Chapter 9

Monetary Policy: Money, or Maybe the Federal Reserve, Makes the World Go 'Round

The Fed is assumed to be all-knowing and all-powerful: wrong and wrong. How monetary policy works is discussed in this chapter, but much more important, how the same policy can be successful or a failure depending on the type of policy and the context in which it is implemented.

In the past two chapters, we saw how difficult it is to create fiscal policy even if the government wasn't as dysfunctional as it is. Whether it is raising taxes or lowering them, how that is done, and the economic implications are frequently unknown even to those making the decisions. Worse, the differential effects of alternative policies may not even be a factor in many fiscal policy decisions since politics rather than economics usually drives taxation decisions.

When it comes to the expenditure side of the budget, be it cutting spending, funding massive stimulus projects, or implementing mindless sequestration, the government rarely has any idea what it is doing. There are even politicians who think it is possible to balance the budget. In other words, fiscal policy is more a matter of political dogma and expediency than any logical or rational approach to economic growth.

In the face of all that chaos, the members of the Federal Reserve have to determine what is the best course for monetary policy. Is this a job that even Superman would hesitate to take on? Probably. But someone has to do it, and it does get done—often better than anyone could imagine.

How Monetary Policy Works

The Federal Reserve came into being in 1914 largely because people basically didn't trust banks. And they had very good reason to worry. No, it wasn't just because Butch Cassidy and the Sundance Kid were riding around robbing banks and trains. Essentially, banks operate in a perpetual state of bankruptcy. They take in money and usually lend out more than they have on hand. That creates a small problem called liquidity. Financial institutions cannot give everyone back all the money they have on deposit if everyone shows up at the same. They are illiquid.

Facing a circumstance where there is not enough cash on hand is not typically a major problem for banks since normally not a whole lot of people ask for their money to be returned at any given time—unless, of course, there is a run on the bank.

How does a run on a bank start? Usually, through rumors or stories that a bank is in trouble. At that point, people panic and run to the bank to get their money. That is what happened to the Building and Loan Association in It's a Wonderful Life. George Bailey had only a limited amount of funds on hand, and when the rumors went out that the bank was in trouble, a flood of customers showed up. The only thing that saved George and Uncle Billy was that they had just enough to pay everyone who came in the door during business hours.

Unfortunately, during the latter portion of the nineteenth century and early parts of the twentieth century, a lot of banks didn't have enough cash on hand. During the normal ebb and flow of growth, what we call business cycles, some banks found themselves in trouble. That led to bank panics, and the runs on banks reduced capital available for lending since so much was leaving the banking system. The loss of available funds and the resulting decline in confidence accelerated downturns. Recessions and bank problems went hand-in-hand and they fed on each other, creating wild swings in the economy.

Into the breach came the Federal Reserve. The Fed was supposed to stop, or at least limit, bank runs. Reserve requirements and other regulations provided a measure of confidence that banks would not fail. Indeed, one of the biggest reasons for the creation of the Federal Reserve System was to stabilize the banking system and limit financial firm collapses.

Of course, nothing could protect bankers from recessions, depressions, or their own stupidity, so failures continued. Indeed, we have had two major periods in the past 20 years of bank shutdowns. First there was the savings-and-loan crisis during the first half of the 1990s and then the financial market collapse toward the end of the 2000s.

What made things different was the ability of the Federal Reserve to stabilize the economy. Economic slowdowns still occurred, and we did have the Great Recession, which was long and steep in no small part because the financial system largely froze up. But the Fed was able to come up with policies to deal with the issues, so the problems were less severe than they would have been.

Given that so many decisions on the part of the Fed had to be made quickly and were often so challenging, it has been critical that we have had and will continue to have an independent Federal Reserve. Can you imagine politicians running monetary policy? They cannot run fiscal policy, which we know is in total disarray.

The Federal Reserve Act of 1913 was structured in a way to keep politics out of the Fed. The Federal Reserve Board of Governors, the overseers of the system, is made up of a seven members led by the chairman. These individuals are nominated by the president and confirmed by the Senate. That immediately puts them into the political arena, at least as far as the selection and confirmation processes go. The chair and co-chair are chosen from the board members by the president.

Once the Fed members have been confirmed, though, they are ostensibly insulated from political interference by giving them 14-year terms of office. That is longer than any president's term so the Fed members are not beholden to the politician who nominated them. Also, the terms are staggered so no more than one member's term ends within two years of another's. No president can appoint more than four members—or so the theory went.

But in reality, few members of the Board of Governors are appointed to a full term. The way the Fed terms of office works is if someone resigns from the Fed, the term of office for that position keeps running until the 14 years is over! It's the dates of the term that are fixed, not the person. Thus, people might be appointed to a slot with as few as two years or even less left. They would then have to be reappointed and reconfirmed, or they would no longer be part of the Fed.

With ample turnover, which happens quite a lot, a president can appoint a large number, if not every member, of the Federal Reserve Board. That doesn't mean the members will simply do the bidding of the president. But it is not unusual for a president to appoint someone whose views on the economy and monetary policy coincide with the president's.

By law and the nature of their responsibilities, Fed members cannot and do not involve themselves with politics. They really do view themselves as being independent of the political process. But they do come to the job with certain views about how the Fed should operate, and that places them along a spectrum of political attitudes. Nevertheless, as so many former members have commented, once you become a central banker, your preconceptions fall by the wayside, and what is best for the country becomes the guiding factor in making monetary policy.

The leader of the pack, so to speak, of the board is the chairman. This is the most powerful person and is the major spokesperson for the Fed. Many people know the name of the Fed chair but would be challenged to name another member of the board.

As is the case with any organization, the head, in this case the chairman, has operated in a style that suits the individual's purposes. In the past decade, due to the attitude of, first, Alan Greenspan, then especially under the guidance of Ben Bernanke, members have been much freer to speak their views, even if they don't fully agree with the chairman's. That said, when it comes to monetary policy, when the chairman of the Federal Reserve Board speaks, everyone listens.

The Board of Governors, which operate out of Washington, D.C., is just one of the two major groups of individuals who oversee monetary policy. The second is the presidents of the 12 regional banks. And that is a story unto itself.

After the particularly bad panic of 1907, it finally dawned on our elected officials that maybe some entity was needed to oversee the nation's banks. Initially, the idea was to create regional Federal Reserve banks that would be situated close to all the local banks so they could be easily reached and reviewed. That is when politics entered, of course.

Since the 12 regional banks that we now have (the initial proposal had 15) would have great power and possibly be a nice source of employment and patronage (shhh, don't tell people that), the political grab was on. The result was a hodgepodge of locations including two that are nearly next-door neighbors, Philadelphia and New York, and two that are in the same state, St. Louis and Kansas City. Meanwhile, San Francisco is the only bank west of Dallas, Texas. So much for geographic diversity and close proximity to your client base. Isn't politics great?

Now we have 12 regional banks, picked to satisfy both the economic/financial concentration needs and political necessities of the times. So that the huge distances between branches, especially west of the Mississippi, could be covered and the changes in business activity and population could be accounted for, there are now also 24 branches (it used to be 25, but the Buffalo, New York, branch was closed).

So, we have a central bank with 7 board members headed by a chairman, 12 district banks and bank presidents, as well as 24 branch offices. It is this organization that is supposed to manage monetary policy and oversee the safety and soundness of the banking system.

Actually, the Fed has two key roles in the economy. The first is to ensure the stability of the banking system, and the second is to help maximize employment as long as inflation doesn't get out of hand—the dual mandate. How well the members handle those responsibilities will always be a subject of great debate. But they do try to do it as best as they can.

Problems Facing the Fed

The major problem facing the Fed members is that economic and financial conditions are always in flux. That can be due to business cycles, congressional “fixes,” or something as simple as changes in regulations. Take, for example, the savings-and-loan crisis. All it took was congressional modifications of the limits on interest that financial institutions could pay on their deposits and the whole world changed. Ultimately, that one move led to the collapse of hundreds of banks.

Until the early 1980s, banks were limited to how much they could pay their depositors. But starting in the late 1970s, banks in New England discovered ways around the limits. Meanwhile, in Congress, retirees, the so-called Gray Panthers, argued that capping interest rates hurt depositors, especially the elderly, who depended on interest income for their retirement.

