed be changing it’s “easy money” stance if the U.S. inflation target were 2%? Would we still be doing QE1 and QE2?
  • If we were to switch to a strict inflation target, would the Fed be in danger of losing its independence?
  • Would the use of a strict inflation target help ‘anchor’ inflation expectations in the general public?

14 thoughts on “ECON430-Topic #1: SOTU, Sound Money, and the Fed”

  1. I think the fact that President Obama did not mention monetary factors in the cause of the economic crisis or, for that matter, at all in the State of the Union address says something about the difficulty of monetary policy decisions in itself…

    I think setting a rule may actually be worth a try. I’ve read many articles where the Fed was criticized for helping cause the crisis by keeping rates “too low for too long” [1]. Setting a rule will prevent this from happening however, I don’t think that rules based on a basket of currencies or an inflation target would be that easy to implement. I believe that the U.S. economy is “complex” [2] and going about enacting policy based off these rules would be hard to do timely and accurately, with lags and other factors to consider. Ultimately, the Fed would still have to make some discretionary decisions.

    It still might make money more ‘sound’ at least then it is now. Switching to an inflation target of 2% would certainly help anchor inflation expectations but who’s to say that we actually want that target in every state of the economy? For instance, right now we have unemployment at 9.4% and inflation nearing 2%[3]. One of those is going to have to give and, if the inflation target became a rule, it would have to be unemployment—which I frankly don’t ever see politicians agreeing to. In the end, this threatens the Fed’s dual mandate and also means that we would not be seeing QE2 had this been the case.

    [1]http://online.wsj.com/article/SB10001424052748703481004574646100272016422.html
    [2] Lecture 2
    [3] http://www.clevelandfed.org/research/data/us-inflation/mcpi.cfm

  2. Let’s break down the two parts of the question: If we were to switch to a strict inflation target, would the Fed be in danger of losing its independence?

    Inflation targeting it is a monetary policy mainly adopted by central banks to maintain price stability, which presumably would lead to employment creation and sustained economic growth. And according to Alesina and Summers central bank independence is both in terms of “political” and “economical” independence. The former means that the central bank is free of the government influence when selecting its policy objectives. And the later means that the central bank can use every monetary policy instruments without restriction.

    And the Fed has two functions: a macro responsibility of directing the monetary conditions and a micro responsibility of satisfying the individual members of the economy. I think on the first function, the Fed has always had independence, while on the second function it has been influence by the government, especially when economy is bad.

    I think on micro level the Fed may respond to the unemployment concerns of the government [to switch to inflation targeting for example] therefore, the ‘political independence’ of the Fed is influenced by the government. On the other hand, since the monetary policy won’t have measurable impacts on the economic growth [stabilizing the economy through targeting inflation] the Fed I think will retain its ‘economic independence’ in the long run.

    Sources:
    Charles Goodhart. The Evolution of Central Banks.
    Albert Alesina and Lawrence H. Summers. Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence.
    Gerald Epstein and A. Erinc Yeldan . Inflation Targeting, Employment Creation and Economic Development http://www.g24.org/pbno14.pdf

  3. Paul Ryan like any other politician is trying to appeal to the American public that the economy has not turned around with the “easy money” policies. He is trying to push for a different monetary policy but I doubt that at politician with B.A in Economics has a better understanding of what the economy needs than the Fed that is full Economics Phds. He can appeal to the average American by saying the fed is not turning the economy around. However, like all economics recession, it takes time for things to get better, no matter how involved the Fed may get. According to Bernanke it may take 4-5 years for just the job market to stabilize [2]. The Fed cannot make people or companies spend money to stimulate the economy. There is a lot of money on the sideline and “manufacturers are operating with 28% of their productive capacity going unused”[1]. I also believe that while unemployment is still at a very high rate, American’s will be hesitant to spend because the uncertainty of the future. I am not saying that unemployment rates need to go back to 4-5%, many economists believe that given the present state of the economy, this is not feasible anymore and those levels may never return. However, there is need for a more healthy unemployment rate where people are more optimistic about the future and it does not decline from 9.8 to 9.4 just because “labor force participation rate fell to yet another 26-year low” [3].

    [1] http://online.wsj.com/article/SB10001424052748703506904575592471354774194.html?mod=WSJEUROPE_hps_LEFTTopStories
    [2]http://online.barrons.com/article/SB50001424052970203793504576059972044372328.html
    [3] http://seekingalpha.com/article/245503-bumping-along-with-news-somewhere-in-between-good-and-bad

  4. When it comes to managing monetary policy, it’s hard to determine what policy is best because a real crisis cannot be foreseen. Although setting rules to help manage monetary policy seems like a great idea, what makes these rules best for all situations? With all rules, people make exceptions and there’s no denying that politicians would be able to find a way to bend them. For a rule-based policy, no one should ever intervene because that would defeat its purpose. With that being said, how could it possibly ever be completely effective?

