The Trump administration’s ability to make a number of key Fed appointments brings an opportunity — and the responsibility — to ask far-reaching questions about the central bank’s mission. Under Paul Volcker, chair between 1979 and 1987, the Fed grappled with how to tame destructive inflation. During the tenure of his successor, Alan Greenspan, it asked how fast the economy could grow without igniting inflation. The central bank led by Ben Bernanke explored how to stem the economic effects of financial instability. Under Janet Yellen, the Fed still struggles with how to exit ultra-loose monetary policy as the economy expands at a rate consistent with many estimates of potential gross domestic product growth and full employment.
The Federal Reserve board shaped by Mr Trump and Mr Powell now faces three big questions about what a “normal” monetary policy looks like in today’s economic environment, what the scope of the Fed’s role in financial regulation should be, and how it can safeguard the independence of monetary policy in a hostile political climate.
The first question of what is “normal” is as difficult as it is important. Normality cannot mean a return to the immediate pre-financial-crisis period. It also cannot mean going back to the seemingly calmer and more rigidly regulated days before the repeal, in 1999, of the Glass-Steagall act which separated commercial and investment banking. And from an analytical perspective, normal cannot just be a matter of specifying a Fed balance sheet level with a particular historical marker or an empirical relationship that fitted well to past data.
Rather, “normal” requires a definition of the Fed’s mission and economic role. Economists generally assign the maintenance of price stability and financial stability to the central bank. Politicians see the job of the Fed as providing macroeconomic support. Defining what normal means in this context, then, requires the Fed to answer the question of what frameworks and processes are required to accomplish these essential or mandated missions. Policy that departs from these definitions should be accommodated as long as the Fed states its reasons clearly. This approach is one of “maintain” (an articulated framework) and “explain” (factors considered in deviating from that framework).
The Fed should be on the front line of financial stability as a lender of last resort in a financial crisis (that is, where contagion and panic spread across financial institutions). The Fed can also play a role in stabilising aggregate demand using monetary policy tools to affect interest rate sensitive spending. Beyond those interventions, a definition of normal should define the proper scope of the Fed’s balance sheet. Purchases of long-dated Treasury securities or mortgages in times of crisis or market dislocation can be consistent with the Fed’s lender-of-last-resort role. But significant such actions on a longer-run basis raise concerns about distorting price signals in capital markets and even about the Fed’s independence. The definition of normality should also specify whether the Fed should take actions to affect important economic variables, such as the labour force participation rate, that are better influenced by fiscal policy simply because the latter is not providing sufficient support.
Second, what should the scope of the Fed’s regulatory authority be? The Dodd-Frank act increased the Fed’s regulatory power substantially. But how necessary would this beefed-up regulation be if there were to be a credible resolution of the “too-big-to-fail” problem? There is substantial room for improvement in simplifying and streamlining capital and liquidity rules. And bank stress tests should be subjected to the rigour of peer review by economic and financial experts. Finally, the question remains whether the monetary authority should take a bigger role in regulation given that the expanded role brings with it greater political scrutiny.
Third, and very important, independence in the conduct of monetary policy is important for financial stability and price stability. The Fed is a creature of Congress through the Federal Reserve act, so Congress should hold the Fed accountable. But accountable for what? Congressional hostility toward the Fed is considerable and bipartisan. Some of this hostility reflects the view that the Fed’s actions during the financial crisis benefited Wall Street, not Main Street. While neglecting many of the benefits of the Fed’s actions during that period, this view is not entirely unfounded. And such complaints will subside in future only if the Fed and its new chair are clearer about the central bank’s frameworks for monetary policy, its role as lender of last resort and financial regulation. Better communication with Congress and the public on these points is essential.
Selecting Mr Powell and making other appointments is a significant opportunity for the Trump administration. But it is answers to all of these questions that will truly reveal the future of the Fed.
The writer, dean of Columbia Business School, was chairman of the US Council of Economic Advisers under President George W Bush
Get alerts on Federal Reserve succession when a new story is published