The Conduct of Monetary Policy

The Federal Reserve's independence is essential to the conduct of monetary policy. But while the Fed is independent within government, it is not independent of government. The grant of authority to the Fed comes from Congress, to which the Fed is ultimately accountable. In my view, the Fed was granted significant powers by Congress, but those powers were not unlimited. The grant of authority was constrained. So by my measure, the Fed is a powerful institution, but a bounded one. The limits on the Fed in the conduct of monetary policy--that is, limits in the grant of government powers and in the efficacy of its actions to facilitate economic growth--are too often forgotten in Washington. We should acknowledge and understand these limits, not seek to manage or circumvent them. Many leading econometric models used by central bankers, and promoted in the academy, suggest that the more the Fed pushes down long-term interest rates, the more that policy actions can be deployed to grow GDP, thereby maximizing employment and minimizing the output gap. The law of diminishing returns, however, applies to financial markets and the real economy, and some leading models are unable to account sufficiently for this nonlinearity. In these remarks, allow me to highlight a few key themes to help guide the discussion on the limits of monetary policy, applicable both at home and abroad. The Fed's Credibility Acknowledging the limits of monetary policy elevates, rather than relegates, the authority of the central bank. Fed officials should do their level best to burnish the most important asset they possess, which cannot be found anywhere on the Fed's audited financial statements. This value resides principally in the Fed's institutional credibility. Consider this credibility a goodwill item of sorts, and it is far more potent than the value of Treasury and related assets owned by the Fed. This credibility of the central bank wasn't granted by statute; it was earned. And each generation of Fed policymakers is rightly asked, however implicitly, to leave the institution with more credibility than was inherited. In the framework I find most persuasive, the Fed's credibility allows it to act powerfully when warranted and stand aside in other times, when the benefits are overwhelmed by the risks. Situational Awareness and the Value of Humility Central banking demands situational awareness. Monetary policy can be considerably more powerful at certain moments, wine sorely lacking efficacy in others. Monetary policy aggressiveness can be demanded in certain circumstances; the utmost modesty is required in others. As a result, policymakers must assess the regime in which they find themselves. For example, if you go back to the depths of the financial crisis in 2008 and '2009, you may reasonably conclude that a panic was under way--perhaps akin to the panic of 1907 that gave birth to the Federal Reserve. That conclusion might well give the Fed a greater right, even obligation, to act aggressively. Monetary policy is a powerful tool to address financial panics--that is, among other things, to infuse liquidity to get bid-ask spreads to narrow and markets to clear. As we emerged from the financial panic, many commentators praised the world's leading central banks for their efforts in helping markets to function once again. On the rare occasion of financial panics, a central bank may well be able to pull the proverbial rabbit out of the hat. Nevertheless, we should push strongly against the view that central bank heroics in times of panic can be replicated in more benign periods. Monetary policy may be considerably more limited in scope and efficacy when markets are functioning, interest rates are at the zero lower-bound, prices are stable, and economic growth remains modest. Consider a regime where an economy is growing well below its long-run potential--say at about 1. …