The president nominated Janet Yellen, a friend and former colleague, to be the next chairman of the Federal Reserve. I expect she will marshal her strong intellect, meticulous preparation and ample experience to lead the central bank successfully.
In the coming weeks and months, financial-market participants will try to gauge whether the change in personnel at the Fed means a change in policy. In particular, they will seek to divine whether Ms. Yellen's views on quantitative easing will lead to still more asset purchases and a longer period of near-zero interest rates.
This line of inquiry is understandable, but the fate of monetary policy and the economy is about much more. The critical issues go to the very remit of the Fed, the efficacy of its tools, its rightful place in government, and its role in the global economy. Allow me to highlight—and then question—some of the prevailing wisdom at the basis of current Fed policy:
• Quantitative easing is nothing but the normal conduct of monetary policy at the zero-lower-bound of interest rates. Lowering short-term rates to bolster economic growth is a traditional tool of central banking. But QE is qualitatively different. The purchase of long-term assets from the U.S. Treasury to achieve negative real interest rates is extraordinary, an unprecedented change in practice since the Treasury-Fed Accord of 1951.
The Fed is directly influencing the price of long-term Treasurys—the most important asset in the world, the predicate from which virtually all investment decisions are judged. Earlier this year the notion that the Fed might modestly taper its purchases drove significant upheaval across financial markets. This episode should engender humility on all sides. It should also correct the misimpression that QE is anything other than an untested, incomplete experiment.
• The absence of higher inflation is sufficient license for the Fed to continue its present course. Low measured inflation and anchored inflationary expectations should only begin the discussion about the wisdom of Fed policy, not least because of the long and variable lags between monetary interventions and their effects on the economy. The most pronounced risk of QE is not an outbreak of hyperinflation. Rather, long periods of free money and subsidized credit are associated with significant capital misallocation and malinvestment—which do not augur well for long-term growth or financial stability.
• The Fed's exit from extraordinary monetary accommodation is about having the tools to drain excess liquidity. Market participants do not doubt the Fed's capabilities as an expert financial plumber. But the foremost attributes needed by the Fed to end its extraordinary interventions and, ultimately, to raise interest rates, are courage and conviction. The Fed has been roundly criticized for providing candy to spur markets higher. Consider the challenge when a steady diet of spinach is on offer.
• The conduct of monetary policy should take the rest of Washington's macroeconomic policies as given. In normal times, central bankers do just that. But these are not normal times.
The administration and Congress are unwilling or unable to agree on tax and spending priorities, or long-term structural reforms. They avoid making tough choices, confident the Fed's asset purchases will ride to the rescue. In short, the central bank has become the default provider of aggregate demand. But the more the Fed acts, the more it allows elected representatives to stay on the sidelines. The Fed's weak tea crowds out stronger policy measures that can only be taken by elected officials. Nobel laureate economist Tom Sargent has it right: "Monetary policy cannot be coherent unless fiscal policy is."
• Highly accommodative monetary policy through QE provides broad support to the economy. Most do not question the Fed's good intentions, but its policies have winners and losers, which should be acknowledged forthrightly.
The Fed buys mortgage-backed securities, thereby providing a direct boost to balance sheet wealth of existing homeowners to the detriment of renters and prospective future homeowners. The Fed buys long-term Treasurys to suppress yields and push investors into riskier assets, thereby boosting U.S. stocks.
The immediate beneficiaries: well-to-do households and established firms with larger balance sheets, larger risk appetites, and access to low-cost credit. The benefits to workers and retirees with significant fixed obligations are far more attenuated. The plodding improvement in the labor markets offers little solace.
• The Fed makes domestic decisions for the domestic economy. Yes, but the U.S. is the linchpin of an integrated global economy. Fed-induced liquidity spreads to the rest of the world through trade and banking channels, capital and investment flows, and financial-market arbitrage. Aggressive easing by the Fed can be contagious, inclining other central banks to ease as well to stay competitive. The privilege of having the dollar as the world's reserve currency demands a broad view of global economic and financial-market developments. Otherwise, this privilege could be squandered.
• "Forward guidance" is a new, independent tool at the vanguard of central bank policy-making. Since QE began, Fed policy makers have tried to explain that asset purchases and interest rates are different. Hence their refrain that tapering is not tightening, and that very low interest rates will continue after QE. Investors do not agree. Once the Fed begins to wind down its asset purchases, these market participants are likely to reassert their views with considerable force.
Recently, the Fed has elevated forward guidance as a means of persuading investors that it will indeed keep interest rates exceptionally low even after QE. Forward guidance is intended to explain how the central bank will react to incoming data. Fed projections for example, may show below-target inflation and a residual output gap justifying very low interest rates several years from now. But words are not equal to concrete policy action. And the Fed hasn't received many awards for prescience in recent years.
• Transparency of the central bank is an abiding virtue in the conduct of policy. Full disclosure of its balance sheet and operations is essential to the Federal Reserve's democratic legitimacy. But transparency in communications about future policy is not a virtue unto itself. The highest virtue is getting policy right. Given manifest uncertainties about the state of the economy, oversharing policy deliberations is not useful if markets are led astray, or if public commitments reduce policy makers' flexibility to call things the way they see them.
The Fed is a powerful institution, but its powers are neither unilateral nor unbounded. The president has nominated a person with a well-deserved reputation for probity and good judgment. The period ahead will demand these qualities in no small measure.
