Monday, January 17, 2011

The Scope and Responsibilities of Monetary Policy

Charles Plosser, the President and Chief Executive Office of the Federal Reserve Bank of Philadelphia gave a must read speech on the scope and responsibilities of monetary policy.

The money quote from his speech is:
Although it has been over 40 years since Milton Friedman cautioned against asking too much of monetary policy, his insights remain particularly relevant today. I too am concerned that we are in the process of assigning to monetary policy goals that it cannot hope to achieve. Monetary policy is not going to be able to speed up the adjustments in labor markets or prevent asset bubbles, and attempts to do so may create more instability, not less. Nor should monetary policy be asked to perform credit allocation in support of particular sectors or firms. Expecting too much of monetary policy will undermine its ability to achieve the one thing that it is well-designed to do: ensuring long-term price stability. It is by achieving this goal that monetary policy is best able to support full employment and sustainable growth over the longer term, which benefits all in society.
It is an interesting exercise to compare current Fed policies against this list of what monetary policy can and cannot do.

Here are three of many potential examples:

  • One of the reasons that the Fed has given for pursuing zero interest rate policies is to encourage investors to acquire riskier assets.  This would appear to be expecting monetary policy to perform credit allocation.

  • The reason given by the Fed for its purchases of mortgage backed securities was to drive down the price of credit for homeowners and potential buyers.  This would also appear to be expecting monetary policy to perform credit allocation.

  • An unstated but well excepted reason for the Fed to pay higher than market interest rates on the reserves held at the Fed is to recapitalize the banking system.  This would appear to be expecting monetary policy to speed the adjustment from asset-bubbles.  

If you believe the limitations of what monetary policy can and cannot achieve as presented by Mr. Plosser, then why did and is the Fed pursuing these and similar policies?  Is it mission creep or does Chairman Bernanke believe that monetary policy can do much more than Milton Friedman or Charles Plosser think it can?

No comments: