Question

Prompt. In the last few weeks, the Federal Reserve has introduced a series of unconventional monetary policy tools—lending facilities, essentially, designed to ease credit strains that firms and municipalities will likely experience as the U.S. economy is buffeted by the novel coronavirus pandemic. The “Fed Brief” that accompanies this prompt outlines these new unconventional tools. Section 13(3) of the Federal Reserve Act grants the central bank the authority, with the approval of the Secretary of the Treasury, to implement these tools in emergency situations—what the Act identifies as “unusual and exigent” circumstances.
The governors of the Federal Reserve reason that these unconventional actions are in the best interest of the economy. Nevertheless, the governors are concerned that these actions, which have attracted the attention of journalists, politicians, and pundits alike, could ultimately politicize the Federal Reserve and, in doing so, compromise its ability to achieve its long-run monetary policy goals. Consider, for example, the recent Wall Street Journal article, by renowned financial journalist Greg Ip, that accompanies this prompt. Thus, the governors—Michelle Bowman, Lael Brainard, Richard Clarida, Jerome Powell, and Randal Quarles—ask you to assess how the central bank’s recent unconventional actions might affect its monetary policy outcomes in the long run. Specifically, the governors ask you to answer the following three questions.

1. In general, would the politicization of the central bank render monetary policy more or less time consistent? Please defend your reasoning.

2. Central banks endeavor to maintain time-consistent monetary policies, because time-inconsistent monetary policies tend to deliver unwanted inflation outcomes in the long run; why do time-inconsistent monetary policies underperform in this way?

3. Finally, provide an example of how the Federal Reserve and, perhaps, Congress could preserve (or, if necessary, restore) the credibility of the central bank’s commitment to maintain low and stable inflation. Again, please defend your reasoning.

Answer 1

1. The politicization of the central bank would render the monetary policy less time consistent. This is because for politicians, only short-term results (till next elections) matter. Hence their goals might not align with many long term goals of the central bank- resulting in more inconsistent monetary policies.

2. Time inconsistent policies behave this way because long run market depends a lot on expectations. If I am an investor, I am looking to invest based on what I beleive the policies of central bank will be in the long run. If the policies are consistent, then I can make assumptions about them and invest accordingly. This results in the economy and people behaving according to expectations. But if the policies are inconsistent, then it is impossible to invest logically in the market. That results in speculators flooding the market- resulting in underperformance of policies.

3. The Federal Reserve can reiterate its long term policies (for example, keeping inflation under check) and behave accordingly once the crisis is over. The reiteration will help in making everyone aware about the cognizance the central bank has for its long term goals.
The congress, on the other hand, can pass laws making sure the independence of the central bank is not threatened and that it cant be influenced or tempered with and has a free hand to make and implement its policies- regardless of the political changes.

These measures will restore the credibility of the central bank towards its commitments for long term goals.