Over the past several years, Federal Reserve officials have issued multiple and often conflicting statements about whether their federal funds rate target should be increased and, if so, when that change should occur. As we discussed in an earlier column, these attempts at “forward guidance” appear to have confused consumers and businesses more often than they enhanced their ability to make informed decisions. Rather than describe the potential harm that excessive “Fedspeak” might inflict on the economy, as we’ve also done before, we focus here on the objectives that motivate it.
The recent volatility in financial markets and mixed signals sent by the latest economic reports provide exactly the kinds of examples that help answer this question. For example, wide swings in the value of equities have led some commentators to suggest, at least implicitly, that the Fed should direct policy actions towards stabilizing these fluctuations. But because “over-valued” stock or bond prices can be illustrative of a “bubble,” it also has been argued that the Fed ought to focus on preventing bubbles in asset markets. Finally, because recent volatility in equity markets frequently has been attributed to a weakening Chinese economy and actions taken by the Chinese central bank to reduce the value of its currency, concerns have been raised about the effects of exchange rate fluctuations on U.S. exports and the associated impacts on output and unemployment.
In addition, the recent revision of second quarter U.S. real GDP growth to a 3.7 percent annual rate, a value well above the economy’s estimated potential to produce goods and services, has been highlighted by some Fed officials as justification for tightening policy at their September policy meeting. Conversely, the persistence with which inflation has remained below the Fed’s own announced objective of two percent has been cited by other Fed officials as a reason not to increase their funds rate target. New labor market data due out tomorrow could complicate or clarify matters further.
By quick count, the foregoing discussion suggests that, as a group, Fed officials wish to direct monetary policy actions simultaneously towards (a) smoothing the volatility of equity markets, (b) preventing bubbles from arising, (c) managing the dollar’s foreign exchange value so that U.S. exports do not decline, (d) slowing economic growth to prevent the economy from overheating, and (e) bringing inflation back towards the two percent target. And this list does not even include other Fed statements about achieving a specific value for the unemployment rate before making any decision to tighten the stance of monetary policy.
Even if one accepts, for the sake of argument, that the Fed can reliably influence each of these variables individually, the idea that it can achieve its goals for all of them simultaneously violates one of the fundamental principles any policymaker must confront. More than sixty years ago, Jan Tinbergen, a Dutch economist who shared the first Nobel Prize in Economics, derived this result: The number of goals a policymaker can pursue can be no greater than the number of instruments the policymaker can control. Traditionally, the Fed has been seen as a policy institution that has one instrument – the quantity of reserves it supplies to the banking system. More recently, the Fed may have acquired a second instrument when it received, in 2008, legislative authority to pay interest on those reserves.
Tinbergen’s constraint therefore limits the Fed to the pursuit, at most, of two independent objectives. To see the conflict between this constraint and statements made by assorted Fed officials, consider the following alternatives. If the Fed wishes to support U.S. exports by taking actions that reduce the dollar’s value, this implies a monetary easing that will increase output in the short run but lead to more inflation in the long run. Monetary ease might help reverse the stock market’s recent declines – or simply re-inflate bubbles in the eyes of those who see them. Conversely, if the Fed continues to focus on keeping inflation low, this requires a monetary tightening that will be expected, other things the same, to slow output growth, increase unemployment, and raise the dollar’s value with deleterious effects on US exports.
The Tinbergen constraint has led many economists outside the Fed to advocate that the Fed set a path for nominal GDP as its policy objective. Although this is a single variable, the balanced weights it places on output versus prices permit a central bank that targets nominal GDP to achieve modest countercyclical objectives in the short run while ensuring that inflation remains low and stable over longer horizons. But regardless of whether or not they choose this particular alternative, Federal Reserve officials need to face facts: They cannot possibly achieve all of the goals that, in their public statements, they have set for themselves.