Congress came to the rescue of this growing and powerful group, and the rest was history. In one (or two or three) stroke of the pen, the savings-and-loan (S&L) industry was essentially rendered bankrupt. Banks that had been making long-term, fixed-rate loans under the expectation that they could fund them with lower-cost, short-term deposits suddenly had to compete for money. And in this case, competition meant raising depositor interest rates to attract more funds.

The net result was that many S&Ls were getting income from 30-year mortgages that were made years earlier and under low-rate environments but were paying higher rates to attract money. If the mortgage rate that the bank was receiving was 5 percent and the deposit payout rate was 6 percent, it became really hard to make up the negative 1-percentage-point difference in volume. Banks started losing money like crazy.

It may have taken almost 15 years to reach its logical conclusion, but the result of the congressional action, which was supported by Federal Reserve regulation changes, was a financial mess known as the S&L crisis. This banking disaster required government intervention and bailouts. Some banks were closed while others were merged. And in the most lasting aspect of the resolution of the crisis, some banks received government funds to absorb insolvent S&Ls and were able to create some of the megabanks we worry about now. There are always winners and losers whenever the government or regulators do something, and the resolution of the S&L problem was no different.

For the Fed, congressional action and rule changes meant dealing with two huge issues: The first was the crisis in the financial sector and the need to stabilize the system. The second was the impact on economic activity when banks became extremely conservative and some stopped lending. The recession that ran from July 1990 to March 1991 was in no small part caused by the financial problems in the financial sector.

What did the Fed do? What the Fed always did, at least until recently—lower interest rates. The Fed's rate-setting group, the Federal Open Market Committee (FOMC), had already been cutting the federal funds rate even before the recession started. This is the rate that banks pay each other for money and is generally considered to be the benchmark for short-term rates.

When the recession started, the rate had already come down from 9.125 percent in May 1989 to 8.25 percent in early July 1990. The economy had already been slowing and the hope was that lower rates would prevent a recession. Obviously, it didn't. Over the next two years, the funds rate was cut consistently until it finally reached a low of 3.00 percent in September 1992, where it remained until February 1994.

During this period, the Fed acted in a totally normal way: In the face of a slowing economy, it started to add punch to the punchbowl. The monetary authorities basic tool is the interest rate, and by lowering it, it hoped to foster more borrowing and faster economic growth.

But there is a long lag between the reduction in an interest rate and its impact on the economy. Households and businesses don't go out and borrow money every day. They do it when they either need to or want to. That is where expectations come in, and we know from the previous chapters that the outlook for the future matters a lot. Thus, the Fed not only has to change the cost of money, but it has to change the frame of mind of borrowers before the policy can work.

And the extent of the change and the level of rates matter as well. When the funds rate was at 9 percent, a change to 8 percent still kept the rate high. But when you go from 3 percent to 2 percent, now you are talking about making the cost of money extraordinarily low and that could, potentially, have a major impact. In other words, the Fed has to determine not just whether to change rates but how much and how fast as well, and that means the context of the policy is critical.

Nothing shows that point more than the actions of Fed Chairman Paul Volcker and his fight against rapidly rising prices. Facing inflation in 1979 that returned to double-digit rates, which was truly scary, the Fed chairman had double trouble: he had to not only cut the inflation rate, but he also had to change the perception that inflation was going to go even higher. He had to lower what economists call inflation expectations.

Inflation and inflation expectations can take years to build, and once they become deeply embedded in the psyche of households and businesses, trouble can only follow. After two decades of growth with relatively limited inflation, conditions began to change at the end of the 1960s. It is never a good idea to fight a war without paying for it, and that is what the nation did with the Vietnam War, which was also being conducted while the War of Poverty was being instituted. The surge in government spending and resulting budget deficit led to a rise in inflation.

But the pressures on inflation were not limited to large budget deficits. Indeed, a slow ending to the Vietnam War allowed the inflation rate to decelerate. The biggest blow was the oil embargo in 1973, which led to skyrocketing energy prices that were translated into double-digit inflation and a recession that started at the end of 1973 and lasted until early 1975.

Then came the second oil crisis in 1979. Energy costs soared again, and so did inflation. Worse, inflation expectations became rooted in the system. If people thought inflation would rise, they acted accordingly. That only fed the inflation cycle as firms raised prices, workers demanded higher wages, and people consumed out of fear their money would be worth less in the future.

