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Alexander William Salter: Modernizing Monetary Theory

The Fed can’t be left to police itself. If Republicans take control of Congress in January, taming inflation should be their top priority. Consumer prices rose 8.5 percent year over year in July. Other measures are somewhat less dire but still unacceptably high — the Federal Reserve's preferred index is up 6.8 percent and, food and energy excluded, consumer prices are up 5.9 percent. This presents the GOP with an opportunity to do well by doing good. By rallying behind sound money, Republicans can solidify their coalition, gain legislative momentum, and set the stage for 2024.

The primary culprit for inflation is the Federal Reserve. Yet central bankers ultimately answer to elected officials, meaning the buck stops with Congress. As Covid raged, Fed policy-makers thought they had a responsibility to support exorbitant government spending; $3.3 trillion in government bonds wound up on the Fed's balance sheet over the last two years, about 55 percent of the budget deficit over that period. As a result, the M2 money supply rose from $15.5 trillion in March 2020 to $21 trillion at the end of fiscal year 2021, massively outpacing the market's demand for liquidity. When the supply of money grows faster than the demand to hold it, inflation almost always follows.

As the party that spent two years playing footsie with modern monetary theory, Democrats largely made this mess. Republicans can perform the nation a major service, and look good doing it, by cleaning up.

The Federal Reserve is largely a failed institution. Despite more than a century of experience, it remains inept at basic monetary policy, let alone extraordinary measures such as last-resort lending. Yet politics is the art of the possible, and in all likelihood the Fed isn't going anywhere. Reforming it is the best option.

Congress is responsible for setting the Fed's objectives. The central bank's mandate of full employment and price stability comes from a 1977 act of Congress. Furthermore, legislative involvement in central-bank governance is fairly common. The Federal Reserve Act has been amended more than 200 times. Congress can and does oversee monetary policy. It's time for legislators to rein in the Fed. The goal should be a single monetary-policy mandate.

As my co-authors and I argue in Money and the Rule of Law, a binding target is the best way to achieve both macroeconomic stability and democratic accountability. In terms of effectiveness and justifiability, rules are better than discretion.

Monetary policy-makers face a host of knowledge problems that make case-by-case decisions highly fallible. Central bankers cannot possibly acquire the information needed to tailor the money supply to money demand in real time. Conducting discretionary monetary policy is like navigating a maze while blindfolded. Even for the best-trained and most accomplished macroeconomists, the knowledge burdens are insurmountable. Remember all the reputable Fed officials who insisted that inflation was transitory.

We must also remember that the Fed isn't run by angels. Central bankers often confront perverse incentives, making discretionary policy even worse. The Fed is first and foremost a bureaucracy. Internal to the central bank, policy-makers' operating environment pressures them to advance the interests of Fed officials, which often diverge from the interests of the general public. There are also pressures external to the central bank. Politicians, other bureaucrats, and private financiers demand accommodative policy. In contrast, there's no pressure group for general market stability. It's no surprise that we get policies (bailouts and credit allocation are good examples) that concentrate benefits on elites while imposing costs on everyone else.

This is why we can't allow the Fed to self-police. By acting as a judge in its own cause, the Fed has become habitually irresponsible. Republican legislators can and should tighten the Fed's leash.

We need sound monetary policy to whip inflation. Congress should amend the Federal Reserve Act to force the central bank to hit a specific target — one that would not be subject to revision by the Fed.

A single mandate would mitigate information and incentive problems. Information-wise, a rule-bound Fed needs only to set the background conditions for markets to flourish — no technocratic tinkering necessary. Incentive-wise, a binding rule minimizes opportunism. Bureaucrats can't bungle and special interests can't lobby if the Fed has no room to grant favors.

Two options for the Fed's mandate are particularly promising. The first, an inflation target, is better politics. The second, a nominal-expenditures target, is better policy.

An inflation target is exactly what it sounds like: Congress picks a specific range for inflation, requiring the Fed to stay within it each year. Unlike the Fed's previous, half-hearted attempts at targeting inflation, a congressional mandate would keep the central bank on the straight and narrow. The easiest path would be to remove the full employment plank from the Fed's mandate, requiring it to focus solely on price stability. A recent bill introduced by two Republicans, the Price Stability Act of 2022, does just that.