    I agree with Paul Ryan that the solution to our crisis cannot be achieved by simply increasing the size of our government and it appears that all of the government spending has been ineffective in improving our economy. However, I think in order for an economy to show improvements, we need to allow more time to pass. If we look back to other times of crisis, we can see that an economy doesn’t turn around in a year or two. Whether Ryan’s belief of a limited government or the Presidents role in an active government is the “right” choice, we can’t really evaluate and conclude on effectiveness until more time has passed and all economic factors have adjusted.

  5. I agree with some of Paul Ryan‘s recommendations for a more efficient monetary policy. Inflation targeting has been successful in several countries and therefore is worth considering. Setting an inflation target reduces uncertainty in the economy and increases the Fed’s accountability. However, my biggest concern is that, to have the Fed operate under constrained discretionary reduces rescue options in times of economic crisis. For example, think of an economy where the inflation rate is at the set level but asset prices are rising rapidly. “What would be the Fed’s appropriate response in this situation?” Price stability is certainly a catalyst for economic growth and full employment but I think that in a world where financial markets have become immensely integrated the Fed needs to be extremely flexible. Setting rules will reduce the Fed’s ability to intervene fast and in time to avert any economic crisis. A strict inflation target does anchor inflation expectations but that is only when people trust that the central bank will actually hit the set target. As a result, setting rules for the Fed takes away the Fed’s independence and that can grave consequences if the economy is not experiencing growth. Paul Ryan further suggests using a basket of currencies, though the argument for sound money is strong, such a move leaves the US economy at the mercy of other countries’ monetary policies. The bottom line is setting rules for the Fed is beneficial only when the policy framework allows for long-run stable economic growth; and that is where the challenge is.

    [1] http://siteresources.worldbank.org/PGLP/Resources/Session8.pdf
    [2] http://www.federalreserve.gov/boarddocs/speeches/2003/20030325/default.htm

  6. As of right now, inflation is not here yet, with University of Michigan Inflation expectations around 2-3 percent and CPI up around 1.4 percent from a year ago.[1][2] It is undeniable that QE1 and QE2 had pumped money in to the system, but is the Fed getting the effect it wants with its monetary policies? I would say maybe not. As many people already argued, money multiplier has been below 1.0 for the past couple years, which means that one dollar spent would cause the output increase by less than that one dollar.[3][4]

    I do think, however, central bank intervention in a crisis like this is necessary because of couple reasons. First of all, in a big market down turn like this, it is important to anchor people’s faith in the system. Secondly, as much as everyone wants to avoid the moral hazard problem, to me slowly tearing off the band aid is a safer play than letting the market crash and cure itself. I would say that the economy is still in the initial phases of recovering right now, slowly unemployment rates dropping and total private hiring picking up.[5][6] Thus inflation might be ahead waiting for us, but an external push is appreciated to get us out of the recession instead of starting to target inflation and slip back into it. As time goes on, an inflation band may be a better choice than a set inflation figure, if it is needed at all.

    [1]http://research.stlouisfed.org/fred2/series/CPIAUCNS
    [2]http://research.stlouisfed.org/fred2/series/MICH
    [3]http://research.stlouisfed.org/fred2/series/MULT
    [4]http://seekingalpha.com/article/170170-money-multiplier-still-sending-deflation-signal
    [5]http://research.stlouisfed.org/fred2/series/UNRATE
    [6]http://research.stlouisfed.org/fred2/series/JTS1000HIR

  7. I do like the idea of inflation targeting, but not now when the unemployment rate is so high. Many people would take a move to inflation targeting, as the fed is not focusing on maximum employment anymore. Furthermore, inflation targeting would hurt the consumer. With import prices so low, in order to hit an inflation target the prices on domestically produced goods (such as food and services) will have to rise. This will hurt the domestic standard of living.

    However, there are many positives to be taken away from adopting an inflation target. First, it would calm people’s nerves about deflation and/or hyperinflation. Also, prices will be stable. Secondly, if the fed switched to an inflation target I don’t think that they would be losing any independence. Rather this would make the fed more transparent in what their motives are. I think in that sense the fed would actually gain some credibility.

    I believe if the fed does move to an inflation target they need to make it clear that in times of crisis or shock, that they have the ability to still use their tools at their discretion and not stick to the inflation target. The fed would still be doing quantitative easing if they had an inflation target of 2%, because slow and steady growth goes along with low inflation.

