Imagine that the Federal Reserve's policy makers were as divided on monetary policy as members of Congress are on almost everything. Imagine that this lack of consensus also typically blocked action. The Fed's post-crash moves on interest rates and its adventurous use of unorthodox measures such as quantitative easing simply couldn't have happened.
Not everybody agrees with me that this would have been a terrible thing. (To get a flavor of the alternative, skeptics could take a look at the euro zone, which has a central bank that's more tightly limited -- and a recovery, if that's the word, far more feeble than the U.S.'s.) For the sake of argument, though, suppose that freedom of action in monetary policy is indeed desirable. The point is, this freedom isn't to be taken for granted. It's about to come under new pressure.
The Fed is more of an anomaly in the U.S. system of government than is generally acknowledged. It has tacit permission to float above politics -- in this country, an almost unique privilege. It isn't as though its decisions stand outside the normal terrain of political debate. How quickly to bring down unemployment, and how much risk of other harms (inflation, financial instability) to tolerate, are contentious matters, or so you'd think. Yet for the most part, the Fed makes these calls as it chooses.
The history of this dispensation is complicated. One of the ideas supporting it was that monetary policy isn't as political as it seems. Economists believed that the trade-off I just mentioned -- between unemployment and inflation -- wasn't that important. In the long term, the Fed doesn't have to choose between goals for inflation and employment, because monetary policy doesn't have much effect on the supply side of the economy. In this view, the Fed doesn't face much of a dilemma. Balancing its main tasks isn't so politically charged after all.
Of course bad recessions do pose this dilemma in the short term, and in an especially acute way. As you'd expect, sniping at the Fed increases at such times. Normally, though, this subsides as the recovery goes on.
This time, maybe not. This time, it might get worse.
The reason is that the trade-off between unemployment and inflation no longer looks so temporary. The recent recession was so severe that it may have caused long-lasting damage to the country's economic potential. In successive announcements, as the recovery fails to pick up momentum, the Fed has been ratcheting down its estimates of long-term growth. Last week the Fed said long-term growth would be 2.1 percent to 2.3 percent. In 2010 it said 2.5 percent to 2.8 percent. The Fed no longer expects the economy to get back on its pre-crash track -- ever.
If this drop in potential was both certain and permanent, it wouldn't make the Fed's task any more difficult. In the long term, the Fed could continue to take the supply side as given. But the drop is neither.
Judging potential output is hard. What's more, it might respond to monetary policy. If a severe recession can destroy potential output, maybe a faster recovery can repair it. Take a chance on inflation, or let it run above target for a while, and see the supply side spring back. Acting on this connection between monetary policy and supply-side potential would make it harder for the Fed to stay out of politics.
That's not all. There's a growing consensus that central banks need to develop a new tool -- so-called macroprudential policy. This involves politics too.
The basic idea is that financial regulation is connected to monetary policy. Financial rules affect the economy in the aggregate. With that in mind, they could and should be tweaked during the course of the business cycle, not set once and for all to keep individual institutions safe.
For instance, if (as in the U.K.) you have a credit-driven house-price boom but inflation is low, what should the central bank do? Raising interest rates might push inflation further below target. Instead, have an adjustable rule for loan-to-value ratios in mortgage lending, say, and use that to dampen housing demand. If credit expansion more broadly is the problem, lean against this by adjusting the capital requirement for banks: Set it for safety on average, but push it higher in booms and lower in downturns.
Macroprudential policies, unlike old-fashioned monetary policy, and unlike some narrower kinds of financial regulation, can't plausibly be seen as technocratic and therefore largely apolitical. The need for such policies will therefore add to the pressure on the Fed.
None of this will need to be explained to Federal Reserve Chair Janet Yellen and her colleagues. I'm not predicting that the Fed will blunder into new political controversies and see its independence cut back. It's more likely that it will keep its head down and move cautiously -- too cautiously -- on supply-side monetary policy and macroprudential innovation. This timidity won't be the Fed's fault. It will happen precisely because it understands the threat to its freedom of action.
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