The problem is that the Fed has too much discretion.
We can only give the central bank so much credit for putting out the fire it stoked.
N ew inflation data suggest that the Federal Reserve made the right call by loosening monetary policy recently. The Personal Consumption Expenditures Price Index (PCEPI), which is the central bank’s preferred metric, rose 2.2 percent on an annualized basis in August. This is the slowest price growth since March 2021. It seems the Fed made the right move by cutting its interest-rate target by 50 basis points.
But let’s not forget that out-of-control inflation was the Fed’s fault in the first place. Its extraordinary policies during the pandemic, combined with its failure to tighten monetary policy in spring 2021, caused prices to rise at a rate not seen in 40 years. We can only give the central bank so much credit for putting out the fire it stoked. We should reform the Fed to prevent another inflation outbreak.
The problem is that the Fed has too much discretion. Congress famously gave it a dual mandate: the pursuit of maximum employment and stable prices. But legislators have never specified what those vague terms mean. How much employment is full employment? How low must inflation be to count as price stability? In practice, the Fed makes these decisions for itself. And that means monetary-policy-makers are judges of their own cause — hardly a recipe for responsibility and accountability.
The evidence is strong that the Fed let inflation get out of control by recklessly venturing into irrelevant policy areas. As Louis Rouanet and I show in a new scholarly paper, America’s central bank is engaged in major mission creep. In recent years, the Fed has focused less on overall employment and more on racial employment gaps. It’s also waded into controversies about climate change. Somehow, the central-bankers got the idea that they had a mandate to use their vast powers to advance social equity and to promote a “greener” financial system. They don’t, but that isn’t stopping them from trying. As a result, they took their eye off the ball and made an elementary blunder, printing money too quickly for too long.
The costs to American businesses and families were and remain severe. Prices are about 9 percent higher today than they would have been had the Fed met its 2 percent inflation target. Wage growth has only recently caught up to inflation. For much of the high-inflation period, 2021 and 2022, workers took pay cuts because prices grew faster than incomes. That purchasing power isn’t coming back. Thanks to the Fed, it’s forever lost.
The way to curb the Fed’s monetary mischief is straightforward: Impose a binding rule for monetary policy that central-bankers and bureaucrats can’t reinterpret or skirt. Congress should embrace a single mandate for the Fed, namely price stability. The only way monetary-policy-makers can help labor markets is by adjusting the money supply to meet the economy’s needs; a commitment to price stability renders the employment mandate redundant. The Fed can’t promote employment except by stabilizing what economists call aggregate demand, meaning total expenditure on goods and services. Keeping prices steady accomplishes both goals while holding policy-makers to a clearer standard. The rule’s specific content (e.g., the mandated inflation rate) is less important than its existence. What matters most is for Congress to force the Fed to hit a verifiable target, and impose real penalties for incompetence and malfeasance.
We should be glad the Fed has started making better decisions. That doesn’t change the fact that it’s cleaning up a mess of its own making. The basic problem — its power to be its own judge, jury, and enforcer — remains. That’s unacceptable, and the economic costs are too great. Furthermore, democracy is difficult to reconcile with the Fed’s technocratic insularity. The only alternative to bureaucratic discretion is a monetary-policy rule. Legislators should work to reform the Fed while painful price pressures are fresh in the public’s mind. There’s no good reason to exempt central banks from the rule of law.