Who is in charge of monetary policy? At a first glance this is a simple question with an obvious answer: the central bank. But managing market expectations now also belongs to the Fed’s brief and some key lines of authority have been blurred.
In many countries, the central bank enjoys full independence from the government. This has proven itself to be a wise arrangement, since it ensures that the power of the printing press – of money creation – is not abused for political purposes. History offers ample evidence that when this function is in the hands of a government, money will be over-supplied. And too much money inevitably sends inflation out of control. Given our world of fiat money – backed only the confidence we have in it – central bank independence is vital. Or so we have been led to believe.
In fairness, central bankers have one of the toughest jobs around. They often take decisions that would surely fail in a public referendum. And as the warrantor of monetary stability, a central bank is not only accountable today but will also be judged harshly by future generations.
While they serve, central bankers rarely if ever get recognition for their good deeds. Paul Volcker, the Fed’s chairman between 1979 and 1987, was vilified during his time in office, even blamed for the double-dip recession of the early 1980s. Today he is universally hailed for reversing the era’s high inflation. And Alan Greenspan’s once impeccable reputation has certainly been tarnished by the financial crisis that followed his unprecedented five terms as Fed chairman, in 2006.
As William McChesney Martin, Jr., a previous Fed chairman, observed that the job of a central bank is “to take away the punch bowl just as the party gets going.” Obviously, this is not a job for people with a strong need for approval.
Over the past thirty years or so, following the overthrow of Keynesian activism in the late 1970s, central banks and monetary policy have evolved to become instruments of economic policy. In the process, they have acquired some new tasks, including that of smoothing out the rough edges of the business cycle. And most recently they have been tasked with managing market expectations.
But market expectations turn out to be rather hard to manage. Ultimately, it can become a game of who is managing whom? Who wields the real, decisive influence?
This dynamic has come to characterize the Fed during the Greenspan and Bernanke eras. By flooding the economy with liquidity after the stock market crash of 1987, the former Fed chairman enshrined the “Greenspan Put,” where the government essentially props up sagging markets by lowering interest rates. This cure-all was prescribed in response to the first Gulf War, financial crises in Mexico and Asia, the LTCM debacle, the Y2K tempest in a teapot, the burst Tech Bubble, the 9/11 attacks and the second Gulf War.
It worked reliably; that is, until it stopped working. It finally came apart when the housing market bubble burst and the banking system went into cardiac arrest. We are still in intensive care from this medicine.
But our infatuation with quick fixes endures. The latest iteration of the Greenspan Put, in our view, is the second round of money creation by the Fed called quantitative easing (QE2). According to Bloomberg, two weeks before announcing the size of its interventions, the Fed surveyed investors and bond traders, asking them how big a package QE2 would (or should) be. This can be seen as a form of reverse engineering, managing market expectations by asking market participants what to do.
But whatever it is, such efforts call the independence of this particular central bank into question. Who is ultimately in charge of setting US monetary policy? One thing is clear: a central bank that is too predictable is a powerless central bank; and a powerless central bank is obviously not in charge.
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