January 26, 2009

Guiding Monetary Policy with Accountable Autonomy

Assessing the work of the Federal Reserve, Frederic Mishkin contends that communication and transparency must counterbalance the necessary independence of a strong central bank.


In your book Monetary Policy Strategy, you establish a scorecard for the Federal Reserve and rate its strengths and weaknesses. How do you score the Fed on its response to the financial crisis?

A lot of criticism has been leveled at the Fed, yet the bank has been extremely aggressive in its response to the financial crisis, in what are arguably the two most critical ways: in monetary policy easing and, to an even greater extent, in injecting liquidity into the system in many forms, some of them very creative.

Central banks have not always understood the necessity of taking these kinds of strong actions. The Bank of Japan was not on top of easing and liquidity provision during Japan’s episode in the late 1980s. I think the Fed has pursued a much more aggressive approach because the academic literature makes clear that standing back in this kind of crisis is a prescription for disaster. That’s what happened during the Great Depression.

A foremost aspect of a central bank’s role is to consider and mitigate financial crises. That has been an undeniably strong element in the Fed’s past policymaking.

What are some of the other policy issues a central bank must consider when determining how to respond to this — or any — financial crisis?

There is a whole set of policy issues, but to illustrate how complex they can be, consider the question of asset-price bubbles.

While it is important to pay more attention to bubbles than in the past, because they affect the overall economy, I argue that central banks should not be involved in using monetary policy to prick these bubbles.

First, asset-price bubbles can be hard to identify. If a central bank tightens monetary policy to restrain a misidentified bubble, it risks weakening economic growth. Even if asset-price bubbles were identifiable, the effect of interest rates on bubbles is extremely uncertain. Some theoretical models suggest that raising interest rates can diminish the acceleration of asset prices, but higher interest rates may not be very effective in defusing bubbles, because market participants expect excessively high rates of return for buying bubble-driven assets. Other research and history suggest that raising interest rates may cause a bubble to burst more severely, damaging the economy further.

Also, there are many asset prices, but a bubble may be present in only some assets. In such a case, monetary policy can be a very indelicate instrument and would probably impact asset prices broadly. It’s not possible to target individual asset bubbles.

As I discussed in my book, central banks are more likely to encourage better economic outcomes by responding to the outlook for inflation and aggregate demand than by pricking bubbles. I retain that position, but there is an additional related issue that I did not discuss in the book. We should not ignore the possibility of bubbles altogether; In a speech I gave as a Governor of the Fed back in May, I argue that the right way to cope with potential asset-price bubbles is through macro prudential supervision — regulatory and supervisory policy — rather than through monetary policy.

In recent years, many central banks have adopted inflation targeting, a practice you’ve strongly advocated that the Fed adopt.

Yes, and there is even stronger need to have a numerical inflation goal on the table given the financial crisis. Setting an inflation goal can better help to anchor the inflation expectations of households and businesses, which helps them make economic decisions in the immediate and moderate-term future. In turn, that would allow the Fed to be more aggressive during shocks, because there is less fear that it will blow out inflation expectations.

Also, we are in a very deflationary shock right now. In terms of price stability, it’s important to keep inflation from rising, but it’s just as important to mitigate deflation by having a commitment to a positive inflation target.

In another book, The Next Great Globalization, you addressed the greater risks that emerging markets face when confronting financial crises. In the past, such crises almost always occurred as a result of regional or homegrown economic strains. Are risks for these markets greater or lesser now that we are looking at a global crisis, and what policy action is called for?

Whenever a nation is subject to an external shock, its vulnerabilities are much greater if it has not pursued certain reforms. Many emerging markets have moved in the direction I suggested in that book, which has made them less vulnerable to the worst effects of the shocks we are all experiencing now. Although emerging markets are getting hit right now, they would be far worse off if they had fixed exchange rates and had a lot of debt denominated in foreign currencies.

Many countries did not learn these lessons, including some advanced and semi-advanced economies. Iceland had a huge amount of dollar-denominated currency and dollar-denominated debt. The same is true of many of the Eastern European ex-Soviet-bloc countries, like Hungary and Estonia.

Your scorecard rates the Fed as mixed on transparency and communication, and you say these areas need some work. One of your recommendations is that the Fed move in the direction of establishing an explicit, numerical inflation goal.

Communication and transparency have improved a lot under Bernanke, but the Fed has not moved nearly far enough. I’d like to see the Fed make longer projections, reach a consensus on a specific numerical value for the desired level of inflation rate and change the consensus value only for good scientific reasons.

The legal concept stare decisis can be useful in thinking about how the Fed should establish and communicate its targets. Stare decisis — literally, “to stand by things decided” — dictates that when the Supreme Court makes a decision, the reasoning behind that decision serves as precedent that guides all subsequent decisions, except when the court finds compelling reasons to modify or overturn that earlier decision. My recommendation for the Fed’s communication strategy is that the Federal Reserve work in a roughly similar fashion: because the way the Fed arrives at its consensus value for the desired level of the inflation rate would be very transparent, the Fed would not make changes, except for sound economic reasons. The Fed would be accountable to explain any change to the inflation goal, and it would therefore provide a firm anchor for long-run inflation expectations. The Fed would still retain enough flexibility to ensure that monetary policy is consistent with exercising its most important mandates — encouraging price stability and maximum sustainable employment.

The Fed has become quite independent in recent years, which is consistent with international trends and with your position that central banks should have more independence, particularly in democratic nations. Do you foresee any change for the Fed as a result of the crisis or the new presidential administration?

I do worry about this issue. There is always some discomfort in having a powerful and independent central bank, and the recent criticism directed at the Fed may result in calls to rein in its independence. We don’t yet know whether Congress will take such action given the prominent role the central bank has had to take during the crisis.

Interfering with the independence of a central bank can produce extremely bad outcomes. One reason I argue so strenuously for transparency is that it makes a strong central bank more conducive to operating with accountability in a democratic society. The best path is to allow the Fed to maintain its independence, while requiring increased accountability by encouraging transparency and improving how it communicates with Congress and to the public.

Frederic S. Mishkin is the Alfred Lerner Professor of Banking and Financial Institutions at Columbia Business School. He is a Research Associate of the National Bureau of Economic Research and from September 2006 until he rejoined the School in August 2008, he was a member of the Board of Governors of the Federal Reserve System.

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Frederic Mishkin

"Monetary Policy Strategy"

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