A recent interview with Anna Schwartz in the Wall Street Journal raised some interesting questions on how the Federal Reserve should respond not only to the current financial crisis, but to monetary policy in general. She blames the Fed both for its accommodative stance toward failing banks and losses in the market, but also for a reluctance to let the stock market fall that created the current crisis in the first place.

In part, the Fed pursues an easy money policy because it’s supposed to. Under the Humphrey-Hawkins Act, the Federal Reserve has a dual mandate — to pursue both “price stability” and “maximum employment.” The problem is that the Fed can’t do both at the same time. In the NFL, they say if a coach thinks he has two starting quarterbacks, he really has none. In the same way that a football coach has to decide on one starting quarterback, a central bank has to decide on one of maximum employment or price stability to pursue a consistent monetary policy.

Schwartz notes here that crashes are caused by asset bubbles, which are a symptom of the Fed’s inability of to decide on one objective for its monetary policy. In the most recent easing cycle before the current one, the Fed cut rates to cushion the fallout from the dot-com bubble burst. Cheap credit helped fuel another asset bubble in housing, which caused the Fed to raise rates. Now, the housing bubble has burst and the Fed is easing again to keep the economy from collapsing. And once again, at least before the failure of Fannie and Freddie raised risk spreads, the loose policy was fueling a commodities bubble. A dual mandate encourages this type of ping-pong monetary policy, where the solution to one problem is the cause of another.

There are two common alternatives to the discretionary policy scheme currently in place at the Fed. One is inflation targeting, where the central bank sets a range for the inflation rate and conducts policy to keep the rate of rise in prices within its comfort range. The Bank of England and the European Central Bank both have published inflation targets. The Reserve Bank of New Zealand’s governor can even be dismissed if the bank fails to meet its inflation target.

An inflation target anchors inflation expectation by clearly communicating to households and firms what inflation rate the central bank intends to allow. It allows for some flexibility by having the target as a range rather than a specific number.

The other policy regime, which Milton Friedman advocated, is an explicit, pre-determined growth rate in the supply of money, for instance 3% per year. Instead of holding regular meetings to gauge the state of the economy, central bank officials would simply administer the pre-determined increases in the money supply.

The drawback to this is that any external shocks, say an oil embargo devastating hurricane or terrorist, get passed through to employment. Current policy allows the Federal Reserve to respond to these shocks to cushion their affects on the economy. But then again that’s Friedman and Schwartz’ point: in trying to be the monetary superhero, the Fed ends up causing more problems than it solves.

Further Reading:
The Structure and Function of the Federal Reserve System — Congressional Research Service
The Goals of U.S. Monetary Policy — The Federal Reserve Bank of San Francisco
The Fed’s Monetary Policy Rule — William Poole, Federal Reserve Bank of St. Louis
Monetary Policy and the Legacy of Milton Friedman — Anna Schwartz