Sunday, September 26, 2010

What "Prices" Are the Federal Reserve Supposed to Keep "Stable"?

The Federal Reserve's latest moves (maintining ZIRP and continuing QE-lite) made me question whether these moves actually further the stated objectives of the Fed, which are set forth in Section 2a of the Federal Reserve Act:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Section 2a was added to the Federal Reserve Act in 1977 by way of an amendment passed in the wake of a 1975 House Concurrent Resolution 133, which expressed "the sense of the Congress that monetary policy be conducted so as to ‘maintain longrun growth of the monetary and credit aggregates commensurate with the economy's longrun potential to increase production so as to promote effectively the goals of maximum employment, stable prices, and moderate longterm interest rates.‘"  House Report 95-744.

Apparently, House Concurrent Resolution 133 was a BIG DEAL.  First, it required the Fed to embrace full blown Chicago-style monetarism, focusing on controlling the money supply instead of merely interest rates.  Second, it instituted semi-annual reporting to Congress, which continues to this day.  Interestingly, House Concurrent Resolution 133 appears to have been a compromise among both parties because then, as now, there was a log of talk about auditing the Fed.

The Fed's forced embrace of monetarism was a testament to the political genius of Milton Friedman's and Anna Schwartz's A Monetary History of the United States, 1867-1960, which was published in 1962.  The book placed the blame for the Great Depression squarely on Fed policy and, specifically, that the Fed's policy caused contraction of M1 money supply.  (Steve Keen has noted, however, that Friedman pulled a fast one, that M0, the monetary aggregate over which the Fed has some control, actually expanded even as M1 contracted, which implies that it was not Fed policy but bank policy and depositors withdrawing their money from banks).  With inexplicably high inflation in the late 1960s followed by stagflation in the 1970s, politicians needed a scapegoat, and Milton Friedman gave them one.

The twin issues in 1975, when stagflation ruled, were unemployment and inflation.  In context, then, the "prices" that were to remain stable were the prices of consumer goods, not asset prices.

By the way, the Fed abandoned targeting money supply aggregates in the early 1980s after doing so proved to be a complete and utter failure.  That should make you wonder, if Paul Volcker really killed the inflation monster with his monetarist policies, how come his monetarist policies were killed shortly thereafter?  This is a topic for a forthcoming post.

Returning to the central question of this post, do the Fed's current policies of ZIRP and QE "promote effectively the goal[] of . . . stable prices?"  Clearly, quantitative easing has no direct effect on consumer prices because it is merely a mechanism for adding to bank reserves in order to promote additional lending.  When nobody wants more credit and/or the banks aren't lending-- both of which seem to be true today, well, then, quantitative easing has no effect at all on consumer prices and cannot be said to "promote effectively the goal of stable prices."  Similarly, the zero interest rate policy, which, like QE, is designed to promote additional lending, fails to "promote effectively the goal of stable prices" for exactly the same reasons as QE.

Okay.  If the Fed's policies of ZIRP and QE are not keeping consumer prices stable (and could actually be encouraging price inflation due to speculation in consumer commodities), are there any prices that they are keeping stable?  Yes, the Fed's policies are propping up prices in the secondary bond and equity markets.  Another way to put it, the bond and equity markets are asset bubbles that the Fed policies are preventing from deflating.

NOTE: Whether or not the Fed is complying with Section 2A of the Federal Reserve Act deserves a lot more attention and will be the subject of at least one more post, this time with data analysis.  Further, I will be updating this post to provide links to some of the source materials I reviewed regarding how Section 2A came about, just in case you're interested.