So, what was a good Fed chairman to do? Well, if you are Paul Volcker, you use what has come to be called the nuclear option. When he took over in August 1979, the inflation rate was above 11 percent and headed ultimately toward a peak of 14.6 percent in April 1980. This was a level that threatened the economic future of the nation.

In order to save the economy by ridding it of inflation, the Fed chairman decided to hike rates to levels never before seen. We are not talking about 10 percent or even 15 percent. At the end of 1980 and during the first half of 1980, Mr. Volcker set the fed funds rate at 20 percent, and that led to a prime rate of 21.5 percent, with mortgage that also pushing 20 percent. Indeed, my first mortgage, taken out in the summer of 1981, was 17.5 percent. I was probably the only person in western Massachusetts to buy a house that August!

Was this a case of a central banker, Paul Volcker, going wild? No, there was a real method to his seeming madness. Not only did the economy need to be slowed, but the belief that inflation would continue at a high rate and even accelerate had to be completely wrung out of the public's mind-set. What better way to do that? By crushing growth, which is precisely what happened.

In July 1981, the economy entered a steep recession as borrowing and spending dried up. That slowed demand, making price and wage increases difficult. But that was not the only benefit of Mr. Volcker's extreme actions: By making clear that interest rates would remain high for as long as necessary, the belief that prices would continue to rise disappeared. Indeed, the University of Michigan's Inflation Expectation Index went from over 10 percent in early 1980 to 3 percent by January 1983. Mission accomplished.

Though Mr. Volcker ended the threat that double-digit inflation posed to the nation's economic future, the cost was high. There were back-to-back recessions in the early part of the 1980s, and many businesses went under. Farmers were so incensed that they drove their tractors into Washington, D.C., to protest. Still, with inflation wrung out of the system, the economy was poised for strong economic growth, and the Reagan expansion would never have occurred if Paul Volcker hadn't saved the nation's bacon, no matter what the pig farmers thought.

The key point here is that how you conduct monetary policy is totally dependent on a variety of economic factors. For most of its existence, the Fed was able to do what it had to do by either raising or lowering the fed funds rate, thereby discouraging or encouraging borrowing and spending by firms and households. At least that was the case until the great financial collapse of 2008 occurred.

Meltdown of the U.S. Financial System

The essentials of the near cataclysmic meltdown of the world financial system in 2007–2008 are known to just about everyone. A housing boom, which coupled strong sales with soaring prices, proved too enticing for some financial institutions. They made decisions that were not based on any logic but on hope and prayers.

Let's review: After the recession of 2001 ended, the economy began to shift gears. Housing, as usual, led the way. Sales spiked, and the real estate market became the place to be—the place to make tons of money. The key ingredient was sharp increases in home prices. As home purchases rose during the 2002–2005 period, prices followed. Using the S&P/Case Shiller 20-City Index, home prices were up 7.3 percent in 2002, 9.2 percent in 2003, and 13.0 percent in 2004, with the gains peaking at 13.4 percent in 2005.¹

It seemed to everyone that prices could increase forever, and that was the trap. They couldn't. A bubble was forming that was unsustainable. But many in the housing and finance sectors wanted to see it go on and on and on. The problem was, in those four years, over 30 million units were sold, and there were not that many more people left who had decent credit and who also wanted to buy homes.

What do you do when qualified buyers become few and far between but there are lots of homes for sale and lots of firms, ranging from realtors to builders to mortgage companies to financial institutions, buying and packaging the mortgages who need the world to keep spinning? You lower the credit standards so more people can buy houses, which is precisely what happened.

By early 2007, as the no-longer-funny joke went, “if you could fog a mirror you could get a loan.” And indeed, the lower credit requirements for buyers made sense, but only under one condition: prices had to keep rising! If that happened, even if a borrower defaulted, the house could be sold and the lender paid back. Unfortunately, bubbles do burst, and when prices started falling, as they did starting in 2007, a disaster was baked in the cake.

Could the Fed have prevented the inevitable housing collapse? That is something that will be argued for decades, but there were regulatory means available that might have limited the damage. The Fed could also have raised interest rates, making loans largely unaffordable, which Chairman Volcker did, though under somewhat different circumstances. What was different, however, was inflation. In the 1970s, the inflation was economy-wide. In the 2000s, it was largely in the housing sector, so the Fed was cautious about creating economic policy for just one part of the economy. That, it turns out, may have been a mistake.

