Arnold Kling  

Blaming the Fed

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Bryan writes,


the effect of the exchange rate on the price of gas turns out to be enormous. Our present search for scapegoats is deeply misguided, but a few people really are personally responsible for the high price of gas. Contrary to popular opinion, though, they aren't CEOs in the oil industry; they're the leaders of the Federal Reserve System. It's easy to point fingers; but sometimes finger-pointing is right on target.

The fact that the depreciation of the dollar caused some of the increase in the dollar price of oil is correct. However, I tend to shy away from Fed-bashing. The problem is that the Fed has only one instrument (intervention in the short-term money market), and in the economy there are many targets. Anybody can blame the Fed for missing target X. But to be useful, such a criticism has to say what other targets the Fed would have missed had it hit target X.

In this instance, Bryan is blaming the Fed for not stabilizing the exchange rate. But treating the exchange rate as the target would have meant messing up the inflation rate as a target. Back when the world was sopping up U.S. assets (the late 1990's and the early years of this decade), stabilizing the exchange rate would have meant printing money like crazy, causing inflation. In the past few years, with capital flows heading the other way, stabilizing the exchange rate would have meant contracting the money supply, with all the consequences that brings.

The moral of the story is that when you criticize the Fed, it should be in the context of understanding the relationship between targets and instruments. Assigning more targets to the Fed (stock prices, home prices, the unemployment rate) without specifying the trade-offs or the additional instruments that might be used to achieve those targets is not a constructive form of criticism.



COMMENTS (5 to date)
Dan Weber writes:

I could've sworn Bryan's post was blaming the Fed for the inflation, not for failing to maintain the exchange rate. (Even though the measure he used was against the Euro, which I took to be a simple proxy for a foreign currency.)

D. Haeck writes:

Well, as elequently pointed out by Martin Wolf and Willem Buiter, eventually it are the central banks to blame for the rising inflation.

When you aggregate the statements made by central banks all over the world, you have to conclude that there must be interplanetary trade: the world is importing inflation.

So it is not only the fed or the bank of china to blame. But all central banks have collectively been supplying too much money. This problem is resolved if every central bank fights domestic inflation and let exchange rates float. Right? Stop the excuses.

Tim Lundeen writes:

Re "...stabilizing the exchange rate would have meant printing money like crazy, causing inflation..."

You are half right :-) I think the Fed should have increased the money supply more in 2000-2002; instead, by being too tight, they created a deflationary environment that caused the world-wide economy to tank.

Now they are too loose, and we are paying the piper in the other direction.

I would be very happy to have the Fed target inflation and let the economy take care of itself.

dearieme writes:

"The problem is that the Fed has only one instrument (intervention in the short-term money market), and in the economy there are many targets." Back in the early Thatcher years, a leading Labour politician, Denis Healey, complained that her economic policies resembled playing golf with only one club. I don't remember any suggestion by him of what other club might be available.

Mick Rolland writes:

This post by Arnold is as surprising as contradictory. The present monetary policy framework already has two (often conflicting) goals for one instrument: guarantee full employment and 'price stability'.

Another problem that makes Bryan's position appealing lies in the definition of 'price stability'. Is it less than 2% growth in the CPI, the GDP deflator, or a broad index that includes all prices, including the purchasing power of financial assets with money? In countries where the CPI is not reliable, the only price worth paying attention is the exchange rate. After the deep methodological changes of the 90s in the CPI, is it the case of the US? Not really, but stabilization of the exchange rate is often a proxy of price stability -not, as Arnold implies, a conflicting goal.

Also, Arnold is treating capital flows as exogenous from monetary policy, but they are to a great extent influenced by monetary policy, 'liquidity conditions' (i.e. monetary conditions) and relative interest rates across countries.

In sum, Bryan's position is much more coherent than Arnold's if we follow the Tinbergen rule of 'one instrument, one goal' and if we realize that monetary policy is not too reliable as a countercyclical tool.

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