The Federal Reserve’s policy-making Open-Market Committee met before Christmas and, as many expected, decided to reduce its large monthly purchases of bonds.
It pays for these bonds by creating new bank reserves that, in turn, increase the money supply and lower interest rates. Buying bonds is a usual procedure by which a central bank lowers interest rates. It becomes “quantitative easing” in the very unusual cases when the purchases continue beyond the point at which short-term interest rates approach zero.
That has been the Fed’s policy for over four years now and everyone knew it had to end. The only questions were when it would end and how rapidly. The first question has been answered: Purchases will be cut by about an eighth in January. Further reductions, the FOMC says, will depend on how the economy progresses.
Not many people were surprised by this. Stock markets, which usually fall when money gets tighter, rose. There are two explanations for this.
First, by finally pulling the trigger, the Fed ended months of nervous uncertainty about when this would happen. “January” is more certain than “sometime” for everyone involved.
Second, some read the nuanced banalities of the “FOMC statement” to mean that the committee is promising to keep interest rates low even longer than previously committed. Take that with a grain of salt, but this interpretation is widespread and also encouraged stock traders.
So the year ends with marginally less uncertainty about monetary policy than when it started. But we are still in uncharted waters. It would be better if our economy, and those of other countries around the globe, were not so dependent on the actions of our nation’s central bank.
All of the hoopla and breathless expectations focused on FOMC meetings this year indicates that John Maynard Keynes’ desired role for economists has not yet come to pass. He argued that economists should be like dentists — pursuing a useful occupation that certainly can make people’s lives better, but that lacks flamboyance and does not give rise to greater public acclaim than the modest level warranted.
Central bankers are a specialized subset of economists, and Keynes similarly wanted them to keep a low profile. Yes, he did argue for a greater role in discretionary policy for central banks. They should adjust the money supply, and hence interest rates, to dampen out the fluctuations in economic activity that we call the business cycle. When the economy boomed and inflation threatened, a central bank like the Fed should decrease bank reserves and thus raise interest rates. When the economy slumped it should do the opposite. Also, following the counsel of earlier economists, Keynes saw a vital role for a central bank in stepping in as a lender of last resort during financial crises.
But I think he would not advocate that central bankers should be a recognized as rock stars, or be lionized on the covers of magazines as members of a “committee to save the world” or be fawningly dubbed “maestro.”
Nor, I think, would any other mainstream economist. Central banks are vital institutions, and governments should staff them with knowledgeable and skilled administrators. But economic activity should be grounded on its own solid fundamentals and not in the decisions of 12 committee members, except in times of emergency. A central bank can provide the conditions for healthy economic growth by providing a currency with stable purchasing power and by administering an efficient payments system. But it cannot make an economy grow faster over the long run or necessarily have higher levels of employment.
However, to paraphrase Donald Rumsfeld talking about war, you go into a financial crisis with the central bank you have and not some ideal one. The Fed made bad mistakes, both in monetary policy and in supervising the banking system, in the decade preceding the acute financial crisis of 2008. Former chairman Alan Greenspan bears much blame for that but other Fed officials had a role too. It has, however, done a pretty good job since 2008 in helping to clean up the mess that the Fed itself had in part created. And it has done so with little help from elected officials.
The fact that we stood on the edge of an economic abyss but were able to step away is due largely to the Fed and owes little thanks to Congress. In its official statement, the committee reiterated its long-stated view that “Fiscal policy is restraining economic growth.”
The fluttering and cases of the vapors that periodically have perturbed financial markets over the past year together with the lemming-like flows of currencies between nations in search of marginally higher rates of return are all indications of a global financial system with serious problems. New regulation of financial markets might help a bit and time might heal some economic wounds. The fact that Fed meetings get so much attention remains an indicator of underlying global economic weakness, not strength.
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at firstname.lastname@example.org.