Regardless, when the bubble burst, it not only took down the housing sector, but all those banks that had been playing musical chairs with housing assets discovered they had no place to sit. The world had changed, prices were falling, and losses were piling up. Ultimately, investment banks such as Lehman Brothers collapsed, while other huge financial institutions such a Countrywide Financial Corporation, Bear Stearns, Merrill Lynch, and Wachovia Bank all had to be merged.

The rout was on and the collapse of the economy was just around the corner. Indeed, the Great Recession had already begun by the time most of the financial institutions went belly up. The result was a massive economic slowdown, where firms were in survival mode and the first to go were employees. In the eight months from October 2008 to July 2009, nearly 5.5 million jobs were lost.

In the face of all this, the FOMC started cutting rates and then cutting rates more. Since this was the standard operating procedure for getting out of a recession, the Fed was simply following normal operating procedures. But this was no normal downturn, which the Fed and everyone found out soon enough.

The Fed's fear of the future was seen in its interest rate policy. In September 2007, the funds rate was 5.25 percent. By the end of 2008, when the world was collapsing, it had dropped to close to zero percent. Yet the worst was still to come.

With the economy shrinking at an enormous pace—the fourth quarter 2008 gross domestic product (GDP) drop was 8.3 percent annualized—it looked like the monetary authorities were out of bullets and all was lost. But that was not the case. Instead, extraordinary circumstances required extraordinary actions, and that is exactly what the Fed did. It abandoned simply targeting the fed funds rate, which it directly controlled, and started focusing on all other interest rates. It introduced the idea of quantitative easing, rather than interest rate easing.

It was nice and simple when all the Fed had to do to control inflation or economic growth was to raise or lower the fed funds rate. It made life easier for so many of us who were called “Fed Watchers” because we interpreted the Fed's actions and forecasted their moves. But the advent of quantitative easing changed everything, for both the Fed and the economy.

The Fed is different from just about any other part of the economy in that it has a balance sheet but it can basically do what it wants with the assets and liabilities. It can buy as many securities as it desires with a flick of the wrist or a click of the mouse. Nothing stops it from doing that. Indeed, before the financial crisis started, the Fed had about $700 billion in assets on its balance sheet. That total moved toward $4 trillion as the Fed kept buying more securities.²

Why did the Fed expand its budget sheet so much? First, it simply could not lower the funds rate any further—no one has figured out how to create negative interest rates so zero is as low as you can go. In addition, banks were not lending out money because they had lost so much money, and in any event, the weak economy made lending much too risky. Therefore, the Fed had to work its magic in different ways. One idea was to lower not just short-term rates but rates all along the yield curve. They did that by buying Treasury securities, and quantitative easing was born.

The monetary authorities knew that if they became the buyer of first and last resort for securities of any maturity, they would change the prices and rates on those assets. When the Fed buys securities, it increases the demand for those assets, causing prices to rise. When it comes to securities, higher prices mean lower interest rates. So the Fed set out to buy all types of securities. It paid for those assets by simply crediting banks with more reserves, and since it controls the computers, it could do as much of this as it wanted.

The Fed's massive asset purchase policy was a response to the changing conditions and the need to be imaginative when the circumstances demanded it. Here, it was the context of a long-lasting, weak economic recovery that required that not just short-term but all interest rates be reduced.

The success of the Fed's quantitative easing can be measured in two ways. The first is direct: how much did it lower interest rates? When you consider that just about all rates, ranging from 3-month Treasury bills to 30-year Treasury bonds, hit record lows, you can conclude that on this measure the Fed was truly successful.

But the second measure is more problematic. Did the lower rates cause the economy to grow faster than it would have if the Fed had done nothing and rates were significantly higher? This is what amounts to proving a negative and is one of the most difficult aspects of evaluating any government policy. A similar issue arose when the 2009 stimulus plan was discussed. Did it work or was it a failure? Those who look only at the lackluster rate of growth that resulted from the stimulus think it was a failure. But that doesn't account for the fact that without the massive government spending, growth may have been different.

The Correct Way to Evaluate the Policies

The correct way of evaluating fiscal or monetary is in comparison to what the economy would have been like in absence of the policy. Firms do that all the time. They say, if we did nothing, this is what our profits would have been. After we invested in the marketing program, our profits are this. They then compare the costs with the benefits and get the return on the investment.

