BREAKING: The Federal Reserve Does Not Know Everything

Transcripts have been released from some Federal Reserve meetings in 2007. I haven’t read through any of the hundreds of pages, but the word on the pundit street is that, despite having a lot of information at their fingertips, the Fed kinda didn’t really at all anticipate the big crisis that was about to unfold. Apparently this revelation surprised some of the pundits, but it did not surprise me in the least.

There are many people who hate the Federal Reserve and wish it could be eliminated. Many of them, though not all, believe the Fed is a corrupt entity that deliberately manipulates the economy. There are also many people who love the Federal Reserve and wish it was even more powerful. Many of them, though not all, believe the Fed is made up of very Smart People who know exactly what needs to be done to “fix” the economy at any given moment.

These are opposing viewpoints, but they share a foundation that the Federal Reserve is, in some sense, “in control.” Either they know exactly what they are doing and are trying to destroy the currency to usher in a one-world government (or something), or they know exactly what they are doing and are trying to save the economy from impending collapse.

In contrast to both viewpoints, I have always suspected that the Federal Reserve is not in control. This comes from my worldview that the members of the Federal Reserve, like all other people, are flawed humans who do not know everything. They may be the Smartest People in the world, but they’re still not smart enough to accurately predict the future or the ways their actions can alter the future.

This viewpoint finds me pointing in the same general direction as the Austrians and gold bugs and other anti-Fed folks, though not (usually) for reasons of conspiracy so much as for reasons of limited knowledge. As with the explicit branches of government, I am concerned about concentrating too much power in the hands of too few people. I am concerned about the Oops Cost of the powerful mistakes these powerful people can make.

I have said before and I will say again that I have been impressed by how non-terrible the consequences of the Fed’s actions have been so far since the big crisis. (Still waiting on that hyperinflation, right?) I believe these folks are doing their best to keep employment up and inflation down, etc, yet I remain highly skeptical that they¬†really know what they are doing. I am encouraged that some of the pundits appear to be awakening to that view as well. If only it would lead them to become more generally skeptical of such concentrated power…

7 thoughts on “BREAKING: The Federal Reserve Does Not Know Everything”

  1. How familiar are you with market monetarism? While I don’t think it beats totally free banking, I think it does beat a gold standard. In particular, the use of level rather than rate targeting would allow past mistakes to be corrected rather than amplified over time.

    1. Is that what Friedman advocates in Capitalism and Freedom? I’m reading through that and I think he said something along those lines… I liked it when I read it but a couple weeks later I’m not sure I remember or understand exactly what it means. The more I learn about Friedman’s views, the more I find myself aligning with them, though I may a few decades behind on critcisims of them.

      1. Suppose you have an inflation target of 2%. In year 1, you miss and get 2% deflation instead. What should your target be in year 2? Rate targeting says still 2% – no change. Level targeting says 4% inflation. The difference is that under rate targeting, errors add up. One years errors combine with the next year’s errors and there is no force pushing back to a stable long run level. Under level targeting, you have instability in the target year to year, but over time, the errors tend to cancel out. If you are making a 10 year loan, under level targeting, you only really have to worry about errors in the final year of the loan. Under rate targeting, you have to worry about the additive effect of all the errors the central bank makes.

        I don’t know what Friedman advocates in Capitalism and Freedom, but it was written in 1962. AFAIC, that might as well be the stone age. That’s even before he advocated his 4% M2 growth rule. He might have been a gold bug back then, which I don’t like much.

  2. Thanks for explaining level targeting; that makes sense. My first thought is, what if you target 2% and hit -2% for five years for some reason so now you’re shooting for +10%… could there be bad side effects of the potential for shooting for much larger values if you try to correct for several off years, especially if having several off years already implies that your tools aren’t as effective as you thought they were and might be causing unintended consequences….? Sort of like a guy swerving left and right to keep correcting but getting worse swerves each time? (I suppose you could add clauses about trying to spread out the auto-correction over X years if you get too far off one way).

    Then I wonder if any criticisms of that nature would basically apply to rate targeting as well, and level targeting sounds like it could be no worse on any level, but decidedly better by the auto-correction ability. Sounds generally reasonable to me, at least with a cursory understanding.

    1. I don’t know if central banks are *that* incompetent. That would imply that in year 3, they’d be 12% off target, year 4, they would be 16% off, etc. up to 40% off in year 10. How many central banks have seriously missed a target by even 5%. Even at the very worst of the crisis, the Fed only missed its implicit inflation target by 4% in Q2 of 2009. Someone would be fired long before then. If the central bank missed the target 4 years running, you’d probably have to just redefine the target based on their past performance. I think most market monetarists think that right now the Fed should not try to hit the 2007 trend line, but instead shoot for about halfway between the current 4.5% trend and the old trend. It’s all about meeting expectations.

      Also, an implicit assumption is that deviations from trend are increasingly damaging the further away you get. Getting 1% inflation instead of 3% isn’t a big deal, but 1% deflation is, and 3% deflation is a major mistake. So you’re guy swerving back and forth wouldn’t be a problem, but slowly drifting off the road entirely would be.

      Finally, the market part of market monetarism refers to having an NGDP futures market. It’s not the central bank doing what they think will hit 5% NGDP growth, it’s what the market thinks will hit that target. So, market monetarists argue that the central bank would be far more competent than under the current discretionary (read: random) policy.

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