In the coming weeks, Donald Trump will announce his choice for the next head of the US central bank. Now is the moment to do something truly bold.
In the endless swirl of noise and controversy emanating from Washington these days, it is easy to overlook a more mundane but significant challenge facing the US government: its institutions are getting old. With the exception of the Department of Homeland Security, most substantial agencies are at least decades old and many date back much longer.
The Federal Reserve was created in 1913, and over the century, it has acquired massive powers over the nation’s financial system. But like anything that has aged, the Fed has become brittle and weathered.
For the moment, the financial system is eerily calm; it likely won’t stay that way forever. Now is an opportune moment to consider whether the Fed should remain the same or should evolve into a role more suited for the particular needs of the 21st century.
It’s a very relevant question just now. In the coming weeks, Donald Trump will announce his choice for the next head of the Federal Reserve. Unlike the vast majority of his appointments so far, this one is unlikely to face partisan blowback. All of the candidates are technocrats acknowledged and respected for their competence, and indeed, he may well elect to renominate the current head, Janet Yellen.
Unlike the rest of the government, the Federal Reserve and the institution of the central bank have largely remained resiliently apolitical in the face of the intense politicization of so many other agencies. It is a powerful agency staffed largely by academic economists and policy chiefs culled for the deep expertise in the arcana of central banking.
And therein lies both the institution’s greatest strength and its supreme weakness. The Fed is an intensely conservative institution, not in the partisan sense, but in how it hews to past patterns and traditions. That may well get in the way of grappling with the unique needs of the present.
Instead of just nominating a new chair, Trump could do something genuinely groundbreaking and ask that the entire mandate of the Fed be reviewed with an eye towards the needs of the present and the future and not the legacies of the past. Just because something is the way it is doesn’t mean that it should continue to be that way.
It’s time to reinvent the Fed, or at the very least redefine its role.
As of now, the Fed has three primary functions. The first is to ensure “price stability”. In practice that has meant a laser-like focus on the peril of too much inflation. Even the Great Depression, which as the name suggests saw dangerously plummeting prices, was in part the result of inflation fears in the 1920s.
The Fed remains hyper-vigilant about the challenge of inflation (see Janet Yellen’s most recent speeches and congressional testimony, where inflation concerns remain primary). Yet over the past decade or more, inflation has been non-existent, insofar as it has barely surpassed 2%, which is essentially about the same rate of US economic growth and American population growth. In looking everywhere for inflation that is nowhere, the Fed may be fighting the last war.
The second function is to use monetary policy – the raising and lowering of short-term interest rates by buying or selling bonds and issuing or withdrawing money from circulation – to ensure “maximum employment”. That is part of the Fed’s so-called “dual mandate” – price stability and employment – but it was only added in the 1970s when the perils of stagflation led Congress in desperation to punt the problem to the Fed.
The belief was that there was a direct link between lots of money in the system and the pick-up of economic activity, that would then lead companies to hire more workers. And, indeed, for much of the 20th century, that was the pattern: economic contraction, followed by the Fed easing and pumping money into the system, followed by companies beginning to hire more workers, who then see rising wages, which in turn sparked inflation.
Today, however, the US economy with a headline unemployment rate under 4.5% is statistically at full employment. That doesn’t mean everyone has a job, only that most jobseekers will find one. But as Yellen and others at the Fed have noted in dismay, that has not led to higher wages, nor generated much more robust economic growth or inflation. Of late, Yellen has wondered if the Fed might have “misjudged” the economy, as past patterns are not repeating as expected.
Finally, the Fed acts as one of the primary regulators of risk in the banking system. The financial system in the United States may be not be effectively regulated, as the 2008-2009 crisis showed, but it certainly does not lack for regulators or regulations.
The Fed is one of at least half a dozen agencies that monitor and regulate the banks, and it does so along with the dozen regional Fed branches maintaining staffs of highly capable economists and well-trained mandarins who manage much of the daily liquidity of a multitrillion-dollar financial system.
Given that both prices and employment are not evolving as expected, it’s time to ask seriously if monetary policy still has the same effect that it did in a 20th century world where nations were more or less closed economic systems and where the intensely deflationary effects of information technology were not in evidence.
Given that the US financial system has too many regulators and not enough effective regulation, it’s apt to ask if the Fed should continue its role as a regulator. And given how vital the Fed was in 2008-2009 in providing the only immediate ballast to a financial system and an economy on the verge of collapse, why not transform the Fed into a lean, powerful crisis machine?
If we were to invent the Fed today, we could strip away the employment mandate: there is no longer good evidence that companies are creating high-quality jobs in response to low rates, and less evidence that wages then increase as economic activity accelerates.
We could strip away the Fed’s regulatory requirements; too many government agencies regulate the financial industry as is. That is not an argument against regulation per se, just that the Fed needn’t be a primary regulator. And we could strip away price stability; in a globalized world where cost and production are driven by technology, that matters more than anything.
That gets to the central debate about whether money supply – an arcane economic concept but still the driving force behind much of central banking – still has the same gravitas in determining prices. At the very least, the Fed ought to tilt away from its laser-like focus on inflation and embrace the degree to which interest rates appear to be set now by a concatenation of forces, from global markets to the lower price of goods and services to multiple central banks acting independently.
What would this remade Fed look like? We would be left with a nimble and innovative crisis management agency, with immense powers in times of financial crisis to stem the tide in a way that legislatures cannot.
It would be charged with monitoring the health of the national and global financial system and working intimately with other central banks to measure and keep a watchful eye on risk. And then when crises erupt, it would be ready, the financial equivalent of firefighters in the face of a blaze.
It would smaller, smarter and less bound by outmoded “laws” of economics and more driven by the very pragmatism and innovation it displayed to great effect in 2008-2009. Instead of just appointing a new head, why doesn’t Trump propose reinventing the Fed for its next 100 years?
It would be one of those bold moves of which he is so fond. It would be innovative and dynamic, designed to meet the challenges of the world as it is evolving. It’s unlikely Trump will pull this off, yes, but at least he could try.