Did the Fed's quantitative easing program work? To determine that, you have to consider what sectors of the economy are most interest sensitive, since it is interest rates that the Fed was changing. Housing construction and sales, motor vehicle demand, and business investment, what are called big-ticket purchases, are viewed by economists to be interest-sensitive sectors and should be the focus of any analysis.

It is difficult to see how the housing market recovery that started in 2011, picked up steam in 2012, and really accelerated in 2013 would have happened without mortgage rates hitting record lows. The huge increases in prices, sales, and construction were all powered in no small part by historically low interest rates.

Similarly, the motor vehicle sector recovered dramatically, especially between 2011 and 2013. During the housing boom years, 2003 to 2006, motor vehicle demand averaged 16.7 million units per year. When the economy collapsed in 2009, it fell to 10.4 million vehicles, a 35 percent drop.³ By the end of 2013, the sales pace had almost completely retraced the decline as the monthly rate broke the 16 million level. Could that huge upswing in demand have occurred without the low vehicle loan rates? Doubtful.

Finally, there is business investment. Private, nonresidential business investment, adjusted for inflation, peaked in late 2007/early 2008 at nearly $2 trillion. By the end of 2009, it had plummeted to only $1.6 trillion, a 20 percent falloff. By the spring of 2013, that decline had been recovered. Businesses were faced with a lethargic economy, but one that had low interest rates. What did they decide to do? They invested in the future. Those low rates had to make a big difference.

So, Fed policy, which for the longest time had been simply linked to changes in the federal funds rate, a short-term rate, had morphed into a policy that could change all types of interest rates. That gave the Fed a whole new set of tools that it will have in its back pocket if another crisis hits.

As we have seen, low rates grow the economy, while high rates slow activity, but that doesn't mean the Fed should simply keep rates low. The Fed's dual mandate of strong growth with low inflation requires a trade-off. One of the biggest fears created by the aggressive quantitative easing program was that all the liquidity the Fed had created by buying assets would eventually be put to use. That would cause the economy to surge, but unfortunately, inflation would skyrocket as well. That would be really troublesome. Low rates are good but only as long as inflation is not a threat.

Similarly, while we fear high interest rates, it is not necessarily bad for the Fed to raise rates, even to very high levels. Paul Volcker may have been vilified for driving interest rates up to levels that were unimaginable, but his policy worked. He destroyed inflation and inflation expectations and set the stage for an extended period of strong economic growth. That he burned down the economy in order to save it is a topic for debate, but only whether he went a little too far.

Both Paul Volcker and Ben Bernanke moved interest rates into previously unheard-of levels. They used imaginative programs to deal with huge, potentially catastrophic challenges. And they did that knowing they had the power to make those changes. They did that without political interference.

Yes, both Mr. Bernanke and Mr. Volcker were attacked for their policies by members of Congress. Indeed, Mr. Volcker probably made it impossible for Jimmy Carter to be reelected as the economy was driven into recession during the first half of 1980, a presidential election year. That did not make a lot of Democrats happy. Similarly, Mr. Bernanke was attacked for keeping rates too low for too long by those in Congress who feared inflation. Many of those were Republicans.

In other words, Fed chairs have angered members of both parties, and they were able to do so because their only concern was doing what was best for the economy. The Fed's independence is critical to the workings of monetary policy. It is hard to see a politically sensitive Fed taking politically unpopular but economically necessary actions. In other words, the best thing about the Federal Reserve is that we don't have politicians running monetary policy.

But that puts pressure on the Fed to communicate its policies clearly. For the longest period of time, the Fed basically said nothing. Those of us who were Fed Watchers had to analyze the data to see if policy had changed. The FOMC didn't come out and tell us what they were doing.

The attitude that the Fed didn't have to say anything changed under Alan Greenspan. He began to explain more about Fed policy, and in 1994, the FOMC actually started issuing statements about their decisions. This was a major sea change from the closed-mouth approach that had previously been Fed policy.

While on the surface it appears that more information is better than less, when it comes to Federal Reserve policy, that may not necessarily be the best way to operate. The reason, as is always the case, is that conditions change and sometimes very rapidly.

