Operating Regimes and Fed Independence.

• Author: Plosser, Charles I.

These are challenging times for the Fed and other central banks. Their credibility and effectiveness are being questioned and, most importantly, the case for their political independence is under scrutiny, if not outright attack. It would be convenient to believe that these threats are entirely external in nature. But, unfortunately, I believe some of the challenge stems from self-inflicted wounds that have enabled these threats to grow and even flourish. While the Fed cannot always control the external political environment in which it exists, it can, and should, seek to avoid undermining its own credibility and the case for its independence.

To some extent, the problems stem from two related trends, both of which the Fed (and other central banks) have often contributed-mission creep, accompanied by elevated expectations of the capabilities of monetary policy, and, more recently, the extensive use of unconventional monetary policies that broke the traditional boundaries separating monetary policy from fiscal policy. Indeed, beginning in 2009 and 2010, I spoke frequently about the dangers of the Fed's unconventional policies and the risks they posed for the Fed's credibility and its political independence (see Plosser 2009, 2010).

Political independence, of course, is widely viewed as an important pillar of sound monetary policy. The case for independence is largely an empirical one. History is replete with examples of undesirable outcomes when the monetary authorities become excessively politicized. While independence for the central bank is crucial, in a democracy, it must be accompanied by constraints on the breadth and use of its powers in order to ensure accountability. (1) Thus, institutional arrangements and frameworks matter, including monetary policy strategies and operating regimes. The choice of such arrangements can act to support or undermine Fed independence.

Friedman's Admonishment

These trends are not entirely new. For example, regarding mission creep and elevated expectations for monetary policy, I often point to Milton Friedman's 1967 presidential address to the American Economic Association where he said: "We are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and, as a result, in danger of preventing it from making the contributions it is capable of making" (Friedman 1968: 5).

Friedman's warning was prescient. The 1970s saw an aggressive attempt by the Fed to influence and control the real economy, and unemployment more specifically, resulting in rising inflation rates that reached double digits. After Paul Volcker regained control of inflation in the early 1980s, monetary policymakers tended to exhibit more restraint toward the feasibility and effectiveness of stabilization policy, implicitly acknowledging Friedman's wisdom. Unfortunately, with the financial crisis and subsequent recession, the Fed seems to have returned to the mistaken hubris of the 1960s, albeit dressed up in fancier models and calls for financial stability.

Thus, Friedman's admonishment seems as relevant today as it was in 1967. We have asked more and more of our central banks and, in my view, they have too eagerly accepted responsibility for economic outcomes that, in some cases, exceed their mandates and, in other cases, lay beyond their capabilities. For example, we often hear pronouncements that monetary policy should seek to address weakness in real wage growth, or low labor force participation rates; the challenges of income inequality, climate change, or the prospects of future trade policy; and the list continues to grow. Yet monetary policy has limited ability to influence these challenges even though monetary policy may have to react to the economic consequences. The extent to which central bankers suggest monetary policy can or should seek to address these concerns fosters a mistaken view of the power of monetary policy and central banks. This broader scope for monetary policy invites politicization and undermines central bank credibility when it fails to achieve the desired results.

Unconventional Monetary Policy

The adoption of unconventional monetary policy that sought to expand the reach and effectiveness of the Fed's tools in order to influence and shape real economic outcomes sometimes broke the traditional boundaries that separated monetary from fiscal policy. One predictable consequence is increased political pressure on the Fed. Indeed, such actions amount to an open invitation to such pressure.

So, let me highlight in a little more detail how unconventional policy choices by the Fed have undermined its own credibility and its case for independence. First, let me say that to...