How the Fed Is Constrained

Blogging has been light as Real Work has pressed, but there is something I don't want to let go. Dan Nexon linked to this post and asked:

The question remains, however, what mechanisms translate [the] pressure [on Bernanke] into constraint [preventing more aggressive monetary policy]?

It's a very good question. I think I've answered it over the past few years, but spread across a number of posts. So it's worth spelling out the mechanisms that could be operating. Some of these are supported by academic literature, some of them are more speculative. I could go into much greater detail on each of these, and have in the past, but I'll try to keep each point brief for now. So:

1. One constraint comes from the Fed itself. That is, Bernanke is not a dictator... he's a chairman of a corporation. This gives him quite a lot of latitude, but not omnipotence. The Fed has a Board of Governors, not all of whom are academics, and the strong norm is to operate by consensus at least as much as is possible. In addition, there are Presidents of the twelve regionals banks that constitute the Federal Reserve System and they also have influence. Remember: a big function of the Fed is to not freak everybody out. If major disagreements within the institution become public, everyone could get freaked out. So Bernanke, as the leader of this institution, may be willing to accept a somewhat sub-optimal outcome if he believes than an even more sub-optimal outcome is likely to obtain if he chooses to hold no prisoners. Central bankers aren't like op-ed writers (or bloggers)... their decisions actually matter. I imagine there is a strong bias against killing the patient that may sometimes preclude aggressive treatment.

2. Another pressure comes from Congress, an institution which has recently blocked the appointment of a Nobel Prize winning economist because he (supposedly) lacked sufficient qualifications for the job. This pressure has, in turn, hamstrung the White House. For much of the last few years the Fed has been understaffed at senior levels, as the Obama administration tried to figure out who they could nominate that would a) be approved by Congress; b) not attract the ire of the progressives who were already upset that the neoliberal wing of the Democratic party -- Summers, Geithner, etc. -- held such sway. This led to the Fed Board of Governors to have persistent vacancies until this past May. Keep in mind that Congress oversees the Fed, and right now the committee charged with that task is helmed by Ron Paul, who wants to abolish the institution and has passed a law through the House to audit the Fed. As I mentioned in my previous post, Republicans in Congress oppose further stimulus by the Fed and Democrats are quiet on the issue. Bernanke's last reappointment vote was the most contentious since three decades, and that was before the Tea Party's 2010 electoral success. In short, the Fed is in a principal-agent relationship with Congress, and this fact is salient. All else equal, the Fed would like to protect its autonomy. (Although, ironically, this discussion suggests that it has no real autonomy.)

3. Much is said about the Fed's dual mandate -- to maintain low and steady inflation while promoting full employment -- but the Fed actually has a triple mandate: those two plus regulation of the commercial banking system. Previous research has shown that locating regulatory authority in the central bank biases monetary policymaking in favor of banks. To some extent, both the Tea Party movement and the Occupy Wall Street movement arose in direct protest against this dynamic, although it wasn't articulated very well. More recently, the Fed has come under fire over the JPMorganChase losses and the LIBOR scandal. Faced with populist opposition from both the right and the left, one could understand why the Fed might choose to shoot for the middle: prevent unemployment from skyrocketing but don't risk any spike in inflation; stabilize the banking sector but don't do much to help repair household balance sheets via an erosion of the real value of household liabilities -- which are, of course, bank assets.

4. Additionally, in an important sense the Fed is the central bank of the world. It acted as a global lender of last resort during the crisis, it injected liquidity into the global monetary system by opening up swap lines with every major central bank, and it's quantitative easing programs have reverberated through the global economy. The Fed, therefore, may be constrained by needing to maintain global stability. In pursuit of this, perhaps, the Fed is willing to accept a somewhat slower recovery in the U.S. in exchange for a reduction in international economic (and political) volatility.

5. The Fed has intellectual biases of its own. This is related to #1 and #3, but deserves its own point. The Fed's experience in the 1970s and 1980s was that it is better to keep inflation low over the long term than to try to correct every uptick in unemployment. The Fed's experience in the 1990s was that if it prevented collapses in the financial sector than than full employment would come more or less naturally. The result is that the Fed knows how to keep inflation low, and can stabilize a faltering financial system, but it's not as good at keeping unemployment low. Moreover, it's only tool to do so is indirect: pump cash into the banking system in the hopes that they'll lend. Not only do politicians on the right and left oppose this for ideological reasons, some members of the Fed appear to believe that many of the economic problems in the country are structural rather than cyclical. If the Fed believes that the economy needs to adapt structurally, it might not pursue policies that could help lower unemployment even if they thought they would be successful. Better to manage the needed adjustment than to prevent it from occurring. Folks like Krugman and Sumner have been arguing vehemently against this view for years, but that doesn't mean that some Fed members don't feel that way. (Keep in mind, too, that Fed policy tends to be more relaxed during Republican administrations.)

To my knowledge there is no good literature on #1. David Singer has done a good work on #2, including this book, and on #3 with this article (with Mark Copelovitch). I'm also doing some research on #3, currently R&R. I don't know of much recent published work describing #4 (although I know some folks are researching it now), but Charles Kindleberger described the dynamic in The World In Depression. I've also blogged about it a lot over the years [e.g. 1, 2, 3, 4, 5]. As linked above, Christopher Gandrud is doing some research with Cassandra Grafstrom on Fed partisanship.