Now is the time to reform the Fed (don’t blow it)19th April 2019
In today’s political environment it is very difficult to get reform measures through Congress. The Democrats control the House, while the GOP controls the Senate and the Presidency. And yet, today is a perfect time for Congress to reform monetary policy.
During the Great Recession, we learned that the current monetary regime is highly flawed and that reforms are desperately needed. Unfortunately, there was no political consensus in favor of reform at that time, as the GOP and Democrats were deeply split on monetary policy. The GOP thought the Fed was doing too much, whereas the Democrats opposed any attempt to restrain the Fed from further stimulus.
Today is very different, as there is no longer a large gap between the views of the two parties. Both parties seem to favor reforms that would make a recession less likely. The GOP has changed the most, becoming much more dovish after the election of Trump. You might argue that this change is not sincere, and that the GOP will revert back if the next President is a Democrat. But politics is the art of making a silk purse from a sow’s ear.
So today is one of those rare times when a Fed reform measure would be politically feasible. Even better, the Fed is doing a major rethink of policy at its June conference in Chicago, and one could imagine them asking Congress for legislative changes after the meeting. I’ve already offered many proposals for policy reforms (such as NGDP level targeting). Today I’ll suggest a few more useful reforms.
One of the reasons for the policy failure of 2009-13 was that Fed officials were reluctant to do enough stimulus to achieve the desired rate of growth in aggregate demand. This reluctance may have been linked to fear of future losses on its portfolio of Treasury securities. And one can also imagine a scenario where the Fed would run out of risk-free Treasuries and MBSs to purchase.
The Fed needs to make sure it has enough “ammunition” to hit its policy target. Therefore the Fed might go to Congress with the following memo:
We believe that current policy tools would be inadequate in the next recession, given the likelihood that rates will fall to the zero bound.
Here are two options for Congress to consider, to assure that monetary policy remains appropriately stimulative during the next recession:
Option A: Raise the inflation target to 3%
Option B: Allow the Fed to save enough of its profits to build up a “war chest” of $250 billion dollars; to be used to cover possible loses from future QE programs. In fact, future QE programs are likely to be highly profitable (as during the Great Recession), but there is always a slight risk of losses. By having a war chest, the Fed would have confidence to do the amount of QE required to hit its Congressional mandate of stable prices and high employment.
In addition, the Fed should be authorized to buy a much wider range of securities when the economy is at the zero bound, with the provision that the non-Treasury portion of their portfolio be sold off within a year of exiting the zero bound.
You might notice that I’ve used a “framing” trick of the sort often employed when you want political leaders to make a certain choice. I’ve given two options, where the second is clearly superior and also less politically controversial. Not many politicians would wish to vote for higher inflation, whereas most voters don’t even know that the Fed earns vast profits that are turned over to the Treasury.
Having the Fed hold on to those profits until they reach a certain threshold is likely to be relatively uncontroversial, as it’s just an accounting issue. Note that the Fed’s balance sheet is already effectively a part of the Federal government consolidated balance sheet, so this reform does not in any way deny money to the Treasury in such a way as to necessitate higher taxes. So I believe Congress would choose option B, which is also my preference.
Of course there are many other options; in a previous post I suggested that the Fed balance sheet could be merged with the Treasury balance sheet, which would remove what Bernanke called the “costs and risks” of a more aggressive approach to QE. Today’s proposals are perhaps a bit more politically feasible, as the Fed keeps its separate balance sheet and merely holds onto a certain sum to cover possible losses from QE. Once the war chest is established, profits continue to be turned over to the Treasury.
It is very unusual to have the stars line up in a way where one could conceive of Congress passing useful reforms to monetary policy, reforms that would make another recession less likely and the recovery much swifter if it did occur. It would be a tragedy if we let this once in a generation opportunity slip by. If the next recession occurs under a Democratic President, I very much doubt whether the GOP would accept a reform package to make monetary policy more effective. They certainly would not have supported such a package when Obama was President. But the Dems would support this package, knowing they might need it in 2021.
PS. Over at Econlog, I provide an overview of what the Fed should be thinking about as they try to reform monetary policy this summer.
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