There are two questions on Central Bank independence.  The first is what are they independent from, and the second is whether they are competent.  Over both of those is a question of accountability.  Ultimately, they are a creature of Congress, and should be directly accountable to Congress.

As I have pointed out before, the Fed protests actions that compromise their independence, while taking actions to serve the political ends of those they favor.  Put more simply, the Federal Reserve, like many nonprofits, is managed for the good of the management of the Federal Reserve.  They do that which maximizes their power and resources, subject to risk constraints.  This isn’t too surprising — most bureaucracies behave that way.

Are things normal or broken?  Did the Fed rescue us, or create a bigger crisis to come?

The Fed governors and a few economists felt that things are mostly normal, while most of the rest felt that things are broken, and a greater crisis could come.

What crises could we face?  There are the simple ones, like sending the emerging markets through the shredder.  Many noted at the conference how the monetary policy of the big nations travels to the smaller nations under a system of floating exchange rates.

Another possibility is with residential mortgage bonds limited to a few coupons — negative convexity is potentially high.  Tightening, if it led to a rise in long rates, could be like 1994, one of the worst years the bond market faced.

More likely is that deflation continues, and the Fed reinforces it with more QE.  All of the Fed’s forecasts have erred on the side of rapid growth that has not materialized.  As it is, with demand growth limited, we continue to bump along the bottom with ZIRP, with the Fed’s balance sheet growing bit by bit.

What will happen when Fed tightens?

Maybe not much.  Maybe too much.  It will be interesting to see how how banks and money market funds react to slightly higher rates.  I lean toward the “maybe not much” if/when they tighten.  I’m still not convinced that the Fed will tighten, simply because they have let a lot of little mini-crises derail them from what could be a more important task — that of normalizing the yield curve.  What will go “boo” next week?

Four Final Notes

  1. The Fed should not do fiscal policy, or quasi-fiscal policy.  The Fed is less effective at its main task of monetary policy because they go after areas outside the core of what they have to do: buying MBS rather than Treasuries only, buying long Treasuries rather than short Treasuries, and being a financial & systemic risk regulator.  A monetary policy that is not aggressive will avoid systemic risk… but the Fed went too far many times in easing policy, and not far enough in tightening policy when it was needed.
  2. The session on the “knowledge problem” was interesting and right, but it is basically the problem that any bureaucrat runs into.  So long as you have regulation, the knowledge problem will exist.  That said, you didn’t need to have this session at a monetary policy conference, because the problem is not unique to monetary policy.
  3. Hilsenrath took up an argument of mine about the Fed — it is an intellectual monoculture of neoclassical economists.  Lacker argued that neoclassical economists often disagree with each other, so it’s not a problem.  It *is* a problem, though, because the methods don’t lead to good forecasts, and thus good policy.
  4. I think the Fed needs to revisit their models, and think more broadly — labor use is getting affected by demographics, technology and global trade.  These factors aren’t going away, and they are resulting in a permanent reduction in opportunities for the lesser-skilled areas of the workforces in the developed world, until the whole capitalist world is developed, and wage rates finish equalizing globally.

What should the Fed expect?  Its ideas are flawed at their core as the world has changed, and closed-economy macroeconomics don’t apply well.  Their efforts to change tinker at the edges, and don’t realize their tools aren’t effective.  Better to set modest goals for monetary policy of a stable price level with no debt bubbles.  That is achievable, and it is better to do what you can do well, than attempt things beyond your ability.