Legislators should also specify what price stability means, in terms of the inflation rate they expect the Fed to hit. Two percent is a popular figure among economists, but there's nothing special about it. Even a completely stable dollar — 0 percent inflation — can work, so long as the rule is credible.

An inflation target stabilizes the economy by neutralizing shocks to aggregate demand (GDP valued at current market prices). When the demand for liquidity unexpectedly spikes, the Fed can expand the money supply to keep the economy at full employment.

The downside of an inflation target is that it increases the economy's vulnerability to supply shocks. If crucial inputs, such as energy, suddenly become scarcer, prices will rise. This will force the Fed to contract aggregate demand to bring inflation down. The result is a double whammy to output and employment.

This isn't necessarily a deal-breaker. By committing the Fed to a stable path for inflation, Congress can anchor expectations about the dollar's purchasing power. This promotes long-term contracting, which boosts capital accumulation and economic growth. A binding inflation rule could be worth the occasional supply-side headache.

But we shouldn't be so quick to overlook the Achilles' heel of an inflation target. In an era of increasing geopolitical instability, we can expect recurrent problems for global supply chains. Suddenly that headache feels more like a migraine. This is where the alternative mandate shines: By forcing the Fed to target aggregate demand directly, in the form of total spending on goods and services (nominal GDP), Congress can get the upsides of an inflation target while avoiding some of the downsides.

When aggregate demand fluctuates, a nominal-spending target works the same as an inflation target. But when aggregate supply fluctuates, a nominal-spending target works better. Rather than kicking the economy while it's down, the Fed permits rising prices to absorb some of the blow from falling output and employment. The result is an intermediate downturn rather than a severe recession. The catch, of course, is temporarily elevated inflation, which is always unpopular.

Economic theory strongly suggests that a nominal-spending target is superior to an inflation target. But members of Congress aren't answerable to economists. Stabilizing GDP at current prices is more opaque to the general public than stabilizing the dollar. For the rule to succeed, citizens must buy into it. An inflation target might be the best we can get. If so, fine. It's better than nothing.

Then again, perhaps a savvy statesman could sell the public on the benefits of nominal-GDP targeting. The key is communicating why higher prices with stronger employment is preferable to lower prices with weaker employment. For those without jobs, cheap goods are small consolation. Everything hinges on the trade-offs the public is willing to bear.

Whichever rule Congress chooses, it needs provisions for its enforcement. A rule without teeth is no rule at all. Legislation creating a target for the Fed should include a way to discipline incompetent or recalcitrant central bankers. This is why the Fed's previous, self-chosen inflation targets failed. Because the Fed voluntarily adopted the rule, it was merely a guideline and could be abandoned at the Fed's pleasure. That must not be an option anymore.

Inflation has Democrats in disarray. Their legislative agenda has stalled. President Biden's popularity has sunk to new lows. A CNBC poll shows his approval rating on the economy down to an abysmal 30 percent. Republicans are uniquely positioned to become the party of economic sanity. Embracing sound money is the place to start.

A single mandate would work even better with supporting legislation. Congress needs to get spending growth under control. Fiscal profligacy invites money mischief. Also, the Fed's regulatory duties need an overhaul. Central bankers somehow got the idea that their supervisory responsibilities included climate change and racial justice. Legislators should strike down this brazenly elastic interpretation. Prudent Republicans will also anticipate and block their own party's temptations to misuse the Fed, for example by financing industrial policy.

Americans want to see that their representatives are serious about curbing inflation. A binding monetary target, including penalties for missing it, is a winning policy for the GOP. Legislators have permitted the Fed to be a judge in its own cause for long enough. By bringing the Fed to heel, congressional Republicans can enshrine the rule of law in monetary policy and create a strong foundation for economic prosperity.

Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics in the Rawls College of Business at Texas Tech University, a research fellow at TTU's Free Market Institute, a Sound Money Project senior fellow, and a Young Voices senior contributor.

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Posted: August 25, 2022 Thursday 04:28 PM