  8. I believe Paul Ryan’s call for an explicit inflation target is not an economically sound idea for many reasons. One in particular has to do with the rule-based system’s alleged benefit of controlling expectations. Many people have shown support for this policy under the belief that it will help to anchor inflation expectations [1], but I think it is important to realize that anchoring these expectations is not necessarily a good thing all the time. A more developed understanding of the relationship between unemployment and inflation suggest that the traditional Phillips curve is flawed because it assumes that both expected and unexpected inflation can change employment levels, when in reality only a unexpectedly high or low inflation rate will have real effects on employment [2]. Right now, it is widely accepted that the Fed has an implicit inflation target of 2% [3]. This allows for a sense of comfort for individuals, as the Fed has historically done a decent job of controlling inflation, while still allowing the Fed a measure of flexibility. However by making this target explicit the Fed would be giving up the ability to, at their own discretion, push inflation to an unexpectedly high level so as to fight unemployment. If forced to follow a set of rules, it would be impossible for the Fed to effectively combat unemployment even if the rules allowed for a deviation from the explicit rate in cases of emergency, because any inflation caused by Fed action would be predictable and therefore expected.

    1 – http://www.ecb.int/pub/pdf/scpwps/ecbwp273.pdf
    2 – http://www.google.com/url?sa=t&source=web&cd=8&ved=0CD8QFjAH&url=http%3A%2F%2Fwww.cabrillo.edu%2F~pharvell%2Fecon1a_files%2FSection%25204%2Fpc%2520notes.doc&ei=H65HTc3IAsOB8gbgyaCWBw&usg=AFQjCNHgzMvTOY-eJGFyG7d0hzh-qSXRAA
    3 – http://everydayecon.wordpress.com/2010/10/

  9. A long-term inflation rate target would help create price stability in the market and make policy decisions such as QE1 and QE2 more justifiable. Though the Fed has a current goal of 2% inflation, making that explicit would help anchor expectations with the public [1]. Despite this target, the Fed should have some discretion in deciding short-term monetary policy in times of crisis. Discretion should be used sparingly, however, as New Classical theory would argue discretionary policy would cause great inefficiency in the market [2]. Without this flexibility, the Fed would lose its independence and congress would ultimately dictate monetary policy. This would strengthen the criticism that the Fed is effectively printing money to service the national debt.

    I do realize, however, that adopting an inflation target would take the focus off of “maximum employment” and increase the focus on inflation. This provision of the Fed mandate is a very ill-defined as is and if one believes that there exists a natural rate of unemployment then price stability should bring markets to equilibrium. Rand Paul seems to emphasize that “sound money” would reduce uncertainty and increase investment in the market [3].

    [1] http://online.wsj.com/article/SB10001424052748703921504576094460047100354.html
    [2] Lecture 2
    [3] http://online.wsj.com/article/SB123595257066605147.html

  10. More importantly than anything President Obama had to say during the State of the Union is the idea that the Fed may move to a policy that would try to regulate an inflation rate. A strict inflation target would definitely help “anchor” the public’s expectations of inflation until reports of inflation are released that are over and under the target. It can take a long time for a monetary policy to affect inflation [1]. The time it usually takes for the policies to have some effect tends to be one to three years, but sometimes even longer [1]. Over this time period many things can happen and in the end the original monetary policy used may no longer be the right one and therefore may over or under-shoot the inflation target. Take the Bank of England for example; they have set an inflation rate target of 2%, much like what the U.S. Fed may do, and they are now dealing with an inflation rate of 3.5% [2]. This is almost double what their goal originally was and just goes to show that controlling the inflation rate is easier said than done.
    I do not think that the Fed would be in danger of losing its independence, but because of the reasons I stated above, I do think it would be losing some of its effectiveness. The Fed would still be able to conduct monetary policy although any type of quantitative easing would most likely have to stop. Quantitative easing puts more money into the economy which in turns raises inflation so I do not think the Fed would take the chance of over-shooting their inflation by doing quantitative easing again.

    [1] http://www.frbsf.org/publications/federalreserve/monetary/affect.html
    [2] http://online.wsj.com/article/SB10001424052748703921504576094460047100354.html

  11. I do not believe we need an explicitly defined inflation target of 2%. The Fed would like to keep inflation low, as the broad consensus is in support of the “principle that maintaining a low and stable inflation rate provides lasting benefits to the economy “[1]. I can only assume the intellectuals at the Federal Reserve by now have keyed in on the fact that high inflation only leads to increased political, social, and economic instability – as a full recovery from high inflation can be painful and take years (late 70’s to early 80’s). Therefore, I am sure the Fed took stagflation into consideration when implementing QE1 and QE2.

    With the soft inflation target implicitly set around 2%, we allow the Fed more flexibility to uphold its mandate through monetary policy. The decade prior to the latest financial crisis, the Fed was able to keep a narrow range of inflation of about 2%, which was predictable and led to consistent investment in employment [3]. The mandate’s objectives are to maximize sustainable employment and moderate long-term interest rates in addition to price stability [1 & 2]. By explicitly targeting an inflation rate, the Fed may no longer be able to alter unemployment levels (even though the unemployment levels are inaccurate due to the new federal unemployment extensions), thus failing to uphold their mandate.

