You don’t have to watch the morning financial news or read the newspapers for long before realising that the day’s market activities will once again be driven by a "will they or won’t they” debate over the US Federal Reserve. Almost every day begins and ends with extensive debate on the same questions: what will the Fed do next? Will there be another round of quantitative easing?
This week is yet another example, with global equity and bond markets now not debating macroeconomic fundamentals but instead placing bets on what Ben Bernanke will or won’t say in Jackson Hole on Friday. We are getting to the point where this question, and Mr Bernanke’s Fed itself, are becoming unhealthy distractions from improving our free market system and engaging in fundamental policy debates.
Close Fed-watching by the markets is to be expected on days around policy announcements by the Federal Open Market Committee. And it is a sign of a healthy market when there are movements in bond prices in response to new pieces of economic data, such as unemployment figures or gross domestic product. There is of course nothing unusual about investors adjusting their expectations of interest rates as new information becomes available. But we are faced with a troubling dynamic where bad economic news is good for stocks because it means more cheap money is on the way and good economic news is bad for stocks because it means less money will be printed.
A big part of the problem is that the US Congress has given the Fed an overly broad "dual mandate” of price stability and full employment. In 1978 Congress congratulated itself for "ending unemployment” via its passage of the Humphrey-Hawkins Act, which added full employment to the Federal Reserve’s existing mandate. This approach has not only proved unsound. It undermines the free market system, allows Congress to use the central bank as a scapegoat while avoiding tough policy decisions, and creates Fed addicts in our financial markets.
We are one of the only developed countries in the world that has such a mandate. The European Central Bank, the Bank of England and the Bundesbank, to name but a few examples, all have single mandates.
Over the past 30 years a lot of thought has been given to the question of what role a central bank should play in a developed economy. Since the financial crisis, the focus has returned to the proper role of monetary policy and the notion that central banks should provide utility services such as money clearing and transfers, serve as an emergency lender of last resort at a penalty rate in times of crisis, and maintain a money supply that provides for stable prices while guarding against inflation. The maintenance of full employment in an economy as a completely separate task from price stability is much too complex for the blunt tools of monetary policy. Even members of the Fed have begun to embrace the notion that what the Fed does best is maintain price stability, with James Bullard, the St Louis Fed president, recently saying "it’s OK to go to the single mandate” and that the Fed should focus on "providing stable prices to get the best employment outcomes” possible.
I hope that in the coming years Congress will make the necessary changes to our central bank’s charter. But the blame does not rest solely with Congress. It would be helpful to have a Fed chairman who acted with a greater sense of humility about what monetary policy can achieve. Mr Bernanke’s comfort with managing long-term interest rates and his unwillingness to stand up and say that there are limits to what monetary policy can accomplish is disturbing, to say the least. We need to do better.
Ultimately, Congress should fix the Fed’s flawed dual mandate. In the meantime, though, we should set the following test for the next nominee to be the Fed chairman: do you see limits to monetary policy and will you stop punishing savers?
We need a Federal Reserve that will help, not hinder, our country’s vital transformation to an economy comprised of savers, and not wholly reliant on over-leveraged consumers. We need a Fed that sees the risks of year after year of zero interest rates wherein investors must hunt for yield in asset classes to which they are not suited. We need a Fed that does not empower runaway spending by the federal government. And most importantly, we must demand a Fed that serves as a utility institution in our economy, not an enabler of some perverse financial system addiction.
The writer is a Republican US senator from Tennessee and member of the senate banking committee.
Copyright the Financial Times 2012.