The ultimate goal of sustained healthy economic growth and higher standards of living is a laudable objective, but it requires the correct set and mix of policies. Policymakers must identify which policy tools are appropriate to achieve desired economic performance and the proper mix of policies. While fiscal, tax and regulatory policies heavily influence economic outcomes, the Fed’s conduct of monetary policy is also important.
Two things have become obvious during the 2002-2007 economic expansion that was marked by the debt-financed housing bubble, the financial crisis and deep recession of 2008-2009 and the current lengthy but slow-growth expansion. First, monetary policy plays a critical role—and serves best by being even-keeled and pursuing a low inflation target during expansions and actively countercyclical in response to downturns and financial crises. Second, there are limitations to what monetary policy can achieve, as some of the sources of under-performance in the economic and labor market are beyond the control of monetary policy and best addressed through other economic, fiscal and regulatory policies—and pushing monetary policy beyond its limits does not improve performance but instead generates risks and uncertainties that undercut desired economic objectives.
The Fed’s creative emergency measures during the 2008-2009 crisis helped stabilize financial markets and avert an even deeper and more damaging recession, but the efficacy of its sustained artificial low interest rates and massive asset purchases, well after the start of the economic recovery is questionable. It has not stimulated faster growth and has distorted economic and financial performance, and poses sizeable risks.
The Fed’s efforts to stimulate economic growth and employment, lift wages and improve other labor market conditions have extended the role of monetary policy beyond its normal scope. The Fed’s massive asset purchase programs and maintenance of an excessively large balance sheet have crossed the border into fiscal policy and credit allocation.
Confusion about the proper role of monetary policy and what it is capable of achieving relative to tax, fiscal and regulatory policies has made Congressional oversight of the Fed much more difficult.
The Fed should continue to normalize monetary policy: it should continue to raise rates, but it should modify its balance sheet unwind strategy to gradually eliminate its entire holdings of mortgage-backed securities and aim to reduce its total asset holdings more than it is currently suggesting. These steps would not harm the economic expansion but would reduce distortions and improve the health of financial markets while reducing the risks involved in the Fed’s current balance sheet policies.
In addition, the Fed needs to adopt a flexible rules-based approach of conducting monetary policy and establish clearer rules for when and how it executes emergency monetary operations. The roles of the Treasury and Congress must also be clarified. A flexible rules-based approach would be a favorable change from its current discretionary approach, increasing its transparency and enhancing the ability of Congress to supervise the Fed.
Ground rules need to be established for the conduct of monetary policy under extraordinary circumstances, including approval processes and responsibilities of the Fed, Treasury and Congress. Many of these governance issues are complex, but several things seem clear. While precisely defining emergency situations—unusual and exigent circumstances—that require extraordinary Fed intervention is difficult, responsibilities and approval processes within and across institutions must be established, and Congressional oversight of Fed operations must be open. The Fed, Treasury and Congress have learned a lot from the financial crisis, and they should coordinate to be prepared for future economic, financial or idiosyncratic shocks.
The economy is now growing on a self-sustaining basis and is far beyond the point of needing the Fed’s excessive monetary ease as a crutch. Now it is time to institute changes that set monetary policy on a course consistent with sustained healthy economic performance and establish a framework for dealing with emergency situations.
Mickey Levy is the chief economist for the Americas and Asia of Berenberg Capital Markets, LLC, and member, Shadow Open Market Committee. The views expressed in this column are the author’s own and do not reflect those of Berenberg Capital Markets, LLC.
This is based on testimony delivered to the House Committee on Financial Services on November 7. The full testimony can be found here.