    [1] http://www.federalreserve.gov/newsevents/speech/mishkin20070410a.htm
    [2] http://online.wsj.com/article/SB10001424052748703921504576094460047100354.html
    [3] http://www.usinflationcalculator.com/inflation/historical-inflation-rates/

  12. I believe a targeted inflation rate of around 2% could be very beneficial in stabilizing our economy. Like in England the government is striving for economic growth in GDP and lowering unemployment, and believe using monetary policies to keep the inflation rate as close to 2% is the best solution. [1] This does limit the Fed’s independences, but why would they need their independence when the are here to do a job. The Fed’s job is to stabilize the economy and with a set target they can do just that, what independence is needed? From elementary economic studies we know that high inflation slows economies and low inflation can lead to liquidity traps [2] so we need to stay find a medium that is suitable to accommodating growth and avoidances of these traps. To stabilize the economy I feel as if this targeting will be a successful way to have predictability for the markets. The fed has always inexplicitly sought after these inflation goals but never announced specific targets so why not officially target to knock out uncertainty. Charles Plosser the president of the Fed in Philadelphia is a huge advocate of targeting rates and loves the “anchoring of expectations” it implies[3]. These anchored expectations can lead to increased consumer spending and investing because of confident outlooks. To me it seems as if targeting inflation can be a really positive way to increase GDP and possibly lowering unemployment.

    [1].http://www.bankofengland.co.uk/monetarypolicy/framework.htm
    [2].http://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf
    [3].http://online.wsj.com/article/SB10001424052748703921504576094460047100354.html

  13. I think the use of a strict inflation target would definitely help anchor inflation expectations in the general public. The media is an effective tool when conveying information to the masses and an announcement of a specific inflation target, such as 2%, would spell a lot of uncertainty. New Push at Fed to set an Official Inflation Target reports an inflation target helps in “making investment and spending decisions simpler,” and, “provides more accountability than vague pledges of ‘price stability'” [1]. Investors would be able to anticipate interest movements because of the target as they would have an idea of what the Fed’s actions would be. The Fed’s actions would also be less likely to be judged or berated as their direct goals would be public knowledge. Thus the current quantitative easing would be more generally accepted. Ultimately however, an inflation target does not ensure a specific amount of inflation. The Bank of England is a prime example, experiencing inflation of 3.5%, despite a target of 2%. This allows the Fed some flexibility in achieving its dual mandate, specifically low unemployment. At this point in time a strict inflation target will allow investors peace of mind and encourage a faster economic rebound than if the Fed maintains its ambiguous soft inflation target. If the target is going to be around 2% anyway, why not set it in stone and alleviate all the uncertainty?

    [1] http://online.wsj.com/article/SB10001424052748703921504576094460047100354.html

  14. I believe it would be ill advised for the Fed to adopt a hard stance on an official target inflation rate. One reason is that it limits the Fed’s flexibility with regards to their discretionary policy making, especially in times of unforeseeable crisis; the Fed can surely act swiftly to mitigate the damage if not bound by rules and regulations. Although an explicit target inflation rate might help ease stability and “anchor” public expectations [2], such policy is not conducive of the governments congressional mandate of maximum unemployment. The current unemployment rate is at 9.1% [1], which is certainly not the highest it’s been in recent years but is not considered low for the “public.” I believe the Fed’s biggest battle not lies in targeting the inflation rate but rather targeting the unemployment rate, which can be approximated at around 7.3% [3]. By adopting a rule to regulate the Fed’s inflation rate, it would negate the effectiveness of QE2. This is due to the Fed’s clear intention of keeping the value of the dollar low to push unemployment down through exports and manufacturing activities [3]. Furthermore, I believe that a drop in the unemployment rate will build faith in the central bank and provide the political stability that an official inflation target would bring. Lastly, Mishkin urges that we focus on lowering unemployment most importantly as he describes high unemployment as “associated with human misery, including lower living standards and increases in poverty as well as social pathologies such as loss of self-esteem, a higher incidence of divorce, increased rates of violent crime, and even suicide [4].”

    [1]http://www.google.com/publicdata?ds=usunemployment&met=unemployment_rate&tdim=true&dl=en&hl=en&q=current+unemployment+rate
    [2] http://online.wsj.com/article/SB10001424052748703921504576094460047100354.html
    [3] http://seekingalpha.com/article/236955-how-qe2-can-bring-down-unemployment
    [4] http://www.washingtonpost.com/wp-dyn/content/article/2010/11/17/AR2010111705316.html

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