During the Bernanke years, the FOMC not only issued statements about what their policy decisions were, but they started explaining them. Then they began releasing minutes of meetings just three weeks after the meetings ended. Those minutes got into further detail about the discussions that occurred and the views of the members.

But the move toward changing the FOMC into the Federal Open Mouth Committee really hit its stride in 2011. Not only were detailed statements and minutes released, but the Fed started to include economic forecasts made by the members. And, maybe most important, the Fed chairman started holding press conferences after four of the eight FOMC meetings, the meeting when the projections were also made public.

This sounds great, but too much of a good thing can be bad. We now know what the members are thinking, especially since they all like to give speeches around the country and the world. Indeed, Fed members, whether they are one of the 7 members of the Board of Governors or one of the 12 presidents of the regional banks, are seemingly out in the world all the time, giving us their views of where things are and where the economy may be going.

That creates a cacophony of policy noise. Frequently, members agree and view the economic situation somewhat similarly. But that is not always the case. For example, just before the economy started to collapse, there were members of the Fed who were against lowering interest rates because they were still worried about inflation. Similarly, the timing of the withdrawal of the quantitative easing, a program nicknamed “tapering,” was heatedly debated. Some wanted to wait until the economy was strong, while others argued that the possibility of sharply rising inflation and the threat of damage to the financial system made an early reduction in bond purchases preferable.

With Fed members bickering in public, the value of more information about FOMC actions was destroyed. The purpose of providing information is for investors to be able to incorporate the material into their decisions and not be surprised. The more the debate, the less clear the future course of action and the less valuable the information.

Worse, the information can be provided badly. A classic example of that was when Chairman Bernanke stated in June 2013 that the FOMC could start reducing its asset purchases later in the year with the goal of ending the policy by mid-2014.⁴ The economy was improving, and so was the outlook for the remainder of the year and 2014. The Fed chairman then proceeded to say that the decisions would be dependent on the economic data. That is, the economy had to continue to strengthen and the outlook had to remain positive for tapering to start.

Unfortunately, but not surprisingly, the markets heard only what they wanted to hear, which is a problem with any type of communication that has a number of parts to it. All that came through was “tapering starting later this year.” That created anticipation that the process would begin at the September 2013 FOMC meeting. What failed to make any impact was the caveat concerning the economy. Basically, the Fed chair created expectations that a certain action was going to occur unless something terrible happened. What he intended to say was that no change in policy would be implemented unless something good happened.

The result was a communications disaster. As the September meeting approached, the economic data began to deteriorate. In addition, there were fears that Congress would shut down the government, which would harm the economy further. The FOMC punted, and the markets were not very happy. This is a classic case of conditions changing and the Fed's wishy-washy communications being made obsolete by the deteriorating circumstances.

Because economic conditions can sometimes change rapidly and dramatically, it is hard to see the value in having an open-mouth policy. Those members who worried about inflation in 2007 appeared to be largely clueless about the emerging economic crisis. Those who argued for a sooner rather than later tapering of quantitative easing also seemed to be out of touch with reality. Where inflation would come from was never made clear. In a world economy where foreign firms are quite willing to undercut U.S. company prices in order to steal market share, surging inflation required a long period of excessive growth. And no one had that in his or her forecast!

By providing so much information, the ability of the Fed members to accurately forecast the future is put on display. How showing that some members are bad economic analysts creates confidence in the markets or the public about the validity of monetary policy is anyone's guess. But the Fed seems to think that is the case.

When we talk about context, to the Fed it alludes to all sorts of economic, regulatory, and political factors. Circumstances change and often rapidly. Few foresaw the oil embargoes, the bursting of the dotcom bubble, or the collapse of the housing market and financial sector, but they happened. Monetary policy has to be conducted with a keen eye toward the context in which it is being made and how those circumstances will change.

One of the factors that can change is what happens outside of America's shores. In the next chapter, we look at some of the ways what happens in places such as Panama or China can affect the shop floor in Small Town, USA.

Notes

1. S&P/Case-Shiller Home Price Index data, analysis by Naroff Economic Advisors, Inc.

2. Federal Reserve Board of Governors, release H.4.1, January 9, 2014.

3. U.S. Department of Commerce, Bureau of Economic Analysis data, analysis by Naroff Economic Advisors, Inc.

4. Chairman Ben Bernanke, press conference, June 19, 2013.