What Should Be Done With the Federal Reserve?

It seems that as soon as the Federal Reserve starts behaving like politicians they get the approval ratings to match (link). According to the poll quoted in the article, 16% of respondents want to abolish the Fed, and 39% say it should be more accountable to Washington.

Perhaps this is just a sign of discontent with current Fed policies. If the Fed were abolished, monetary policy would presumably fall to the Treasury, and stronger oversight would give Washington significant influence over monetary policy.

The result would surely be undesirable, because monetary policy would become a tool for politicians to help their reelection bid rather than a way of ensuring the long-term health of the US economy. Needless to say, buying some short-term goodwill from voters is generally requires different measures than ensuring the long-term success of the economy would require.

So if abolishing or declawing  the Fed is not such a good idea, what should be done?

First, the Fed’s mandate should be clarified. The first mandate of the Fed is to ensure price stability. Working towards this goal doesn’t buy political goodwill as Fed Chairman Volker found out in the early 80s, but it is key to maintaining a viable economic environment.

The Fed’s second mandate, to ensure full employment, is a political goal. Full employment helps politicians get reelected, but it is not at all clear that maintaining full employment is even desirable from an economic perspective.

As we are seeing now, the Fed has to resort to expensive and ineffective measures that are harmful in the long term in order to lower unemployment. Furthermore, the majority of the unemployed are people with very little formal education. As technological sophistication increases, as more and more manual labor is done by machines, and as the complexity of economic activity in general increases, it is not clear that policies that boost unskilled labor are in the long-term interest of the country.

It would probably be more fruitful to boost our competitive edge by investing in R&D, in education, in innovation, in technology, and in basic science which always provides the seeds for the next step in technology. This won’t do much to lower unemployment, but as the world gets more complex and more routine jobs get automated, being on the leading edge of new technology will be key to survival. Of course such policies are unlikely to come out of Washington, because they run counter to politician’s desire to get reelected.

As far as the Fed is concerned, eliminating the political mandate of maintaining full employment, but leaving the economic mandate to maintain price stability in place, would do the trick. It would also be desirable to maintain or increase the Fed’s independence to make sure political pressures don’t inform policy, and increase transparency so the public knows how the Fed is going about fulfilling its mandate.

Posted by Martin Gremm (Pivot Point Advisors)

About the author

Marc Schindler, CFP®

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